When the Internal Revenue Service audits you, the agency compares your tax return against your records to see if you have underpaid your taxes. If the IRS finds an underpayment, you will have to make arrangements with the agency to bring your account current. The agency will also levy penalties and interest, although you may be able to have them reduced or even eliminated.
How Penalties and Interest Work
The IRS levies two types of penalties. The penalty it levies for the failure to pay taxes is one half of 1 percent of your unpaid tax each month; this penalty can continue compounding until it reaches a total of 25 percent of your unpaid tax. The IRS also levies a penalty for the failure to file your taxes. That penalty is 5 percent per month, capped at 25 percent of the tax you would have to pay, although it gets dropped to 4.5 percent per month if you also have to pay a failure-to-pay penalty on the same tax. If you max out both penalties, you could owe 47.5 percent in penalties on top of the unpaid tax. The IRS also charges interest on your unpaid tax, unpaid penalties and unpaid interest. The interest rate is variable, but is 3 percent above the federal short-term lending rate. For the first quarter of 2013, the rate is 3 percent, as the federal short-term rate is zero percent.
Debts After an Audit
When the IRS completes your audit, you get a final statement showing what you owe. However, you don't owe the taxes as of the date of the audit. You owe the taxes from the date that you should have paid them. If the audit comes three years after you should have paid the taxes, you'll be billed for the taxes as well as three years' worth of penalties and interest. Furthermore, penalties and interest will keep accruing after the audit until you pay off your balance in full.
The IRS will allow you to request leniency so penalties and interest charges can be waived. To receive a waiver, you will need to give the agency a good reason for allowing you to escape the penalty. If you could document that you were following the instructions of an IRS agent and his bad information caused you to be subject to penalties, that might be reason enough. Cases of extreme hardship may also qualify for a penalty waiver.
Offers in Compromise
Another option to reduce your tax and penalty liablity is to attempt to complete an offer in compromise. If the IRS believes that it will not be able to collect your tax debt from you, it might be willing to settle for a lump sum of money to close the matter. While getting the IRS to agree to an offer in compromise can be challenging, obtaining one can wipe out your penalties and interest and even a portion of the taxes you owe.
FIling bankruptcy may be the best way to avoid interest and penalties on taxes levied as the result of an IRS audit. If you file for a Chapter 7 liquidation, you might be able to discharge all of your taxes, penalties and interest if you have no way to pay them back. With a Chapter 13 bankruptcy, you will have to make payments to the IRS, but they will probably be much less than they would be if you did not file bankruptcy.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.