5 Tax Mistakes You Don't Want to Make

Last Updated Apr 3, 2010 3:25 AM EDT

Income tax season can be a stressful time for simplest of reasons. We all want to take every tax deduction and credit we're due, but no one wants to make a mistake that draws an IRS agent to your door. Some tax mistakes are toxic enough to generate massive fines and even land you in jail.
The good news? Most income tax mistakes aren't like that. If you make a simple error -- like you lost a 1099 and failed to include some interest or investment income on your tax return, for instance -- the penalties are minor. You'd pay the tax due on the undeclared amount, plus interest, which is currently assessed at a yawn-worthy 4% annual rate.

To be sure, you also could be subject to a "failure to pay" penalty that amounts to one-half of one-percent per month. (That's 6% of the underpaid amount per year.) But if you have a good excuse, the IRS has the ability to "waive" these penalties, said Eric Smith, an IRS spokesman in Washington, D.C.

What's a good excuse for making a tax mistake? You relied on bad advice from a tax advisor or the IRS; you never had been penalized before and didn't know that you were messing up; or the information on your W-2 or 1099 was wrong and you didn't know it, said Mark Luscombe, principal tax analyst with CCH, a Riverwoods, Ill.-based publisher of tax information.

"It's very case-by-case," said Smith. "But there is a 'reasonable cause' exception for most tax penalties."

But beware. The government considers some tax errors so eggregious that they'll slap you with eye-watering fines and might even send you to prison. What are the tax mistakes you don't want to make?

  • Failing to file. There are a few people who earn so little that they're not required to file a tax return. For the rest of us, tax filing is only "voluntary" if you don't mind going to prison. The penalty for failing to file is: Interest (currently at 4% annually); a failure to pay penalty of 0.5% per month; plus a failure to file penalty that can amount to 5% per month up to 25% of the amount due. If you go the extra step of saying that you don't need to file because you don't think income taxes should be applied to you, you could be subject to an additional penalty of $5,000 for making a "frivolous" argument. The IRS has posted a whole litany of the commonly used frivolous arguments that taxpayers have claimed for not filing a return. If you make any of these claims, watch-out. They can even land you in prison.
  • Inflating the value of charitable contributions. So you gave your clunker to charity and decided to pretend that the Toyota that had to be towed out of your driveway was worth $10,000--about 4 times the truth. That's a 'substantial value' misstatement that can land you a penalty ranging from 20% - 40%, plus interest, on the unpaid amount, said Luscombe.
  • Not reporting income from illegal activities. This is what got Al Capone. If you're a drug dealer, it could also apply to you. Like Capone, it's often easier to follow the money to show that a criminal didn't pay tax on his ill-gotten gains than it can be to prosecute the illegal activity that's generating the income. Penalties here? There are economic penalties for failing to pay; substantially understating your tax; plus civil fraud penalties that can amount to 75% of the underpayment. And, then, of course, you can also get sent to prison for criminal tax evasion.
  • Fraudulently claiming the first-time homebuyer credit. The lucrative $8,000 credit for first-time homebuyers was just too tempting for a lot of larcenous taxpayers to pass up. Some 74,000 people, who had previously claimed mortgage interest and property tax deductions indicating they had owned homes before, said they were "first-time" buyers, the Treasury Inspector General for Tax Administration reported to Congress. Another 19,000 claimed the credit for houses they hadn't purchased (at least yet); and some 580 deductions were claimed by kids under the age of 18. It's a little early to know exactly how the IRS is going to penalize these folks, Luscombe said. But the IRS did a great Queen Victoria impression when the news came out: "We are not amused." At the very least, these fraudulent claims would generate failure to pay penalties of 0.5% per month, but could warrant bigger fines if the tax underpayment was significant enough or if the IRS sensed the taxpayer intended to cheat, Luscombe said.
  • Failing to pay tax on income earned from offshore accounts. Hiding money in overseas tax havens has become the target of serious IRS enforcement action in recent years, and the agency has become increasingly good at ferreting out the goods. After a couple of calls for past cheats to come forward and pay their fines, the IRS has started prosecuting the ones that didn't come clean. Now a half dozen have gone to jail and more are expected to follow, said Luscombe.
If you are a run-of-the-mill taxpayer (not a business owner; they're subject to different rules) and you didn't do any of these things, you don't have a lot to worry about from the IRS.

But be sure to be polite if the tax man calls you out for making a mistake. Many penalties are discretionary. If you're nice and well-meaning, the IRS has been known to eliminate them on the spot. Act like a jerk, on the other hand, and the auditor can start looking more closely at every open tax year for mistakes. Chances are good that he'll find more mistakes and fine you for everything legally possible, too.

If you've made a mistake that's substantial, get professional advice -- preferably from the person who helped you prepare your return. Remember, there's no reason to be cheap here. Professional service fees are deductible.

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