The most common payroll tax penalty you could encounter

The IRS’ penalty writers are a fascinating bunch of people who think creatively and abstractly. Upon meeting them, you can get the impression that none of it is real to them; instead, it’s sort of like game theory. Tax penalties, of course, aren’t a game if you get caught up in them. They’re steep and punishing for a reason: Withheld taxes are the key revenue source for the federal government.

Lately, the IRS has been trying to make payroll tax penalties a bit more transparent. So let’s look at the penalty you’re most likely to encounter, if only because of the way the payroll tax deposit schedules are constructed: The failure-to-deposit penalty.

Three ways to get snagged

Undeposited payroll taxes pile up so fast the IRS has a special name for them: pyramiding. Once taxes go undeposited, the IRS considers it more than likely taxes will continue to go undeposited. So it works very hard to bring you back into compliance as soon as possible.

Pre-pandemic, as part of the effort to prevent pyramiding, the IRS would send revenue officers around to employers to encourage compliance. If you came into compliance, you were off the hook for penalties. But if you didn’t, the full hammer would come down.

IRC § 6656 is the failure-to-deposit penalty provision. You will be assessed this penalty if your deposits are late, incorrect, or made the wrong way (i.e., not electronically). You can attempt to beat this penalty if you have reasonable cause, but this bar is so high we aren’t aware any employer has ever been able to vault it.

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The basic penalty is:

  • 2% of the amount required to be deposited, if the failure is for not more than five days,
  • 5% of the amount required to be deposited, if the failure is for more than five days but not more than 15 days,
  • 10% of the amount required to be deposited, if the failure is for more than 15 days.,

The penalty amounts aren’t cumulative. For example, if your deposit is more than 15 calendar days late, the IRS doesn’t add a 10% penalty to the earlier 2% and 5% late penalties. Instead, your new total penalty would be 10%:

And don’t forget interest charges.

One get-out-of-jail-free card for the incredibly compliant

The IRS will almost always abate a first-time penalty for failing to deposit payroll taxes, but you must have established a good track record with it beforehand. The IRS may decide on its own to not assess a penalty, but you may have to wait a long time for it to act.

Best strategy: Write a letter to the IRS asking for a penalty abatement. Be sure to include a copy of the notice and proof you made the deposit. As a good-faith gesture, enclose a check for the interest. Tip: Resist the temptation to be intemperate.

Here’s some sample language you can consider using:

“[Name of company] has deposited its payroll and corporate taxes in full and on time since [fill in the first year the company was in business]. However, due to a [fill in the reason], the payroll deposit for the [fill in the semimonthly or monthly pay period] was not made. This was an inadvertent error, which was corrected on [fill in the date the deposit was made].

We are enclosing the penalty notice for your reference and a check for the interest. We are, however, requesting the penalty be abated, based on the company’s past good compliance record. To prevent a recurrence, we have corrected the error and introduced additional internal controls.

Thank you for your attention to this matter.”