Accuracy-Related Penalty

• The IRS will charge you a 20 percent penalty if, as a result of your negligence or disregard of the tax rules, you underpay your taxes. However, your underpayment must be greater than $5,000 or more than 10 percent of the correct tax, whichever is greater (as of February 2011). The penalty is calculated as a percentage of the tax you underreport and fail to pay. The penalty still applies even if you were diligent and made a good faith effort to comply. When the IRS evaluates whether you are negligent, all it needs to show is that you were careless.
  
  

Fraud

• Most taxpayers who incur penalties are not accused of fraud; however, if you make up deductions that you're clearly not eligible for or decide to throw that 1099 away and hope the IRS does not catch on, you may find yourself paying a 75 percent penalty on the amount you underpay because of the fraud (as of Feb. 2011). All the IRS needs to show is that you filed the return with the goal of evading income taxes.
  
  

Interest

• Penalties are not the only way the IRS deters taxpayers from underpaying their income tax. The IRS can also charge you interest on top of penalties. This is because the interest is not viewed as a punishment by the IRS; rather, it only applies to taxes you don't pay on time. The most honest and accurate of taxpayers can end up paying interest if payments don't reach the IRS by their due date. But the IRS not only charges interest on your tax underpayments, it also imposes interest on those penalties that remain unpaid, too.
  
  

Eliminating Penalties

• Situations arise where your personal circumstances make incurring a penalty unavoidable. In some cases, if you send the IRS a written explanation as to why your tax return was inaccurate or why it was riddled with errors, it can waive or reduce the penalty charges if it's satisfied that you had reasonable cause. Keep in mind though that the IRS is not looking for excuses such as your dog ate your W-2, which is why you just estimated your income for the year. A more reasonable explanation could be that your employer intentionally withheld your W-2 and you were therefore forced to make a good faith estimate of your annual income from various pay stubs.