What are the penalties and interest? Can they be avoided?

In 1989, the IRS revamped its tax penalty system. Before the reform, more than 150 overlapping tax penalties existed. Consequently, a single infraction could result in multiple tax penalties. Below are the current tax penalties for various infractions.

Infraction: Penalty
Late Filing
(If the tax return is more than 60 days late, the minimum penalty is the smaller of $100 or 100% of the tax owed.)

5% per month of the net tax due (maximum 25%)

Late filing due to fraud

15% per month of the net tax due (maximum 75%)

Late tax payments

0.5% per month of the unpaid tax due (maximum 25%) The 0.5% rate increases to 1% after the  IRS issues a notice of intent to levy.

Negligence or disregard of tax rules and regulations

20% of tax underpayment

Fraud

75% of tax underpayment

Substantial understatements of income tax (tax underpayments that exceed the greater of 10% of the correct tax liability or $5,000) 20% of tax underpayment
Over valuations of 200% or more but less than 400% of the correct amount 20% of tax underpayment
Over valuations of 400% or more of the correct amount 40% of tax underpayment
Estate tax and gift tax under valuations of 50% or more of the correct valuation and if the tax underpayment exceeds $5000 20% of tax underpayment
Estate tax and gift tax under valuations of 75% or more of the correct valuation and if the tax underpayment exceeds $5000 40% of tax underpayment
Interest, compounded daily, is charged on any unpaid tax from the due date of the tax return until the date of tax payment. The interest rate is the federal short-term rate plus 3%. That rate is determined every three months.
From To Interest Rate
4/1/09 12/31/09 4%
1/1/09 3/31/09 5%
10/1/08 12/31/08 6%
7/1/08 9/30/08 5%
4/1/08 6/30/08 6%
1/1/08 3/31/08 7%
7/1/06 12/31/07 8%
10/1/05 6/30/06 7%
4/1/05 9/30/05 6%
10/1/04 3/31/05 5%
7/1/04 9/30/04 4%
4/1/04 6/30/04 5%
10/1/03 3/31/04 4%
1/1/03 9/30/03 5%
1/1/02 12/31/02 6%
7/1/01 12/31/01 7%
4/1/01 6/30/01 8%
4/1/00 3/31/00 9%
4/1/99 3/31/00 8%
1/1/99 3/31/99 7%
4/1/98 12/31/98 8%
7/1/96 3/31/98 9%
4/1/96 6/30/96 8%
7/1/95 3/31/96 9%
4/1/95 6/30/95 10%
10/1/94 3/31/95 9%
7/1/94 9/30/94 8%
10/1/92 6/30/94 7%
4/1/92 9/30/92 8%
1/1/92 3/31/92 9%
4/1/91 12/31/91 10%

For current interest rates go to News Releases and Fact Sheets and find the most recent IRS release entitled Quarterly Interest Rates.

Acting on bad IRS tax advice
There is no tax penalty imposed if you rely on erroneous written advice from an IRS official. You must show that you provided accurate tax information to the IRS when you asked the IRS for the tax advice.

Honest mistakes
You may be able to get the IRS to drop the tax penalty if you can show that your mistake was an honest error. Send the IRS a check for payment of the tax and interest along with a letter explaining how the mistake was made and a request to eliminate the tax penalty.

Disputing assessed tax penalties
Tax penalties can be avoided if the relevant facts affecting the item's tax treatment are adequately disclosed in the tax return. However, disclosure cannot be used to avoid incorrect valuation tax penalties.

Another way to dispute a tax penalty is to show that substantial authority exists for your tax treatment of an item. To establish substantial authority for a position, look to tax documents published in the Internal Revenue Bulletin, tax court cases, private letter rulings issued by the IRS, and some congressional reports. Authority supporting your tax position should be substantial in relation to the weight of authorities supporting contrary tax treatment.

If a tax penalty is assessed by the IRS, you can appeal. While the appeal is under consideration, payment of the tax penalty is suspended. You also have a right to representation and can ask to have a meeting with the IRS.

The tax penalty for filing a frivolous tax return is not based on your tax liability and will be assessed immediately and added to any other tax penalties.

 Related information about penalties and interest
How to avoid an IRS audit?
How to prepare for an IRS audit?
What are my appeal rights?
How does the Statute of Limitations affect income tax obligations?
How does the Bankruptcy Code affect income tax obligations?
Taxpayer Bill of Rights
Tax Payments and Tax Refunds
Tax Audits, Tax Collections and trouble with the IRS
IRS publications about penalties and interest:
For more details on IRS penalties and interest refer to Tax Topic 653, IRS Notices and Bills/Penalty and Interest Charges, and IRS Publication 594, Understanding the Collection Process. For further information on the appeals process, refer to Tax Topic 151, Your Appeal Rights. Also see IRS Publication 1,Your Rights as a Taxpayer, IRS Publication 5, Appeal Rights, IRS Publication 556, Examination of Returns, Appeal Rights.., and IRS Publication 17, Your Federal Income Tax.
IRS Links:
IRS Appeals
IRS Problem Resolution Office
IRS Taxpayer Advocate
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For further information regarding IRS rules and regulations and your particular tax or IRS situation you should consult with a Certified Public Accountant, Enrolled Agent, Attorney, or other tax advisor. 
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