The IRS Hit Me With a $10,000 Penalty -- and It Could Happen to You, Too!

I’m not sure I had ever been that scared in my life…

…and it all started with a simple LLC!

Despite being a letter from the government, it was clear as could be: I was being charged a nearly $10,000 penalty from the IRS.

What was I going to do? I didn’t even have $10,000!?

And why was I being charged this?

After several panicked hours of research, I finally realized why I was being hit with this fee:

Because I was stupid.

OK, being stupid isn’t technically the reason why I was being charged $10,000.

Maybe “over zealous” is a better term — and it’s a simple mistake anyone could make.

Including you.

It Started With An LLC…

Here’s the deal:

When I first started investing in real estate, I heard a lot about LLCs.

I needed one, right? At least, that’s what I thought.

I had just purchased a triplex with some good friends of mine, so of course, we wanted to be ~~cool~~ “official.”

So I went to my Secretary of State’s website and paid the $300 or so for an LLC. I printed out the documents, made a nice file folder for it, and put it in my file cabinet.

Now I was official, right?

(In reality, because I never transferred the property into the LLC, the LLC wasn’t doing anything. I assumed I would get the property transferred in soon, but never had the time. Besides, the “Due on Sale Clause” made it a little sticky if I wanted to transfer the property into an LLC anyway. More on that here.)

So the LLC was formed, and the LLC just sat there.

Maybe a mistake — but definitely not a $10,000 mistake. Sure, I wasted $300 on an LLC that I didn’t use.

But the real problem didn’t start until tax time.

The Fateful Mistake

A year later, I started working on my taxes.

Back then, I did all my own taxes using a popular online tax planning software, which was relatively cheap and easy to use.

Because my LLC had absolutely no activity (due to me never transferring the property into it), it didn’t make a profit. So, total taxes owed on that LLC would be $0, of course.

So I just ignored it.

I mean, the IRS wouldn’t care if I mentioned it on the taxes because it made no money, right?

WRONG.

Here’s the problem: The IRS requires that every non-single member LLC (in other words, any LLC that you have that is not you alone or you with your spouse) must file a business tax return (Form 1065) every year — even if the LLC makes no money.

So, had this LLC been just my wife and I, things would have been fine.

But because it was a partnership with another couple, a business tax return was required, along with K-1s for each partner.

Whoopsies.

About a year after filing those taxes is when I received the letter in the mail. The IRS was fining me almost $10,000.

Why?

Because according to the official 1065 instructions from the IRS, “The penalty is $195 for each month or part of a month (for a maximum of 12 months) the failure continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due.”

So, with four partners on the LLC:

$195 x 12 x 4 = $9,360.

Ouch. And that was just for that one year. I could have been hit with several years, and I’m sure I would have, had I not fought my way out.

How I Avoided the Penalty

This post could easily turn into a rant against the IRS, but honestly, it was my own stupidity that caused the problem.

Simply put: I didn’t know what I was doing.

So what happened? Did I have to pay the fine?

Nope!

The first thing I did was called a CPA I had heard about on BiggerPockets named Amanda Han (from Keystone CPA). I explained the issue to her, and she helped explain the problem and how to correct it. (Thanks, Amanda!)

A phone call to the IRS, with a promise not to do it again, and the penalty was waived. One hundred percent of it.

Phew!

This is why I still use Amanda Han and Keystone CPA today for my own investing. Not only did she help me out there, but she’s helped me out numerous times since, including preparing my taxes each year.

She even recently helped me create a Solo 401(k) so I can use it to fund my real estate deals! Whoop whoop!

And this is also why I pushed so hard to have Amanda write The Book on Tax Strategies for the Savvy Real Estate Investor, which launched last week here on BiggerPockets and is on sale until Friday, February 26th.

How YOU Can Avoid Penalties from the IRS

So, what’s the point?

I made a lot of mistakes, but I guess if I could summarize my entire experience it would be this:

You need to understand basic tax stuff. If not, you’ll do stupid things.

Don’t go opening up an LLC because you think it’s the cool thing to do. Learn why an LLC is important and the right way to do it.

How?

Well, a good way to start would be to pick up a copy of The Book on Tax Strategies for the Savvy Real Estate Investor today. Inside, you’ll learn about LLCs, deductions, using retirement accounts, and more.

(Also, trust me, it’s not boring, as you would imagine a tax book would be. It’s filled with stories, humor, education, and wisdom that will help make sure you pay less to the IRS so you have more capital to build your business!)

As a reminder, or in case you didn’t know, there is an awesome promotion on the book that ends on Friday, February 26th, 2016, at midnight. If you buy the book on BiggerPockets before then, you’ll get the digital book plus a bunch of great bonuses — and one of those bonuses is ONLY available until Friday at midnight, which is called “How to Use a Self-Directed 401(k) To Fund Your Real Estate Deals!”

This video/audio/transcription bonus will explain the ins and outs of using the Solo 401(k) to fund your deals — and if you are looking to borrow money from private lenders in the future, this is one video you CAN’T afford to miss.

To pick up a copy, click here.

Conclusion

Mistakes happen.

While you can always learn from your own mistakes, you can also learn from the mistakes of others — like me.

Mistakes generally happen when you don’t know enough, but don’t let that stop you from moving forward.

The point of this post was not to scare you into inaction but to show you that mistakes can be overcome with knowledge.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.