What to Do When You Can't Pay Your Taxes

Photographer: Fuse/Getty Images

Photographer: Fuse/Getty Images

The economy has taken a brutal toll on the finances of many Americans these past few years. Unemployment, underemployment, medical and family emergencies and other unforeseen circumstances can result in a tax bill  beyond one's means. The good news: Debtors' prisons are a thing of the past and the Internal Revenue Service will not seize your paycheck or bank account on April 16. 

The key is not to hide your head in the sand if you face a payment dilemma. The IRS offers a host of reasonable ways to pay off your debt. If you ignore the situation, its agents eventually will find you. They can unleash a powerful arsenal of tax collection weapons such as liens, levies and seizures. 

Low rates 

If you can't pay some or all of the tax, file your return by April 15 (or by Oct. 15, if you have obtained  an extension), paying as much as you can. The late filing penalty generally is 5 percent of the unpaid tax for each month, or part of a month, that a return is late; it maxes out at 25 percent of the unpaid tax. If the return is more than 60 days late, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax.

In contrast, the late payment penalty is ½ of 1 percent of the unpaid tax for each month, or part of a month, that the tax remains unpaid, maxing out at 25 percent of the unpaid tax. It falls to ¼ of 1 percent for each month an installment agreement (which we'll discuss below) is in effect. If you request an extension and pay at least 90 percent of your 2012 tax liability by April 15, you won't face a late payment penalty, provided the remaining balance is paid by Oct. 15, 2013.

The interest rate for underpayment is adjusted quarterly. For the calendar quarter beginning on April 1, 2013, the rate is 3 percent.

Be creative

Before contacting the IRS, take a hard look at your finances and what or whom you might be able to borrow from. Can you sell a stock that generates a tax loss? Resist the temptation to cash in an IRA -- that will generate additional taxes (and a 10 percent penalty, if you're making an early withdrawal). Also resist payday lenders and other types of quick cash solutions, as they may solve a short-term problem but charge fees and interest rates that leave you worse off in the long run.

If you do need to call the IRS, it may be less painful than you anticipate. Despite what many taxpayers think, the IRS has become more flexible in recent years and stands ready to help, up to a point. The key is to know what payment options are available so that you have a realistic idea of what type of solution best fits your situation. 

Here are the options available:

Short-term payment extension. If you need a little extra time to pay, ask for a short-term extension of up to 120 days. There's no fee. You can make the request online through the IRS's website and usually get a written confirmation within 10 days.

Guaranteed installment agreement. The IRS must accept an installment agreement request if you: (1) owe $10,000 or less; (2) have filed and paid all tax returns during the five years prior to the year of liability; (3) can fully pay the tax liability within three years; (4) file and pay all tax returns during the agreement; and (5) have not had an installment agreement within the last five years preceding the year of liability. 

You can qualify so long as the tax amount owed doesn't exceed $10,000, though your tax bill may exceed $10,000 when it includes penalties and interest. The IRS generally does not file a lien to secure the agreement. You can apply online and there is no financial disclosure.

Streamlined agreements. You can also apply for this agreement online through the IRS website, without having to provide extensive financial disclosure, if your unpaid liability (including tax, assessed penalties and interest) is $50,000 or less and you can fully pay it within 72 months. If your unpaid liability exceeds $50,000, you can become eligible by paying the balance down to $50,000. 

The IRS generally does not file a lien to secure the agreement. If the total owed is greater than $25,000, you can avoid having to provide an extensive financial disclosure statement by agreeing to direct debits for installment payments.

Regular agreements. If you owe more than $50,000, you can apply for a more traditional type of installment agreement -- but you will have to provide extensive financial disclosure. The IRS will conduct its own fairly detailed analysis to determine the amount and duration of a payment plan. The amount you'll be asked to pay will be largely based on IRS national and local financial guidelines, which may significantly alter your lifestyle. The IRS may file a public tax lien to secure the agreement.

Partial pay installment agreements (PPIA). In certain limited circumstances, the IRS may allow for a “partial payment” agreement if you can make partial payments but cannot fully pay before the expiration of the 10-year statute of limitations on collection.

Final options

Suspending collection due to economic and other hardships. If you can show that collection of the tax debt would cause a financial or other hardship for you or your family -- such as preventing you from meeting necessary living expenses -- the IRS may agree to temporarily delay collection until your finances improve (classifying the account as “currently not collectible”). After about a year the IRS will review your case to determine if the hardship still exists. Penalties and interest accrue during the period.

Offer in compromise (OIC). The IRS may compromise your tax liability, accepting less than full payment, on a variety of grounds that can include: (1) doubt as to liability; (2) doubt as to collectability; or (3) to promote effective tax administration in exceptional circumstances, or to avoid economic hardship. 

Contrary to the late night ads by tax-debt resolution firms, OICs are granted sparingly. The IRS's definition of a particular taxpayer’s “reasonable collection potential” and “ability to pay” generally differs substantially from a taxpayer’s definition. Generally, the amount offered must exceed the total value of your equity in all of your assets, and the IRS will consider present and future earning capacity.

If an offer is accepted, the IRS may require you to agree to pay a percentage of future earnings and relinquish certain present or potential tax benefits. There's a $150 nonrefundable fee (unless you meet certain low-income guidelines) and you must: (1) submit 20 percent of the offer amount as a lump-sum payment, or make such payment in five or fewer installments; (2) agree to pay the offer amount within 24 months, submitting the first payment with the application; or (3) agree to pay the offer amount over the remaining statutory period for collecting the tax, submitting the first payment with the application.

The fees for setting up an installment agreement are: $52 for a direct debit agreement; $105 for a standard agreement or payroll deduction agreement; and $43 if your income is below a certain level.

The last option

Bankruptcy generally should be your last option. Seek out a good bankruptcy attorney before making a final decision. Filing a bankruptcy petition will stop tax collection in its tracks through an “automatic stay.” The IRS may then file a claim for the unpaid taxes with the bankruptcy court, which will determine whether and when these taxes are to be paid. Certain taxes that cannot be paid from the bankruptcy estate may be discharged. Discharge generally is limited to taxes incurred more than three years before the bankruptcy petition is filed.

(Kenneth Savell is a tax law editor for the IRS Practice & Procedure Group at Bloomberg BNA.)

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