It happens – You’ve had a good year and get surprised by your tax liability when your return is ready to file. The growth in your business has tied up funds that you need to pay taxes. Or maybe you took a retirement plan distribution to pay outstanding medical bills and didn’t withhold for the related tax liability.
First and most importantly, taxpayers should not let the inability to pay their tax liability in full prevent them from filing tax returns properly and on time. When you find yourself in this situation, pay as much as you can, and consider borrowing the funds for payment. In most cases, it is advisable to pay state liabilities first so that you are only dealing with one taxing agency on past due balances. Filing without full payment can save you substantial amounts in filing penalties, as discussed below. Following procedures for payment extension and installment payment arrangements can keep the IRS from instituting its collection process (liens, property seizures, etc.).
Common Tax Penalties
Federal “Failure to File” penalties accrue at the rate of 5% per month or part of a month (to a maximum of 25%) on the amount of tax your return should show you owe. The Federal “Failure to Pay” penalty is gentler, accruing at the rate of only ½% per month or part of a month (to a maximum of 25%) on the amount actually shown as due on the return. In cases where both apply, the failure to file penalty drops to 4.5% per month so the total combined penalty remains at 5%.
The maximum combined penalty for the first five months is 25%. Thereafter the failure to pay penalty can continue at 1/2% per month for 45 more months (an additional 22.5%). Thus, the combined penalties can reach a total of 47.5% over time. Both of these penalties are in addition to interest you will be charged for late payment.
Missed estimated tax payments result in an additional penalty for the period running from each payment's due date until the tax return due date, normally April 15th. This penalty is computed at 3% above the fluctuating federal short term interest rate for the period.
Undue Hardship Extensions
Keep in mind that an extension of time to file your return does not mean you have an extension of time to pay your tax bill. An extension of time for payment may be available, however, if you can show payment would cause "undue hardship”. If granted, you will avoid the failure to pay penalty, but you will still be charged interest. The undue hardship extension will give you an extra six months to pay the tax shown as due on your tax return.
If the IRS determines a "deficiency," i.e., that you owe taxes in excess of the amount shown on your return, the undue hardship extension can be as long as 18 months and in exceptional cases another 12 months can be tacked on. However, no extension will be granted if the deficiency was the result of negligence, intentional disregard of the tax rules, or fraud.
We won’t get into specifics of what the IRS considers an undue hardship here, but merely being inconvenienced by the tax liability is not enough for the IRS to grant the extension. You’ll have to document and support the undue hardship.
Also, as a condition to the granting of an extension of time for payment of any tax or deficiency, the IRS may require a bond not exceeding twice the tax.
To apply for an undue hardship extension, you’ll file form 1127 with the IRS. The process requires a statement of assets and liabilities as well as an itemized list of receipts and disbursements for the 3 months preceding the tax due date.
Borrowing Money to Pay Taxes
Consider borrowing money, if you don't think you can get an extension of time to pay your taxes. Loans from relatives or friends are often the simplest method to pay the bill. One advantage of such loans is that the interest rate will probably be low. Obtaining a loan from a bank or other commercial source is another alternative, but such loans are not likely to be made on favorable terms to a hard pressed taxpayer. Moreover, interest on a loan to pay taxes is nondeductible personal interest. In contrast, taking out a home equity loan and using the proceeds to pay off your tax debts, will probably be at a lower rate than other types of loans, and the interest payments may be deductible even if the loan proceeds aren't used in connection with the house.
You can also use credit cards or debit cards to pay the income tax bill whether you file your income tax return by mailing a paper copy or by computer. Several companies are authorized service providers for purposes of accepting credit card or debit card payments. Only those cards approved by IRS may be used. However, as with other loans from businesses, credit card loans are likely to be at relatively high interest rates and the interest is not deductible. Moreover, the service providers also charge a fee based on the amount you are paying.
Installment Agreement Request
Requesting the IRS to enter into an installment payment agreement is another way to defer your tax payments. This request is made on Form 9465 or by applying for a payment agreement online. The IRS charges a fee for installment agreements, which will be deducted from your first payment after your request is approved.
Form 9465 requires less information than the hardship extension application. For liabilities under $50,000, you will not be required to submit financial statements. Even if your request to pay in installments is granted, you will be charged interest on any tax not paid by its due date. But the late payment penalty will be half the usual rate (1/4% instead of 1/2%), if you file your return by the due date (including extensions).
The fee for entering into an installment agreement is $120, except that the fee is $52 when the taxpayer pays by way of a direct debit from the taxpayer's bank account, and, notwithstanding the method of payment, the fee is $43 if the taxpayer is a low-income taxpayer.
Note that an installment agreement request can be made after your hardship extension period expires. Additionally, IRS has the authority to enter into an installment agreement calling for less than full payment of the tax liability over the term of the agreement. It may do so if it determines such an agreement will facilitate partial collection of the liability.
The IRS may terminate an installment agreement if the information you provided to IRS in applying for the agreement proves inaccurate or incomplete or IRS believes collection of the tax involved is in jeopardy.
The IRS may modify or terminate an installment agreement if the taxpayer misses a payment, fails to pay other tax liabilities or to provide the IRS with requested financial information, or the taxpayer’s financial condition changes significantly.
The IRS must give you a 30 day notice before altering, modifying or terminating the installment agreement and it must explain its reasons for the action. This notice requirement does not apply when collection of the tax is in jeopardy.
A $5,000 penalty applies to any person who submits an application for an installment agreement if any portion of the submission is either based on a position which the IRS has identified as frivolous, or reflects a desire to delay or impede the administration of federal tax laws. The IRS may also treat that portion of the submission as if it had never been submitted. However, the penalty is clearly aimed at those who abuse the process and should not deter taxpayers with legitimate applications from using the installment agreement process.
Avoiding More Serious Consequences
Don’t hide your head in the sand if you run into financial difficulties. Failing to file their tax returns only complicates the situation. It is very important to file a properly prepared return even if full payment cannot be made. Include as large a partial payment as you can with the return and start working with the IRS for a hardship extension or installment agreement as soon as possible. The alternative will include escalating penalties, plus the risk of having liens assessed against your assets and income. Down the road, the collection process will also include seizure and sale of your property. In many cases, these tax nightmares can be avoided by taking advantage of arrangements offered by the IRS.
Don’t let financial circumstances prevent filing timely and accurate returns. Address the issue directly and pay as much as you can afford to pay. Installment agreements and hardship extensions are tools that can help in dealing with the balance due. Loans or credit card payments can be another solution for paying the tax debt.
If you find yourself in a position where you cannot pay your current liability, consult a qualified tax professional to walk you through the options and represent you when dealing with the IRS or state tax authorities.