What Can Taxpayers Do If They Can't Pay Their Taxes?
April 6, 2009 (SmartPros) Are there options for Americans who cannot pay their taxes, due to their financial difficulties resulting from the down economy?
According to Jim Keller, of Thomson Reuters, more taxpayers will face this challenge during the coming filing season. Taxpayers who fail to timely file and pay their taxes face penalties and interest charges. Not only that, says Keller, these folks can expect to come up against a more aggressive IRS. For example, the number of levies issued by the IRS increased by 1,608% from 2000 to 2007—from 220,000 levies to more than 3.75 million levies. A new factor that will play into taxpayer collections is that the IRS (as noted by IRS Commissioner Doug Shulman in a recent press release) has decided not to renew contracts with two private debt collection agencies but instead anticipates hiring more than 1,000 new collection personnel as IRS employees in fiscal year 2009.
Fortunately, there are some options available to help taxpayers pay their balance due. Here’s a scenario of problem solving from Thomson Reuters:
Let’s assume that Bob and Judy’s 2008 tax return shows unpaid tax of $5,000, but they don’t have the cash to pay the tax. First, they should not ignore the IRS—it will not go away. They should either file their return by the April 15 due date, or request a filing extension. Either way, the failure to pay the taxes due on April 15 will result in interest charges and a penalty for failure to pay of ½% per month on the unpaid balance (up to 25%) until the taxes are paid. But by filing or extending their return, they’ll avoid the more onerous late filing penalty of 5% per month on the unpaid balance (up to 25%) until the return is filed.
If Bob and Judy don’t do anything by April 15th, but file the return and pay their taxes three months later, they’ll owe a failure to file penalty of $750. If they extend the return and then file it and pay their taxes three months later, they’d pay a failure to pay penalty of $75— $675 less than if no extension had been filed. “This shows how important it is to file or extend by April 15th even if you don’t have the money,” says Keller.
Keller points out that getting an extension is pretty easy these days. Taxpayers no longer have to pay the balance due or sign the extension request for a valid six-month filing extension. However, the liability must be properly estimated and the amount due entered on the appropriate lines of the request, or the extension will be disallowed. “While doing so will avoid a failure to file penalty, interest and the failure to pay penalty will accrue from April 15 until the tax is paid,” he warns.
Some taxpayers can qualify for an extension to pay the tax because of undue hardship, or because of a federally declared disaster, terrorist act, or military action. This type of approach would allow Bob and Judy to avoid the failure to pay penalty but not the interest charge. “However, hardship relief is difficult to obtain,” says Keller, “because of the restricted definition of hardship, and most taxpayers do not experience a federally declared disaster, like a hurricane or flood.”
Financing the Payment
Borrow from a bank or family. “Since the failure to pay penalty and interest applies to the late payment of tax, borrowing from a family member, bank, or other lender can be less expensive than paying penalties and interest to the IRS,” says Keller, pointing out that the IRS interest rate changes quarterly. For the first quarter of 2009, the underpayment rate is 5%. Tax penalties are nondeductible, and interest expense associated with an individual’s federal tax liability, whether paid to the IRS or to a commercial lender, generally is nondeductible personal interest.
Home equity loan. If Bob and Judy can finance the tax payment with a home equity loan, the interest may be deductible for regular tax (but not AMT) purposes. A home equity loan is debt (other than acquisition debt) secured by a qualified residence. It generates deductible interest to the extent the loan doesn’t exceed the lesser of $100,000 ($50,000 for married filing separately), or the FMV of the residence less acquisition debt. There’s no limit on the number of qualified home equity loans a taxpayer can take out (as long as the loans collectively meet the $100,000/$50,000 or FMV limitation) and use of the debt proceeds is irrelevant unless they’re used to purchase or carry tax-exempt obligations.
Credit card. Another option is paying the tax by credit card. Applicable finance charges (according to the credit card agreement) and processing fees will apply, but if Bob or Judy has a low interest rate card, these will be kept to a minimum until the balance is paid in full. While the interest on the credit card is nondeductible personal interest, some credit cards provide low rates, airline miles, or other incentives. For more information, go to the front page of www.irs.gov and type “paying tax by credit card” in the Search box.
Request an Installment Agreement with the IRS. A final option is to request an installment arrangement from the IRS. Form 9465 is the application to the IRS requesting an installment payment arrangement. Once submitted, the IRS will notify the taxpayer within 30 days if the request is approved or denied, or if additional information is needed. The IRS would charge Bob and Judy a $105 fee for entering into the agreement, but that fee would be reduced to $52 if the direct debit option is selected, and can be reduced to $43 for certain low-income taxpayers.
Under current administrative procedures, the IRS will approve installment agreements up to $25,000 (including tax, penalties, and interest) when the taxpayer agrees to pay the amount due in five years or less. Also, since Bob and Judy owe $25,000 or less, they can use the online payment agreement (OPA) application at www.irs.gov to request a payment agreement. This application is available to taxpayers who meet the $25,000 requirement, have filed all required tax returns, and are current with their tax payments. The OPA application would enable Bob and Judy to obtain a short-term extension of up to 120 days to pay, or request a longer monthly payment plan.
Says Keller: The bottom line is that if you can’t pay taxes you owe on April 15, either file your return or file for an extension, and pay as much as you can to avoid penalties and interest. You can then work on a solution to pay the unpaid balance. “Never ignore the filing deadline,” says Keller.