If you are unable to pay your tax liability, there are some things you need to know. Most importantly, don't let your inability to pay your tax liability in full keep you from filing your tax return properly and on time. Why? Because there is a "failure to file" penalty that accrues at the rate of 5% per month or part of a month (to a maximum of 25%) on the amount of tax your return shows that you owe. The tax ramifications, penalties and possible solutions are included in the article.

Extensions - Although an extension provides you more time to file the actual return and avoid the "failure to file" penalty for six months, it is not an extension to pay. Not paying the balance of your tax liability will subject you to the "failure to pay" penalty. The "failure to pay" penalty accrues at the rate of 1/2% per month or part of a month (to a maximum of 25%) on the amount actually shown as due on the return.

Penalties - If both the "failure to file" and the "failure to pay" penalties apply, the "failure to file" penalty drops to 4.5% per month or part thereof, 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 the interest that you will be charged for late payment.

Bottom line…if you owe money, file your return on time even if you can't pay the entire liability. That will minimize your penalties. Pay as much as you can with the return to further minimizing your penalties. By the way, the penalties and interest are not tax-deductible.

Loans From Relatives and Friends – Borrow the money from family members or close friends. 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, but you must also consider that loans over $10,000 at below market interest rates may trigger tax consequences. Any interest paid on this type of loan would be non-deductible.

Home Equity Loan – A home equity loan is also a potential source of funds with the advantage that the interest would be deductible as long as you itemize your deductions and your total equity loans on the home don't exceed $100,000. However, in today's financial environment, qualifying for these loans may be too time-consuming in some situations.

Pay By Credit Card – Using your credit card to pay your taxes is another option. The IRS has approved two firms to provide this service. The disadvantage is that the interest rates are relatively high, and you must pay the "merchant" fee because the IRS does not. The fees are deductible as a miscellaneous itemized deduction on your tax return. For information about the amount of the fees, contact the firms below:

Withdraw Money From Retirement Plans – Tapping into one's pension, IRA or other retirement plan should be the last resort, not only because it degrades your future retirement but because of the potential tax implications. Generally, except for Roth IRAs, the funds in the retirement accounts are pre-tax and, as a result, when withdrawn become taxable. Even part of a Roth distribution could be taxable, depending on your age and how long you've had the account. If you are under 59½, the taxable part of a retirement plan distribution will also be subject to the 10% early withdrawal penalty. The federal tax, state tax (if applicable), and the penalty can chew up a hefty amount of the distribution and be too high a price to pay.

Set-Up an IRS Installment Agreement – You can request an installment arrangement with the IRS to make monthly payments. However, there are fees associated with setting up an installment agreement, and you must follow some strict payment rules or the agreement can be terminated. The agreement requires approval and, if your liability is under $50,000 (was $25,000 prior to the IRS initiating the "fresh start program" in 2012), you will not be required to submit financial statements.

The fee for establishing the agreement is $105, but is reduced to $52 when the taxpayer pays by way of a direct debit from the taxpayer's bank account. For certain low-income taxpayers, the fee is reduced to $43. You will also be charged interest, 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 installment agreement may terminate and all your taxes become due immediately if any of the following occur: the information you provided to the IRS in applying for the agreement proves inaccurate or incomplete; you miss an installment; you fail to pay another tax liability when it is due; the IRS believes collection of the tax involved is in jeopardy; or you fail to provide an update of your financial condition where the IRS makes a reasonable request for you to do so.

Guaranteed Installment Agreement - The IRS is required to enter into an installment agreement at your request (a guaranteed installment agreement) if the following apply:

  • The tax liability is $10,000 or less.
  • Within the prior five years, you have not failed to file returns or pay taxes and have not entered into a previous installment agreement.
  • IRS determines the tax liability cannot be paid in full (1).
  • The installment agreement provides for full payment within 3 years.
  • You agree to comply with the tax laws during the agreement period.

(1)As a matter of policy, the IRS will generally grant installment agreements even if taxpayers are able to fully pay their accounts.

If the full amount owed can be paid within 120 days, a formal installment agreement, and fees, can be avoided. To establish a request to pay in full, the taxpayer must contact the IRS by phone at 1-800-829-1040 or apply online at the IRS web site.

Final Word of Caution – Ignoring your filing obligation only makes matters worse and can become very expensive. It can lead to the IRS collection process, which includes attachments, liens and even the seizure and sale of your property. In many cases, these tax nightmares can be avoided by taking advantage of the solutions discussed above. If you cannot pay your taxes, please call this office to discuss your options.