What if you can't pay the IRS?

By Jeff Schnepper

It's getting on April 15. You've finished your return, and you're still in shock. You made a lot of money and paid a lot of bills. But now you're looking at a tax bill that you just can't afford to pay.

Relax. You're not alone, and your plight is not unusual. Moreover, you're not going to jail. There are criminal penalties if the Internal Revenue Service can prove (the burden of proof is on the agency) that you intentionally didn't pay your taxes, but we'll assume that's not the case here. You just ran low on cash, and nobody goes to jail just because they owe money -- even to the IRS.

Your return is done -- that's how you know the magnitude of your debt. Send it in. Don't hold it just because you owe money that you can't pay.

You can't go to jail because you don't have the money to pay your tax bill, but you can go to jail for not filing. It's a criminal act, and you're not a criminal, so get that return in the mail.

If you file and don't pay in full, IRS computers will automatically send you a letter asking for the tax due and any interest from the due date.

There is a penalty for late filing of 5% of the tax not paid by the due date for each month, or part of a month, that your return is late. Generally, the maximum penalty is 25%. But if your return is more than 60 days late, the minimum penalty is $100 or the balance of the tax due on your return, whichever is smaller.

Begging and borrowing

But avoiding the late-filing penalty doesn't get the tax paid. Consider all of the possible sources of money. Can you borrow from friends or relatives? Do you have any equity in your house? If so, a home-equity loan might help eliminate or minimize your tax liability. Moreover, the interest on the loan likely would be deductible on next year's return.

Do you have potential cash in your credit cards? The interest wouldn't be deductible, and it probably would be much higher than the rate the IRS would charge. Still, you might prefer to eliminate the specter of the IRS and the post-midnight nightmares that go with it. (And, you could get mileage on your credit card for a potential future vacation.)

But what if you decide to negotiate directly with the government? Understand that the government ranks at the top of the list of creditors who must get paid. Any assets (other than your home or selling your business) are potentially fair game if you owe taxes. Don't try to hide your assets. That comes under the heading of fraud, and you can go to jail for that.

If you can't come up with the money

What if you can't find the cash? Remember, you're not alone.You can ask for a streamlined installment plan. You will need to submit an Installment Agreement Request using Form 9465 (.pdf download). The form comes with instructions. Additional information can be found at IRS Topic 202 or in Publication 17 (.pdf download). Fill the form out and send it to the IRS for review and approval.

You may qualify for a streamlined plan if you don't owe more than $25,000. Also, you must be able to pay your tax bill off within five years. The true length of your payments is a function of both how much you owe and the interest rate charged. Since that rate changes every three months, these figures are estimates, not guaranteed maximum payments. If the interest rate goes down, you may actually pay over a shorter period of time.

The rate is calculated on the basis of the short-term federal rate plus 3 percentage points, as of the first month of each quarter. The IRS issues a news release in the last month of each quarter announcing its rates for the following quarter. (To check on current rates, check here for the applicable IRS news release. This is the release for the first quarter of 2008.)

I should add that, if you overpay, the IRS will owe you interest.

If you don't meet the criteria for a "streamlined" agreement, you can compare your monthly expenses to the amounts allowed under the IRS' Collection Financial Standards to determine an appropriate tax-payment amount.

If the IRS approves your request, you will be charged a $102 fee. Don't submit the fee with Form 9465. The IRS normally will deduct the fee from your first monthly payment. If you're setting up as direct debit arrangement, the IRS will charge an additional $52 one-time fee.

Even if your Form 9465 request is approved, you still will be charged interest and may be assessed a late-payment penalty on any tax not paid by its due date. To limit interest and penalty charges, file your return on time and pay as much of the tax as you can.

Form 9465 is easy to complete. It asks for your name, address, Social Security number, the name of your bank and your employer. (Relax. Based on your W-2 and the 1099 the bank sends, the IRS already has that information.) It then asks how much you owe and how much you want to pay each month. You don't need an attorney or an accountant to fill it out. If you can pay the outstanding liability within 12 months and promise to keep current with this year's taxes, almost all requests are granted.

If you can't pay what you owe within 12 months, request an installment plan that you can realistically meet. The IRS takes a harder line on longer payment periods, but the government has granted such requests after investigating the individual circumstances.

What if an installment plan just won't work for you? As in the past, you have the opportunity to ask for what's called an offer in compromise. Under this program, you pay the IRS, but less than 100% of what's due.

In the past, there were only two situations where the IRS would consider an offer in compromise:

• Your liability for the taxes owed was in question.

• The IRS wasn't sure it could collect the taxes, no matter what it did.

The IRS can now approve offers in compromise based simply on economic hardship.

You can qualify for this new provision if you have a history of filing and paying your taxes and "collection of the entire tax liability would create economic hardship, or exceptional circumstances exist where collection of the entire tax would be detrimental to voluntary compliance."

To apply for this program, you must first submit a copy of Form 656, the standard offer in compromise application. This form also can be downloaded (.pdf download) from the IRS Web site. And you must now pay a $150 application fee.

The IRS has cautioned that this program is designed only for taxpayers in extreme circumstances. It's not designed for everyone with a financial problem, nor should it be viewed as an invitation to avoid paying taxes.

In making an offer in compromise, you can offer to make a lump-sum, cash payment or fixed payments over a short period. In many cases, people borrow from friends and relatives. However, these people have to know upfront, before they commit any money, that the IRS is going to accept those dollars as payment in full.

The fixed-payment option combines all debts, including interest, owed under the terms of the offer into a single payment. Be warned, however, that the law still requires interest to be accrued. That means that if you default on your agreement, the entire amount of taxes owed, plus penalty and accrued interest, will then be due.

The IRS wants to make a deal

The IRS is interested in settling your tax liability. The number of acceptances was around 25,000 to 30,000 annually over the previous five or six years but fell to 14,526 in fiscal 2005, General Accounting Office examination of the program showed. Applications were as much as 120,000 in fiscal 2001 through 2003 but dropped to 100,000 in 2004 and about 73,000 in 2005.

IRS statistics show the agency has been increasing its enforcement efforts. About 629,000 liens were filed in fiscal 2006, up from 522,000 in 2005. Seizures dropped from 10,090 a year up until 1997 to only 399 in 2003 and 440 in 2004 but reached 590 in 2006.

Levies, meanwhile, dropped from nearly 3.5 million in fiscal 1997 to a low of about 200,000 in 2000. By fiscal 2004, the total was 2.03 million, and it moved up to 2.7 million in 2005 and 3.7 million in 2006.

Don't hide from the IRS

The final word on what to do when you can't pay your taxes is communication. The IRS is a vast bureaucracy filled with people asked to do an impossible job. Talk to them; don't hide. The sooner you approach them, and the more often you respond with changes in your situation, the more comfortable they will be in working with you.

Always get the names of the people you speak with and keep notes of what was said. The commissioner of the IRS has asked that agency employees stress "customer service." After all, isn't "service" part of the agency's name?

Updated April 14, 2008