First and 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. If you don’t file your tax return, it only makes things worse.

If you can, include as much of a partial payment as you can, and consider borrowing the funds for payment. As discussed below, just filing without full payment can save you substantial amounts in filing penalties. More importantly, procedures exist for payment extension and installment payment arrangements which will keep IRS from instituting its collection process (liens, property seizures, etc.).

Overview of the most common penalties. There are several penalties you should be aware of before you try and postpone payment.  These can quickly add up and make things inevitably worse as you try to deal with the problem.

  • “Failure to file” penalty 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 should show you owe.
  • Failure to pay” penalty is gentler, accruing at the rate of only 1/2 % per month or part of a month (to a maximum of 25%) on the amount actually shown as due on the return. (If both apply, the failure to file penalty drops to 4.5% per month (or part) 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. If you also missed estimated tax payments, an additional penalty is tacked on for the period running from each payment’s due date until the tax return due date, normally April 15th (or earlier, if the payment is made before the due date). This penalty is computed at 3% above the fluctuating federal short term interest rate for the period.

Undue hardship extensions. It’s important to remember 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,” as discussed below. You will avoid the failure to pay penalty if an extension in granted, but you will still be charged interest. If you qualify, you will be given an extra six months to pay the tax shown as due on your tax return. If 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.

To establish undue hardship it is not enough to show that it would just be inconvenient to pay your tax when due. For example, if you would have to sell property at a “sacrifice” price you may qualify. But if a market exists, having to sell property at the current market price is not viewed as resulting in undue hardship.

You would have to show that you do not have enough cash and assets convertible into cash in excess of current working capital to meet your tax obligations. You would also have to show you cannot borrow the amount needed except on terms that would inflict serious loss and hardship.

To qualify for an extension, you have to provide security for the tax debt. The determination of the kind of security—such as bond, filing a notice of lien, mortgage, pledge, deed of trust, personal surety, or other form of security—will depend on the particular circumstances involved. When your application for an extension is granted you must deposit any collateral agreed upon with the IRS. No collateral will be required if you have no assets.

Form 1127 is used to apply for an extension. A statement of assets and liabilities must be attached as well as an itemized list of receipts and disbursements for the 3 months preceding the tax due date.

Borrowing money to pay taxes. If you don’t think you can get an extension of time to pay your taxes, borrowing money to pay the taxes should be considered. 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. Where loans from individuals are not available, a loan from a bank or other commercial source could be sought, 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, if you can take out a home equity loan and use the proceeds to pay off your tax debts, you will probably be paying at a lower rate than with other types of loans, and the interest payments will be deductible even if the loan proceeds aren’t used in connection with the house.

Home equity loans are, of course, not an option for everyone and they may be too time-consuming in some situations. However, it is relatively quick and easy to 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. Another way to defer your tax payments is to request IRS to enter into an installment payment agreement with you. This request is made on Form 9465 or by applying for a payment agreement online. 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. If the liability is 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 $105, 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. A low-income taxpayer is an individual who falls at or below 250% of the dollar criteria established by the poverty guidelines updated annually in the Federal Register by the U.S. Department of Health and Human Services.

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.

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.

IRS may modify or terminate an installment agreement if any of the following occur:

  • you miss an installment.
  • you fail to pay another tax liability when it’s due.
  • you fail to provide an update of your financial condition where IRS makes a reasonable request for you to do so.
  • IRS determines that your financial condition has significantly changed.

IRS must give you 30 days 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 IRS has identified as frivolous, or reflects a desire to delay or impede the administration of federal tax laws. 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. Too many taxpayers hide their heads in the sand when they run into financial difficulties, for example, by failing to file their tax returns. But tax liabilities do not go away if left unaddressed. It is very important that you 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.

I know this is a difficult topic, but if you are in this predicament and need to discuss the situation further, please contact an attorney or CPA in our office that can discuss the situation with you.

Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”  and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.