For federal income taxes in the United States, you send in your tax return and the payment to the Internal Revenue Service (IRS). You know the drill. Come April 15th, taxes need to be field and paid or a problem could start that causes big problems.
The US tax system is a “pay as you go” arrangement. If you are a W-2 wage earner, your employer withholds taxes from your income. If you’re self-employed, you pay estimated taxes on a quarterly basis. Each year, you file a return to determine any under- or over-payment, and collect a refund or pay any additional tax due. Payment is “voluntary.” That doesn’t mean you can choose not to pay without consequence, but that sufficient monies are automatically held back from your earnings to cover your taxes.
You can end up owing money to the IRS after your return is calculated for a number of reasons.
Here are a few:
It may not be wise to give the IRS an interest-free loan by over-withholding, but under-withholding can cause financial difficulties if you’re unprepared to pay the shortfall. In addition, you can be assessed a penalty if you owe more than $1,000 and did not withhold at least 90 percent of your current year’s tax debt or 100 percent of your previous year’s tax debt, whichever is less.
Under-withholding can happen when taxpayers guess wrong about the number of exemptions to take on their W-4 forms. This is more likely when dealing with multiple jobs or two-earner households.
Self-employed taxpayers don’t just pay income tax – they pay payroll tax on their earnings, and those extra amounts – an additional 15.3 percent -- can create a surprise obligation to an unprepared taxpayer.
Income not Subject to Withholding
If you sell stock, real property or other assets at a profit, you may owe tax on your short- or long-term gains. Unexpected interest or dividend income can also trigger additional tax.
Failing to File
Failing to file your return (or filing late without requesting an extension) triggers a very harsh penalty. It’s much worse than the penalty for failing to pay, so even if you can’t afford your tax bill, file a return or an extension request. If you don’t, you can be assessed five percent of your unpaid taxes per month (up to 25 percent of your tax liability) for not filing a return or for filing more than 60 days past your due date or extended due date.
If you’re already enrolled in a payment plan for a previous year, failing to file and pay for a subsequent year invalidates your plan and leaves you open to aggressive IRS collection efforts.
Finally, if you fail to file a return, the IRS might take the income reported in your name and file a return for you. If the IRS files a Substitute for Return (SFR) for you, has none of the deductions and / or credits you might be entitled to, other than a standard deduction. Unless you replace their return with your own filing, if you had any deductions to claim, the SFR will almost certainly require you to pay more than is legally necessary. If you are self-employed, an SFR can be disastrous.
Assessments for Additional Tax
Your return may be selected for examination randomly, because it scores high on the Discriminant Inventory Function System (DIF) or because a third-party form like a 1099 doesn’t match what’s on your return. If the IRS determines that you owe additional tax, you might not be able to pay it immediately and will have to deal with a tax debt.
Consequences of Tax Debt
The biggest mistake you can make is ignoring tax debt and / or failing to file. The IRS offers several ways for you to pay what you owe over time, but it’s up to you to request that help. If not, here’s what can happen.
The IRS can file a public Notice of Federal Tax Lien. This becomes part of your credit report, making it difficult for you to finance anything. It also attaches to your property, including any businesses you have, giving the IRS first rights to any money generated from selling assets.
Tax levies are legal seizures of property, investments and cash to satisfy tax debt. The IRS may take money from your bank or other financial accounts, and it can repossess and sell your vehicle(s), real estate and other personal property. Never ignore a document entitled Final Notice of Intent to Levy and Notice of Your Right to a Hearing.
Interest and Penalties
When you can’t pay your tax bill in full by the deadline, you incur interest charges and failure to pay penalties. The failure to pay penalty is assessed monthly and it’s .5 percent of your outstanding balance (six percent per year). The interest rate you’ll be charged is the Federal Short-term Rate (one percent in the 3rd quarter of 2016) plus three percent. So you’re looking at about ten percent per year in penalties and interest when you owe tax debt.
Another collection tool employed by the IRS is garnishment, or a wage levy. Some portion of your wages, depending on your filing status and exemptions, is exempt from wage levies. The remainder is up for grabs, and the IRS will direct your employer to withhold that amount from your check until your debt is cleared or you make other arrangements to pay it. You can avoid wage garnishment by contacting the IRS and making your own repayment arrangements.
If you owe $50,000 or more, the IRS can get your passport revoked. If you’re out of the country when this happens, you could find yourself stranded overseas and unable to return home. If you’re home when this occurs, you won’t be able to leave the country for business or pleasure.
Ways to Pay Your Debt
The IRS offers several payment options for taxpayers who contact it for help.
Extension of Time to Pay
If you qualify due to hardship, you may receive an extension of time to pay, with late payment penalties waived as part of the IRS Fresh Start initiative. You’d submit Form 1127, Application for Extension of Time for Payment of Tax Due to Undue Hardship.
Additional Time to Pay
By submitting an Online Payment Agreement application, you can get an additional 120 days to pay your bill in full. The IRS says that with this agreement, you "generally will pay less in penalties and interest."
Temporary Delay in Collection
If your circumstances make it impossible to pay your tax debt, the IRS may designate your account "currently not collectible" (CNC). CNC doesn’t stop interest and penalties from accruing.
There are several installment plans, depending on the amount you owe. If you owe $50,000 or less, and have filed all your returns, you can apply for an online payment agreement. The IRS accepts credit card payments, but you’ll pay a fee of about two percent for the convenience, in addition to any charges and interest your credit card issuer assesses
Offer in Compromise
If you cannot repay your entire tax debt because of hardship, the Offer in Compromise allows you to settle your debt for less than the full amount owed.
Partial Payment Installment Agreement
Another repayment option is the Partial Payment Installment Agreement, or PPIA. This agreement is for those who are willing to make installment payments, but who can’t afford a payment that would fully discharge their liability within the ten-year statute of limitations. It is a hybrid of a payment plan and an Offer in Compromise.
The IRS is not infallible. You have the right to due process, meaning you can represented by a tax attorney, Certified Public Accountant, or Enrolled Agent (a tax professional licensed to practice in tax court). You have the right to appeal its decisions in tax court. Your other civil rights, including the right to financial privacy, remain in force when dealing with the IRS. The IRS publishes its Taxpayer Bill of Rights online.
Statutes of Limitations
The statute of limitations for collecting taxes owed is ten years. That means once the IRS bills you for taxes, it has ten years to take you to court, garnish your wages, or levy your assets.
Preventing Tax Debt
There are ways of avoiding ugly and expensive tax surprises. If you’re a wage earner, the IRS has worksheets to help you determine the proper number of exemptions to claim on your Form W-4. Don’t just guess, because that can be expensive. When dealing with multiple jobs or earners, consider the total income when estimating, not from each job individually.
When you sell stocks or other assets, determine your gain on the sale (your sales proceeds less your acquisition cost, or basis), and set aside enough proceeds to cover the taxes due.
If self-employed, you should be completing form 1040-ES four times a year if you anticipate owing more than $1,000 in taxes when you file. The worksheets walk you through estimating your taxes and determining your payment.
Be proactive and amend a return if you realize you filed a return with a mistake on it. The longer the time that passes before the IRS catches it, the more interest and penalties will fall on you.
Getting Help with Tax Debt
If you’re overwhelmed by tax debt, you have options.
- Contact the IRS. You can call them, go to the office in person or download and submit the required forms yourself to settle your debt or get a payment plan.
- If you dispute the amount owed, you can file an appeal yourself with the IRS Office of Appeals, or you can contact a tax attorney, CPA or EA to argue your case for you. These professionals can also help you with an Offer in Compromise or PPIA if you qualify.
- You can contact a tax settlement or tax resolution firm. These companies specialize in helping taxpayers negotiate with the IRS. They vary in quality, so choose a reputable one – the FTC says beware of outfits that charge high fees upfront, and do not provide personal information to anyone until you know they are legitimate – identity thieves may mask as companies and steal your information. Check the Better Business Bureau rating and only work with a firm that employs a CPA, tax attorney or EA.
- You can file bankruptcy. Under the right circumstances, you can discharge tax debt in a bankruptcy.
- Only income taxes can be eliminated in bankruptcy.
- You cannot commit fraud or willful evasion.
- The debt must be for a return that was due at least three years before.
- You must have filed a tax return at least one year ago.
- The assessment must be at least 240 days old.
Tax debt can be dealt with, and you can move on from it. Don’t ignore it, seek the help you need, and follow through. Then take steps to avoid it in the future.