Don’t let your inability to pay your tax liability in full keep you from filing your tax return properly and on time. Include as large 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

The “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. The “failure to pay” penalty is gentler, accruing at the rate of only ½% 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. 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 is 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 the property at a “sacrifice” price you may qualify. But if a market exists, having to sell the 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.

As a condition to the granting of an extension of time for payment of any tax or deficiency, IRS may require a bond not exceeding twice the tax.

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.

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 $120, 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 the 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 the 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 on 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 doing so. This notice requirement does not apply when the collection of the tax is in jeopardy.

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.

Keith Jarmusch, CPA
Keith Jarmusch, CPA

With over twenty years of combined experience in both industry and in public accounting, DMJ Senior Tax Manager Keith Jarmusch, CPA, has the unique knowledge of how day-to-day issues affect clients and the daily challenges they may face. Keith works with clients in a variety of industries including trucking and transportation, hospitality, medical, and manufacturing.

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