- Tax debt is possibly the worst type of debt to have, so handling it should take priority over most other financial obligations.
- Loans from a bank or retirement savings plan can help settle the debt quickly.
- The IRS may be open to setting up a payment plan or accepting a smaller settlement payment.
A big wad of debt owed to the IRS can be a soul-crushing burden, but the worst thing you can do is to ignore the issue. It will not go away.
"It depends on the level of debt you have, but it can be overwhelming," said Beverly Winstead, a tax attorney based in Laurel, Maryland.
"For some people, $10,000 in IRS debt can seem like $100,000 for someone in my private practice, but you can't bury your head in the sand," she said. "There are options to get you moving in the right direction."
The right direction is resolving the issue by filing current tax returns and setting up a potentially longer-term plan to pay off back-taxes owed.
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The IRS will continue to levy penalties and charge interest on unpaid tax balances until they are settled. In 2019, the service placed nearly 543,604 tax liens on property and issued 782,735 notices of levy to third parties garnishing income from delinquent taxpayers.
The longer you leave a tax debt problem, the deeper the hole will get.
"Taxpayers with IRS debt need to deal with it sooner rather than later, because it can linger for years," said Tom Gibson, a CPA with Tax Saving Professionals in Vero Beach, Florida. "Putting it off will only make it worse."
Gibson suggests taxpayers make resolving tax debt their top priority as far as managing their obligations — trumping even a home mortgage. "The IRS can seize your home or your business assets," he points out.
What do you do if you can't pay?
A first option — particularly for business owners — is to take out a bank loan or line of credit to cover what you owe. The interest may not be deductible, but it will almost certainly be lower than the effective rate charged by the IRS.
Penalties on unpaid tax balances accrue at a rate of 0.5% per month. The IRS also charges interest on the balance at the rate of the federal short-term interest rate — currently 0% — plus 3%. All in that equates to a 9% obligation that will increase further if interest rates rise.
A second alternative is to take out a loan from a qualified pension plan like a 401(k) or an individual retirement account that you can pay back over time. You will miss out on the potential investment returns from the money and there will be some interest due in replacing the funds, but again it will be far less than the carrying cost of debt with the IRS.
Do not simply pull the money from your plan. "I think a lot of people pull it out as a taxable distribution and that makes things much worse," said Gibson.
If paying off the debt immediately is not a viable option, taxpayers can set up an installment payment plan with the IRS of up to 72 months to tackle the issue. For balances of less than $10,000, you can set it up yourself at the irs.gov website without having to disclose any financial data. If the debt is more than that, you'll have to submit information about your monthly income and expenses to the IRS.
"In a lot of instances, people can just handle it themselves on the IRS website," said Winstead. "But if it's too overwhelming, they should at least talk to a lawyer or tax representative about it."
People who can't afford advice can get a free consultation through organizations like the low-income taxpayer clinic Winstead helps run through the University of Maryland.
Taxpayers in truly dire financial straits, who feel they can't cope with a tax debt, can present an "offer in compromise" to the IRS. It is essentially a plea for a reduction of the amount owed. Beware of companies that promise to resolve tax debt for pennies on the dollar. It will take pretty serious circumstances for the IRS to agree to a haircut on tax debt.
Things like catastrophic medical expenses, a lost job or unemployed family members relying on you may qualify. However, if you still have a good income, your chances are probably slim. "The IRS won't likely compromise with a high-earning doctor or dentist," said Gibson.
In 2019, the IRS received 54,225 compromise offers from taxpayers and accepted 17,890 of them, according to IRS data. To make an offer, you will have to be up-to-date on your tax filings and have paid estimated taxes for the current year.
The IRS is not heartless, but its decision will be based on how collectible it thinks your debt is and how exceptional your circumstances are. "At the end of the day, it will depend on how much disposable income you have and how much equity and assets you own to pay the debt," said Winstead.
She suggested that now is the time to address the problem, as the IRS has been more lenient with taxpayers during the pandemic. That may not last.
"As we come out of this, I think they will go back to more normal collection tactics," said Winstead. "If you have unresolved issues with the IRS, now is the time to take a step in the right direction."