Tax Dilemma: Seven Options If You Can't Pay Your Taxes

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Tax day comes a few days late in 2011 – on April 18 instead of the usual April 15. If you're worried about owing the IRS money this year, that extra weekend offers you a little more time to figure out how you are going to pay what you owe.

Of course, if you can afford to write a check and pay off your tax debt, that's your best bet. But if you don't have the cash available to do that, read on. There are other options. Keep in mind, of course, tax rules change frequently, so talk with your tax preparer or check with the IRS for updates to this information.

Pay…or Else

One of the main reasons it's important to find a way to deal with your tax debt is that if you don't pay what you owe, the IRS may file a Notice of Federal Tax Lien. Tax liens are reported on your credit reports, and they are one of the most negative types of information that can be reported. Your credit score can drop significantly as a result.

[Related: When Will the IRS Place a Tax Lien?]

Even without filing a lien, however, the IRS can take serious enforced collection action, such as taking money from your bank accounts, wages, or other income—or taking other assets. In general, they have many more options available to collect your tax debt than traditional companies to whom you may owe money.

Option #1: Don't File (Bad Choice)

Not filing your tax return because you can't pay what you owe is not a valid option, even though some taxpayers are choosing to go that route.

"We're seeing people who have perfect records (of paying taxes) who aren't even filing because they can't pay," warns Scott Estill, a tax attorney with Estill & Long LLC and the author of Tax This! An insider's Guide to Standing Up to the IRS (8th Edition 2011). There is a thought that if you don't file, you don't have to pay, but that's wrong."

You may have to pay a steep failure-to-file penalty if you don't file your return by the due date (including extensions). The penalty is usually 5% for each month or part of a month that a return is late, up to a total of 25% of the amount not paid by the due date. That means the tax bill you already can't afford to pay becomes that much harder to pay.

Option #2: Charge It! The IRS will accept payments by major credit card (American Express, Discover, MasterCard, or VISA credit card). You can pay by phone, Internet or when e-filing.

The IRS doesn't collect fees for credit card payments, but the companies that process these transactions are allowed to charge a "convenience fee," which ranges from 1.90% – 2.35% of the amount charged. In addition to the convenience fee, you will pay interest on the amount you charge at whatever rate your issuer charges. This can make this a pretty costly option – but at least you won't owe the IRS.

Tip: If your credit card issuer sends you promotional checks, you can use one of these to pay your taxes. You won't receive reward points or other offers, but you won't pay a convenience fee and the interest rate may be lower than your normal interest rate for purchases. Watch out for fees associated with these checks – they can be higher than the convenience fee that would be charged if you use your credit card. If there are fees, ask the issuer whether it will waive them.

[Related: Four Reasons Why You Should Not Use Your Credit Card to Pay Taxes]

Option #3: Use a Personal Loan

Whether it's a personal loan, a home equity line of credit, or a loan from your retirement account, there are times when it makes sense to borrow to pay off the IRS. Here are some questions you will want to ask yourself before you go this route:

Questions to ask yourself before using a loan to pay your tax debt:

- Will using a personal loan help you avoid a tax lien? If so, this may be a good option since tax liens can hurt your credit scores significantly.

- What is the interest rate? How does that compare with an installment agreement through the IRS? (See option #4: Request a Payment Plan from the IRS.)

- Can I really afford the payments? Before you tap home equity or borrow against a retirement account, for example, make sure you can afford the payments. If not, you may be better off considering options like an Offer in Compromise. (See option #6: Offer in Compromise.)

Estill warns that using a home equity loan to pay the IRS is particularly risky. "If you use a HELOC or other loan tied to your house and you default, you may lose your house so taxpayers should be very careful about proceeding in this manner," he says. "It is very unlikely, though, that the IRS would foreclose on its tax lien and try to sell the house at a foreclosure/tax sale."

[Related: IRS Eases Up on Tax Liens: Good News for Credit Scores]

Option #4: Request a Payment Plan from the IRS

If you can't pay your tax bill right away, but the debt would be manageable if you had more time to pay, you can request an installment agreement that allows you to make monthly payments until your tax bill is resolved. You can only request this option if you are current on filing all of your tax returns.

If you owe $25,000 or less in combined tax, penalties, and interest, you can use the IRS Online Payment Agreement (OPA) to request your installment agreement, or you can call number listed on the bill or notice you received. If you need to mail in a request, you can use the Request for Installment Agreement, Form 9465.

You'll pay a fee to set up an installment agreement. For the 2010 tax year, the cost is $52 if you agree to have the monthly payments taken from your bank or credit union account, or $105 if you want to pay by check or have payments withheld from your paycheck.

You'll also pay interest compounded daily—plus a late payment penalty. This penalty, usually 0.5% of the balance due per month, drops to 0.25% when the IRS approves the agreement for an individual taxpayer who filed the return on time and did not receive a levy notice. The penalty will be charged until it reaches 25% of the original balance due.

[Resource: Prioritizing Financial Literacy in 2011]

What interest rate will I pay?

For individual taxpayers the underpayment rate is the federal short-term rate plus 3 percentage points. For example, for the first quarter of 2011, the rate is 4%. This rate changes quarterly, and may increase.

Installment agreement requests are automatically approved, as long as:

- You have filed your tax returns on time for the last five years, - You've paid the taxes you've owed during that time without using an installment agreement, - The IRS determines you can't pay the full amount you owe right away, - You agree to pay your tax bill in full within three years.

There's bad news too, though. Even if the IRS approves your installment agreement and you make your payments on time, the IRS may still file a Notice of Federal Tax Lien. However, if you owe less than $10,000 you will probably avoid a tax lien. And if you enter into an installment agreement and allow the IRS to deduct payments from your bank account each month, you can request that the IRS withdraw the tax lien after you've successfully made several payments. This is part of the IRS Fresh Start program launched in 2011.

Option #5: Request a Short-term Extension

If you can come up with the money you need to pay your tax bill within the next four months, you may be eligible for a short-term extension to pay — up to 120 days. (This is different than the extension to file that gives you additional time to file your tax return.) You will have to file a completed Form 1127 along with a statement explaining why paying now would be a financial hardship for you. There is no fee associated with this form.

Estill warns that the IRS does not approve the majority of these requests. Form 1127 is complicated and requires you to provide the IRS with a detailed list of your assets, along with your itemized spending and income for the last three months. He says that most taxpayers will be better off requesting an installment agreement or an offer in compromise, or finding another way to pay.

Option #6: Request an Offer in Compromise

An Offer in Compromise (OIC) is an agreement between a taxpayer and the IRS that resolves the taxpayer's tax debt. It essentially allows you to settle your debt for less than you owe, under certain circumstances. An Offer in Compromise might be used if there is a reasonable doubt that the tax liability is correct, if there is doubt the taxpayer could pay the tax debt, or if paying the tax would create an economic hardship for the taxpayer. Historically, it's been very difficult to get an OIC approved. In the past, the IRS said it resolved less than 1% of all balance due accounts through an OIC program.

In early 2011, however, the IRS announced it was expanding a new streamlined Offer in Compromise (OIC) program to cover a larger group of struggling taxpayers.

The new streamlined OIC allows taxpayers with annual incomes up to $100,000 to resolve up to $50,000 in tax debt (up from $25,000 or less previously). This does not mean you cannot try to get an OIC if you make more than $100,000 or owe more than $50,000. It simply means you won't be eligible for the streamlined program.

More Options If You Can't Pay Your Taxes

If you apply for an OIC, you'll have to submit Form 656 and include a $150 fee (waived for low-income taxpayers).

If you propose a lump sum offer that will resolve the debt in five or fewer installments, you must include a non-refundable payment of 20 percent of the offer when you file Form 656. (There are additional OIC payment options available to small businesses.) If you propose a "periodic payment offer" (six or more installments), you must pay the first proposed installment payment with your application, and make additional non-refundable payments while the IRS evaluates the offer. (Payments may be waived for certain low-income taxpayers, or where there is a doubt as to the liability.)

The IRS generally has 24 months to accept or reject your offer, or negotiate a further compromise.

Should you get help applying for an Offer in Compromise? You may have seen ads on television or online from companies promising to help you settle your tax bill. These ads are usually offering services to help filing for an OIC. Be careful. The IRS warns that some companies are collecting excessive fees from consumers who will never qualify for these programs. The IRS says you can complete all the paperwork on your own by following the instructions found at the IRS website.

On the other hand, getting an OIC approved can be difficult. Estill recommends you consult with a CPA, Enrolled Agent or tax attorney who does a lot of work in this area and is familiar with the process. "The more you owe, the more likely you are to get an OIC," he says.

Option #7: Apply for Currently Non-collectible Status

If you can't afford an installment agreement or an Offer in Compromise, and have no other way to pay the taxes you owe, you may be able to get a temporary reprieve by applying for currently non-collectible status, says Estill. You'll typically have to complete a Form 433-F detailing your financial situation. "If you qualify you may be able to put your tax bill on hold," says Estill, "and the IRS would reevaluate it again in a year." He says you can call the IRS and explain your situation to find out whether you qualify. Interest and penalties will continue to accrue, however, making this a potentially expensive option.

Look Forward

Once you've figured out how to resolve this year's tax bill, make sure you adjust your withholding or increase your estimated tax payments. You don't want to be in the same situation next year!

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