When Tax Liabilities Can't Be Paid - Risks, Ramifications and Resolutions
By Michael A. Gillen and Steven M. Packer
April 1, 2008
The Legal Intelligencer
With more than 60,000 people leaving the workforce in February, the largest drop in payrolls in four years, the continued housing and credit crunch and the current volatility in the financial markets, some of your clients may be facing serious financial difficulties and may be unable to pay their upcoming tax obligations. Unaware of the alternatives and fearful of the consequences, many of these individuals delay taking action in the hopes that the Internal Revenue Service will simply disappear.
First, and most importantly, do not ignore the IRS, and do not let your inability to pay your tax liability in full keep you from timely filing or extending your tax return. If you do, your penalties will significantly increase and the IRS, generally a preferred creditor, will likely exercise its wide reaching levy, lien, collection and seizure authority. If tax obligations are not paid timely, or other arrangements are not made with the IRS, penalties will escalate, as will the risk of enforced collection efforts by the IRS along with the business and personal embarrassments that typically follow. In many cases, these tax nightmares can be avoided by consulting with a qualified and experienced tax professional and taking advantage of the best available alternatives, all of which will typically stop the IRS from raising its mighty hand.
Some of the options available to individuals and businesses confronted with this dilemma include the filing of a request for abatement of penalties, entering into a short or long-term installment payment agreement, the filing of an offer in compromise or filing for bankruptcy.
Overview of the Most Common Penalties
The most frequently imposed penalties are the failure to file and failure to pay penalties. These penalties can be quite substantial, therefore, if full payment cannot be made when filing the tax return, include as large a payment as possible when filing the tax return. Filing the return with the largest possible payment in and of itself can reduce penalties substantially. The failure to file penalty accrues at the rate of 5 percent a month (to a maximum of 25 percent) on the outstanding balance due. The failure to pay penalty is somewhat gentler, accruing at the rate of only .5 percent a month (to a maximum of 25 percent) on the unpaid balance due.
Both of these penalties are in addition to the interest charged for late payment, which is currently assessed at a rate of 6 percent. Additionally, if estimated tax payments were also disregarded or delayed or insufficiently paid, an additional penalty (currently 7 percent) is tacked on for the period running from each payment's due date until the tax return due date, April 15 (or earlier, if the payment is made earlier).
These penalties add up quickly and can be as much as the tax obligation itself in a short period of time.
Undue Hardship Extensions
It's important to recognize that an extension of time to file a tax return does not mean a concurrent extension of time to pay any tax due that exists. An extension of time for payment may be available, however, if it can be shown that payment would cause undue hardship. Failure to pay penalty can be avoided if an extension is granted, but interest will still accrue. If qualified, a short extension of time to pay the tax shown as due on the return of up to 120 days will be granted.
To establish undue hardship it must be shown that it would be more than just inconvenient to pay the tax when due. For example, undue hardship might be established if property would need to be sold at a sacrifice price to satisfy the tax liability. However, if a market does exist, selling property at the current market price is not viewed as resulting in undue hardship.
A taxpayer must establish that insufficient cash and assets convertible into cash in excess of current working capital exists to meet current tax obligations. Additionally a taxpayer must demonstrate that he or she has no borrowing capacity to satisfy the tax obligation except on terms that would inflict serious loss and hardship.
To qualify for the undue hardship extension, security for the tax obligation must be provided. The determination of the kind of security – such as a 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 the application for a hardship extension is granted, any collateral agreed upon with the IRS must be deposited. No collateral will be required if no assets exist.
There is a specific process used to apply for an undue hardship extension. A statement of assets and liabilities must be submitted with an itemized list of receipts and disbursements for the three months preceding the tax due date. Be very careful when undertaking an application for the extension, as the IRS will examine these requests in great depth.
Another alternative for deferring payment of a current tax obligation is to request an installment agreement with the IRS. Such an agreement can last up to five years. This option is much simpler than the hardship extension application process, however, penalties and interest still accrue while the installment agreement is in effect. Thus, attempts should be made to make payments as large as reasonably possible as soon as possible to minimize these additional charges.
Specific forms are necessary to request an installment agreement and the IRS charges a small installment agreement user fee up to $105, which can be added to the tax due. Less information than the hardship extension application is required and if the liability is under $25,000 submission of financial statements is not required. More than $25,000 in combined tax, penalties and interest may still qualify for an installment agreement, but Form 433F, Collection Information Statement, must be completed and submitted.
Additionally, an installment agreement request can be submitted after the hardship extension period expires.
It is vital for a taxpayer to respect the terms of the installment agreement as it may be terminated and all unpaid tax obligations become due immediately if any of the following occur:
- The information provided to IRS in applying for the agreement proves inaccurate or incomplete;
- An installment is missed;
- Other tax liabilities are not paid when due;
- IRS believes collection of the tax involved is in jeopardy; or
- Update of financial condition is not presented when the IRS makes a reasonable request for such update.
Finally, all required tax returns and payments, inclusive of any required estimated tax payments or federal tax deposits must be filed and paid timely during the life of the installment agreement for the agreement to remain in effect and valid. As a condition of the agreement, refunds due in any future year will be applied to the amount owed.
Offers in Compromise
Under certain circumstances an individual or business taxpayer may compromise or settle a liability with the IRS by offering to pay a smaller sum as payment in full, even though a larger sum may be owed. The offer in compromise process allows the settling of disputed issues without resorting to costly litigation for both the taxpayer and the government. It accomplishes this by establishing an agreement between a taxpayer and the IRS.
The IRS will accept an offer in compromise to settle a tax deficiency for amounts less than the amount owed, when there is either doubt as to the taxpayer's ability to ever pay the full amount of the tax owed, or doubt as to the correct amount of the tax liability assessed. The ultimate goal of an offer in compromise is a settlement that is in the best interest of both the IRS and the taxpayer. It is the taxpayer's responsibility to show how the offer would be in the best interest of the government. The offer must equal or exceed what is known as the reasonable collection potential, defined as the amount which is expected to be realized through asset sales less any amounts owed to secured creditors. In order to be considered for an offer in compromise, a taxpayer must not be a debtor in any open bankruptcy proceeding.
Taxpayers submitting lump-sum offers must make a 20 percent nonrefundable, up-front payment to the IRS, and taxpayers submitting a periodic-payment offer in compromise must make a nonrefundable, up-front payment, plus any other proposed payments that may be due, while the IRS is evaluating the offer.
In evaluating an offer, the IRS considers the amount collectible from assets, from present and future income, from third parties (i.e., family members, friends, bank, credit cards) and sources of funds that are available but are not subject to the IRS's reach (i.e., workers' compensation and veterans benefits, spouse financial condition, etc.).
When doubt as to collectibility exists, the taxpayer must complete Form 433-A or B, Collection Information Statement for Individuals (A) or Businesses (B) disclosing all assets owned, all liabilities owed and net monthly income after taking into consideration ordinary and necessary living expenses. When special circumstances exist, such as advanced age, serious illness, among other circumstances, the taxpayer should provide a compelling statement with the offer explaining the basis for the offer.
Once an offer is accepted, the taxpayer is required to remit the agreed-upon amount, satisfy all terms of the offer and remain in compliance and current with all tax filings and payments for a period of five years following acceptance of the offer in compromise, or until the offer in compromise is paid in full, whichever is longer. Once the amount is paid in full, the tax liability is considered settled and removed from the taxpayers' records. In essence the taxpayer is provided a "fresh start."
Separate and apart from penalty and interest accrual, there could be negative implications of requesting an installment agreement or filing an offer in compromise, the greatest of which is providing the IRS a financial road map for seizure and enforced collection action in the event the installment request or offer is rejected, withdrawn or the taxpayer defaults on either agreement. Additionally, submission of an offer in compromise will automatically extend the statute of limitations for collection during the pendency of the offer, plus one year.
It is critically important that taxpayers suffering financial hardship and who are unable to pay their current tax obligations not ignore them, but consult with a qualified and seasoned tax professional to avoid or minimize interest and penalty assessments and aggressive IRS collection, enforcement and seizure activity.
Michael A. Gillen is the director of the Tax Accounting Group of Duane Morris, a group of certified public accountants providing tax, accounting and consulting services as an ancillary business of the law firm, where he devotes his practice to federal, state and local income taxation and litigation consulting services.
Steven M. Packer is a manager in the Tax Accounting Group of Duane Morris, where he devotes his practice to federal, state and local income taxation, litigation consulting services and business development.
As required by United States Treasury Regulations, you should be aware that this communication is not intended by the sender to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.
This article originally appeared in The Legal Intelligencer and is republished here with permission from law.com.