One of the most nerve-wracking experiences an American can have is discovering they owe money to the Internal Revenue Service and cannot pay what is owed. Sometimes people just don’t submit a tax return and pretend nothing is wrong. Other times, they submit their return but do nothing about the outstanding tax arrears. Both responses put the taxpayer’s assets and freedom in jeopardy if the Service decides to pursue them for the unpaid tax.
The purpose of this article is to briefly explain what to do (and not do) if you discover you owe money you can’t pay when you begin filling out your tax return. First, I will explain why you absolutely should file your income tax return on time every year even if cannot pay the tax owed. Second, the options available will be discussed.
Please note that this discussion will be limited to federal income tax issues. Over half of the United States also must pay state income tax and some even owe local taxes. While the discussion here might be applicable to your individual state, you should seek advice from a licensed attorney in your area for specific direction. Additionally, this article is limited to individuals only.
1) Why You Should ALWAYS File a Federal Income Tax Return
A) It’s a crime to not do so.
You read that right. Anyone who makes over $12,500 in a single year — and even less in certain circumstances — is obligated to file a federal income tax return.[i] It’s a federal crime to not file an income tax return if you’re required to do so.[ii] Failing to file a return is a federal misdemeanor which is punishable by up to a year in prison and a fine of $25,000. If the Service feels you intentionally did not file your tax return in order to evade paying your taxes, it can potentially upgrade this to a felony which is punishable by up to five years in prison and a fine of up to $100,000.[iii]
B) The Statute of Limitations Does Not Begin Running.
Once tax has been assessed, the IRS generally has ten years to collect on any unpaid tax owed by a taxpayer.[iv] The problem is that tax is “assessed” only after a tax return is filed. The result being that the IRS has unlimited time to collect on its unpaid tax if a taxpayer never files a return.
You might think this is a good idea nonetheless. If tax is never assessed, you never have a debt, right? Wrong. The Service will eventually file a tax return on your behalf in order to facilitate assessment. It will also add in penalties, fees, and interest which will only inflate the tax owed.
2) So What Should You Do If You Owe Tax You Cannot Afford to Pay?
Let’s assume you filed a return and received a letter from the IRS requesting payment for the tax you cannot afford to pay. Where do you go from there? The answer will largely depend on your individual circumstances. How much you owe, how much you make per year, how many dependents you have, and several other factors must be analyzed before a choice can be recommended. With that said, here are four broad options available to a taxpayer in such a position.
A) Do Nothing.
Owing the IRS money is not a crime in itself. Similarly, they cannot put you in prison for just failing to pay the Service. Criminal penalties only begin to become an issue if a taxpayer takes steps to hide assets, lie, or otherwise evade paying his or her tax debt.
You might then ask: why isn’t doing nothing a viable option? The answer is what the Service will do in response. First, any tax return you have will be kept to go toward your tax debt. This makes some intuitive sense. Why would they return money you overpaid in one year when you underpaid in another?
Second, the Service will engage in collections activities. The IRS has the power to levy bank accounts, garnish wages, and place liens on property owned by the taxpayer. If a taxpayer does nothing about an underlying debt, he or she might wake up one day to find her rent money was taken from her bank account due to a levy imposed by the IRS.
Finally, the IRS could reduce the debt to a judgment and seek to seize assets owned by the taxpayer. As mentioned above, the statute of limitations for collections is generally ten years BUT the Service could reduce that debt to a court judgment and use all the powers of a creditor to collect. This can include having a sheriff seize personal property through a writ of execution. Once reduced to a judgment, the Service may get ten or more years to continue trying to collect on your unpaid tax debt.
While doing nothing is an option, it is far from ideal for all these reasons.
B) Become Classified As “Currently Not Collectible”
Most Americans live paycheck-to-paycheck and cannot afford to pay $1,000 for an emergency.[v] If they cannot replace a tire when needed, they definitely cannot pay the IRS. Because of that, the Service is willing to suspend collections activities if collecting unpaid tax would impose a hardship on the taxpayer. This is known as “Currently Not Collectible” status.
To become classified as Currently Not Collectible, a taxpayer must submit detailed financial information to the Service for it to assess whether collection efforts would impose such a hardship. This will include lists of all assets, income sources, monthly expenses, and any sources of credit available. If the Service determines collection efforts would cause the taxpayer to become homeless or unable to support the household, it will stop.
While this is a good step, it isn’t an ideal one. First, the Service reassesses whether to attempt collections every year when the taxpayer files a new return with his or her income information. Any increase might result in a loss of Currently Not Collectible Status. Second, penalties, interest, and fees continue to accrue during the entire period. This can make resolving the debt even harder later on. Finally, the Service will still seize most tax returns and apply them toward the tax debt.
If the taxpayer is in Currently Not Collectible status and maintains it for ten years without the Service reducing the debt to a court judgment, the debt will go away. Ten years is a long time with Uncle Sam watching over one’s shoulder. With that said, such an option is still better than doing nothing.
C) Payment Plans
The IRS, like most creditors, does offer a payment plan option. If a taxpayer’s income is too high or they have too many assets to become classified as Currently Not Collectible, this can be a cheaper option to avoid surprise bank levies or wage garnishments. At the end of the day, something is better than nothing, right?
There is, however, one significant problem with payment plans. Even though payment arrangements have been made, interest, fees, and penalties continue to accrue. The result is that the taxpayer could pay for the entire ten-year statute of limitations without so much as making a dent in the principal amount.
D) Offers in Compromise
This final option is, in my opinion, the best method of eliminating owed tax debt. Like most creditors, the IRS will accept less than the money owed in exchange for treating the debt as paid-in-full. Collecting something is better than nothing, right?
The major drawback is that a taxpayer must have some amount of money to apply toward the debt. While the Service has accepted offers as low as $1, one should expect to pay roughly 50% of the debt; there is no set percentage it will accept. Most taxpayers must include 20% of the underlying debt in the initial offer. If the Service declines the offer, the payment will be applied to the tax debt rather than refunded back.
The steps are similar to becoming classified as Currently Not Collectible: supply detailed financial information, complete the forms required, and submit along with any required amount due up-front. The offer can be in one lump sum or it can be spread across a limited number of payments within one year. If accepted, then compliance with the debt will result it being paid in full.
There are some caveats, however. First, the Service will impose various conditions AFTER payment that the taxpayer must comply with. These generally include filing a tax return every year for five years afterward and staying compliant with any future tax debt. Second, the statute of limitations for collections is tolled while the Service considers your offer. This can take months and is thus a significant extension of time for the IRS to levy bank accounts and garnish wages.
With all that said, an Offer in Compromise can effectively resolve a tax debt without paying the full amount or waiting ten years for the statute of limitations to run.
As mentioned above, your individual circumstances largely determine which option is best if you owe unpaid tax. Do you have unfiled tax returns or is the IRS attempting to collect unpaid tax? Please feel free to reach out for a consultation through either the website’s Contact Us form, calling our office at (903) 221-9180, or emailing me directly at firstname.lastname@example.org.
Note: This article was not written with any particular state law in mind. It is generalized information intended to be used exclusively for educational purposes. This is not legal advice, and no attorney-client relationship has been formed between the reader and the Law Office of Matthew C. Lewis.
[i] I.R.S. Pub. 501 (2021), https://www.irs.gov/publications/p501.
[ii] I.R.C. § 7203.
[iii] Id. at § 7201.
[iv] I.R.C. § 6502.
[v] Carmen Reinicke, 56% of Americans can’t cover a $1,000 emergency expense with savings, CNBC (Jan. 19 2022, 12:21 PM EST).