You can be in a streamlined monthly installment plan to pay back income taxes even if you owe the IRS a lot of money. But should you be?
The IRS “Streamlined Installment Agreement”
Under its “Fresh Start” initiative, started in 2008 during the Great Recession and expanded two years ago, the IRS allows the following:
- If a taxpayer owes $50,000 or less to the IRS in tax, interest and penalties, he or she can enter into a monthly installment plan to pay the debt. That maximum dollar amount was increased in 2012 from the previous $25,000.
- The total amount due can be paid over the course of as many as 72 months. This is an increase from the earlier 60-month limit.
- “Streamlined” means that below this maximum dollar amount and length of payment period, the taxpayer does not need to give the IRS a financial statement.
Its Potential Problems, the Possibly Better Bankruptcy Solutions
Whether to settle your debts owed to the IRS through its installment payment program vs. doing so through some bankruptcy solution certainly depends on your individual circumstances. Sometimes the IRS’s payment program is definitely the best way to go, but often it is not. The purpose of this blog post is to give examples of reasons why you should at least consider the bankruptcy options in certain circumstances.
Some Income Taxes Do Not Have to Be Paid
The IRS payment program requires you to pay all your taxes, every penny, even taxes that are quite old.
In contrast, under Chapter 7 “straight bankruptcy” you may be able to legally discharge (write off and never have to pay) some of those taxes, including many that are just a few years old. Under a Chapter 13 “adjustment of debts” those same older taxes could be paid little or nothing, essentially based on what you can afford, regardless how much you owe in taxes. These would be paid something only after you paid other more important debts, with the unpaid balance then also forever discharged.
Can Avoid Ongoing, Fast-Accruing Penalties
Under the IRS installment payment plan you are required to pay all accruing penalties. The penalties can easily reach 50% of the tax amount. There are usually two main penalties. The failure-to-file penalty is 5% of the tax-due amount, assessed every month or portion of the month that the tax return is past due, up to a maximum of 25% of the tax due amount. The failure-to-pay penalty accrues more slowly—0.5% per month—but can also total as much as 25% of the tax amount.
In contrast, under Chapter 13, no more penalties accrue from the day your case is filed. Previous accrued penalties are often paid little or nothing. Under Chapter 7 if the tax is old enough the penalties are discharged along with the tax. If the tax is not old enough to discharge, the penalties continue to accrue but at least you’ve discharged all or most of your other debts so that you can focus all your available money on paying off the tax debt as fast as possible, thereby reducing the amount of penalties accruing before the tax is paid off.
Can Avoid Ongoing, Compounding Interest
Under the IRS payment plan, you are required to pay all accruing interest until the tax, penalties, and interest are all paid in full. The interest rate is currently relatively low—3%—but it can change quarterly. It was 9% during parts of the year 2000 and as high as 16% back in 1983, so it certainly could go up as other interest rates do. Also interest accrues on the unpaid tax AND also on the penalties. Plus interest compounds daily, so you’re also paying interest on the daily accruing interest.
In contrast, under Chapter 13, in most cases no more interest accrues from the day your case is filed. Under Chapter 7, if the tax is old enough, the accumulated interest is discharged along with the tax. If the tax is not old enough to discharge, the interest continue to accrue but, again, at least you’ve discharged all or most of your other debts so that you can focus all your available money on paying off the tax debt as fast as possible, thereby reducing the amount of interest accruing before the tax is paid off.
Limited Flexibility/No Protection from the IRS
In setting up your monthly installment payment amount, the IRS generally does not care much about your other important and/or urgent creditors. Also, if your financial circumstances change and you need to reduce your payment amount, you are at the mercy of the IRS’s rules and discretion about whether and to what extent you can do so.
In contrast, during a Chapter 13 case (which usually lasts 3 to 5 years), other creditors which are more important to you can often be paid ahead of the IRS. The newer tax debts that must be paid are paid based on your budget, not on the whim of the IRS. And throughout the payment period, the IRS can almost never take any collection action against you or against any of your money or assets.
And during a Chapter 7 case (which usually lasts only about 4 months) the IRS cannot take any collection action against you or any of your money or assets. If an older tax gets discharged in the case, the IRS can never again try to make you pay that tax.
Goes Counter to Sensible Pre-Bankruptcy Planning
The IRS payment plan requires you to pay your oldest taxes first. That may seem sensible. But that is generally contrary to wise pre-bankruptcy planning. Because older taxes either can be discharged or are usually closer to being able to be discharged in an anticipated bankruptcy case, it’s often in your best interest to NOT pay the older taxes. Instead if you have money available you should pay the newer taxes which would not be able to be discharged when you file that anticipated bankruptcy.
Avoid Falling Further and Further Behind
Simply put, the IRS payment plan can be a trap that devours years of your financial life as you fall further and further behind in your taxes (and probably on your other debts as well). By allowing you to fall as much as $50,000 behind on your taxes, and giving you 72 months to pay it—all without needing to document any evidence of your ability to pay it off eventually—you could be paying back taxes, and accruing ongoing interest and penalties, year after year. It could easily become a vicious cycle, in which you are struggling to pay off the tax of two or three years ago, along with its constantly accruing penalties and interest, so that you are unable to pay an adequate amount of wage withholding or estimated quarterly taxes for the current tax year.
If you see yourself heading in this direction, you would be wise to seek out a bankruptcy attorney to learn more about the bankruptcy options. Feel free to read some of the other blog posts on this website of the last month or so about income tax issues and bankruptcy. And if you live anywhere near our office, give us a call.