How to Get Out of Tax Debt
Not many things in life can be more stressful than owing the IRS money, particularly if you can't easily lay your hands on it. What should you do? How should you deal with the IRS? What are your options?
First step is to get an overview of how much is owed.
It's important to document how much unpaid tax you owe for each tax year and for each tax agency. This will become a useful summary of your tax situation, and will help you keep track of what's going on.
Let's take an example. Billy, who lives and works in Ohio, emailed me. "I owe the IRS about $30,000 for the last two years of tax returns," Billy said. "I have already filed the return, but I am considering the amending the return to take advantage of tax deductions I overlooked in my haste to file the returns quickly. I am also reading about Tax Amnesty. Are there special CPA's out there who deal only with this scenario? I have seen a lot of ads promising tax freedom, but I don't want to cheat the government or to reduce my debt to nothing. I just want to try as hard as I can to pay this. Where should I start looking?"
Billy's email provides a terrific example to help us get started. Notice the details. Just from his email, we know that Billy owes approximately thirty thousand dollars to the IRS for his federal income tax. This is related to the last two years. He has already filed his tax returns.
All Billy needs to do now is figure out how to pay the IRS.
Whenever I begin working on tax debt project, I start by creating a spreadsheet with just the details needed to provide an overview of the situation. I'm going to take the details that Billy shared in his email, and re-arrange these details into a spreadsheet format that might look like this:
|State of Ohio tax|
Current balance due
As of (date)
Current balance due
As of (date)
mailed check with 2014 tax return on 4/10/2016
Qualify for an installment agreement?
mailed check with 2015 tax return on 4/15/2016
Is the federal subtotal $50,000 or less?
mailed check with payment voucher on 6/15/2016
Are all tax returns filed?
waiting for bill for penalty and interest
If both are yes, then the client qualifies for an installment agreement
Client will be paid in full with Ohio after client pays any penalties and interest.
Calculate the Minimum payment the IRS would accept:
Round up to a whole dollar amount
I have taken the liberty of specifying more details than Billy shared in his email.
With this spreadsheet, we can see at a glance:
- The client has filed all his tax returns
- The client's state taxes are pretty much paid off. There was a balance due when the returns were filed, and the client mailed in checks. The client will owe some late penalties, and the client expects to pay that in full when those billing letters arrive from the state.
- So the only remaining problem is figuring out how to pay the IRS.
- We can tell that the client will qualify for an installment agreement with the IRS.
- And we know how much the minimum payment the IRS would accept if we set up an installment agreement.
A spreadsheet such as the one above helps us keep the big picture in mind. If the client's situation is more complex, we can build off this basic spreadsheet template.
Second step is to figure out if an installment agreement is the right option.
The IRS will approve an installment agreement if, among other things, the client has filed all tax returns and the total balance owed for all years is less than or equal to $50,000. If you owe more than fifty thousand dollars, your next step to conduct a thorough financial analysis, which is discussed in the third step, below.
Billy owes just over $30,000 to the IRS. And he has filed all his tax returns. Billy did file his 2014 tax return late. If Billy had asked the IRS for an installment agreement a few months ago, the IRS would not approve his request. Instead, the IRS would have told Billy to first file his missing tax returns, and then set up a payment plan once the IRS processed the tax returns. Now that Billy has filed all his tax returns, he can now proceed to setting up an installment agreement.
Billy's outstanding balance due is around $30,000. His total balance due is less than $50,000. So he qualifies for a streamlined installment agreement. Streamlined means the IRS does not ask Billy any questions about his current financial situation. All Billy needs to do is figure out if he can afford to pay the $422 minimum payment each and every month. Billy might need to re-arrange his finances. He might need to cut back on spending in other areas of his life. Or he might need to generate more income. Two important things to note here:
- Billy can agree to any payment amount as long as the payment amount is at least the minimum the IRS will accept.
- You can always pay more, but you can never pay less, than the amount you agree to pay the IRS each month.
The minimum payment is calculated by taking the grand total owed to the IRS for all tax years (including penalties and interest), and dividing that total balance due amount by 72.
In Billy's situation, the minimum payment the IRS will accept is $422 per month. Billy could set up his installment agreement for $450 per month, or $515 per month, or any amount just so long as the amount is at least the minimum of $422 per month.
In general, I advise clients to set up their installment agreement for the minimum amount the IRS will accept, and to pay extra when they can. Suppose Billy tells me, "Yeah, I can afford to pay $422 per month. I'd rather make the payment for $500, though, because I want to hurry up and get this debt to the IRS paid off." That's an admirable goal. Billy certainly could set up his installment agreement for $500 a month. The IRS would approve that amount, as it is at least or more than the minimum payment. And here's where I push back on the client. What is the likelihood that you might need to skip a payment, or pay a lower amount, because your finances get tight? If the client needs some flexibility in his budget, I would much rather have the client set up the installment agreement for the minimum amount and pay extra when they can, rather than setting up the installment agreement for higher payment but have to revise their payments in the future when the client gets into a bind. In Billy's situation, I would recommend he set up his installment agreement for $422 per month, and to make extra payments of $78 per month. Suppose a few months down Billy has an unexpected health issue and needs to come up with $60 a month to pay for medicines he needs. Here, Billy could reduce his extra payments from $78 to $18, and thereby use the $60 he would have sent to the IRS to pay for the new medicines he needs. In this situation, Billy won't need to call the IRS and explain the situation and ask them to revise his monthly payments. Billy can continue along with his minimum payments and remain in compliance with the terms and conditions of his installment agreement.
Let's suppose Billy's health condition gets worse. He needs more medications and more procedures. And now it will be a struggle to afford even the $422 minimum payment to the IRS. If this happens, Billy should call the IRS right away, explain what's going on, and see what the IRS can do. The IRS is surprisingly reasonable and easy to work with if we are being proactive and calling them before skipping a payment.
In step two we are analyzing whether an installment agreement is the right option for the client. To do this, we need to know the total balance owed to the IRS, and calculate the minimum payment the IRS will accept for an installment agreement. In step two we are only concerned with one question: Can the client sustain monthly payments to the IRS for the minimum amount? In Billy's case, can he afford to pay $422 each month?
If yes, then set up the installment agreement for at least the minimum payment amount. Pay extra when you can.
If the client cannot afford to pay the minimum the IRS would accept, then we need to do some in-depth analysis of the person's finances. We'll need to move to step three.
Third step is to conduct a thorough financial analysis.
So far we have been talking about Billy and his tax situation. Billy owes the IRS about thirty thousand dollars. His payments would be $422 per month if we set up a streamlined installment agreement. Billy feels that paying $422 each and every month to the IRS is doable. In fact, he would like to pay more when he can. So we move ahead with a streamlined installment agreement and set that up with the IRS. For Billy, our project is now over.
Now let's take a different scenario. Hilda also owes the IRS about thirty thousand dollars. She is not sure if she can afford to pay the IRS $422 per month. She feels she can afford to pay about $200 per month. Can you guess what we need to do in this situation? We will need to take a close look at Hilda's financial situation. How much money does she make? What is she spending her money on? Are there any circumstances that make her situation unique?
There is a specific process for analyzing one's finances for the purpose of figuring out how much to pay the IRS. We are looking at three aspects of your finances:
- If you were to sell all your assets, how much money could you come up with to pay the IRS? This is a question about your net worth, and we are measuring the current value of your assets and subtracting any loans against those assets.
- Do you have any available credit? Could you borrow money (such as through a credit card or home equity loan) to pay the IRS?
- How much money do you have left over each month after you pay for necessary living expenses? We are measuring your income and subtracting necessary living expenses. This is how much the IRS will expect you to pay to them every month.
Quite often, the crucial question is how much money a person has left over each month after paying for necessary living expenses.
In one sense, all we are doing is subtracting living expenses from a person's income. The amount of income left over after paying living expenses is the amount we would set up a payment plan for. For example, let's say Hilda earns on average $3,600 per month in wage income, and spends on average $3,350 on living expenses. Subtracting living expenses from income, Hilda has $250 left over each month. This net difference between monthly income and monthly expenses is what the IRS would look for in a payment plan.
But in another sense, the IRS often does not take expenses into consideration. By not taking some expenses into consideration, the IRS in effect is saying that the taxpayer is spending too much money, and that more of their income should be going to pay the IRS. The IRS disregards spending in two ways: either by saying the expense is not necessary, or by saying that the expenses is higher than average.
Not every expense counts as necessary living expenses. Necessary expenses, the IRS says, are those "expenses that are necessary to provide for a taxpayer's and his or her family's health and welfare and/or production of income." (Allowable Expense Overview section of the Financial Analysis Handbook, Internal Revenue Manual 18.104.22.168, IRS.gov.) Necessary expenses include:
- Food, groceries, clothing, housekeeping and personal care items.
- Housing and utilities. This includes rent, mortgage payments, property taxes, and homeowner's or renter's insurance. It also includes telephone service, trash, water, gas and electric, propane, cable television and internet service.
- Transportation. This includes car payments, gasoline, oil changes, maintenance and repairs, auto insurance. It also includes public transportation such as bus passes, train, and other mass transit fares.
- Health insurance premiums and out-of-pocket medical expenses.
- Child care.
- Term life insurance premiums.
- Estimated tax payments and withholding for the current tax year.
- Installment payments for past due state and local taxes.
- And other expenses if they can be shown to be necessary for health, welfare or the production of income.
Expenses not only have to be necessary, but they also need to be reasonable. The IRS compares your actual spending to averages. Those averages vary by region, to take into account that some areas have a higher cost of living than other area. These expense averages are called collection financial standards. If a person is spending more than the collection financial standards, then the IRS will assume that a person needs to spend only up to the amount specified by the collection financial standards and that any spending above that amount is discretionary rather than necessary.
Let's go back to Hilda's situation. She feels that she can afford about $200 per month to the IRS. But once we work through her finances, analyzing her assets, debts, income, and necessary living expenses, we find out that Hilda actually has $250 of disposable income every month. Hilda may need to change her spending habits so that can make make room in her budget for the $250 payment plan to the IRS.
Be aware that the IRS will review your financial documents, including bank statements and pay stubs and other documents that verify the your income and spending.
By analyzing your financial situation, you can figure out which method or methods for dealing with the tax debt will make the most sense. And there are seven possibilities:
- We could sell assets to generate some ready cash to pay over to the IRS.
- We could take out a loan or use credit cards to pay the IRS.
- We could pay IRS an amount that would bring the total balance due under $50,000, and thus enable us to set up a streamlined installment agreement.
- We could set up an installment agreement based on our current ability-to-pay.
- We could request an offer-in-compromise, which is a proposal to pay the IRS less than the full amount due.
- We could ask for a deferment, where the IRS agrees that you do not need to make payments until your financial situation improves.
- We could file for bankruptcy, which is a legal procedure for working out a plan to pay off all your debts, including your tax debts.
And sometimes, the right answer is a mix of several of these options.