What Should I Do If I Owe the IRS But I Don't Have The Money?

by Bill Sweet

Instead of receiving a refund, about 10% of my clients end up owing the IRS an income tax payment on April 15th. It's usually unpleasant because it's a surprise a little less than half of the time. Poop happens.

When it is unexpected, the hopeful question that I'm always asked is this: "Should I file an extension?"

The answer is almost always no.

Here's a simple three step process that I recommend in nearly all situations:

   1 - File your return prior to April 15th (this is the most important step!)

   2 - Pay what you can with your tax return

   3 - Make a plan to pay the rest, either:
          - Whenever you have the money, mail it in to the IRS
          - Set up a payment plan with the IRS (you can do this online)

That's it! 

The important thing to understand about extensions is that they extend the time to FILE, they do not extend the time to PAY. This simple fact is on my Mount Rushmore of good tax advice, along with "Don't Ever Take An Early IRA Distribution, Even If You Really, Really Want To" and "If You're Single With No Dependents, Don't Be a Hero And Just Keep Your Tax Withholding at Single / Zero."

The rules work like this: if you think that you owe a large amount of taxes on April 15th but don't have the energy or the patience to get your return complete by then, you are supposed to make an estimated tax payment of the amount (plus a little extra for good measure), and then when you're able to file you can claim any excess as a refund. That rule kind of defeats the utility of a tax extension if the whole point is to delay the tax payment. Penalties and interest accrue for late payments whether you've filed an extension or not, making extensions functionally useless for someone who can't (or just doesn't want to) write that check off to Uncle Sam.

Probably the most important thing that you can do if you owe income taxes is to get your return filed and accepted prior to April 15th. Simply doing this accomplishes two important things: 1) It alleviates the 25% late filing penalty, which is rather severe on purpose, and 2) it establishes good will with the IRS in that you're a taxpayer that wants to play by the rules and make good on your obligations as a US citizen and/or taxpayer. That will make it easier to ask for them to wipe away any penalties should they arise during the process.

Thus, procrastinating beyond the deadline because you don't want to write that check and face the ugly truth is one of the most harmful things that you can do. The IRS already has your W-2 and all of your pertinent tax information, so avoiding the inevitable accomplishes nothing.

Once the return is filed, there is no reason to panic. Alarm bells will not go off immediately & you will not lose your driver's license for having a tax liability with the IRS (my friend Peter Reilly says "There will not be IRS commandos surrounding your house and auctioning off all of your possessions on April 16th").

If the balance is relatively small compared to your income, I would just make a plan to aggressively save the necessary funds and then get a check in the mail as close to the deadline as possible. If you'd prefer to save a few bucks, send in whatever you can as soon as you can (for example, pay $1,000 with your tax return, then $500 per month after that). The IRS will credit your account until you're square with the US Treasury. In general, this will work if you can get everything paid off in 12 months or so.

If you have a high balance due and don't think you can make good in a year or so, that's what installment agreements are for. Setting up an installment plan will keep nasty things from happening during the collections process like tax levies and wage garnishment.

In observing behavioral trends in my practice (and personally - I write a large check on April 15th, too, and it's the most painful day of my entire year), I know that people have a natural aversion to paying taxes and will rationalize and justify just about anything to avoid (or delay) doing so. But filing a tax return late that has a balance due is an instant and guaranteed way to unnecessarily increase your liability, since the facts that you have for the prior tax year are going to be the same on April 15th as they will on July 15th.

Do yourself a favor and just file your tax return before the deadline, even if you can't pay.

- Bill