Interest & Penalties - Unpaid Taxes

[JohnH]

We sometimes have discussions about the cost of penalites & interest on unpaid taxes when clients are thinking about a payment arangement, and it happened that I had an opportunity to run some numbers on an actual situation this morning.

The taxpayer filed an extension on Apr 15 2009 and filed the return on Oct 15, 2009. Both the extension and the return were accompanied by small token payments, but here is the overall result. I'm lumping penalties & interest together for the sake of simplicity and because there's really no difference between the two since neither is deductible - it's all just an expense of using someone else's money.

Balance due on the return filed Oct 15 was $ 4,427 and the first IRS notice called for a balance due of $4,738 by Dec 15. The $311 diffrerence works out to the equivalent of a 10.44% APR since that is what the taxpayer would pay for the use of the money for 8 months.

The taxpayer called IRS yesterday and arranged to pay off the balance by March 8, 2010. There was no fee or other charge for this short-term arrangement The payoff figure for that date is $4,904, so the additional $166 difference works out to the equivalent of a 14% APR for the use of the money for 3 more months.

I'm fairly sure that the 14% will hold constant for any length of time beyond the initial filing period. So I think it's safe to say that setting up a payment arrangement is roughly the equivalent of borrowing money at 14% (not counting the relatively small fee to set up the payment arrangement itself), Certainly not a bargain interest rate, but when compared to using credit cards or unsecured debt of any kind, I'd say it's close to a wash.

[Edsel]

Comments

Owing the IRS is more expensive than making a trip to the bank, and historically that has nearly always been the case.

I have deducted the interest portion in cases where it would be deductible. Of course, this could not be on a schedule A, but if any of the deficiency were for business taxes, I am comfortable deducting it in the proper place so long as it is paid.

I also have a scenario where I deduct penalty, but I'm not going to discuss it. I don't think anyone on this forum would agree with me. IRS position is that it is NEVER deductible.

I am surprised that your client was not charged an up-front installment fee. The fee, last I heard, was just under $100, and is IN ADDITION to penalty and interest. I'll bet if you check with your client and got to the bottom of the situation, IRS probably DID charge this fee and is a factor in raising the effective rate from 11% to 14%.

[JohnH]

No, there was no installment fee - the fee only applies when a long-term installment agreement is formally established. I was on the phone with the client when the extension was discussed. (As I've said in other posts, I like to conference the client in on calls that I expect to be dispensed with in a single conversation in order to save lots of useless POA paperwork back & forth). IRS can grant up to a 120 day extension with no fee of any kind and if everything is handled right it will delay any further collection action. The 120 days can also be extended in some cases with a partial payment, but I didn't obtain the details on that. And even if there HAD BEEN an installment fee, it it relatively insignificant. A one-time $100 or so simply would not have that much impact on the effective APR on a $5K debt, so it's more or less irrelevant in the total scheme of things.

While it is true that borrowing from the IRS is more expensive than borrowing from the bank, it is less costly than paying taxes with a credit card unless the taxpayer pays with a card that offers a bargain rate. Obviously it's better to pay the tax due, even if it means using a HELOC or some other available source of moderate-interest credit. But most taxpayers who owe & can't pay simply aren't in a position to do that - this is why they owe to begin with.

Given the current state of the economy, I expect to see more clients who owe and have problems paying in the future. People desperate to get through their financial crises still sometimes make bad financial choices. They will borrow against their 401(k) and then get laid off a few months later, fail to have taxes withheld on their unemployment compensation, or show up with COD income. I think we can help them if we provide them accurate information on how to navigate the process when they owe and can't pay.