This week we are going to cover what happens if you owe taxes and can’t pay. We will start by discussing penalties and interest in this issue, and next week, we will discuss different options for financing your tax balance.
I wanted to share a useful link. The link to the IRS video portal.
The IRS video portal is an IRS website that provides access to educational tax videos. Below is the link to one of those videos, the one about US tax residency, which may be helpful to a few of our readers:
Determining your Tax Residency Status
This video explains who needs to file a US tax return as a resident (Form 1040) or as a nonresident (Form 1040NR). The video answers questions such as:
- I am an American living abroad, do I need to file?
- I live in the USA but I am foreign, do I need to file?
- I have a green card but live abroad, do I need to file?
- I spent six months in the USA but then returned home to country X, do I need to file?
If you have some time on your hands, you may want to explore some of the other videos in this library, such as the one covering foreign tax credits, or the one covering the relief procedures for accidental Americans who renounced their US citizenship.
Understanding IRS Penalties
As we mentioned in our prior post, July 15 is a triple bomb of three tax payment deadlines: the 2019 tax balance, and the 2020 first and second estimated payments.
What happens if you owe tax and are unable to pay by July 15?
Penalties and interest start to accrue.
That’s what happens.
Late Filing or Failure to File Penalty
This penalty applies when a tax return is filed after its due date or its extended due date. It applies to the unpaid amount of tax still owed after the filing deadline.
The failure to file penalty is 4.5% per month. Not per year. PER MONTH. This penalty maxes out after 5 months. If you do not file your tax return and do not pay the tax balance after 5 months, the total penalty is capped. The maximum failure to file penalty is 22.5%.
Late Payment or Failure to Pay Penalty
This penalty is 0.5% per month of the unpaid tax balance. It continues to accumulate until the tax is fully paid, or until the maximum penalty of 25% is reached.
The maximum combined late filing and late payment penalty are therefore 47.5%.
Late Payment Interest
The IRS applies an interest charge on the unpaid tax balance from the date the tax return was due until it is paid in full.
The current IRS late payment interest rate is 5% per year. This interest is calculated monthly on the unpaid tax + unpaid penalties + unpaid interest. Because the interest applies to the entire balance owed to the IRS, and they continue to accrue until the entire balance is paid down, interest charges can snowball quickly.
Penalty Relief
The best way to obtain penalty relief is by avoiding the penalties in the first place.
The easiest penalty to avoid is the Late Filing Penalty. A lot of people incorrectly assume that because they do not have money to pay the tax, they should not file their tax return, when they should do exactly the opposite.
The monthly failure to file penalty is 9 times the monthly failure to pay penalty. By filing the tax return when they cannot pay the tax, taxpayers automatically reduce their penalty by 90% for the first five months.
Another way to obtain penalty relief is through the First Time Abate (FTA). This relief was implemented in 2001 and it is available the first time a taxpayer is subject to one or more of the penalties described in this newsletter.
There are three requirements to qualify for the FTA:
- The taxpayer hasn’t been assessed a penalty during the prior 3 years
- The taxpayer has filed the relevant tax return and
- The taxpayer has paid or has arranged to pay the tax due
If the FTA is not available, a taxpayer may be eligible for penalty relief under Reasonable Cause. Reasonable cause can include taxpayer incapacity, divorce, death, illness, mental impairment, IRS error and other mitigating circumstances.
There are some nuances for claiming tax abatement under reasonable cause, so read up before requesting it. Here is the link to the IRS penalty handbook. Enjoy!
Until next week,
Marina