Paying off tax debt might be the worst financial hardship to happen to many people. A lot of people gripe about owing money when they file their income tax return. But when you can’t actually pay the tax bill, it can feel like you’re drowning.
As a financial planner and tax advisor, I’ve seen plenty of tricky tax situations. But the worst financial situation I saw was the first client I ever had.
Real client story
My first major client came to me with the following question:
“My husband and I owe the Internal Revenue Service $86,000 in back taxes. Last year, we had to liquidate our retirement plan just to pay our tax liabilities down this far, so I think that this year’s tax return will make it worse. Can you help us?”
My response: “I don’t know, but I can try.”
Honestly, I had no good idea of how I was going to help this client. But I came into this profession to help people. I decided that I would calculate my financial planning fee and present it to them.
If they agreed to pay my fee, then I would do everything within my power to help them. Here was the situation at hand.
The clients (we’ll call them John and Mary, even though those are not their real names) to the fee. Immediately, I discovered that the situation was much worse than I originally thought. For several reasons.
- The $86,000 in unpaid taxes did not include penalties or interest. That was another $10,000 or so.
- The day before we signed our client agreement, they received their tax return for the previous year (on tax day, no less!). That year’s tax return was for another $46,000. It included their CPA’s highest recommendation: “You should pay your tax liability as soon as possible.” With what money?
- John had taken a second job to earn extra money. But they were not having taxes withheld. So things would only get worse going forward!
It was clear that this wasn’t an easy fix. They had no savings because they drew down their retirement account just to get to this point. So we had to figure something else out.
Fortunately, they had three things going for them.
He earned a lot of money.
This was a big problem, and wasn’t going to be fixed overnight. Fortunately, John in a field where he is highly compensated, and earns $500,000 per year.
His ‘side job’ was taking an extra weekly shift with a local business. That earned $2,500 per 24-hour shift. Doing one shift per week would add up to $130,000 per year.
They had home equity.
While their savings accounts were depleted, we were fortunate that they had some home equity. This gave us a little flexibility.
I don’t normally advise using home equity as a way to restructure unpaid debt. However, their home equity did come into play here. I’ll explain in more detail in a bit.
They were willing to work with me.
In order to be successful, any financial planning relationship has to be a two-way street. I was willing to commit whatever it took to help them get to a better place.
Whether that was time, knowledge, energy, emotional capacity, my client knew that I would go the extra mile. But I needed them to do some things as well.
There were certain things that I couldn’t do for them. And Mary, who handled the family finances, understood that. And once that was settled, I knew that we would work well together.
In fact, Mary was a true rock star throughout all of this and our plan would have never succeeded without her diligence and effort.
The other thing that my clients and I mutually understood was that the IRS would expect them to repay the full amount of their tax balance due. We did not discuss an offer in compromise.
An offer in compromise (OIC) is where the IRS will allow certain taxpayers to pay less than they owe. OICs are usually for people whose disposable income would not allow them to make the required payments to fully repay their debt under an installment plan.
In this case, I had run their numbers through the IRS’ OIC Pre-Qualifier tool. When I did, I saw that an OIC was not a serious option.
The only question now was whether we could convince the IRS to agree to a payment plan. One that worked for my client.
How IRS Payment Plans Work
I won’t bore you with all the details about how IRS payment plans work. For detailed information on installment payments, you can find everything at the IRS website.
However, there are a few things that you should know.
The taxpayer has to come up with a payment plan.
From there, the IRS can choose to accept it or not.
This is done by filling out Form 9465, Installment Agreement Request. This is a major drawback from a negotiating perspective, we were able to use this to our advantage. I’ll outline this in more detail later.
The amount you owe determines how much flexibility you have.
The IRS has certain limits on your ability to negotiate. Here’s how it usually works.
Taxpayers who owe less than $25,000
If you owe less than $25,000, you can pay by credit card. If you owe more than this, you must use a direct debit option from a bank account.
Taxpayers who owe less than $50,000
If you owe less than $50,000, you can avoid having the IRS place a lien on your primary residence. Those who owe more risk having that lien in place until the loan is paid off.
Taxpayers who owe more than $100,000.
If you owe more than $100,000, your local IRS office probably can’t help you. We learned (the hard way), that these cases are usually referred to an escalated office.
So negotiating in person is off the table.
There are fees to set up a payment plan.
To set up an IRS tax payment plan, you’ll need to pay an application fee. This fee depends on:
- The length of the payment plan
- Whether you qualify for a low-income fee reduction
- Whether you apply online or over the phone
- If paying by credit or debit card, additional fees apply
You may be asked to list out all of your assets.
Listing your assets is done by completing. Form 433-F, Collection Information Statement.
Penalties might NOT apply.
You may be able to erase the penalty charges through a process called penalty abatement. The IRS’s website specifically discusses how first time offenders may seek penalty relief.
Unfortunately, this doesn’t apply to accrued interest. So any interest that has accumulated sticks with you.
In our case, there were still about $10,000 to $15,000 in tax penalties at stake. So some good news.
Dealing with the IRS
First, we set up an appointment with our local IRS office. If you ever have to set up an appointment at the IRS office, make sure you get there at least 15-20 minutes in advance. Because it’s a federal facility, you’ll go through a metal detector, and they’ll verify that you have an appointment.
Once there, we found out that the local office couldn’t help us. It turns out that the recent tax return had just been uploaded in the IRS’ system.
This made my clients’ unpaid balance go over the $100,000 threshold. This gave me another reason to dislike their CPA.
If the CPA had filed tax extension, this would have kept my clients’ balance below the threshold. That way, they could have negotiated an agreement in person.
Instead, we were ‘escalated’ to a centralized collections office. This meant all of our business would be done over the phone. Ugh.
This also meant that we had to come up with a plan by filing the Form 9465 online.
Our Tax Payment Plan
My client wanted to negotiate a plan that involved NOT putting a lien on the house. This meant getting the balance to below $50,000.
So we had to factor three things into our payment plan.
Pay the current year’s tax bill.
As previously mentioned, I noticed that John & Mary were woefully under-withholding for the current tax year.
It would make no sense to pay off the existing tax obligation if that meant they were going to take a major hit next year. And they were on track to do just that.
Establish enough cash flow to support the IRS payment plan.
We didn’t know what the IRS would allow us to negotiate into the installment plan. But we could estimate using a couple of factors.
First, our magic number was $50,000.
Second, the maximum period of time for an installment plan is 72 months.
You can find this in the instructions for Form 9465, Installment Agreement Request. Throw in interest, and this comes out to approximately $700-$750 in monthly payments.
After the IRS accepted the plan, our financial planning goal was to free up $750 per month in cash flow by cutting down on monthly expenses. But first, we had to come up with the down payment.
Find money for the down payment.
This was the challenge. How were we going to come up with approximately $80-$90K to pay the down payment?
There was only one option: take out some home equity.
Home Equity: An Unconventional Source of Capital
Before we go further, I want to point out a couple of things.
First, I almost never advise people take out home equity debt. There are a few instances in which home equity debt makes sense. Like home improvements.
But I truly believe that financial stability lies at the heart of financial planning.
Second, taking out a home equity line of credit (HELOC) has a lot of risk. Especially for folks who aren’t disciplined in paying down revolving debt. Like credit cards.
The HELOC wasn’t our best option. It was the only option. And there were two things that worked in our favor.
I knew a lender who could finance this.
While my clients had equity, they didn’t have a ton. They needed special financing called a 90/10 loan.
This means that the total amount borrowed was 90% of the home’s value. Usually, the lending limit on home equity loans are calculated using 80% of the home’s value.
The lender couldn’t do this type of financing under a loan, only a HELOC.
We needed the flexibility.
There was still a lot that I did not know about my new clients’ finances. So I needed to have some immediate flexibility while I helped them with their cash flow.
If I could do this, then I knew we could always make extra tax payments down the line as they pay off other debt.
Submitting the Tax Payment Plan
The first time we called the IRS collections number, we spent about 45 minutes on hold.
Note: set aside about 2 hours for each phone call you have to make. The wait times are pretty long.
Eventually, we got to a collections agent, who walked us through the process. Basically, we would have to submit our plan, then wait.
The IRS would notify us whether the plan was accepted. No bargaining, no negotiation, nothing.
The agent couldn’t tell us anything over the phone. She could only accept the numbers that we gave her, then input them into the IRS’ system.
From our understanding, the proposed plan would then go to a supervisor, who would use a set of IRS guidelines to determine whether nor not to accept the plan.
We had already determined what our offer would be, and we submitted it. While I had worked with my clients on the ‘worst case scenario,’ we had submitted a number that was a little less than that.
After all, the worst that could happen is that the IRS would say no. The unintended benefit was that this gave us a little time to get the HELOC in place. And having a submitted plan put a pause on the collections process.
The collections process
According to IRS Publication 594, The IRS Collection Process, the collections process may be suspended
“while the IRS is considering your request for an Installment Agreement or Offer in Compromise. If your request is rejected, we will suspend collection for another 30 days, and during any period the Appeals Office is considering your appeal request.”
In other words, since my client had submitted an offer, the IRS’ collections process stopped. This included the process of placing a lien on their home.
I had a suspicion that the IRS would not accept anything less than the most aggressive payment plan. After all, this is a high-earning household. So I doubted any IRS supervisor would have pity for them.
Fortunately, we had the HELOC in place by the time we received the rejection notice.
We made another call, and submitted the plan that I thought would be accepted:
- Submit a down payment to get the balance below $50,000.
- Pay off the outstanding balance in monthly installments over a 72 month period.
This time, the offer was accepted with a direct debit option.
Additionally, we were able to abate approximately $12,000 in penalties by submitting a Form 843, Claim for Refund and Request for Abatement.
Since this was a first-time incident, the agent told us that there was a ‘high degree of confidence’ that this would be accepted. And it was. But that’s not the end of the story.
Bumps in the Road
As you can expect in dealings with the IRS, there were a couple of hiccups.
The IRS put a lien on the property anyway.
The IRS supervisor overseeing the case decided to place a lien on the property, anyway. This was a shock, since Mary, John, and the IRS had negotiated an installment plan.
Interestingly, the IRS anticipates this in Form 12277, Application for Withdrawal of Filed Form 668(Y), Notice of Federal Tax Lien. There, Block 11 cites the following as a reason to request withdrawal of a filed Notice of Federal Tax Lien:
“The taxpayer entered into an installment agreement to satisfy the liability for which the lien was imposed and the agreement did not provide for a Notice of Federal Tax Lien to be filed.”
Regardless, filing Form 12277 was no walk in the park. my client had to enlist the Taxpayer Advocate Service to state her case. In spite of the fact that she had already negotiated an agreement with the IRS in the first place!
Of course, since the lien had already been filed, my client also had to follow up and ensure that the lien was withdrawn, and subsequently, any negative impact to her credit report.
It took longer than we expected, but Mary was able to eventually clear this obstacle.
I couldn’t represent Mary and John.
Second, throughout the process, it was nearly impossible for me to actually represent Mary and John in any IRS conversation.
There is an IRS Form, Form 2848, Power of Attorney and Declaration of Representative, which allows a taxpayer to authorize a tax professional as their representative. We had submitted a not once, but twice!
We worked through these two obstacles and eventually got the plan in place. Once the agreement was in place, we agreed that Mary would probably be more efficient in working through the Taxpayer Advocate Service by herself.
And the Taxpayer Advocate Service did as advertised: advocating for the client. After all, there’s only so much you can learn online. There comes a point at which you need a person who can reach out to the right people to make something happen.
The IRS didn’t even take the down payment out on time.
Ugh. While this might not seem like a big deal to most folks, this was a major point of stress for Mary & John. And after all the hard work Mary had put into this plan, it was another point of frustration.
Mary had to enlist the support of her Taxpayer Advocate to make sure the IRS withdrew the money.
Eventually, everything worked out. But it’s worth sharing some of the lessons we learned along the way.
This experience taught me a lot! And I think I can speak for Mary and John in saying that they learned a lot as well! Below are a couple of lessons that we learned:
Negotiating a debt payment plan with the IRS takes time!
I met Mary & John in April. We didn’t feel like we cleared all the hurdles until the following January. That’s nine months!
And half that time was just prodding the IRS to do what they said they were going to do.
But they didn’t get into six figures of tax debt overnight, either.
Don’t expect to sit back and let things happen.
That is the surest way for things to go against you. The IRS already has a collections process in place.
If you do nothing, or wait until you get around to it, the IRS will figure out a way to start collecting. And you probably won’t like it.
You’re going to have to sacrifice something.
It might be your money, your credit or both…you decide.
It’s pretty rare that the IRS is going to let you run up a serious amount of tax debt, then claim poverty and get out of it.
Of course, there are plenty of circumstances which warrant an offer in compromise. But if you owe the IRS money, the IRS will find ways to force you (or strongly incentivize you) to pay what you owe. And to pay it sooner rather than later.
The longer you wait to make a serious commitment, the worse your options can get.
Bankruptcy might be an option. But it won’t help.
As a general rule of thumb, tax debt is very difficult to discharge.
So much so, that filing for bankruptcy is generally not considered a realistic option. unless you’re willing to also walk away from many other things you own, like your house or car.
Publication 908 outlines the ways to discharge tax debt. But it’s worth pointing out a couple of things:
- Chapter 13 bankruptcy allows tax to be discharged only after paying all debt under the debt payment plan.
- Chapter 7 only allows for the discharge of certain tax debt, under certain conditions.
- You have to have filed all tax returns in order to be eligible for any discharge of tax debt.
- If there is a notice of federal tax lien (NFTL) in place from before the bankruptcy hearing, any discharged debt can still be collected against that property!
If you did a double-take on that last one, that’s right! Even if you get your debt discharged, the IRS can still collect against any outstanding liens placed upon your property.
In short, consider bankruptcy ‘a nuclear option.’
Taxpayer Advocate Service really helps!
It’s ironic that our taxpayer dollars pay for a group of IRS employees to go to battle against IRS employees for the benefit of the taxpayer.
But when you look at how massive the IRS really is ($3.5 trillion in collections for fiscal year 2020), it’s easy to see that mistakes are made.
So it’s a good thing that the Taxpayer Advocate Service exists to help keep those mistakes from having a lasting impact on taxpayers. Here are three benefits:
- The Taxpayer Advocate Office has access to the exact information that the IRS’ collections office does. That means they can give you up-to-date information on your total liability. This is more than your accountant or tax lawyer can do for you.
- The Taxpayer Advocate Office knows the IRS rules and procedures better than most tax professionals.
- When you talk with the Taxpayer Advocate Office, notes are kept for future reference. This is to your benefit.
Even if you hire a tax professional, expect to do some heavy lifting yourself!
While there are folks who can help you work through the process, there are certain decisions you just need to make yourself.
For example, if cash flow is a problem, no one will cut your spending but you. The best way to get to the solution that you want is to be proactive.
If you do insist on paying someone to help you, there are probably three main ways they can help you.
They can help you with an offer in compromise.
Offers in compromise (OIC) generally are an offer to the IRS for less than the full value of your tax debt. There are many firms that ‘specialize’ as tax settlement firms.
They boast about being able to help clients with offers in compromise, and usually make their money by collecting a flat fee up front. Be forewarned that the ‘tax settlement’ industry is fraught with misrepresentation and underperforming firms.
According to the IRS Data Book for 2017, the OIC acceptance rate was 40%, with an average dollar amount of just over $10,000 for accepted offers. If you’re struggling with six-figures of tax debt, you’re probably not going to want to go through the ordeal of an OIC, trust me.
They can help find an error.
Odds are, if you’re dealing with six-figures of tax debt, there’s something more than a tax mistake at hand here. Every person I’ve met with six-figure tax debt has had:
Multiple years of ‘problematic tax returns.’ To me, problematic tax returns could be ones that result in significant amount of overdue taxes owed, or ones that simply weren’t filed at all. It’s not uncommon for people to have not filed tax returns for 5 or 6 years (or more).
They can help you with penalty abatement.
Many tax attorneys and tax relief companies claim that they have the secret recipe for getting IRS penalties removed. Below are verbatim claims from tax lawyer websites that I found in a quick Google search:
- “XXX will work with you and make payment arrangements that the IRS will allow.”
- “If there were circumstances beyond your control that prevented you from paying your tax debt and led to delinquency, we are able to challenge the penalties that have built up.”
- “An experienced tax attorney should be able to help assess your situation and come to a solution that works for you, as well as the IRS.”
Here’s a secret—you can do much of this yourself.
For example, the IRS’ First Time Penalty Abatement Policy erased my clients’ penalties (over $10,000 in accrued failure to file & failure to pay penalties). All of this additional information was free on the website.
And the Taxpayer Advocate walked my client through the steps free of charge.
But if you hire someone, make sure you get a free consultation first.
Tax debt is a daunting challenge. But whether you hire a professional or do it yourself, it is possible to do.
The important thing is that you just have to be willing to take the first step.
After retiring from a 24-year career as a Naval officer in 2017, Forrest became a financial planner to help people achieve success in managing their personal finances. In 2022, he sold his partnership stake in his financial planning firm to focus on helping people full-time through his writing.
Featured in: Forrest’s writing has been featured in the following publications: Forbes, Military.com, NerdWallet, Yahoo Finance, The Military Guide, The Military Wallet, Christian Science Monitor, and many other publications.
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