When you make a payment to the IRS, it will be automatically applied to your account in a manner that is in the IRS’s best interest.
But what is best for the IRS in handling your payment can be different from what is best for you.
In some situations, it is in your best interest to make a designated IRS payment, which tells the IRS how you would like them to handle and apply your payment.
Designated payments should be considered in the following situations:
1. If you owe income taxes, it may be beneficial to designate your payment to pay a more recent tax liability off before paying an older liability. This is recommended due to the 10 year IRS statute of limitations on collection.
Example: If you owe taxes for 2001 – 2008, collection of the 2001 liability should expire well in advance of the 2008 debt. If you are about to make a payment that will pay some – but not all – of your taxes, you could be best served by designating the payment to be applied to the most recent debt (2008) first. This allows the older taxes a greater chance to expire from the statute of limitations on collection.
Without the designation, the IRS will apply the payment to the oldest tax year first (the one in which collection is set to expire).
If you are considering bankruptcy, voluntary payments can also be designated to pay nondischargeable taxes.
2. If you owe employment taxes, a designated payment can help reduce exposure to the trust fund recovery penalty. The IRS uses the trust fund recovery penalty to hold owners and employees of a business personally responsible for a portion of unpaid employment taxes.
If your business is set to make a payment on a past due employment tax liability, consider designating the payment to the trust fund portion of the employment taxes. This strategy reduces the exposure of the operators of the business to the IRS while simultaneously paying down the business debt.
You can make a designated payment only if your payment is submitted voluntarily. Payments made by installment agreement or by enforced IRS collection action (i.e., levy) are not considered voluntary and cannot be designated. A payment is voluntary even if you are working with a Revenue Officer or Automated Collection Service provided it is made by your own choice and without an installment agreement or levy.
To properly make a designated payment, you need to specifically tell the IRS how to earmark it. To accomplish this, first, in the memo portion of your check, insert your tax identification number, the tax form to which your payment relates (i.e., “Form 1040”) and the tax year or period you want to pay (i.e, “Tax Year 2003”). Second, a cover letter should accompany your check stating the same information. Keep a copy of the cover letter and your cancelled check as proof of the designation.
It is important to understand why, how and when IRS payments can be applied to your benefit. Designating payments to the IRS is a right that should not be overlooked when voluntarily paying down your account.