As a general rule, count on IRS interest and penalties doubling the amount you owe every five years. Interest is only part of the cause; it is the penalties that really hurt.
Interest rates charged by the IRS are not unfair – the federal short-term rate plus 3%. This has left IRS interest hovering in the 5% range. Think about it – you owe the IRS money, they are now your bank, and they are charging you a reasonable rate of interest for a loan that they really never agreed to.
The penalties is where the hurt comes in. The IRS charges multiple penalties, mainly for penalizing you for not doing something when you should have. The most common penalties are for not paying on time and not filing on time. If you owe taxes to the IRS, chances are you also owe them at least one of these two penalties.
Here is how the penalties add up to make repaying the IRS difficult:
1. Not paying what you owe when you file your return. The late-payment penalty is one-half of one percent of the tax owed for each month it is unpaid. Every month you owe, the penalty amount increases by a half of a percent. So the first month the IRS will charge you a half percent of the tax due, the second month 1%, the third month 1.5%, etc. The late-payment penalty does max out at 25%. So if you have owed the IRS for more than 24 months, your late-filing penalty has hit its limit – 25% of the tax. (Note: the half percent rate increases to one percent (1%) if the IRS issues a final notice of intent to levy and the tax remains unpaid for 10 days thereafter.)
2. Not filing your return on time. The late-filing penalty is sort of like the late-payment penalty – it escalates every month, only quicker. The late-filing penalty starts out at five percent (5%) of the tax owed for each month your return is late. The penalty increase by 5% every month for a maximum of five months, hitting its limit at 25% in the fifth month your return is late.
When both penalties run concurrently, the late-filing penalty is reduced from 5% to 4 1/2% monthly. When both penalties apply, the late-filing penalty hits its max at 22.5%, with the late-payment still maxing out at 25%.
The combined penalty for not paying on time and not filing on time: 47.5%.
By example, if you filed your return more than five months late, and owed $50,000 on the return, you could eventually owe an additional $23,750 in penalties. As for interest, as an estimate, let’s say it is running at 5% – say $2,500/year. In five years, you would have a minimum of $12.500 in interest (and that is without calculating interest on the penalties). That is $36,250 of interest and penalties on $50,000 of tax after five years. (Please note these numbers are for illustration only – you get the idea.)
In all fairness, don’t necessarily blame the IRS for these rules – they do not make the laws, Congress does. The IRS enforces the laws that Congress gives us. And Congress has made repaying credit cards look like a walk in the park compared to tax delinquencies.
Penalties can be abated for reasonable cause, but my experience is that the IRS is relatively stingy in granting equity to late-payers and late-filers.
Solutions? Repaying the IRS through bankruptcy is often an excellent option to dealing with interest and penalties. A Chapter 13 repayment plan can stop interest and penalty accruals, and can also reduce the amount that the IRS receives on their interest and penalty charges to as low as 5% of what is owed (known as a “cramdown” in the bankruptcy speak). An offer in compromise settlement entails the IRS accepting a number less than what is owed, which can effectively result in forgoing interest and penalty charges. And the IRS has 10 years to collect taxes, interest and penalties – after that time, the charges are cleared off the IRS’s books.
Owing tax to the IRS is often just the starting point. Interest and penalties are going to be added to the equation, and can make repayment difficult, leading to alternative solutions for a fresh start.