Howard's IRS and the Law Blog

I recieved a good question about how the IRS applies payments on employment tax liabilities.  The question was in response to my article and recent post about IRS trust fund investigations.

This is important.

If a business does not specifically designate the application of  a payment on an employment tax liabilty, the IRS will apply the payment in its own best interest. That means the payment will be applied to non-trust fund taxes first, allowing the IRS more collection options.  This will include the IRS pursuing collection of the trust fund taxes from the owners and select employees.  The result:  the non-trust fund taxes get paid by the business and others get assessed.

Internal Revenue Manual 5.19.14.5 provides that non-designated payments are applied as follows:

First, to the non-trust fund liability for the oldest payroll tax quarter

Second, to the trust fund liability for the oldest payroll tax quarter

Third, fees and collection costs

Fourth, assessed penalty followed by assessed interest

Fifth, accured penalty followed by accrued interest

To protect against this result, any voluntary payment on an employment tax liability should be specifically designated in writing to be applied to pay trust fund taxes first.  This decreases the exposure of those behind the business of having to endure an IRS investigation and being held responsible for the trust fund taxes.   These designations cannot be made with a required federal tax deposit or during an in-business installment agreement; only on voluntary payments.

But when things are quiet or hanging in the balance, work to reduce the personal liability first by designating voluntary payments to trust fund taxes.

Every IRS problem has a solution. Some solutions are quick. Other workouts require more creativity, planning and patience.  When meeting with a client  – or during an initial telephone consultation – I like to discuss the following options and how each might fit in towards the ultimate goal of a fresh start:

1.   Offer in compromise.  This is the first option on every one’s mind.  But it can be difficult to obtain an compromise under current IRS procedures – it is not for everyone.  Many compromises are initially rejected by the IRS and have to be appealed.  And with IRS expense allowances lower than what most people need to live, the best chance of success is to be pretty much broke.  The IRS compromise program is not dead, but caution needs to be exercised and other options reviewed first to avoid disappointment.

2.     Tax bankruptcy.   I emphasize this all the time – with the results of the IRS compromise program difficult to predict, bankruptcy is often the next best option.  A Chapter 7 bankruptcy can eliminate an income tax liability without any recovery to the IRS and without losing any of your property. A Chapter 13 bankruptcy can allow you to continue or set up an installment agreement to repay your taxes without interest and penalties.  In many Chapter 13’s, the amount of tax repaid is less than what you actually owe.

3.     Uncollectible.  The IRS does make “bad debt” decisions on its collection inventory.  This is known as being uncollectible.  To be a bad debt, the IRS will require a financial statement listing income, living expenses, assets and liabilities to prove that any attempt to collect the debt would result in a hardship. Sometimes, the IRS will put an older tax debt in its nonactive queue on its own. It is important to carefully analyze and understand when to call the IRS, and when to let sleeping dogs lie.

Next: IRS installment agreements, statute of limitations and interest/penalty abatements (Part II).

In addition to (1) offers in compromise, (2) bankruptcy and (3) uncollectible (See Part I, above), here are three more solutions to owing back taxes to the IRS:

4.      Statute of limitations on collection.  The IRS has 10 years to collect unpaid taxes – starting from when the IRS puts the tax liability on its books (this is usually when a tax return is filed or an audit is completed). The limitations period is is the ultimate ace in the hole and is not to be squandered – there is an end date to your IRS problem.  Getting there requires properly calculating the end date and navigating getting to the goal line.

If the end is near, great care should be excercised not to cause unnecessary disruption – options like submitting an offer in compromise or filing a collection due process appeal should be carefully considered in advance.  They extend the IRS collection timeframe.

5.     Installment agreement.  If you can, it is always best to repay the IRS.  But installment agreements do have ongoing interest and penalty accruals that make repayment difficult.  Rule of thumb:  If the liability cannot be repaid in five years, it likely will never be.  In those situations, a Chapter 13 bankruptcy may be beneficial to make your payments as it can stop interest, penalties and repays principal.

6.     Interest and penalty abatement.  It would be nice to have the IRS abate interest and pay tax only, but the IRS only abates interest due to their own errors.  For examplke, interest could be abated if the IRS unreasonably delayed responding to your correspondance.  As to penalties, there needs to be reasonable cause why a penalty should not be imposed.  Not having the money to pay your taxes unfortunately won’t do it.  Generally, penalty abatement works best with factors out of your control – failed health, out of the country, lost records from fire.  See my letter to Treasury Secretary Tim Geithner about easing interest and penalty abatement policies and my written testimony before the House Subcommittee on Oversight.

In today’s difficult economic environment, expect more businesses to resort to using payroll tax money to stay afloat and a corresponding increase in IRS enforcement measures. With bank lending tight, employee tax withholding is a ready —but dangerous—source of immediate operating capital.

But the IRS does not like being made an unwilling partner to a loan…

Read the full EA Journal article “IRS Trust Fund Investigations: The Best Defense is a Good Offense”

Download IRS interview Form 4180

It is not unusual for my clients to find themselves indebted to two masters – the IRS and credit card companies.  Both want a piece of the pie, but there is not enough to go around.  So who do you pay first? How do you make both go away?

The IRS comes first.  Here’s why:

1.     Unpaid credit cards can be annoying – harassing debt collectors calling for money.  But it is important to remember that credit card companies and debt collectors cannot take your wages, bank accounts or property.  That can only be done by the filing of a lawsuit, which the debt collector cannot do (they are not lawyers).  Once we are retained, the debt collectors are directed to confirm that all calls are to be directed through our office, which they are obligated to follow by law.

2.     The only restriction that the IRS has in taking your wages or bank accounts is to issue a notice of intent to levy to you first. And have you ever seen a debt collector appear at your home or business demanding payment like the IRS does?

3.    In legal terms, IRS taxes are considered priority debts, while credit cards are categorized as lower unsecured general debts.  That means credit cards can be readily eliminated in bankruptcy.  Taxes can be eliminated in bankruptcy too, but the rules for taxes are much more stringent because of their “priority” status.

No one sets out to file bankruptcy, but when the IRS and credit card companies compete for limited cash, bankruptcy is often the complete solution.  A Chapter 7 bankruptcy eliminates the credit cards and older taxes if your budget does not permit monthly payments.  If you can pay a little bit back, a Chapter 13 can be the answer. Chapter 13 is a debt reorganization, where bankruptcy law determines who gets your cash flow.  It divides the pie by law, so you do not have to.  Chapter 13 can also stop the accrual of credit card interest and IRS penalties.  Anything you cannot afford to repay is eliminated by bankruptcy law.

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