If you owe the IRS more than you can pay, file the return on time anyway. Not filing costs far more than not paying. Then choose how to pay: a short term plan if the balance can be cleared within 180 days, an installment agreement if it cannot, and in a narrow set of cases an offer in compromise.
File first, even without the money
The belief that stops people acting is that owing money they cannot pay is a reason not to file. It is the reverse.
The failure to file penalty is 5 percent of the unpaid tax for each month or part of a month the return is late, up to 25 percent. The failure to pay penalty is 0.5 percent a month, also up to 25 percent. Filing on time without paying stops the larger of the two before it starts. Everything else in this guide assumes the return is filed.
The full cost of a year left unfiled is set out in what it costs to miss a deadline outright.
Which option fits
The right option depends on how long it will realistically take to clear the balance, not on how large it is.
Paid within a few months. A short term payment plan gives up to 180 days to pay in full. Interest and the failure to pay penalty still run, but there is no long running arrangement to keep in good standing. Where the balance can be cleared from savings or the next few months of income, this usually costs less than anything longer.
Paid over time from income. An installment agreement spreads the balance into monthly payments. It suits someone whose income can carry the payments but whose savings cannot clear the balance.
Cannot be paid at all. This is a different conversation, about what can actually be collected and over what period. It is covered below, and it should not be approached as if it were a payment plan with a smaller number.
Borrowing to pay the IRS sometimes costs less and sometimes does not. It depends on the rate you would be borrowing at compared with the IRS’s own rate, which is covered in the section on cost.
Setting up an installment agreement
Most individuals can apply through their IRS online account. For an online long term plan, the combined balance of tax, penalties and interest must be 50,000 dollars or less. Above that, or if you prefer, you can apply by phone or by mail on Form 9465, and the process asks for more information about your finances.
There is a setup fee, lower for an online application and for payments by direct debit, and reduced or waived for lower income applicants. The current amounts are on the IRS’s payment plans page.
Direct debit is worth choosing for a reason beyond the fee. A missed payment is the easiest way to default, and a payment that takes itself cannot be forgotten.
Keeping the agreement
The part that nobody covers is what happens next year.
An agreement requires you to file every return on time and pay every new tax in full and on time, as well as making the monthly payment. The usual way one fails is not a missed installment. It is the next return showing a new balance, because whatever caused the first shortfall was never fixed.
So the most important step is taken in the same month the agreement starts: adjust your withholding, or start making estimated payments, so the current year is covered as it goes. Sizing those payments is explained in quarterly estimated payments. A defaulted agreement can often be reinstated, usually with a fee, but it is simpler to never need to.
What it costs while you pay
People are often surprised that interest does not stop when an agreement is in place. Interest and the failure to pay penalty both continue on the unpaid balance until it is paid.
There is one improvement. For an individual who filed on time, the failure to pay penalty drops from 0.5 percent to 0.25 percent a month while an approved plan is running. That is one more reason filing on time matters even when paying on time is not possible.
Interest is charged at the federal short term rate plus 3 percentage points, set every quarter and compounded daily. The rate for the current quarter is published on irs.gov. Paying more than the minimum whenever you can shortens the time all of this runs.
Ignoring the balance makes it worse. After a notice of intent to levy, the failure to pay penalty rises to 1 percent a month if the balance is not paid within 10 days.
Offers in compromise
An offer in compromise settles a tax debt for less than the full amount. Advertising has made it sound like something most people can get. It is available to far fewer people than believe it is.
The IRS generally accepts an offer only when the amount offered is the most it could expect to collect within a reasonable period, based on your income, your necessary expenses and the equity in what you own. Someone who could pay in full over time through an installment agreement is generally not a candidate. To apply at all, every required return must be filed and estimated payments made, and you must not be in an open bankruptcy.
The IRS publishes a pre-qualifier tool that gives an honest first answer. Nobody can promise an offer will be accepted, and anyone who does is selling something.
Where to start
If the return for the year is not filed, start there. If it is filed and the balance is known, the decision between a short term plan, an agreement and anything else follows from what you can realistically pay each month. Where several years are involved, or the balance includes penalties that may qualify for first time abatement or reasonable cause, the order in which those are dealt with is part of what a back taxes engagement covers.