WalletPop experts answer questions about 401(k)s to back taxes
--Lee Coit, 55, Denver
Answer from John Ellis, CPA, John Ellis Company in Long Beach, CA
This is a tough situation for anyone to find himself or herself in. Before I answer the question, I would just like to point out that whenever a financial decision is made, all emotion, including fear, needs to be removed. This can be easier said than done. If you are facing a major financial decision and dealing with emotions at the same time, you should talk to a trusted CPA, a financial adviser, or even someone at your bank who can look dispassionately at the problem.
Now to the question. There are three alternatives, but to determine which one is best, you need to consult with a CPA who has experience in tax resolution about your specific situation. A word of caution: You may have seen claims on TV or Internet advertising of settling your tax problems for "pennies on the dollar" or for 99% of the tax due, but many who make wild claims cannot produce. I have seen people offering tax resolution who are more concerned about getting a payment than actually providing a resolution. Many scams are out there telling taxpayers they have a good case to have their taxes forgiven who in reality have no basis for such forgiveness.
Here are your three alternatives:
By looking at a strict formula, the IRS determines the tax cannot be collected from the taxpayer. The formula used is net income less basic living expenses [generally, credit card payments are not allowed as a living expense] plus available credit available and liquid assets like savings, 401(k)s or stocks. Non-collectible status does not forgive the tax, but the IRS "shelves" the liability and stops collection activities for a period time. Interest continues to accumulate on the tax debt, and the IRS will quietly review the case, generally annually, to determine if the taxpayer's financial condition has changed and will resume collection activity if the IRS feels it is warranted.
Internal Revenue Code [IRC] section 6159 provides the statutory authority for the IRS to enter into an installment agreement, and IRC sections 6331 and 6159 have requirements to protect taxpayers, including giving them the right to appeal. If the total tax due is $25,000 or less, the IRS will enter into an installment agreement through the streamlined installment agreement program, without giving them financial information. Generally, they just have to give the IRS the name and address of their employer and their bank. For larger debt, the taxpayer is required to fill out form 433F and in many cases, a 433A or 433B. In this case, a strict formula is used and documentation of your finances is required.
Offer in Compromise [OIC]:
IRC code section 7122 establishes the Offer In Compromise [OIC]. There are three types of OICs: (1) Offer based on doubt of liability, (2) Offer based on collectibility, and (3) Effective tax administration. In summary, Offer based on liability is when there is a strong basis that the liability assessed by IRS in incorrect. It is not commonly used.
An OIC based on collectibility is more commonly used, and the basis is the taxpayer does not have the income and assets to pay the tax. In other words, the minimum offer amount must generally be equal to (or greater than) the taxpayer's reasonable collection potential. It is basically a once in a lifetime forgiveness of a tax debt, and the taxpayer agrees to NEVER have outstanding tax liabilities in the future. If they do, the OIC is rescinded and the taxpayer is required to pay all of the tax that was previously forgiven with interest. A strict formula is used, more involved than for installment agreements, and is about a 12-month process requiring documentation of 100% of one's finances.
Effective, July 17, 2006, a 20% payment of the tax liability is required before an OIC is accepted for evaluation unless the taxpayer meets a low-income test. There is federal legislation to force the IRS to remove this requirement [HR. 2343 – Tax Compromise Improvement Act of 2009]. It is currently going through the first step in the legislative process in the House Ways and Means Committee. I have also seen this being tacked on to other recent legislation.
An OIC based on effective tax administration is where the IRS considers exceptional circumstances in which the taxpayer demonstrates that the collection of the tax would create an economic hardship or would be unfair and inequitable, as in the case of severe illness or disability.
Another alternative is bankruptcy. According to Bankruptcy Code 507, income taxes can be discharged in bankruptcy if all the following conditions are met:
- All tax returns have been filed.
- The taxing authority has assessed the tax within 240 days of filing the bankruptcy.
- The tax return due date, plus extensions, is more than three years old.
This is only a high-level summary, and a CPA or tax attorney should be consulted to determine if your taxes are dischargeable.
Therefore, the specific answer to the question is, "it depends." It depends on your income and assets. If there is equity in your home, that equity will be used by the IRS in their formulas to determine reasonable collection potential. Nevertheless, remember, no matter how bad a situation might look, there is always an answer, and you just need to get advice from qualified professionals.
I have three adult sons still living here, one 23, making about $900/month take home, the other 21, not ever having a steady job. I pay his car, car insurance and phone. The third pays all his own bills, and makes a good living (especially with no living expenses to pay). Is there a way to claim the first two as dependents? I haven't since they turned 18 or ended college.
I took a partial withdrawal from my IRA CD at age 60. With this, our combined income is under $32,000. I heard that I do not have to pay taxes on this withdrawal. Any truth to this?
The tax treatment of IRA distributions (withdrawals) can be very complex. There are a number of different types of IRAs and a wide variety of circumstances within which distributions can occur. There may also be penalties associated with some distributions. That said, let me address your specific situation.
Distributions from an IRA can start at age 59.5 without penalty. Prior to this age, distributions will incur a penalty of 10% plus the regular income tax on the money unless very specific circumstances apply. The good news is that your withdrawal is not subject to a penalty because of your age.
What I can't tell you is whether your distribution (withdrawal) is taxable. The tax applied to distributions from a traditional IRA depends on whether or not your contributions to the IRA were tax deductible at the time they were made. If your contributions were deductible, your distributions will be taxable. On the other hand, if you made nondeductible contributions, the distribution of your contributions will be tax-free. Any earnings in an IRA will always be taxable.
I wish I could be more definitive, but I hope the general rules above will enable you to reach the right answer based on your situation.
For future reference, readers with tax questions can also visit freetaxquestion.com between now and the end of January. Just visit, request a time for call back, and an expert will get back to you with a free answer to your question.
My husband and I have our own business in trucking. We owe back taxes on our home and have not filed personal taxes in two or three years solely because we have no profit in the business and knew we would not receive a return of money or owe anything. We also owe employee tax of $20,000, because we did not know better and had an accountant who was not helpful and didn't bother to tell or explain to us all we were doing wrong. He just bought a new house, and we are losing ours. We need help! Call us old-fashioned or ignorant or worse, but we don't really believe in bankruptcy. We want to pay back what is owed if at all possible. We went from having 20-plus employees to just my husband driving a truck, and it is a struggle just coming up with fuel money each week, much less trying to get caught up on bills and keep the truck legal with taxes and tags. Where do we go for help and information on what to do? We cannot afford to pay much if any for help. Any input would be greatly appreciated.
Answer from Wray Rives, CPA, Outright.com, which offers free bookkeeping tools for small businesses
If you can't afford to hire someone, contact the IRS yourself to start the process with their assistance; then find the local CPA society or Bar Association. These groups will often have programs where professionals offer pro-bono services. Rest assured, you'll make it through the IRS hurdles without help, but it is always wise to have a professional on your side who is experienced dealing with the Service.
Here's why: The employment tax owed is a particularly serious and urgent problem to address. The government considers that employers have a "fiduciary duty" to pay employment taxes that are withheld from employees, and they take a very dim view of businesses that fail in that duty. Failure to pay employment taxes can result in some pretty extreme penalties and is another reason to find someone who can help calculate the actual amounts owed while contacting the Service to quickly to work on a solution.
The IRS is often willing to work out an installment agreement for unpaid taxes, but they have to believe the taxpayer is making an honest effort to get their liability paid off, and not just avoid their obligation. That alone is the reason that, if you know you have a problem, you should be proactive about contacting the Service before they come after you; you honestly help yourself, and they will help you. More good news is that the Service can and will, in the right circumstances, waive penalties, and the interest charged on installment agreements right now is fairly low. You are working with them to do just that.
By the way, not only do we agree that bankruptcy isn't the right answer, but you really should avoid it in this case. Bankruptcy does not discharge you of your liability to pay employment taxes. You still owe the employment taxes in full, even if you declare bankruptcy.
Bottom line, start right now resolving the problem with a little help and an honest plea to the IRS.