My first major client came to me with the following question:
“My husband and I owe the IRS $86,000 in back taxes. Last year, we had to liquidate our retirement plan just to pay our taxes down this far, so I think that this year’s tax return will make it worse. Can you help us?”
My response came fairly naturally:
“I don’t know, but I can try.”
Honestly, I had no idea of how I was going to help this client. But I came into this profession to help people. I decided that I would calculate my financial planning fee and present it to them. If they agreed to pay my fee, then I would do everything within my power to help them. This article tells that story.
After the clients (we'll call them John and Mary, even though those are not their real names) and I agreed to the fee, I discovered that the situation was much worse than I originally thought.
1. The $86,000 in taxes did not include penalties or interest. That was another $10,000 or so.
2. The day before we signed our client agreement, they received their tax return (on tax day, no less!). That year's tax return was for another $46,000 and included their CPA's highest recommendation that they pay their tax return as soon as possible. Sound advice. But with what?
3. I had noticed that while he had taken a second job to earn extra money, they were not having taxes withheld. That meant that this could get even worse going forward!
It was clear that this wasn't an easy fix. The fact that they had no savings (their retirement account had been depleted just to get to this point) meant that we had to figure something else out. Fortunately, they had three things going for them.
1. High earnings. This was a big problem, and wasn't going to be fixed overnight. Fortunately, the husband works in a field where he is highly compensated, and earns $500,000 per year. His 'side job' was taking an extra weekly shift with a local business. That earned $2,500 per 24-hour shift. Doing one shift per week would add up to $130,000 per year. Having a high income meant that there was some potential to pay down debt quickly, once we got the cash flow under control.
2. Home equity. While their savings accounts were depleted, we were fortunate that they had some home equity, which gave us a little flexibility. While I don't normally advise using home equity as a way to restructure debt, their home equity did come into play here. I'll explain in more detail later on.
3. Willingness to work with me. In order to be successful, any financial planning relationship has to be a two-way street. I was willing to commit whatever it took to help them get to a better place. Whether that was time, knowledge, energy, emotional capacity, my client knew that I would go the extra mile. But I needed them to do some things as well. There were certain things that I would not be able to do that just needed to get done. Mary, who handled the family finances, understood that. And once that was settled, I knew that we would work well together. In fact, Mary was a true rock star throughout all of this and our plan would have never succeeded without her diligence and effort.
The other thing that my clients and I mutually understood was that the IRS would expect them to repay these taxes in full. We did not discuss an offer in compromise. An offer in compromise (OIC) is where the IRS will allow certain taxpayers to pay less than they owe. OICs are usually for people whose disposable income would not allow them to make the required payments to fully repay their debt under an installment plan. In this case, I had run their numbers through the IRS' OIC Pre-Qualifier tool. When I did, I saw that an OIC was not a serious option.
The only question now was whether we could convince the IRS to agree to a payment plan that worked for my client.
How IRS Payment Plans Work
I won't bore you with all the details about how IRS payment plans work. For a comprehensive view on installment plans, you can find everything at the IRS website. However, there are a few things that you should know:
- The taxpayer has to come up with a payment plan, then the IRS can choose to accept it or not. This is done by filling out Form 9465, Installment Agreement Request. While this is a major drawback from a negotiating perspective, we were able to use this to our advantage. I'll outline this in more detail later.
- The amount you owe determines how much flexibility you have. The IRS has certain limits on your ability to negotiate. For example:
- Taxpayers who owe less than $25,000 can pay by credit card. Those who owe more must use a direct debit option.
- Taxpayers who owe less than $50,000 can avoid having the IRS place a lien on their primary residence. Those who owe more risk having that lien in place until the loan is paid off.
- Taxpayers who owe more than $100,000 are usually referred to an escalated office. That means if you wanted to go to a local IRS office and negotiate in person, that option is off the table.
- There are fees to set up a payment plan. These fees depend on:
- The length of the payment plan
- Whether you qualify for a low-income fee reduction
- Whether you apply online or over the phone
- If paying by credit or debit card, additional fees apply
- You may be asked to list out all of your assets. This is done on Form 433-F, Collection Information Statement.
- You may be able to erase the penalty charges. The IRS's website specifically discusses how first time offenders may seek penalty relief. Unfortunately, this doesn't apply to accrued interest.
First, we set up an appointment with our local IRS office. If you ever have to set up an appointment, make sure you get there at least 15-20 minutes in advance. You'll go through a metal detector, and they'll verify that you have an appointment.
Once there, we found out that the local office couldn't help us. It turns out that the recent tax return had just been uploaded in the IRS' system. This made my clients' outstanding balance go over the $100,000 threshold. This gave me another reason to dislike their CPA. If the CPA had filed an extension, this would have kept my clients' balance below the threshold. That way, they could have negotiated an agreement in person.
Instead, we were 'escalated' to a centralized collections office. This meant all of our business would be done over the phone. Ugh. This also meant that we had to come up with a plan.
Our Tax Payment Plan
My client wanted to negotiate a plan that involved NOT putting a lien on the house. This meant getting the balance to below $50,000. Factoring this into the plan meant three things:
- Withholding enough estimated taxes to pay the current year's tax bill. As previously mentioned, I noticed that they were woefully under-withholding for the current year. It would make no sense to fix the previous years' tax problems if that meant they were going to take a major hit next year. And they were on track to do just that.
- Establishing enough of a cash flow for the payment plan. We didn't know what the IRS would allow us to negotiate into the installment plan. But we could estimate using a couple of factors. First, our magic number was $50,000. Second, the maximum period of time for an installment plan is 72 months. You can find this in the instructions for Form 9465, Installment Agreement Request. Throw in interest, and this comes out to approximately $700-$750 per month.
- Coming up with a down payment. This was the challenge. How were we going to come up with approximately $80-$90K to pay the down payment? There was only one option: take out some home equity.
Home Equity: An Unconventional Source of Capital
Before we go further, I want to point out a couple of things.
First, I almost never advise people take out home equity debt. There are a few instances in which home equity debt makes sense. For the most part, I usually advise that people find another way to finance whatever it is they feel they need home equity for.
Second, taking out a home equity line of credit (HELOC) has a lot of risk, especially for folks who need more structure in repaying debt. Taking out a fixed home equity loan allows for some structure in how you repay the loan. On the other hand, a HELOC allows you to carry a balance and make flexible payments, like a credit card. Unfortunately, this makes it easy for people to get used to carrying the balance, and only making interest payments, which can be a slippery slope. However, we were past the slippery slope and facing a cliff. There are two things that moved us in the direction of a HELOC.
1. I knew a lender who could finance this. While my clients had equity, they didn't have a ton. They needed special financing called a 90/10 (which meant that the total amount borrowed was 90% of the home's value, versus the standard 80% that's calculated in home equity loans). The lender couldn't do this type of financing under a loan, only a HELOC.
2. There was a lot that I did not know about my new clients' finances. I needed to have some immediate flexibility while I helped them with their cash flow. If I could do this, then I knew we could always make extra payments down the line as they pay off other debt.
Third, the amount of mortgage debt (including a HELOC or home equity loan) factors into your credit score. As you can guess, the higher the debt is related to your home's value, the more detrimental it is to your score. But not as detrimental as a lien on your home.
Now that we knew this was part of a plan, we still needed time for the lender to make the financing available. How would we do this, knowing the IRS wanted a plan ASAP?
Submitting the Tax Payment Plan
The first time we called the IRS collections number, we spent about 45 minutes on hold.
Note: set aside about 2 hours for each phone call you have to make. The wait times are pretty long.
Eventually, we got to a collections agent, who walked us through the process. Basically, we would have to submit our plan, then wait to be notified as to whether it was accepted. No bargaining, no negotiation, nothing. The agent couldn't tell us anything over the phone. She could only accept the numbers that we gave her, then input them into the IRS' system. From our understanding, the proposed plan would then go to a supervisor, who would use a set of IRS guidelines to determine whether nor not to accept the plan.
We had already determined what our offer would be, and we submitted it. While I had worked with my clients on the 'worst case scenario,' we had submitted a number that was a little less than that. After all, the worst that could happen is that the IRS would say no. The unintended benefit was that this gave us a little time to get the HELOC in place.
According to IRS Publication 594, The IRS Collection Process, by law, the collections process may be suspended "while the IRS is considering your request for an Installment Agreement or Offer in Compromise. If your request is rejected, we will suspend collection for another 30 days, and during any period the Appeals Office is considering your appeal request." In other words, since my client had submitted an offer, the IRS' collections process (including placing a lien on their home) stopped.
I had a suspicion that the IRS would not accept anything less than the most aggressive payment plan. After all, this is a high-earning household. Even if there was an emotional component, I doubted any IRS supervisor would have pity for them.
Fortunately, we had the HELOC in place by the time we received the rejection notice. We made another call, and submitted the plan that I thought would be accepted: a down payment to get the balance to below $50,000, coupled with a 72-month payment schedule for the remaining balance. This time, the offer was accepted with a direct debit option.
Additionally, we were able to abate approximately $12,000 in penalties by submitting a Form 843, Claim for Refund and Request for Abatement. Since this was a first-time incident, the agent told us that there was a 'high degree of confidence' that this would be accepted. And it was. But that's not the end of the story.
Bumps in the Road
As you can expect in dealings with the IRS, there were a couple of hiccups.
First, an IRS supervisor decided to place a lien on the property, anyway. This was a shock, since Mary, John, and the IRS had negotiated an installment plan. Interestingly, the IRS anticipates this in Form 12277, Application for Withdrawal of Filed Form 668(Y), Notice of Federal Tax Lien, as Block 11 cites the following as a reason to request withdrawal of a filed Notice of Federal Tax Lien:
“The taxpayer entered into an installment agreement to satisfy the liability for which the lien was imposed and the agreement did not provide for a Notice of Federal Tax Lien to be filed.”
In fact, there's another check box next to the "Direct Debit Installment Agreement" section, as if that lends further credence to the debit option under an installment plan.
Regardless, filing Form 12277 was no walk in the park; my client had to enlist the Taxpayer Advocacy Service to state her case...in spite of the fact that she had already negotiated an agreement with the IRS in the first place! Of course, since the lien had already been filed, my client also had to follow up and ensure that the lien was withdrawn, and subsequently, any negative impact to her credit report.
It took longer than we expected, but Mary was able to eventually clear this obstacle.
Second, throughout the process, it was nearly impossible for me to actually represent Mary and John in any IRS conversation. This was in spite of the fact that they had submitted a Form 2848, Power of Attorney and Declaration of Representative, not once, but twice!
While this was inconvenient, I was able to assist them because we made a mutual commitment that I would be there for every phone call she made. In other words, I would be there for every conversation, even if she had to lead that conversation with the IRS agent. I might not have been able to represent her, but I was able to listen to the conversations and give her guidance as the conversations progressed.
However, once the agreement was in place, we agreed that Mary would probably be more efficient in working through the Taxpayer Advocacy Service by herself, since this did require going back and forth repeatedly. Otherwise, setting up an appointment for each phone call just so I could be involved would have taken much longer. Besides, the Taxpayer Advocacy Service did as advertised: advocating for the client. And the Taxpayer Advocacy representative was more effective than an outsider, such as myself or Mary, would have been, when it came to navigating the IRS administrative processes. After all, there's only so much you can learn online...there comes a point at which you need a person who can reach out to the right people to make something happen.
Third, the IRS didn't even take the down payment out when it was supposed to! Ugh. While this might not seem like a big deal to most folks, this was a major point of stress. After all, this was a major source of stress for Mary & John. And after all the hard work Mary had put into this plan, it was another point of frustration. Mary had to enlist the support of her Taxpayer Advocacy representative to make sure the IRS withdrew the money.
Eventually, everything worked out. Mary & John are on a payment plan, they're current on their taxes, their credit is restored, and they're paying off their debt across the board. Mary's stress level has gone down immensely, and we're now focused on next-level financial planning topics, such as restoring their retirement savings and tax planning. But it's worth sharing some of the lessons we learned along the way.
This experience taught me a lot! And I think I can speak for Mary and John in saying that they learned a lot as well! Below are a couple of lessons that we learned:
1. Negotiating a debt payment plan with the IRS takes time! I met Mary & John in April. We didn't feel like we cleared all the hurdles until the following January. That's nine months! And half that time was just prodding the IRS to do what they said they were going to do.
2. Don't expect to sit back and let things happen. That is the surest way for things to go against you. The IRS already has a collections process in place. If you do nothing, or wait until you get around to it, the IRS will figure out a way to start collecting. And you probably won't like it.
3. You're going to have to find a way to sacrifice something. It might be your money, your credit or both...you decide. It's pretty rare that the IRS is going to let you run up a serious amount of tax debt, then claim poverty and get out of it. Of course, there are plenty of circumstances which warrant an offer in compromise. But generally, unless you've suffered from a series of misfortunes, the IRS will find ways to force you (or strongly incentivize you) to pay what you owe, and to pay it sooner rather than later. To point #2, the longer you wait to make a serious commitment (i.e. cutting cash flow elsewhere to pay down taxes), the worse your options can get.
4. Bankruptcy might be an option. But it won't help. As a general rule of thumb, tax debt is very difficult to discharge. So much so, that filing for bankruptcy is generally not considered a realistic option, unless you're willing to also walk away from many other things you own (such as your house and car). While Publication 908 outlines the ways a taxpayer can discharge tax debt, it's worth pointing out a couple of things:
- Chapter 13 bankruptcy allows tax to be discharged only after paying all debt under the debt payment plan.
- Chapter 7 only allows for the discharge of certain tax debt, under certain conditions.
- You have to have filed all tax returns in order to be eligible for any discharge of tax debt.
- If there is a notice of federal tax lien (NFTL) in place from before the bankruptcy hearing, any discharged debt can still be collected against that property!
If you did a double-take on that last one, that's right! Even if you get your debt discharged, the IRS can still collect against any outstanding liens placed upon your property. In short, consider bankruptcy 'a nuclear option.'
5. Taxpayer Advocacy Service really helps! It's a point of irony that our taxpayer dollars pay for a group of IRS employees to go to battle against IRS employees for the benefit of the taxpayer. But when you look at how massive the IRS really is ($3.3 trillion in collections for fiscal year 2016), it's easy to see that mistakes will be made. And it's a good thing that there is a safety mechanism such as the Taxpayer Advocacy Service to help keep those mistakes from having a lasting impact on taxpayers.
6. Even if you hire a tax professional, expect to do some heavy lifting yourself! While there are folks who can help you work through the process, there are certain decisions you just need to make yourself. For example, if cash flow is a problem, no one will cut your spending but you. The best way to get to the solution that you want is to be proactive.
While this was an emotional experience for everyone involved, I came away with a much better appreciation for my clients. Without Mary taking some of my advice to heart & having frank conversations with her family, this would never have worked. But after a while, as she gained confidence, it was very clear that Mary was driving this train, even if I helped her get started. It is not an exaggeration to say that all of the success here is attributable to Mary and her desire to take control of a bad situation.
And despite its shortcomings, the IRS does have a decent process for helping taxpayers implement payment plans. After all, the primary focus of a payment plan is to ensure that the taxpayer eventually pays the taxes that they owe.
If you know of anyone who might need assistance in navigating this process, please contact us. Scheduling a complimentary 30 minute consultation will help us get the information we need to determine whether we can be of assistance. If not, we'll help you get started in the right direction.