In some of our previous articles, we have talked about setting up a payment plan with the IRS if you have a tax debt and are unable to pay it off in a timely fashion. Just to summarize, you can apply for a short-term plan if you believe you will be able to pay off your debt within 6 months, or you can apply for a long-term plan if you will need between 6 and 72 months of monthly installments to resolve your debt. Exactly which payment options are available to you will depend on your specific tax situation, but bear in mind that interest and penalties will be added to your remaining balance until the debt is paid in full. In other words, the sooner you can pay off your debt, the less you will need to pay.
In those articles, we talked mainly about the types of payment plans that are available from the IRS, but we didn’t provide any details about the interest and penalties that are involved. But that is not to say that those items are unimportant because they have had a significant impact in the current economic environment where we have seen successive increases in interest rates over the last year or two.
If you have an outstanding debt with the IRS, the agency will calculate your interest and penalties daily and add them to the amount you owe. This means that even though you may be making your payments on time each month, the balance of your debt will increase during the 30-day period until you make your next payment.
For example, let’s say you have a debt of $10,000 and you have agreed to a payment plan of $150 per month. After making your first payment, you are relieved to know that you have taken a small bite out of your debt, which has now been reduced to $9,850. But by the time you are ready to make your next payment, you find that your debt has crept back up by $60 and is now $9,910. In other words, paying your tax debt is like paying your mortgage in that part of your monthly payment goes toward paying interest on your debt while the remainder reduces the balance of the principal amount.
In the example above, the $60 of extra debt that was added on during the month is made up of two parts:
- Failure-to-pay penalty at a rate of 0.25%
- Interest at a rate of 7%
Yes, you read that correctly. As of May 2023, the balance of your outstanding tax debt increases each day at an annual rate of 7.25%, thanks mainly to the 7% interest rate. According to the Internal Revenue Code
1, the interest rate for underpayment of tax by individual taxpayers is calculated by adding 3 percentage points to the current short-term Federal interest rate. The applicable short-term Federal rate that applies to the second quarter of 2023 is 4.33% – which, together with the standard 3% addition, yields an interest rate of 7.33% – is then rounded to the nearest whole number to create the 7%
2 rate.
Although 7% is the current rate at the time of writing, it may change for the next quarter of the year based on the change in the Federal short-term rate. For example, the interest rate one year ago in the second quarter of 2022 was 4%
3 because the short-term Federal rate was lower at that time. Rate fluctuations such as these can make it difficult for taxpayers to manage paying off their debt within the time horizon agreed with the IRS. For example, a taxpayer who established a payment plan during 2021 when the interest rate was 3% would find that unless he has increased his monthly payments to reflect the rises in interest rates that began during 2022, he is no longer on schedule to pay off his debt on time. Interest and penalties on tax debts continue to get added on daily up until the final balance is paid, and it would be a very unpleasant surprise for the taxpayer to find that he still owed hundreds or thousands of dollars to the IRS on the day that he made (what he thought would be) his final payment.
For reasons such as these, it would be wise to seek professional advice if you need to set up a payment plan or are unsure about your current payment plan. Expert and confidential advice is available at no charge and with no obligation when you
contact one of our experienced tax professionals to discuss your case. They will help you understand the
steps required to resolve your tax debt on time – with no unpleasant surprises on the final day!
1 I.R.C. §6621. Determination of rate of interest
2 IRS Rev. Rul. 2023-11
3 IRS Rev. Rul. 2022-15