Answer: Depending upon the specifics of your situation, it may be possible to avoid hundreds, or even thousands, of dollars in penalties simply by “designating” voluntary payments applied toward your tax liability. Keep in mind that payments made in accordance with a formalized installment agreement are not considered voluntary, so you have no right to designate those. However, if you are on an installment agreement, and you wish to make additional payments above and beyond your minimum payment, you may designate those additional payments.
There are several important factors to consider when making a voluntary back-tax payment so that such a payment is applied in your best interest, and not that of the IRS. I will discuss these below.
First, it is important to understand that you have the right to tell the IRS how you want a voluntary payment applied. If you make a voluntary payment, but fail to designate it, the IRS will apply that payment in the government’s best interest. IRS procedures instruct it to apply non-designated payments to periods in the order of priority that the IRS determines to be in its own best interest. In most circumstances, this means that the IRS will apply the non-designated voluntary payment to the oldest period for which you owe, and the IRS will apply it to tax, penalty, and interest, in that order.
This procedure gives the IRS several major advantages: 1) it increases the chances that the IRS will collect all of the oldest liability within its collection statute of limitations, 2) it maximizes the amount of time that the IRS will have to collect on more recent tax liabilities prior to the expiration of the collection statute of limitations, and, 3) because the oldest tax liabilities are more likely to have already hit the maximum late payment penalty, it gives the IRS a better chance of maximizing late payment penalties on more recent tax liabilities. In short, the procedure tends to keep delinquent taxpayers in collections as long as possible while, at the same time, racking up as much as possible in penalties against delinquent taxpayers in the process.
So, how should you go about designating voluntary payments to the IRS in a fashion that will take these advantages away from the IRS, and give you the advantage? Unfortunately, there is no one-size-fits-all answer to this question. Rather, there are several factors to consider, including the risk of enforcement, whether the tax liabilities are trust taxes owed by a business, and whether there is a significant chance that one or more of the tax liabilities will become uncollectible due to the expiration of the IRS’s collection statute of limitations.
If you only owe for one tax period, there isn’t much advantage in designating your voluntary payments. However, as I will explain, if you owe for more than one tax period, you may be able to avoid a large sum in penalties simply by wisely designating voluntary payments. In order to understand why, it is first necessary to understand the basics of late payment penalties (the IRS may also impose late-filing penalties and failure-to-deposit penalties, among others, but those will not be discussed in this article).
When an IRS tax obligation isn’t paid on time, the IRS will begin by charging a penalty of ½ of one percent of the unpaid tax obligation per month following the date the tax was due. If the tax liability remains unpaid, the IRS will eventually issue an Intent to Levy notice. Once it issues this notice, it will increase the late payment penalty to one percent per month until the penalty reaches a limit of 25%.
Thus, tax liabilities that are 50 months past due have necessarily reached the maximum 25% late payment penalty. Assuming, an Intent to Levy notice was issued, the 25% maximum may have been reached much sooner than 50 months past the date when the tax was due. For example, it would not be uncommon for a tax liability that is 36 months past due to have reached the maximum 25% late payment penalty. More recent tax liabilities may have many more months to go before reaching that 25% maximum.
With this in mind, it is often advisable to designate voluntary payments to the tax portion of the most recent tax liability for which you owe. Once the tax portion (not including the penalties and interest) of the most recent period is paid off, then begin paying down the tax portion of the second-most recent tax period for which you owe. Continue working your way backward until all of the principal tax is paid. Once the tax portion has been paid off on all delinquent periods, then designate payments to the penalties in the same order (unless you succeed in getting your penalties abated). Finally, designate to interest in the same order.
The procedure outlined in the preceding paragraph will often minimize the accrual of penalties due to the fact that you will have a much higher likelihood of paying off the more recent periods before the late payment penalties for those periods hit their maximum. The penalties, in a sense, are like water leaking through a hole in a boat. When the IRS applies non-designated voluntary payments in its own best interest, the payments are like bailing a bucket of water out of the boat. While the old water (penalties) is being bailed out, new water (penalties) is leaking into the boat to replace the old. In the method that I outlined in the preceding paragraph, the designated voluntary payments are going towards plugging the hole in the boat. Once that hole is plugged, the penalties stop accruing. At that point, you can focus on bailing the remaining water out of the boat without a constant stream of new water entering the boat to replace the old.
With that said, it is important to understand that there are circumstances under which the procedure I have outlined might not be in your best interest. One such circumstance is when there is a significant risk that the IRS will take enforcement against the older periods, but the IRS is not in a position to take enforcement against the newer periods. How to go about assessing the risk of enforcement is beyond the scope of this article. However, suffice it to say that the IRS must follow certain procedural requirements before it is in a position to enforce. The IRS may have followed those requirements for the older periods, but not for the newer ones. If that is the case, and you have nothing in place to prevent the IRS from enforcing (e.g. a formalized installment agreement, certain appeals pending, etc.), it may be wise to designate your available funds to the oldest periods for the purpose of reducing or eliminating your exposure to enforcement. To learn more about the IRS’s prerequisites to enforcement, see IRS Wage Levy and IRS Seizure of Assets.
Another set of circumstances under which it might not be in your best interest to designate voluntary payments by way of the method described above is when you are a responsible individual for a business that owes trust taxes (e.g. 941 employer withholding taxes and certain federal excise taxes). The IRS can assess willful and responsible individuals with personal liability for a business’s unpaid trust taxes. Thus, if you are in this situation, and wish to minimize or avoid personal liability, you may wish to designate payments specifically to the “trust tax” portion of the business’s tax liability. In the case of employer withholding taxes, this is the amount actually withheld from the employees’ paychecks and not turned over to the IRS (the employer matching portion is not considered “trust”). The same considerations regarding risk of enforcement and sequence of tax periods as discussed above apply. To learn more about personal trust tax liability, see Trust Fund Recovery Penalty: Personal Liability for Unpaid Business Trust Taxes .
Finally, it may be in your interest to deviate from the payment designation method described above if there is a reasonable chance that the oldest periods for which you owe will soon become uncollectible due to the expiration of the IRS’s collection statute of limitations. With some exceptions, the IRS has ten years from the date that a tax liability is assessed to collect that tax liability. If some of the oldest tax periods are getting close to the collection statute expiration date, and there is no significant risk of enforcement, then it may be wise not to designate any payments to the oldest period or periods, and instead focus solely on the more recent periods.
As you can see, there can be huge advantages to designating voluntary back-tax payments, particularly if you or your business owe for multiple tax periods. While the above provides a general guideline to designating payments in your own best interest, it is not intended to be a substitute for seeking advice from an experienced tax resolution professional. Taxpayers in collections with the IRS have a seemingly infinite set of unique circumstances, and an experienced professional should be able to tailor a payment designation strategy to the circumstances and goals of each individual taxpayer.