Council Post: How Inflation Can Impact Your IRS Tax Bill

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David King is the CEO of Optima Tax, Over the last 10 years, he has grown Optima to be the industry leader for post-filing tax issues.

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Every year, my team and I hear from thousands of taxpayers who are unpleasantly surprised at how quickly an unpaid IRS tax balance has grown over time. Although the bulk of an aged tax debt is typically due to non-filing or nonpayment penalties, it is also important to understand that interest plays a significant role—especially during an inflationary period when interest rates are likely to rise.

Under the Internal Revenue Code, the rate of interest for an unpaid balance is determined quarterly, using the federal short-term rate as a basis. For individual taxpayers, your rate of interest on a tax balance will be the short-term rate plus three percentage points. The add-on is three percentage points for corporations but is as high as 5% for large corporations.

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Interest And Its Compounding Effects

It is also worth mentioning that IRS interest on an unpaid balance will compound daily—much like a credit card, it never stops growing until the underlying balance is paid. For unpaid taxes, interest accrues on the total unpaid balance in addition to whatever penalties may be accruing. This can lead to the balance ballooning quickly as interest is charged and compounded daily on the sum of the tax balance, penalties and the compounded interest that accumulates over time.

Non-Filers And The Whiplash Effect

Whether you file a return or not, interest starts accumulating on the corresponding tax year’s payment due date—usually April 15. If you choose not to voluntarily comply with your obligation to file a tax return, the IRS may file a return for you, known as a Substitute for Return (SFR), at a later date. Aside from the likelihood of this return having a higher tax amount due, the IRS will backfill all corresponding penalties and interest from the return’s due date, which can result in a tax whiplash to surprise taxpayers when they get their first amount due notice.

IRS Interest Rate Trends

Over the last couple of years, taxpayers who owe have been somewhat protected from spiraling balances as the IRS interest rates have been hovering around the historical low—in the low 3% range. With the IRS recently announcing its first interest rate increase in two years and the Federal Reserve announcing its first hike in three years, the reprieve from ballooning interest is likely ending.

Options

While IRS interest is charged by law and will continue until the tax balance is paid in full, there are ways to get indirect relief. The most common is a penalty abatement that will reduce the overall tax balance—and the subsequent interest. Taxpayers who can owe this type of relief by arguing that there was reasonable cause for them being late, or more commonly, through the first-time penalty abatement (FTA).

With all signs pointing toward an extended period of inflation, and multiple rate increases, it is worth pointing out that the IRS interest rate was as ominous as 20% in the 1980s. Although I would not expect it to rise as high as 20%, I would caution every taxpayer that is carrying a balance, or ignoring their tax filing obligation, to act before the issue becomes overwhelming.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.


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