Your # 1 goal should be to reduce your IRS bill; this way you can pay the IRS some of what you owe as opposed to the entire amount you owe. So let's take a look at how to make a payment towards your back taxes in a way that provides the most bang for your buck.
Applying payments to particular tax years (or quarters)
Chances are, you're not going to owe the same amount for each individual year that you've accrued back taxes. Some years are going to be more and some are going to be less. This is nothing revolutionary but plays an important role as tax years matter. The last thing you want to do when applying a cash payment to your debt is to hand over a lump-sum to the IRS. This completely removes your ability to be strategic, as you're handing over your ability to apply your payment to particular tax years and specific types of taxes.
Before we take a look at how you can tailor your payment to best suit your needs, it's important to understand how the IRS normally distributes a payment. (Hint: it's not in your best interests)
How the IRS applies back tax payments
In order to figure out how to apply any voluntary payments you wish to make to the IRS, it's necessary to understand how the IRS will apply back tax payments. The IRS typically applies your payment directly to the oldest tax liabilities. This is the case even if you are in an Installment Agreement or Partial Payment Installment Agreement (PPIA). If you looked at your IRS account transcript (to get yours from the IRS, click here), you would see your installment agreement payments are automatically applied to your oldest tax liabilities. Now we have to ask ourselves, "Why is it that the IRS wants to apply back tax payments to the oldest tax liabilities?"
Because, and we need to be painstakingly clear on – the IRS does not have our best interests at heart.
The answer to why old liabilities are targeted is easy to understand once you realize that the IRS has a limited amount of time to collect back tax debts. Because your oldest liabilities are going to be the first to become uncollectable due to the collection clock running out, it makes sense that the IRS would want to collect on those heading for expiration. By ensuring that they receive money on the liabilities that have a threat of evaporating, the IRS is able to keep the newer liabilities open to collect on in the future.
How to apply a chunk of money to back tax liabilities
That is how we find the answer to the best way to apply a big chunk of money towards your back tax debt: if you are looking to make a big payment to the IRS, it makes sense to apply that payment to the tax years that have the longest collection period left, i.e., the newest assessments. So, if you owed taxes for 2008, 2009, 2010, 2011, and 2012, and then were to file your current year's taxes on time, it's likely that you'll want to pay off 2012 first, and then work back from there.
Note: If you are in an IRS installment agreement and try to apply your payments to more recent years, that may very well cause a default (please keep this in mind!). With an installment agreement, the IRS agrees to forgo enforced collections, but then they get to apply payments the way that they want. It's a trade off, but sometimes can be worth it to gain some security.
While the IRS gets to direct payments with installment agreements, payments made through an offer in compromise are up to your choosing. You can apply offer in compromise payments any way you want (though the processing department doesn't always do it)!
How to apply a chunk of money to back payroll tax liabilities
The general concept that we just saw for personal back taxes holds true for payroll back taxes as well. If you owe 941 taxes for Quarters 1, 2, 3, and 4 for tax years 2011-2014, you would want to first start paying off the 4th Quarter of 2014. But you don't just want to stop there, as there is a huge favor you could do for yourself by taking things just one step further.
Instead of applying your back tax payment to 941 taxes, what you might want to do is pay off ALL trust fund taxes first (Learn about trust fund taxes here). From 2011 to 2014, you would want to go in and make payments to cover ALL of the accrued debts for these years. Why? Well first, the IRS gets real testy about trust fund taxes seeing as they had to credit your employees for withholdings they didn't actually receive. On top of that, the IRS had to pay them any refunds they had coming, even though the IRS didn't actually get the money from your employees in the first place. Secondly, but no less important, the trust fund taxes are what you are personally on the hook for. You cannot discharge them in bankruptcy, so getting rid of them should be a priority.
Once you pay off the trust fund portion of payroll taxes, your personal liability is extinguished. The IRS can only seek repayment from the business, assuming the business has any assets or income stream left to pay off the debts. By planning carefully, you can do yourself a massive favor by eliminating the dangerous trust fund taxes that threaten you as an individual. By removing the personal liability, all that's left are the employer taxes that the IRS has limited ways to collect and, in all honestly, aren't particularly aggressive in demanding repayment.
Is someone giving you a loan to pay back your taxes?
If your answer to the above question is "yes," you may want to consider submitting an offer in compromise. Why? When the IRS calculated your Reasonable Collection Potential (RCP), loans you get are not added in. For instance, say you are just keeping your head above water, and your father is willing to loan you $100,000 to pay off an IRS debt. In that case, you may want to look at submitting an offer for less; your RCP, which is your ability to pay the IRS back, does not extend to your ability to get a loan, and that can work immensely to your advantage.
If you're wondering if this is "scammy" or underhanded, allow me to convince you otherwise. First, this is entirely legal and above-board (after all, the IRS were the ones who created the RCP rules). Second, and this is a big one, what happens if you borrow that $100,000 from your father and you get another tax problem? You see how easy it is to fall into that trap, right? Maybe it is a good idea to leave a little ammunition in reserve for the unexpected. You owe it to yourself and your family to take tax debt seriously as it has the potential to derail your future. The last thing you want is to deplete all of your resources just so you can say that you were a "good citizen." If you have the opportunity to pay the IRS less than the full amount of your back tax, don't hesitate. They're beating the collection expiration and you're getting a chance to move on with your life.
Warning about making large payments to the IRS
Whatever you do, don't make a lump sum that causes you to be NOT current (What does it mean to be current? Read this article to find out). You just came into a big chunk of cash, right? Well, guess what? Often you will owe taxes on that money. So be 100% sure you set enough aside so that you won't have a tax problem for this year. Your goal should be to permanently end your tax problem, not just kick the can down the road.
Making a plan to eliminate your IRS debt
If you are going to make a huge payment to the IRS, there are so many more factors to know in order to make the optimal decision. Factors such as the total debt, your total RCP, if there are any strategies we can employ to legally lower your RCP, risks for a new tax problem, cash-flow demands, or if you are better off using that money for a structured payment plan with the IRS are all points that demand consideration. Without taking the time and energy to carefully craft a strategy for you to repay the IRS, it's not unlikely that you'll be paying significantly more than you owe. Failing to carefully consider various factors can be the difference between paying the IRS back for a portion of what you owe and ridding yourself of IRS involvement in your life and setting yourself up for a bright future.
To apply a poker analogy: If you go "all-in" for one hand, you may have nothing left for the next deal, which could be a lot better.
