If You Thought the Recession Was Bad, Wait Till You See The Tax Problems Many Will Have as a Result

Jim Buttonnow from easyIRS.com sent me over the following article to post in an attempt to warn consumers of the looming tax problems to come as a result of living through tough times.

He raises some very important points and issues that will undoubtably catch consumers and land them in trouble with the IRS. This will lead more people to fall victim of dubious tax relief companies and create yet more pain and suffering.

Damon Day - Pro Debt Coach

As the recession continues, More Americans owe and cannot pay the IRS

Many believe the longest economic downturn since the Great Depression is over. However, for the unemployed and those who had to sustain by taking on debt, it seems like the recession never ends. It appears Congress may extend long term unemployment benefits that will help more than 2 million Americans whose benefits were due to expire this month. But, absent on the mind of Congress are any tax breaks for the unemployed in 2010 as well as any other significant tax relief for Americans affected by the recession. This is in contrast to 2009, when Congress provided some tax relief to the unemployed.

How does this impact taxpayers and the US Treasury? Since the recession, tax problems, specifically tax debtors, have been on the rise. More Americans are pursued by the IRS for unpaid tax debt. In fact, federal tax liens for the largest unpaid liabilities are up 41% in the past two years. The recession has created many of these tax problems because the tax laws are not gentle to those who are down on their luck. As a result, many in financial distress have created unintended tax problems for themselves.

In many instances, these tax problems will manifest itself in the form of “balance due” letters from the IRS that cannot be paid.

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Consider this:

  • The current unemployment rate in the United States remains high at 9.8%. In fact, it has remained over 9% since May, 2009. There are currently 6.3 million individuals who are long-term unemployment, i.e. over 27 weeks without work. Currently, there are about 8.5 million Americans collecting unemployment benefits. In 2008, the IRS saw a 48.5% increase in the amount of unemployment reported on tax returns. With higher unemployment in 2009, the amount will only increase. These benefits are taxable.
  • Many Americans are strapped with credit card and mortgage debt that they cannot pay due to unemployment. The Center for Responsible Lending reports that 2.5 million have already lost their homes to foreclosure and there are 5.7 million more homeowners who are currently at-risk for foreclosure. Homeowners in Nevada, Arizona, California and Florida will feel the cancellation of debt affects from home foreclosures the most. The debt cancelled may be all or partially taxable, especially if it is credit card debt or a refinanced mortgage.
  • With 15.1 million Americans currently out of work, many have no choice but to distribute from their pension or IRA to meet expenses, often long before they are ready to retire. For example, from 2007 to 2008, the number of taxpayers who reported a premature distribution to the IRS from an IRA increased 12.6%. From 2005-2008, IRA premature distributions reported increased by 63%. These distributions may be taxable and subject to an early withdrawal penalty. In 2008, 60% of reported pension distributions were taxable income.
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Financial woes may bring tax woes

These situations may signal future tax problems in addition to their current financial burden. In many cases, these problems are a surprise on April 15th because many believe that “if they do not make money, they probably do not owe taxes.” However, in these three situations that may not be the case:

  1. Taxes due on unemployment compensation – In 2009, those collecting unemployment was allowed to exclude the first $2,400 from income. Not so for 2010- every dollar received for unemployment is taxable income. Adding to the problem: as the amount of unemployment paid is barely enough for most to make ends meet, most do not have any tax withheld on their unemployment income. On April 15th, many will be surprised that unemployment if fully taxable. They may be faced with a tax bill on top of catching up with their other bills.
  2. Debt forgiveness must be reported on your tax return, and it may be taxable income- Unbeknown to many, when your credit card or mortgage debt is forgiven, this may be taxable income. At a minimum it needs to be reported on your tax return along with a calculation of taxability of the debt that was cancelled. Unless you meet one of the exceptions such as bankruptcy or insolvency, you may have a significant tax bill due. Most in this situation probably do not have the financial means to pay the potentially large tax bill. They definitely will have problems borrowing more money to pay the IRS as their credit probably has been damaged by the past creditors who wrote off the debt.
  3. Taxes AND a 10% penalty for an early withdrawal from IRAs/401k plans – Many are misled to believe that when they have their IRA administrator withhold 20% of their early distribution for taxes that they have paid ALL of their taxes on this income. However, for those who have spouses with income or have other income during the year, 20% may not be enough to cover their taxes at the end of the year. Why? Add a 10% early withdrawal penalty on top of the income taxes due, and there is only 10% remaining to pay for the income taxes on April 15th. The additional 10% penalty for early withdrawal surprises many who believe that their money woes will allow them leniency on April 15th. There is no “financial hardship” exclusion to the 10% penalty. The result for many: a tax bill with little means to pay.
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Recession aftermath: more cannot pay the taxes they owe

Alarmingly, there are an increasing number of Americans who cannot pay their taxes each year. Furthermore, the IRS is serious about investigating whether they can pay, and they are willing to enforce payment. For example, from 2005-2009, the amount that the IRS was actively collecting at the end of year increased 48% – that amounts to over $103 billion under IRS collections at the end of 2009.

Furthermore, the Federal tax liens filed for those who cannot pay increased 53% to almost 1 million new liens filed in 2009. This adds to the economic woes of those trying to meet their financial obligations by downsizing property as they now have a tax lien that may hinder their sale.

For those making ends meet by getting cash from unemployment and premature distributions of their retirement plans or faced with debt forgiveness from unpaid loans, April 15th may bring another financial problem- a tax bill. With pressure on the government to collect more taxes, these people may go through another round of stress called the IRS.

If you owe, face it head on and get it behind you

If you find you owe, ignoring the problem will not help. In fact, if you owe more than $5,000 and you do not make arrangements to pay by an IRS installment agreement, you are almost certainly facing a tax lien, which will add to your woes by lowering your credit score by 100 points and complicating the ability to sell property.

When you know you owe, contact the IRS with a proposal. Look for an arrangement that meets your budget so you do not overextend yourself. When you are in an agreement with the IRS on your unpaid taxes, you will avoid the surprise of the IRS levying your bank account or garnishing your wages. And if you can pay your entire balance, look on the bright side. The current interest rate the IRS charges on unpaid balances is only 3%.

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Steve Rhode is the Get Out of Debt Guy and has been helping good people with bad debt problems since 1994. You can learn more about Steve, here.
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