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How Inflation Can Affect Your IRS Tax Bill

Every year, my team and I hear from thousands of taxpayers who are unpleasantly surprised at how quickly the IRS tax balance has grown over time. While most old tax debt is usually due to failure to file or non-payment penalties, it's also important to understand that interest plays a role, especially during an inflationary period when interest rates are likely to rise.



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


Interest and its compound effects


It's also worth mentioning that IRS interest on an unpaid balance will accrue daily; Just like a credit card, it never stops growing until the underlying balance is paid off. For unpaid taxes, interest is accrued on the total unpaid balance in addition to any penalties that may be accruing. This can lead to the balance growing rapidly as interest is charged and compounded daily on the sum of the balance of taxes, penalties, and compound interest that accumulates over time.


Non-Filers and the whiplash effect


Whether you file a return or not, interest begins to accrue on the applicable 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 of Return (SFR), at a later date. In addition to the likelihood that this return will have a higher tax amount due, the IRS will refund all applicable penalties and interest from the due date of the return, which can result in a tax whiplash to surprise taxpayers. when they receive their first notice of amount due.


IRS Interest Rate Trends


Over the past two years, taxpayers who owe have been somewhat protected from spiraling balances as IRS interest rates have been hovering around record lows, 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 increase in three years, the interest hike relief is likely to end.


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 reduction that will reduce the overall tax balance and subsequent interest. Owing taxpayers can apply for this type of relief by arguing that there was reasonable cause for their delay, or more commonly, by first time penalty reduction (FTA).


With all the signs pointing toward a prolonged period of inflation and multiple rate hikes, it's worth noting that the IRS interest rate was as ominous as 20% in the 1980s. %, I would warn all taxpayers who have an outstanding balance or are ignoring their tax filing obligation to act before the problem becomes overwhelming.


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