When the tax man comes knocking

So you go to your mailbox, and you get an unpleasant surprise: The Internal Revenue Service says you owe back taxes. Or you figure out your tax bill for the year or quarter, and you're having to pay a lot more than you expected.

Experts say physicians easily can find themselves in this situation because their status as self-employed can make it easier to miscalculate or otherwise unintentionally err on taxes. So what do you do if it happens to you?

The most important thing is -- don't panic.

The IRS has procedures in place that allow you to repay or challenge your bill, although the agency recently has put some strictures on some methods. Also, some experts advise finding alternate means of financing -- through a loan, for example -- to cover the debt and get the IRS monkey off your back.

The first signs of trouble may come in the form of notices from the IRSletting you know that you owe a large bill that hasn't been paid. The notices may be issued every 30 days or so for a few months, and they may get increasingly "hostile," said Steve Katz, a tax attorney with Sideman & Bancroft LLP in San Francisco. He said it is imperative not to ignore these notices.

At some point, the IRS will issue a notice giving the taxpayer the right to a collection due process hearing to discuss options for handling the debt, including the possible pursuit of an installment plan or offer in compromise. Taxpayers have 30 days to respond to the notice or they lose the right to have the hearings.

Katz said it is a good idea to have a tax professional assist in this process to help ensure that the rules of procedure are being followed properly.

Along the way, the IRS may have placed a lien against the taxpayer's assets to help ensure that it will collect something. Katz said the agency is prohibited from issuing levies against the taxpayer until after the collection due process hearing, but the lien alone could hinder financial dealings.

Robert Brennan, a certified public accountant in Plymouth Meeting, Pa., and director of litigation support for the financial services firm CBIZ, said that assuming the cash to pay the bill isn't available, it also might be cheaper to borrow money from a bank than spend time haggling with the IRS. During that period, interest and penalties could accrue to as much as 16% to 18% annually. The IRS might be willing to work with the bank to lift any sort of lien to allow for a loan -- as long as it's being used to pay back the IRS.

The IRS also might be willing to accept an installment plan offer. In fiscal 2005, the IRS accepted 2.6 million installment agreements. Taxpayers whose bills were less than $10,000 probably had the easiest time getting those deals. They may have been able to have their requests granted with little negotiation or paperwork, said Brennan, who was an IRS revenue agent for 13 years.

Those with larger bills have to fill out a detailed financial statement, including information about income sources, assets and other debts as well as an inventory of necessary expenses such as food and housing.

Brennan said the IRS then does an analysis of the figures and comes up with a proposed installment plan dictating how much would be owed each month.

"That's where the problems start, because what they perceive as your normal monthly expenses and what the taxpayer perceives he needs as monthly expenses can be dramatically different," he said.

There may be some room for the taxpayer to object to the proposal and request that it be reconsidered, or at least request more time to adjust his or her lifestyle to meet its requirements.

In extreme cases -- for those who can't work out an installment plan that they can afford, and can't pay their bill by any other means -- the IRS will consider extending an offer in compromise, essentially saying it will accept a reduced payment as an alternative to having no prospect of payment.

The taxpayer would have to submit the same kind of detailed financial information as what is required for larger installment plans. Again, there may be some room for negotiating the proposed amount in the offer.

If a taxpayer is granted an offer in compromise and it is paid, Katz said it likely wouldn't have any adverse effect on his or her credit rating or standing with the IRS. It simply would resolve the outstanding bill, wiping the books clean.

The prospect of such instant debt reduction is alluring. But Brennan said for most people, it won't be worth the effort. "This is a very tedious process and more often than not you're not granted an offer," he said.

The IRS said it received 74,000 proposals for offers in compromise in 2005. Of those, 19,000 were accepted.

The process can take nine months to a year before a decision is rendered. The IRS will suspend any collection activity while considering an offer, but that doesn't mean they will suspend interest and penalties during that time.

And the process may have become more expensive July 16, when new rules took effect stipulating that proposals for lump-sum offers in compromise must be accompanied by a 20% down payment that is nonrefundable. If the proposal is rejected, the money will go toward the tax bill, but the taxpayer can't get it back.

Brennan said he expects fewer proposals in the wake of the new rules, because taxpayers will find it harder to come up with down payments if they are nonrefundable. "The 20% rule is maybe a death knell to the program itself," he said.