Well over 50 million Americans received unemployment benefits during 2020 due to COVID. The spike in jobless claims, starting at the end of March 2020, was like nothing we’ve ever seen before. Between state benefits and federal benefits provided under the CARES Act, many recipients were (and some still are) getting more in unemployment compensation than they were in wages. (The wisdom of that is a subject for another day.)
The question at hand is what will those tens of millions of people do when they discover, to their chagrin, that their benefits are fully taxable? That’s right. One of the ten or twelve most common misunderstandings about the federal income tax laws is that unemployment benefits are fully taxable, just like wage income. While it’s true that some states don’t tax such benefits, the federal government most certainly does.
People believe that unemployment benefits are tax-exempt for a number of reasons. One common reason is they think that because there is no withholding from the payments, they must be tax-free. But whether or not there’s withholding does not control the issue of taxability.
The real problem arises when the payments create an unfunded tax debt. This happens because unemployment benefits generally comprise just a fraction of a person’s ordinary wage income. For example, suppose a person has a wage income of $6,000 per month. The unemployment benefits might be just half that, or even less. Yet people’s monthly bills don’t drop just because they are unemployed. Because of that, all of the benefits are used to pay monthly necessary living expenses. Nothing is left for taxes. That means when it comes time to pay up, people just don’t have the money.
And frankly, even for those who might know that such benefits are taxable if they are receiving just a fraction of what their necessary living expenses are each month, what do you expect them to do? They can either pay their taxes or feed their family. You can guess what choice the vast majority of people make when dancing on the horns of such a cruel dilemma.
Because we saw record-high numbers of people getting unemployment benefits in 2020, there is no doubt in mind but that we will see record-high numbers of tax delinquencies come April 15, 2021, as people discover they don’t have the money to pay what they owe.
It is therefore imperative that people understand certain fundamental taxpayers’ rights to avoid the sword of IRS-enforced collection action (levies, seizures, etc.). At a minimum, wrap your arms around the following three ideas.
- You have the right to seek an extension of time to pay your taxes. Most people understand they have the right to seek an extension of time to file their returns (IRS Form 4868). However (another of the most common misunderstandings), the filing extension does not give you more time to pay. And while the IRS denies the existence of a payment extension, the procedure is most definitely available. You seek a payment extension by filing IRS Form 1127 on or before April 15. The payment extension is not automatic. You must show that you experienced “hardship” during 2020 and therefore cannot pay on time. Under our national COVID emergency, that should not be hard for most people. If granted, you can get up to six additional months to pay your taxes, without penalties.
- You have the right to seek an installment payment agreement if you need more than six months to pay. For many people, six months will not be enough time to pay in full. In that case, you have the right to seek an installment agreement allowing you to pay over an extended period. If you owe less than $50,000 and can pay within seventy-two months, the installment agreement is generally accepted by the IRS. You can apply for an installment agreement using IRS Form 9465. The bad news is that penalties continue to apply even if the agreement is accepted. However, you may seek cancellation of the penalties based on reasonable cause and “hardship” regardless. The good news is that once the installment agreement request is either pending or accepted, the IRS cannot pursue any collection action whatsoever. This keeps them off your back as long as you make your payments.
- You have the right to have your delinquent account frozen as “uncollectible” in certain cases. If you are either unemployed or under-employed and your income is down considerably for any reason (COVID or otherwise), you can get your case closed as “uncollectible due to hardship.” This right arises out of Internal Revenue Code section 6343. This law prohibits the IRS from engaging in any collection action if such action will make it impossible for a citizen to pay basic, necessary living expenses. This is the legal definition of “hardship.” When you demonstrate the inability to pay because income and expenses are such that there’s nothing left at the end of the month for back taxes, the IRS will put your tax debt on the back burner. And while the debt is not extinguished, the collection freeze keeps the IRS out of your face while you get back on your feet.
Do not hide your head in the sand if you will owe taxes you can’t pay this April. The above three steps, and many other taxpayers’ rights (discussed in my book How to Get Tax Amnesty), will keep you from getting run over by the IRS because of circumstances beyond your control.