In this downbeat economy, with record sustained unemployment, negative real estate equity, a continuing wave of foreclosures, and politicians acting out a Keystone Cops routine, more and more people find themselves robbing Peter to pay Paul in trying to stay afloat financially.

If you are struggling with dwindling assets and cash flow, it is more important than ever to prioritize where your money goes - especially in meeting your tax obligations. Many people who are already in financial distress aggravate their situation by responding to their urgent (but less important) obligations, such as credit card debt, instead of keeping current with their income taxes (whether with quarterly estimate vouchers or with their annual income tax return), in hopes that they will be able to pay them with funds they expect to receive in the future.

There are at least two major flaws with this thinking: first, too often the anticipated funds are not received (or, if they are received, they are then used for whatever urgent need then exists); second, the IRS can be your worst creditor. This article addresses the second issue.

Penalties. Unlike all other creditors, federal and state taxing authorities can assess penalties on top of the interest that accrues on overdue amounts. Penalties can include:

  1. a 20% penalty for underestimating your income tax liability; and

  2. a 75% penalty if the IRS determines that you fraudulently failed to file a tax return (15%/month up to five months), a 0.25% to 1% penalty per month up to a 22.5% maximum for failure to timely pay, and a 25% penalty for a late filed return (5% per month up to five months).

Further, interest accrues on the unpaid taxes, penalties and interest (interest compounds daily on both taxes and penalties).

More can be said about the horrific quagmire of unpaid taxes, but it should already be clear that no other creditors can come close to applying the financial pressure that the IRS can. The reason: Congress benefits from the IRS collecting over $6 billion a year from penalties alone.

Exemptions. In a previous article I detailed the exemptions from creditor collection available in Arizona. In a bankruptcy context, each state has its own homestead exemptions and the ability to opt for those exemptions over federal exemptions. Unfortunately, there is a much shorter list of assets that are exempt from IRS tax levies.

A more detailed analysis will be the subject of a future article; for now, here is a brief overview of assets that are exempt from IRS collection power:

  1. Wages. The exemption is minimal, far below the level that most families require to maintain a reasonable standard of living.

  2. Furniture, provisions and personal effects. Up to $6,250 (adjusted for cost of living increases after 1999).

3.Books and tools of trade or business. Up to $3,125, once again adjusted for cost of living increases after 1999.

4.Entitlements. Unemployment benefits and workers' compensation are exempt before they are paid to you, but fair game after they are paid to you.

  1. Annuities and Pension Plans. They are exempt only if payable by armed forces or are railroad-related. Otherwise, once they are paid, they are again fair game.

  2. Residences. If the total of taxes, penalties and interest owed are under $5,000, there is no levy; if over $5,000 (and that can accrue quickly), the IRS can obtain federal judicial approval for a levy.

Pay Your Taxes First. As you prioritize payments to your creditors, strongly consider payment of an IRS debt ahead of your other creditors, particularly if they are unsecured. The tax man may not pursue you as quickly as other creditors, but when he does, the results can be much more devastating.