There are occasions when you are concerned what will happen and what you should do in the event you cannot pay your taxes on time.

First and most importantly, don’t let you inability to pay your tax liability in full keep you from filing your federal and state tax return properly and on time. At a minimum pay the State of California in full. Include as large a partial payment to the IRS as you can. Just filing without full payment can save you substantial amounts in filing penalties. More importantly, procedures exist for payment extension and installment payment arrangements which will keep the IRS from beginning its collection process (liens, property seizures, etc.).

MOST COMMON PENALTIES: These penalties discussed here are federal only, as the presumption is that you have paid the State of California in full. The "failure to file" penalty accrues at the rate of 5% a month (maximum of 25%) on the amount of tax your return should show you owe. The "failure to pay" penalty is lighter, accruing at the rate of only 1/2% a month (maximum of 25%) on the amount actually shown as due on the return. If both apply, the failure to file penalty is reduced by the failure to pay penalty. However, if the return is filed more than 60 days after the due date or extended due date, the minimum failure to file penalty is the smaller of $100 or 100% of the unpaid tax. Both these penalties are in addition to interest you will be charged for late payment. If you also missed estimated tax payments, an additional penalty is tacked on for the period running from each payment’s due date until the tax return due date, April 15th (or earlier, if the payment is made earlier). This penalty is computed at 3% above the fluctuating federal short term interest rate for the period.

UNDUE HARDSHIP EXTENSIONS: It’s important to remember that an extension of time to file your return does not mean you have an extension of time to pay your tax bill. An extension of time for payment may be available, however, if you can show payment would cause "undue hardship". You will avoid the failure to pay penalty if an extension is granted, but you will still be charged interest. If you qualify, you will be given an extra six months to pay the tax shown as due on your tax return. If the IRS determines a "deficiency," i.e., that you owe taxes in excess of the amount shown on your return, the undue hardship extension can be as long as 18 months and in exceptional cases another 12 months can be tacked on. However, no extension will be granted if the deficiency was the result of negligence, intentional disregard of the tax rules, or fraud.
To establish undue hardship you must show that it would be more than just inconvenient to pay your tax when due. For example, if you would have to sell property at a "sacrifice" price you may qualify. But if a market exists, having to sell property at the current market price is not viewed as resulting in undue hardship. You would have to show that you do not have enough cash and assets convertible into cash in excess of current working capital to meet your tax obligations. You would also have to show you cannot borrow the amount needed except on terms that would inflict serious loss and hardship.
To qualify for an extension, you have to provide security for the tax debt. The determination of the kind of security-such as a bond, filing a notice of lien, mortgage, pledge, deed of trust, personal surety, or other form of security-will depend on the particular circumstances involved. When your application for an extension is granted you must deposit any collateral agreed upon with the IRS. No collateral will be required if you have no assets. Form 1127 is used to apply for an extension. A statement of assets and liabilities must be attached as well as an itemized list of receipts and disbursements for the 3 months preceding the tax due date.

INSTALLMENT AGREEMENT REQUEST: Another way to defer your tax payments is to request the IRS to enter into an installment payment agreement with you. This request is made on Form 9465. The IRS charges a small fee for installment agreements, which can be added to the tax due. Form 9465 requires less information than the hardship extension application. If the liability is under $10,000, you will not be required to submit financial statements. However, penalties and interest accrue on the outstanding portion of your tax liability while the installment agreement is in effect. Thus, you should attempt to make your payments as large as reasonably possible to minimize these additional charges. Note that an installment agreement request can be made after your hardship extension period expires.
The installment agreement may terminate and all your taxes become due immediately if any of the following occur:
< The information you provided the IRS in applying for the agreement proves inaccurate or incomplete.
< You miss an installment.
< You fail to pay another tax liability when due.
< The IRS believes collection of the tax involved is in jeopardy.
< You fail to provide an update of your financial condition when the IRS makes a reasonable request for you to do so.
The IRS must give you 30 days notice before altering, modifying or terminating the installment agreement and it must explain its reasons for the action. This notice requirement does not apply when collection of the tax is in jeopardy.

AVOIDING MORE SERIOUS CONSEQUENCES: Too many taxpayers avoid facing reality when they run into financial difficulties, for example, by failing to file their tax returns. Tax liabilities DO NOT go away if left they are not dealt with. It is very important that you file a properly prepared return even if full payment cannot be made. Include as large a partial payment as you can with the return and start working with the IRS for a hardship extension or installment agreement as soon as possible. The alternative will include escalating penalties, plus the risk of having liens assessed against your assets and income. Down the road, the collection process will also include seizure and sale of your property. In many cases, these tax nightmares can be avoided by taking advantage of arrangements readily offered by the IRS.