IRS Publication 594 sets out the measures the IRS can take to collect owed taxes, how you can work with the IRS to pay your tax bill, and how you can legally dispute your tax bill or appeal IRS decisions.

If you simply lack the funds to pay your income tax, you may want to apply for a payment agreement on the website of the IRS. For those who qualify, this usually results in the arrangement of an installment plan, which you request on IRS Form 9465.

When All Else Fails: Offer In Compromise

In limited circumstances (if you are in deep financial distress), you can make an "offer in compromise" (OIC) with the IRS if you never will be able to pay your tax debts (see IRS Form 656). If accepted, an OIC settles a tax claim for less than its full amount. Though you must pay a fee of $150 to make an offer in compromise, the fee is sometimes waived or refunded. Under tax law effective from July 2006, when submitting a lump-sum OIC you must make a down payment of 20% to the IRS.

According to experts, the IRS typically accepts an offer in compromise only if the taxpayer faces exceptional hardship, such as long-term illness or hospitalization, or the very severe financial crisis that a retiree would face if forced to deplete a retirement fund to pay a tax bill. The IRS does not even consider an OIC until it has exhausted other alternatives, such as an installment plan. Even the definition of "hardship" is open to interpretation. As one case in 2005 showed (Speltz, 124 TC, No. 9), the IRS can demand payment of the full tax as long as a taxpayer's assets and future earning capacity are sufficient to eventually meet the obligation. In this case, the IRS rejected the arguments that (1) the married taxpayers' standard of living would suffer from paying the tax and (2) the AMT was significantly more than the stock's worth.

You can consult state and local tax professional groups and directories to find CPAs and attorneys who can advise you and help you prepare an OIC if you qualify.

Alert: The IRS has warned taxpayers about "unscrupulous promoters" who charge exorbitant fees for advising taxpayers to make OICs that have no chance of being accepted.