Anytime you make a voluntary payment to the IRS, you have the absolute right to tell the IRS how to apply the money. For most taxpayers, this may never be an issue because they only owe one type of tax for one tax year. But for some, there may be a number of unpaid tax obligations. If that is the case, how the money is applied may be important. For example, if some tax debts are joint obligations with a spouse and others are not, you may want to pay off the joint obligations so your spouse’s assets are no longer exposed to collection efforts. If you owe money for a number of years and some of the years can be discharged in bankruptcy and some can not (a topic for another day), you will want to pay the taxes that can’t be discharged first.
You may think this payment strategy could be used when you file a tax return with an overpayment. If so, you would be wrong. If you file a tax return that reports an overpayment of tax, you generally lose the right to tell the IRS how to apply that overpayment. Most people know that if they file a tax return with an overpayment, rather than ask for the money back in a refund they can check a box on the return and apply the overpayment towards their tax liability for the next year. For individuals that need to make estimated tax payments, this is often a mechanical choice since otherwise they are asking the IRS to send them a check the same time they are mailing in their estimated tax payment. This is a good system as long as there aren’t other unpaid tax obligations, and sometimes nontax obligations, outstanding.
If you owe other taxes, whether income tax, employment tax or excise taxes, the IRS is going to override your election to apply an overpayment to the next tax year and, instead, use the money to pay your other outstanding tax obligations. The overpayment will be applied first to the tax, then to penalties and then to interest for the oldest obligation. Certain kinds of other obligations such as child support and student loan payments may also be satisfied with a tax overpayment. If you have these sorts of obligations, you need to be very careful when doing your estimated tax payment planning for a subsequent year. If you think your overpayment is going towards your estimated tax payment and it doesn’t, you may now be underpaid in your estimates which will result in penalties.
A good tax preparer can help you think through this situation, but they need to know that you have these outstanding obligations. Once a return that reports the overpayment is filed, it is too late. If you don’t want your overpayment to be used to pay off another tax obligation, then the best advice is to plan in advance not to have the overpayment.