Interest, Penalties and Refunds While You Are in CNC Status

The most common misunderstanding about CNC status is that the debt freezes. It does not. The IRS stops collecting, but the balance keeps growing. If you go in knowing that, CNC is still a valuable tool. If you go in thinking the number is locked, you will be surprised later.

The IRS has to tell you

IRM 5.16.1.2.9 requires it: "Taxpayers must be advised that interest and penalties will continue to accrue on the account even though the collection action is suspended." The same paragraph says that "before reporting an account CNC, other collection options such as Offer in Compromise should be discussed with the taxpayer."

If no one mentioned either point to you, that is worth noting. It does not undo a CNC determination, but it is part of the conversation you were supposed to have.

Interest

Interest on unpaid tax continues to accrue on the balance while the account is in CNC. The CNC manual itself points to the rule in IRC 6601(g): interest "may be assessed and collected as long as the underlying tax can be collected." That ties the life of the interest to the life of the tax. When the collection statute on the tax expires, the interest goes with it.

The failure-to-pay penalty

The failure-to-pay penalty under IRC 6651(a)(2) applies to tax shown on a return that is not paid on time, and IRC 6651(a)(3) applies to tax assessed later that is not paid within 21 calendar days of notice and demand (10 business days if the amount is $100,000 or more). Each runs at 0.5 percent of the unpaid tax for each month or part of a month the failure continues, "not exceeding 25 percent in the aggregate."

Two points matter for CNC taxpayers:

• The cap. The 25 percent cap means the failure-to-pay penalty stops growing once it reaches its maximum. Many CNC taxpayers have older balances that are already at or near the cap.
• The increase after a levy notice. IRC 6651(d) raises the rate to 1 percent per month beginning after the earlier of 10 days after notice of intent to levy under IRC 6331(d), or the day notice and demand for immediate payment is given. Many hardship cases arise after a levy notice, so this higher rate may already apply.

There is a reduced 0.25 percent rate under IRC 6651(h), but it applies to individuals who filed on time during months an installment agreement under IRC 6159 is in effect. CNC is not an installment agreement, so that reduction does not apply while you are in CNC.

Penalty relief is still available

IRC 6651 imposes the failure-to-pay penalty "unless it is shown that such failure is due to reasonable cause and not due to willful neglect." Being in CNC does not take that defense away. The same illness, job loss or disaster that put you in hardship may support reasonable cause for the late payment. A successful penalty abatement reduces the balance and, because interest runs on penalties too, reduces future interest.

Whether it makes sense to spend effort on penalty relief while in CNC depends on your timeline. If the collection statute will expire before you could ever pay, abatement may not change much in practice. If you expect to pay or compromise later, a smaller balance helps.

Refunds

Expect the IRS to keep your refunds while you owe. The Internal Revenue Code gives the IRS authority in IRC 6402 to credit overpayments against outstanding tax liabilities, and the CNC procedures in IRM 5.16.1 include steps for flagging accounts for refund offset when they are closed. A refund on your current year return will usually be applied to the old balance instead of being sent to you.

For many hardship taxpayers, that is a real loss: the refund was going to fix the car or cover rent. Plan for it. If you have a predictable refund from withholding, consider adjusting withholding so less is taken from each paycheck, as long as you still cover your current year tax.

New balances are a different problem

CNC applies to the periods included when the account was closed. It does not cover next year's tax. If you file a return with a balance due while in CNC, that new balance starts its own notice stream. For in-business cases, IRM 5.16.1.6 notes that the IRS monitors compliance and that if additional liabilities are not resolved, "the CNC accounts will be reactivated for collection action."

The lesson: get your withholding or estimated payments right so you do not create new debt while the old debt sits in CNC.

Should you pay anything voluntarily?

You can. Voluntary payments reduce the balance and the interest. But if you truly cannot meet basic living expenses, the money should go to rent and food, not the IRS. If you have some small ability to pay, a partial pay installment agreement may be a better fit than CNC, and the IRS can set one up with a backup CNC report in case it fails. Compare the options in CNC vs. installment agreement vs. offer.

One caution: once the collection statute expires, the IRS is told not to solicit payments on barred accounts. IRM 5.16.1.2.2.1 says a payment on an account barred by statute should be identified as voluntary, treated as a gift to the Treasury if the taxpayer still wishes to make it, and returned if the taxpayer's intent cannot be determined. Do not send money on a balance that has expired.

A simple illustration

Take a taxpayer who filed on time but could not pay $12,000 of tax shown on the return. The failure-to-pay penalty under IRC 6651(a)(2) adds 0.5 percent of the unpaid tax per month, or $60 a month at that balance. After a levy notice, IRC 6651(d) can raise the rate to 1 percent, or $120 a month. Either way, the penalty cannot exceed 25 percent of the tax, which is $3,000 in this example.

Interest is added on top, on the tax and on the penalties, at the underpayment rate determined under IRC 6621. I am not going to quote a rate here because it changes. The point is the direction: the balance on a CNC account goes up every month until it is paid, compromised, discharged, or expires.

For a taxpayer who will never be able to pay, that growth is mostly academic. For a taxpayer who expects to recover and pay later, it is a real cost of waiting, and a reason to look at whether an installment agreement or offer makes more sense once things improve.

Keeping records while you wait

Keep copies of every notice and letter you receive during CNC, especially the closing letter and any refund offset notices. Offset notices help you, or your representative, track the balance and confirm that credits were applied to the right periods. Misapplied payments and credits are more common than people think, and they are easier to fix with paper in hand.

What the growing balance does and does not mean

A balance that grows in CNC can look frightening on a transcript. But the growth does not change your ability to pay, and it does not restart the collection clock. What matters most is whether, when, and how the account will be resolved before the collection statute expires. See CNC and the collection statute for how that clock works.

CNC stops the collector. It does not stop the meter. Know both facts, and you can decide what to do with the time CNC gives you.