Use of tax credits

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Dear Tax Talk,
I’ve had two IRS payment plans that I haven’t followed through on, and I owe for the last 10 years of taxes. The actual cost of the taxes owed is less than half of what they are penalizing me for (with interest on late fees). I adopted a child this year, and now have a $10,000 tax credit to use. Can I use this to negotiate dollar for dollar owed, or will I still have to pay the additional $13,000 late fees and interest fees?
— Cyndie

Dear Cyndie,
Unless you adopted Uncle Sam, I’m afraid that the adoption tax credit won’t help you wipe out the back taxes immediately. The adoption credit has various rules associated with it that allow taxpayers to qualify for a tax credit of up to $11,650 in 2008. The credit is available for most adoption expenses for children under 18 years old, provided they are not your spouse’s kids and some other rules are satisfied.

A tax credit allows you to reduce, dollar for dollar, your current tax obligations. In the case of the adoption credit, if the total that you are allowed to claim exceeds you current year tax, you can carry-over into the next five tax years the unused amount. You cannot carry-back the credit against prior year’s taxes, where your $13,000 problem comes from.

The credit will help you increase any current and future year refunds that can go to offset the $13,000 debt. For example, if your 2008 tax was $3,000 and your withholding was $4,000, the credit should reduce your income tax to zero and allow the $4,000 to be applied to your outstanding taxes.

If you owed $13,000 now, you will owe only $9,000 and your credit carry-forward will be $7,000. Unfortunately, you do not earn interest on any unused credit, and interest will continue to run on your outstanding debt until it is paid in full. With interest, your debt may be $10,000 next year if you do not make any other payments, but your credit will still only be $7,000.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.