If you owe money to the IRS is it better to pay by credit card or paying penalties to the IRS?

First, let me emphasize that you should file your tax return on time whether or not you can pay your taxes on time. The penalty for failure to file on time is TEN TIMES the penalty for failure to pay on time. File on time even if you can't pay.

The IRS failure to pay penalty is 0.5% per month or partial month as long as the taxes remain unpaid. That works out to an APR of roughly 6% per year. (It's actually a little more since you get charged the full amount for even a partial month.) In addition to the failure to pay penalty, interest is added. The interest rate is a variable rate that changes quarterly. It is currently 4% per year, accrued on a daily basis.

Once the IRS sends you a notice of intent to levy, the failure to pay penalty goes up to 1% per month, roughly equivalent to 12% per year.

So interest plus penalties add up to 10% to 16% per year. If your credit card rate is less than that, it is obviously better to pay by credit card. And don't forget credit card cash back and bonus miles and other perks in your calculation. A lot of credit cards are still offering promotions like 0% for the first twelve months for new applications. I still get convenience checks from my existing credit cards offering 3.99% for a year or more. Look into these offers.

If you don't pay the IRS, sooner or later in addition to the penalties, they will start to threaten other enforcement action, such as levying your bank accounts or paycheck. Once they start doing this, you need to pay them off. Responding to IRS notices is quite expensive for your employer, it can kill your career. Even if they aren't supposed to retaliate officially, you can bet that the next time there is a review, you will be passed up for a raise or promotion for some other reason. Having your bank accounts frozen can also be a downer. The bank will charge you a big fee, all your checks will bouce, which will cause everyone you paid to also charge you fees and cancel your credit, and so on.

It is also possible to request an installment agreement from the IRS. A set up fee of $43 to $105 applies, plus all of the above penalties and interest still apply. However, if you keep up with the term of the agreement, it will avoid collection action. See:

http://www.irs.gov/businesses/small/article/0,,id=108347,00.html