The IRS entrepreneurs' Rescue Plan.

If you haven't been paying taxes quarterly, and don't have the cash, there is hope and help

IF YOU WORK FOR YOURSELF, THIS CAN BE THE time of year when dreams turn into nightmares. You probably have the cold sweats because you haven't been making your estimated tax payments to the IRS for the past year. Now the bill has come due. Suppose, for example, in 1998 business was much better than you had anticipated. That's good news--for the IRS. "You may owe substantial amounts of taxes, plus interest and penalties, if you underpaid your estimated taxes for 1998," says Larry D. Bailey, partner in the Washington, D.C., national tax services office of PricewaterhouseCoopers. "What's more, your first installment payment for 1999 will be due on April 15, and the amount you owe will be based on your tax liability for 1998."

In short order, you'll have to find a pocketful of cash. That won't be easy, especially if you plow all your earnings back into your business, which is typical for the self-employed. The IRS, though, can be a nasty debt collector. When you're caught between a rock and a hard place like this, where can you turn? Instead of buying an extra lottery ticket, there are some practical suggestions you can follow to solve your dilemma with Uncle Sam.

Reconstruct your records

Go back over your 1998 paperwork with an eye toward squeezing out every possible deduction. More 1998 deductions will mean less tax you'll owe on your 1998 return as well as lower estimated tax payments in 1999. Fortunately, if you're self-employed, you have some leeway in claiming legitimate deductions. Most of your legitimate business expenses (except capital expenses) are tax deductible.

What if your record keeping has been less than immaculate, a fault to which many sole proprietors admit? In some cases you can estimate what you spent--with the law on your side.

When you prepare your income tax return you can use any numbers you choose. Your risk is that the IRS will question your numbers. That means, you must justify (not "it seemed right") your entries if you're audited.

Don't cheat; gray areas should be resolved in your favor if you have a reasonable explanation for your claims. "The better your records, the better your chances of supporting deductions, so it pays to take some time to keep current records of your expenses," says Eardley G. Willock, tax manager in the New York office of the accounting firm Grant Thornton.

Suppose, for example, that you don't keep track of every cab fare you pay. You estimate that you take three round-trip cab rides on business per week, at an average cost of $5 per ride. That's $30 per week, or $1,560 per year. If you're questioned, you'll need to produce some evidence that you actually took those cab rides. You might show notes you took at client meetings, for example, in addition to a log that includes at least some records of cab fares during the year.

Where does the law come in? With the long-established "Cohan" precedent. George M. Cohan (composer of "Give My Regards to Broadway" and "You're a Grand Old Flag") deducted $55,000 for travel and entertainment expenses--an enormous amount in 1921 and 1922--but couldn't produce any receipts. The IRS disallowed all of his deductions and he fought back in court.

In 1930, a federal appeals judge ruled that Cohan was on the road constantly, so it was likely he did engage extensively in business travel and entertaining. Therefore, he was entitled to some deductions. The IRS was ordered to "make as close an approximation as it can" of the actual expenditures.

So that gives you some leeway in approximating expenditures. Overnight travel and business entertainment, for example, is subject to certain record keeping requirements. However, you don't need receipts for expenditures under $75. Thus, if you take business trips and keep a log, you might be able to take reasonable deductions for airport cabs, tips to hotel personnel, etc., even if you don't have receipts for every expense. If it's not practical to keep track of such incidentals, you can make reasonable estimates.

In the same fashion, you may not be able to keep track of all the petty cash you spend on office supplies, business gifts, business-related periodicals and reference books, photocopies or other small business purchases. "It's better to estimate such expenses now, when you're filing your tax return, rather than just making up numbers and having to justify them during an audit," says Larry Torella, tax partner, in the accounting firm Richard A. Eisner & Co. in New York. "The reality is that the IRS won't disallow everything during an audit. If you have some records to support a deduction, take the deduction."

But don't be a pig about these deductions. If you spend $200 in cash per week ($10,400 per year), don't "estimate" $9,500 worth of cash outlays for business purposes. But you might estimate that you spent $1,000 or $2,000 a year ($20-$40 per week) on incidental cash expenses that are ordinary and necessary for your business. Take your best guess and give yourself the benefit of the doubt, as long as you can support your claims.

Don't forget to Fund your future

Beyond scouring your records for extra deductions, there's another step you can take to reduce your taxes: make deductible contributions to a retirement plan. "If you had a Keogh plan in place by the end of 1998, you can make contributions up until the due date of your plan, including extensions," says Willock. The amount you can contribute (and deduct) will depend on the terms you established when you created the plan.

Suppose, as is likely, that you were too busy running your business last year to set up a Keogh. "In that event, you still can create a simplified employee pension plan (SEP) for 1998," says Willock. As the name suggests, SEP plans require virtually no paperwork. Most banks, brokers and mutual fund companies will help you set up a SEP with a minimum of aggravation and make "look-back" (to 1998) contributions until the due date of your return, including filing extensions. "Generally, you can contribute up to approximately 13% of your self-employment income to a SEP each year," says Torella. "The current maximum is $24,000."

Borrow some breathing room

Great, you say. You can cut your 1998 income by up to $24,000, which would cut your tax bill. All you have to do is find the $24,000! If you had $24,000, you wouldn't be worrying.

Well, that's what lenders are ' for. You can borrow money to pay the IRS or borrow money to make deductible contributions to a retirement plan. "Your best choice may be to draw against a home equity line of credit," says Bailey. "On such loans up to $100,000 of the interest will be deductible, no matter how you spend the money." Typically, home equity lines of credit are relatively inexpensive, with current rates ranging around 6%-7%.

"Even if you can't tap a home equity loan, it still makes sense to borrow to pay the IRS," says Donald Carroll Moragne, a former IRS agent and manager who now heads the Tax Zone, a Silver Spring, Maryland, firm specializing in resolving IRS disputes. "When you owe the IRS, the debt builds up rapidly." You'll owe interest on late tax payments, which now runs around 8% per year, as well as a penalty for late payments of 0.5% per month (6% per year). There may be other penalties, too, that will increase your debt burden, so you'll probably find it cheaper to pay back your local bank or your Uncle Harold.

Make a deal

Unfortunately, many sole proprietors already have tapped friends, relatives and credit card companies to the max. If

you're in that position with no borrowing power to your name, don't despair. It's possible to negotiate payment terms with the IRS, as long as you know how to do it.

"The first step," says Willock, "is to be sure to file your 1998 tax return on time, or ask for an automatic filing extension. The penalties for late filing are 5% per month, up to 25%, which you certainly will want to avoid.

"A lot of people don't do anything if they can't pay, which is a serious error," says Torella. "Sooner or later, the IRS will catch up with you, and the bill likely will be much higher than if you had come forward right away."

Remember even if you can't pay on time, you must file on time. You can file your 1998 return, write $500 or $50,000 or whatever on the line that says "taxes due," but send in little or even no money with your return. "When you file in this manner," says Willock, "you can attach Form 9465, an installment payment request. On this form, you can propose a schedule for paying the IRS what you owe." If you owe $12,000, for example, you might propose paying $1,000 per month for 12 months, plus interest. "The IRS will occasionally, although rarely, waive penalties if you file on time and show good faith," says Willock.

What if you have some cash on hand but not enough to cover all your debts? "I generally advise clients to put any money they have toward their next year's estimated taxes--1999, in this case," says Moragne. "By doing so, you'll restrict your tax problems to one year: 1998. If you start to fall behind for two or more years, you may never match up."

According to Moragne, the IRS usually reacts well to proposals for extended payments if the amount involved is under $10,000. "Taxpayers typically will be allowed to spread repayment over three years," he says.

Larger tax deficiencies, though, are another matter. "The IRS has a series of financial statements--Forms 443 (a),(b), (d) and (f)--that you'll have to fill out. From these statements the IRS will determine how little of your income you'll need to live on and how much you can afford to pay."

Don't rush to fill out these forms before seeing your tax advisor, Moragne cautions. "You don't want to lie and you don't want to omit information that's on the public record," he says. Don't say you have one car if you have three cars registered with the motor vehicles bureau, for example. Other issues need to be considered, though. The IRS will ask for a list of your accounts receivable. If you provide this list, the IRS will attempt to collect from your customers, who may never do business with you again. Therefore, providing this list might put you out of business. "Before deciding how you want to proceed," advises Moragne, "meet with an experienced tax professional who can spell out all the possible consequences."

"Many taxpayers get very emotional when they receive correspondence from the IRS," says Torella. "You'll save yourself a lot of stress by hiring someone who knows how to deal with the IRS." In practice, Moragne says, most tax delinquencies eventually are settled, usually through an installment agreement.

At the same time, you should be realistic about what you can afford to pay. "Don't agree to pay so much that you'll strain your finances," Moragne says. "If you don't make the agreed-upon payments, the IRS will assert that you've broken your agreement and go after your income, your house, your car, your bank account and so on."

To avoid such harsh measures, Moragne counsels taxpayers to stay in communication with the IRS. "When the IRS moves to attach your income and your assets, the agency is just trying to get your attention. You can save yourself a lot of grief by showing that you're aware of the problem and doing everything you can to get it settled."