It is always better to file your tax returns, even though you can not pay the taxes owed since it lowers the failure to file penalty which can amount to about 25% fine. Unfiled tax returns and penalties that they accrue are a substantial risk. If the IRS owes you money, you will not receive the refund unless you file a tax return (e-file or paper filing). If you do not file in three years from the tax filing date, your anticipated refund will be lost forever.
If you owe tax, the IRS will file a substitute tax return, at the highest tax rate possible. They will then take steps to collect the tax debt, even though it might be the wrong amount. The IRS often shares these calculations with the state tax authorities, and they charge a tax bill as well. The states also have the power to revoke drivers licenses for not paying your taxes, thus the penalties can be very harsh.
The penalties for not filing and not paying on time accrue until the tax is paid. There are limits, such as 25% of the tax owed for not filing on time at a rate of 5% a month, but overall the quicker you pay the taxes, the lower the tax penalties will be. Therefore, it best to reduce the tax penalties to avoid paying thousands more in taxes than what you would have owed.
If the tax remains unpaid, they can issue a income tax levy. A tax levy is where they take your property (often money in a bank account or your wages) in order to satisfy the tax debt issue. Therefore, it best to try to settle with the IRS before they levy since once they levy they will not give the money back.
You can settle your taxes for less than what you owe, but there are a lot of complications, so each case needs to be analyzed on its own merits. From a high-level perspective, the chances of a tax reduction through a settlement is best when a hardship, financially or otherwise, can be proven. Often, if a person has minimal assets, and moderate income, a settlement that is favorable to the taxpayer can be reached. This is the case since it will be possible to prove the taxpayer will not be able to pay the taxes owed.
It also is possible to have the IRS declare your tax account uncollectable if you can not afford to pay them back. Unfiled tax returns and penalties go hand in hand. However, the IRS likes this status over the settlement process since there is always a chance they will be paid back. The IRS will stop collection activities, but the interest and penalties mount so the issue in some ways is not getting better. The IRS will review your account every one or two years, to make sure your financial situation has not changed. If you can create an installment agreement, this is often the best answer since the penalties charged will be lower with a payment plan than if you do not have one.
It is best to not ignore the IRS and deal with them in an aggressive manner and to avoid negative issues, like wage levies, or taking your money. You also want to resolve the issues so you do not face IRS criminal issues.