The “Offer in Compromise” is the typical way for Americans to resolve outstanding tax liabilities that they are unable to meet.1
It is a reasonably fair process with levels of Taxpayer protections. However, it is not as is often advertised, a procedure that produces the miracle of reducing $50,000 in tax liability to $5,000 without extraordinary circumstances. Right now, any Taxpayer that has the ability to meet a portion of their outstanding tax liabilities, if they have a breathing period of several years, should give an Offer in Compromise serious consideration. Offer in Compromise settlements are based upon the Taxpayer’s assets and overall financial situation. The worse the Taxpayer’s financial situation looks, the better the settlement with the I.R.S. The bad economy is one reason why now is the time to consider an Offer in Compromise.
Offers in Compromise
The IRS has the authority to accept less than full payment and to compromise a taxpayer’s tax liabilities if it is unlikely that the IRS can collect the tax liability in full.
The basis for a settlement for less than the full amount of the liabilities by the I.R.S. must be either
(1) There is a dispute as to the amount that the taxpayer owes (Doubt as to Liability);
(2) There is doubt that the liability can be collected in full. (Doubt as to collectability); or
(3) If a settlement of a tax liability will promote effective tax administration.
Doubt as to Collectability
The IRS will accept an offer in compromise if it achieves the collection of an amount that is potentially collectible at the earliest possible time and at the least cost to the government. In order to accomplish the goal, the Internal Revenue Code provides the offer in compromise as the exclusive method for compromising all taxes, penalties, and interest for the periods and taxes covered by the offer.
An offer is legally sufficient to be accepted due to doubt as to collectability of the full tax liability if it closely approximates the amount that the IRS could reasonably collect by other means, including through an administrative or judicial proceeding. The I.R.S. will consider four components in determining doubt of collectability (i) net equity in assets, (ii) present and future income, (iii) amounts collectible from third parties, and (iv) amounts that the taxpayer should reasonably be expected to raise from assets available to the taxpayer but beyond the reach of the IRS.
In calculating the maximum collectible amount from a taxpayer, the IRS determines if the taxpayer’s assets and present and future income are less than the full amount of the assessed liability. In determining ability to pay, the IRS permits taxpayers to retain sufficient funds to pay basic living expenses. Basic living expenses are based upon an evaluation of the individual facts and circumstances of each case, taking into account published guidelines on national and local living expenses standards.
Effective Tax Administration
If there are no grounds for compromise based on doubt as to liability or doubt as to collectability, the IRS may accept an Offer to Compromise to promote effective tax administration. Generally, this means that the I.R.S. will settle for a compromised tax liability if the collection of the full liability is possible, but will create economic hardship.
The following are examples of this category:
Economic Hardship: Long-term Illness
Taxpayer has assets sufficient to satisfy the tax liability. The Taxpayer provides full time care and assistance to her dependent child, who has a serious long-term illness. It is expected that the Taxpayer will need to use the equity of her assets to provide for adequate basic living expenses and medical care for her child. The Taxpayer’s overall compliance history does not weigh against compromise.
Economic Hardship: Liquidation of Assets
The Taxpayer is retired and his only income is from a pension. His only asset is a retirement account and the funds in the account are sufficient to satisfy the liability. However, the liquidation of the retirement account would leave the Taxpayer without an adequate means to provide for basic living expenses. His overall compliance history does not weigh against compromise.
The Proposal to Compromise
The Form 656 is the starting point for an offer in compromise. The taxpayer must indicate the facts and reasons why the IRs should accept the offer and which of the three categories, (doubt as to liability, doubt as to collectability, or effective tax administration); apply to the Taxpayer’s situation.
A Taxpayer seeking to compromise a liability based on doubt as to collectability or effective tax administration must also submit a Form 433-A (Financial Statement for Individuals) and any other financial statement prepared by the Taxpayer signed under a penalty of perjury.
Taxpayers that submit an offer to compromise individual income tax liabilities and who also have substantial business interests may also be required to submit a Form 433-B for the business.
The taxpayer may make a cash offer or a deferred payment offer.
The taxpayer is responsible for initiating the first specific proposal for compromise. A taxpayer must make partial payments to the IRS while the taxpayer’s offer is being considered. For lump sum offers, taxpayers must make a down payment of 20% of the offer with the application. For these purposes, a lump sum offer includes single payments as well as payment made in five or fewer installments. If the taxpayer proposes to pay in installments, the first installment must accompany the offer, and the taxpayer must comply with the proposed payment schedule while the offer is being considered (or the IRS will consider the offer withdrawn).
Application Process
The Taxpayer wants to make sure the offer is in an acceptable form or it will be rejected if it cannot be processed. In such instances, the IRS will contact the taxpayer to indicate and request the information that is missing or needs to be corrected.
Some items to double check before an offer in compromise is submitted are:
The taxpayer must identify the tax liabilities and years to be compromised;
The taxpayer must make a financial offer; and the
Payment terms must be specified;
The pre-printed terms of the Form 656 must not be altered and it must fully disclose assets and liabilities owed jointly and owned individually;
The taxpayer’s taxpayer identification number must be correctly stated;
The offer must be signed;
Necessary financial statements – Form 433-A and/or 433-B – must be completed and signed.
When the offer is submitted by a person who shares household expenses, disclosure of the non-liable individuals’ financial information can be required to determine the taxpayer’s share of the household expenses.
Collection Proceedings During Offer
Once the offer in compromise is received, the IRS will not automatically withhold collection activity. Generally, collection activity is suspended if the offer is not frivolous and if the tax liability that the taxpayer seeks to compromise is not in jeopardy.
The IRS will not make any levies to collect the liability that is the subject of the compromise during the period the IRS is evaluating whether such offer will be accepted or rejected, for 30 days immediately following the rejection of the offer, and for any period when a timely filed appeal from the rejection is being considered by Appeals.
The IRS directs the examining officer to determine processibilty of the offer as soon as possible, but within 14 days, and to then contact the taxpayer. If the IRS determines that the offer is processible but needs to be perfected, the IRS may communicate with the taxpayer by letter or by personal contact or request the additional information needed to perfect the pending offer. If the taxpayer does not respond timely, the IRS closes the offer as a return.
The IRS’s goal is to collect the tax liability a quickly as possible. In other words, immediate resolution of the liability is desired. To this end, the IRS will analyze the taxpayer’s assets to determine ways of liquidating the account. If the taxpayer has cash to pay the tax liability, the IRS will demand immediate payment. Otherwise, the IRS will consider if there are other assets which may be pledged or readily converted too cash; unencumbered assets; equity in encumbered assets; interest in estates and trust; lines of credit; and the taxpayer’s ability to obtain an unsecured loan. If there are assets with value and the taxpayer is unwilling to raise money from them, the IRS will consider enforced collection (i.e., levy and distrait). On the other hand, if the taxpayer has no borrowing power, the IRS will request that the taxpayer defer payment of certain other debts if this would allow payment of the tax liability.
Determining Maximum Collectability
Determining Equity in Assts: As part of its financial analysis, the IRS first examines the taxpayer’s equity in assets as the existence of equity may militate against the granting of an installment agreement.
When analysis of the taxpayer’s assets does not provide any obvious collection solutions, the IRS will turn to analyze the taxpayer’s income and expenses to determine the amount of disposable income available to apply to the tax liability. The IRS’ policy is that expense analysis is necessary only if it is unable to collect the liability from available assets. The taxpayer’s expenses must be reasonable in amount for the size of the family, the geographic location, and any unique individual circumstances. In some cases, the IRS will allow more than a reasonable amount on a substantiated expense if the tax liability, including projected accruals, can be fully paid within five years.
Valuation of Taxpayer Assets
Quick Sale Value: In determining whether the taxpayer’s offer is adequate in a doubt as to collectability situation, the IRS starts with the value of the taxpayer’s assets. This analysis begins with the value of the taxpayer’s assets minus the encumbrances having priority over the federal tax lien, i.e., the assets’ net realizable equity. The value assigned to these assets generally is the quick sale value (i.e., the amount that a taxpayer under financial pressures would realize on selling the assets in a short period of time). Quick sale value is defined as a value less than fair market value and greater than forced sale value, with forces sale value being no less than 75% of the asset’s fair market value
The IRS’s position in doubt as to collectability situations is that the taxpayer must offer an amount equal to the realizable equity in assets plus the value of future ability to pay, i.e., the reasonable collection potential. Thus, all assets – even those with no fair market value or those that the IRS would not attempt to collect should the offer be rejected – must be considered in determining the amount that is collectible form the taxpayer. However, if a taxpayer is not able to offer this amount due to special circumstances, the IRS may review the offer using the same factors as are used for economic hardship under effective tax administration.
The IRS examiner, therefore, conducts an investigation of the Taxpayer’s assets and income to determine if the amount offered reasonably reflects collection potential.
Allowable Expenses
Allowable expenses include necessary and conditional expenses. Necessary expenses are allowable if they are reasonable in amount.
Conditional expenses are allowable if the tax liability can be fully paid within five years through an installment agreement.
There are three types of necessary expenses: National Standards, Local Standards and Other Expenses.
Necessary Expenses – National Standards:
These establish standards for reasonable amounts for five necessary expenses: food, housekeeping, supplies, apparel and services, personal care products and services, out-of-pocket medical expenses and miscellaneous. The National Standards are available on the IRS’s website and are updated periodically.
A taxpayer who claims more than the total allowed by the National Standards must substantiate and justify as necessary each separate expense of the total. For instance, a taxpayer claiming more for food than is allowed can justify this expense if there are special prescribed or required dietary needs.
Finally, if the taxpayer can fully pay the tax liability, including projected accruals, within five years, the taxpayer may be allowed more than the amount allowed by the National Standards. To obtain the additional amount, the taxpayer must substantiate all the expenses that constitute the National Standards.
Necessary Expenses – Local Standards:
The National Standards do not adequately capture certain expenses. Housing and transportation are two such expenses. This also includes utilities and telephone expenses. Transportation includes car insurance and public transportation. Local standards for housing and utilities, and transportation may be found on the IRS’s website.
Necessary Expenses – Other:
The IRS recognizes that there are expenses other than those listed in National Standards or Local Standards that nevertheless may be necessary expenses. If the liability can be fully paid within five years, the IRS generally will allow excessive necessary and conditional expenses. If the liability cannot be fully repaid within five years, such expenses may be allowed for up to one year to give the taxpayer time to modify or eliminate the expense.
Examples of other necessary expenses include:
Taxes;
Charitable contributions;
Education;
Health care;
Court ordered payments;
Involuntary deductions;
Accounting and legal fees for representing a taxpayer before the IRS;
Secured or legally perfected debts (minimum payments); and
Accounting and legal fees other than those for representing a taxpayer before the IRS which meet the necessary expense test of health and welfare and /or production of income.
Where other expenses are claimed as necessary, the taxpayer may have to substantiate the amounts and justify the expenses. The IRS’ general rule is that unless the tax liability will be fully paid, including projected accruals, within three years, such other expenses must be reasonable in amount. The IRS considers the following non exhaustive list of expenses under this category.
Life Insurance;
Disability insurance for a self-employed individual;
Union dues;
Education;
Child care;
Dependent care – elderly, invalid, or disabled; Charitable contributions;
Repayment of loans made for payment of Federal taxes;
Secured or legally perfected debts;
Internet provider/email;
Professional association dues;
Accounting and legal fees other than those for representing a taxpayer before the IRS which meet the necessary expense test of health and welfare and/or production of income; and
Negotiating an Acceptable Offer:
Generally the amount of an acceptable offer equals: (1) the value of the taxpayer’s equity in assets subject to the IRS’s tax lien; plus (2) the present value of the taxpayer’s ability to make monthly installment payments over a five year period
If the amount offered by the taxpayer does not meet what is determined to be an acceptable offer, the taxpayer can request a conference with the IRS to discuss the amount that is acceptable as a compromise.
Settlement Discretion:
The IRS has discretion to determine to what extent to compromise a tax liability. IRS settlement offers are not legally required. However, the IRS must maintain a duty of “administrative consistency” and Taxpayer equality when rejecting offers. In settlement discretion cases, courts generally apply an abuse-of-discretion standard of review.
Appeals:
The taxpayer may appeal the rejection of the proposed offer in compromise to the Appeals office within the 30-day period beginning the day after the date of the letter of rejection.
Finality of Agreement:
An offer in compromise is considered to be accepted only when the taxpayer is notified by the IRS, in writing, of the offer’s acceptance. The acceptance of an offer in compromise conclusively settles all questions regarding the liability that is the subject of the offer. The form used to make an offer in compromise states that the taxpayer no longer may be able to contest the amount of his tax liability.
A case may be reopened even though an offer in compromise has been accepted, if the following situations exist:
A taxpayer falsifies or conceals assets on completing Form 656 or Form 433-B
There is a mutual mistake of a material fact sufficient to cause a contract to be reformed.
Footnotes:
1. A little used procedural method that is very helpful if the taxpayer has a good case that has not been presented properly, or if the taxpayer has new documentation to present is a Request for Audit Reconsideration which differs from an offer in compromise based upon doubt as to liability. In several types of cases the IRS may make arbitrary adjustments, usually involving the denial of the deductions or exemptions that were the subject of an audit. If there is significant new or additional convincing information not previously seen that will prove a taxpayer’ point, the taxpayer may request “audit reconsideration”. The taxpayer must provide additional information or there is no basis for reconsideration.
