Absolutely! Well not always….
Before we begin let’s review a few things. When a tax return is filed that the IRS “assesses” the tax (make a record of the return filing). If the return reflects a tax due (total tax liability exceeds tax withholding and estimated tax payments) the IRS expects payment of the amount due. If no payment is made the IRS begins collection efforts. The IRS has a period of 10 years from the assessment date to collect the debt (the Statute of Limitations or SOL).
An Offer In Compromise (OIC) is, as the name implies, an offer by the taxpayer to the IRS to pay less than is owed. Why would the IRS agree to accept less than is legally owed by a taxpayer? The short answer is that they don’t believe that the tax debt can be collected before the expiration of the SOL.
Do you just tell the IRS you can’t pay the entire amount and they will accept an offer? Not quite - there’s a formal process that needs to be followed in order to make a request.
As previously discussed the IRS has a number of programs available to assist taxpayers with settlement of their tax debts - Installment Agreements (discussed in our last post), OIC, Innocent Spouse, etc. In dealing with any tax debt we review three areas: compliance with the tax laws, the payment amount that could be made to the IRS (lump sum and monthly payments), and the SOL expiration for the debt. Let’s discuss each of these items.
Compliance - in order to consider debt settlement offers the IRS requires that a taxpayer be in “compliance” with the tax rules. This means that all tax returns are required to be filed or, for the most recent year, a filing extension has been requested. IRS rules require that tax returns for the the most recent six years be filed. They also require that payments are being made towards the current year tax obligation - through wage withholding and/or payment of estimated taxes. The IRS wants to ensure that they are considering all amounts due and that the taxpayer is not falling further behind for the current year.
The IRS then considers the potential for a taxpayer to make payments towards the tax debt. This concept is referred to by the IRS as the “Reasonable Collection Potential” (RCP). The general approach taken is to consider what assets the taxpayer currently has and what future income is available for debt payments - after consideration is given to the taxpayers payment of living expenses.
This analysis is basically a cash flow analysis. Although governed by IRS rules the computation is not based on taxable income. For example Social Security benefits may not be taxable however for purposes of the RCP the receipt of these payments is considered income.
With respect to expenses the amounts used for RCP are determined based on specific RCP rules - which can be actual expenses, IRS allowable expenses (local or national standards), the lower of actual or IRS allowable, etc. As an example for the category of Housing and Utilities the allowable amount is the lesser of actual or the local standard amount. For many taxpayers the local standard amount is less than actual. The common question is “does the IRS expect me to sell my house and buy something less expensive”. The short answer is no - this just represents the amount they will allow in the computation of RCP. How a taxpayer makes payments is irrelevant to the IRS.
In evaluating all tax settlement options the first step taken should be a listing of all assets, gross income from all sources, and all actual expenses. With this information an informed decision can be made as to settlement options.
In making the determination of whether or not to accept an offer the IRS will compute RCP with future income through the SOL. If RCP is greater than the tax owed the IRS will not compromise the debt - they expect full payment. Usually an installment agreement can be used to make payments over time if no compromise is available.
There are two types of offers available: lump-sum offer and short-term deferred offer (periodic payment).
With a lump-sum offer the total payment (the amount the IRS is willing to accept as settlement) is paid within five months of the date of offer acceptance. The settlement amount is calculated based on net equity in assets and 12 months of future income. A payment of 20% of the offer amount is required to be paid upon submission of the offer. The balance would then be due within five months.
With a short term deferred offer the settlement amount considers net equity in assets plus 24 months of future income. The settlement amount is required to be paid back within 24 months of offer submission. With this type of offer the monthly payments begin upon offer submission and continues to be made monthly.
If an offer is ultimately not accepted any payments made are applied against the tax liability. Payments are not refunded.
Related issues:
- Dissipated Assets - prior transfer of assets that could have been used to pay the IRS - for example the taxpayer may decide to sell stock and use the proceeds to pay off a personal loan while the tax debt is outstanding - in this type of circumstance the amount would be added back to current assets in order to determine RCP. The IRS typically reviews tax returns for the past three years for evidence of these types of transactions.
- Non-Cash Expenses - in determining taxable income from a business depreciation expense is a deductible item - however since it is not a cash expenditure the deduction is not considered in the RCP computation.
- Income Averaging - the IRS will review the previous three years tax returns when reviewing the RCP computation. If the gross income is these past years is greater than the amount used in the RCP the IRS may require that the average gross income be used in the computation.
The OIC program can provide taxpayers with significant benefits. The primary objective of the IRS Collections division is to work out tax debts - they aren’t interested in seizing assets or garnishing wages in order to enforce collection (although these steps may and will be used if necessary). As discussed the IRS has specific rules when considering tax debt compromises. Although not all of the rules make sense they are what they are - the IRS is potentially willing to reduce the amount legally owed - if you choose not to follow their rules they will enforce collection with all available tools.
In our next blog post we’ll discuss RCP.
Link to Outline Slides: Offer In Compromise Slides
Link to Video: Video - Offer In Compromise
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