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By Michael S. Anderson of Anderson Tax Law logo for Arizona tax attorney Michael S. Anderson P.C.
  • Why IRS offers in compromise fail

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    WHY IRS OFFERS IN COMPROMISE FAIL

    Thousands of Americans have serious tax debt.  They are often taken in by the promise of an easy solution via the IRS offer in compromise (OIC) program.  The problem is that most people aren’t good candidates for the OIC program.

    In an OIC the IRS is empowered to accept less than what they are owed if:

    1. The debt amount is incorrect
    2.  The debt isn’t reasonably collectible
    3. The debt is collectible but there is some other reason that would make it unfair for the IRS to collect the debt.

    Most OIC cases are those that are based on #2 – the debt isn’t reasonably collectible.  Most people don’t try an OIC and of those that try, most fail.

    Here’s why.

    Reason 1 – The debt is collectible

    The IRS is allowed to use a “formula” to determine whether a debt is collectible before the 10 year statute of limitations (SOL) on collection runs out.  The formula is theoretically simple.

    • Average Income – “necessary” Budget = Excess Income
    • Excess income multiplied by time left in SOL + asset value = amount collectible over remaining time in SOL
    • If amount collectible over remaining SOL is less than the debt:
    • Cash Offer – Excess income x 12 plus asset value = OIC amount
    • Payment Offer – Excess income x 24 plus asset value = OIC Amount

    The formula is simple on it’s face and for those that make little money and have few assets the formula often works well.  The problem and the reason why so many OIC’s fail,  is found in the details of the formula.

    How does the IRS calculate income?   If you have had a down year income wise, will the IRS limit it’s calculation of your income average to that year?

    How does the IRS calculate your budget?   It uses a standard budget with variations.  Not your budget.  If your house payment is $2500 per month and the standard for your household size is $1500 per month, it will usually use the lower number creating a larger excess income amount and phantom income.

    The formula usually results in a failed OIC based on one of two things:

    1. The IRS sees the ability to pay the entire debt before the statute of limitations runs out
    2. The formula works but the taxpayer can’t afford to pay the settlement amount

    Reason 2 – The process can be difficult

    The IRS purposefully makes the process difficult. It initially rejects many cases and many do not have the funds or desire to continue the fight.

    Reason 3 – Large amount paid upfront 

    The taxpayer must typically pay 20% of the debt with the offer (in a cash offer) or start making monthly payments equal to the offered monthly payment amount and loses those funds if the offer is unsuccessful.

    Reason 4 – Full compliance is often a problem after acceptance

    IF the offer is successful, the taxpayer must file tax returns and pay tax obligations for 5 years, if not, the offer is over, the money paid is lost, and the total original debt with it’s accrued interest, continues to be owed, minus what has been paid.

    Reason 5 – Offer in Compromise is not a complete solution

    Often, the taxpayer proposing the OIC has medical bills, credit card debt, personal loans, state tax debt etc. all of which must still be dealt with outside of the offer in compromise. The payments on these debts aren’t always allowed as part of the budget in calculating the reasonable collection potential of the taxpayer, making it difficult to comply with the requirements of the OIC.

    OIC’s have other problems as well

    1.  When an OIC is rejected, the taxpayer still owes the entire debt with interest, while the statute of limitations period on the collection of the debt has been stopped.  The taxpayer is right back where he or she began.

    2.  The taxpayer who has been rejected, has provided every detail about his or her financial life to the IRS making it easy for it to collect the debt.  They’ve provided a detailed roadmap.

    3.  The OIC stops certain time-period(s) from running for purposes of bankruptcy requiring a payment plan to be negotiated post rejection in order to run out the time.

    BANKRUPTCY – is it really an alternative?

    Believe it or not many people with tax debt use bankruptcy to reduce, eliminate or control tax debt.

    A quick review of bankruptcy in relation to tax debt will help to explain why:

    There are two types of bankruptcy that pertain primarily to consumers. Chapter 7 and chapter 13.

    A chapter 7 bankruptcy is the more commonly filed, and is a liquidation case. In a chapter 7 bankruptcy, the debtor loses all assets not protected by statute and is forgiven his or her dischargeable debt.

    Chapter 13 bankruptcy is a “reorganization” bankruptcy. The debtor attempts to keep his or her assets and pay some or all of the debt depending on income and budget amounts. The plan length varies between 3 and 5 years depending on a number of factors.

    Tax debts as alluded to above, are classified in either a chapter 7 or chapter 13 as either dischargeable or non dischargeable on the date the bankruptcy petition is filed.

    Non-dischargeable tax debts include:
    1. collected and unpaid sales tax (of the trust fund nature)
    2. trust fund recovery penalty (employment tax unpaid by a business assessed against a “responsible party”).
    3. Trust fund tax
    4. Income tax related to a return that was not filed or filed but within 2 years of filing the bankruptcy.
    5. Income tax related to a return that was due including extensions within the last three years
    6. Income tax related to a return for which fraud was involved
    7. Income tax for a tax liability that was assessed by the taxing authority within 240 days prior to the date of the bankruptcy filing.

    Dischargeable tax debt includes:
    1. Those income and certain other non “trust-fund” taxes that meet the following criteria:
    A “return” was filed
    It was filed more than two years ago
    It was due more than three years ago including extensions
    The tax was assessed more than 240 days ago
    There was no civil or criminal fraud nor did the taxpayer willfully evade or defeat the payment of the tax debt.

    In essence, a tax motivated bankruptcy is a bankruptcy case that takes into account filing issues, timing and taxpayer history in a way to take maximum advantage of bankruptcy law in relation to the tax debt.

    Or in other words, what may be a non-dischargeable tax debt today may become a dischargeable tax debt tomorrow.

    The other benefits in comparison to an offer in compromise are as follows:

    1. OIC’s factor in the taxpayer’s income while chapter 7 bankruptcies usually don’t. In a chapter 7 if the majority of the taxpayer’s debt is tax debt, then the income is irrelevant as to whether the taxpayer qualifies to file a chapter 7. The bankruptcy means testing shouldn’t apply.

    2. OIC’s factor in future income potential while most bankruptcies don’t. It may not matter in bankruptcy that the taxpayer may be making more next year. Many offers are rejected on that basis alone.

    3. OICs factor in asset equity. Bankruptcies do not. Equity in bankruptcy has little to do with ability to file or the dischargeability of the debt itself. Certain assets may be liquidated in a chapter 7, most consumer assets are safe.

    4. The largest benefit of bankruptcy over the Offer in Compromise is that a bankruptcy can be crafted to deal with all of the other taxpayers debts at once. State tax, credit card, medical bill, personal loans and other consumer debt.