The following is a list of the most common legal ways to deal with large IRS tax debt. Some are obvious, some are difficult and require extensive planning and some only work best in combination with another option.
Despite the fact that a review of the list alone won't solve the problem, it should provide you some additional knowledge about existing options and some hope that there may be a solution.
Pay the Debt
If the funds exist to pay the debt in full, it often makes sense to do so, paying the debt off at once or in a few payments, stops liens, levies and interest. Borrowing to pay it off at once or in a few payments, stops liens, levies and will often reduce interest.
However, if you are considering the use of retirement funds or home equity to pay the debt off or to borrow against in order to do so, some additional thought may be in order.
Use the Statute of Limitations to Your Advantage
Congress decided at some point, that it would make sense to limit the time the IRS has to figure out how to get paid. It does things right once in a while.
26 U.S.C Section 6502 provides the limit and as a result, the IRS has ten years to get it done.
This seems like a long time, but you would be surprised at how many people with serious tax debt are able to use this law to their advantage. In fact, the wise use of the Installment Agreement/Non-Collectible Status option combined with the statute is what I often call the “poor man's” offer in compromise. (see below for more about installment agreements and offers in compromise)
Imagine a tax debt of $100,000.00. Imagine that the IRS has let 7 years pass without attempting to collect the debt, but they are now at the doorstep. The debt has grown to $300,000.00 with penalty and interest over time, but the taxpayer can only afford to pay $100.00 per month toward the balance. If the taxpayer were able to negotiate such a payment, only $3600.00 of the $300,000.00 would be paid before the debt disappeared.
Filing an offer in compromise, bankruptcy or pursuing some other legal remedy in an attempt to slow down the collection, would stop the statute from running. So some serious thought would be required before doing so.
There are other statutes that limit time periods in which the IRS may act:
- Assessment: The IRS has only three years to assess a tax from the date a return is filed in most circumstances.
- Liens: Liens have the same 10-year statute as debt collection. I.e. if the IRS has not reduced the debt to judgment, the lien is no good once the statute on collection runs out.
- Payroll Tax Assessment: Only three years again to assess payroll tax withholding amounts from the date of the filing of the return or the date the return was due whichever later.
- Trust Fund Recovery Penalty Assessment: The IRS has three years to assess personal responsibility for corporate payroll withholding amounts from the filing of the applicable return.
Challenge the Tax Debt
The IRS screwed up. They assessed a debt against you that you know isn't correct. Typically, this is the result of an audit gone bad or the creation of a tax return by the IRS, because you didn't file it yourself. They don't use correct deductions when they do that by the way.
IRS Audits that go badly can be appealed. If done right, they can be appealed all the way to tax court and beyond. If your audit result is wrong, you have a limited amount of time to bring the appeal, so call someone now.
Tax returns filed by the IRS come with appeal rights as well. Most people don't respond in time and lose them, however. Thankfully, the assessment of the tax from the incorrect return can be challenged using the IRS audit reconsideration process.
In English…you can file the correct return and use it to try and replace the incorrect return.
The ability to do this isn't guaranteed and doesn't come with appeal rights. Also, failing to file your own return before the IRS files a return can cause another big problem. Namely, the potential inability to discharge the debt in bankruptcy if necessary.
There are other things the IRS does to assess a tax that can result in incorrect debt amounts, like the assessment of the trust fund recovery penalty against a responsible party.
Where the business has withheld the employee portion of the payroll tax, but used the money for advertising and rent payments instead of sending it in, the IRS can add the amount up and stick it as a penalty on the individual person who they consider to have been responsible for the diversion of the money.
There are defenses to this, however, and the assessment of the debt can be challenged as a result.
Sometimes the tax is correct but it just isn't fair that the spouse should be stuck with it. The law provides the ability to challenge the debt based on some theories about innocent spouses.
26 U.S.C. Section 6159 allows the taxpayer under various and specific circumstances to pay the debt over time. These types of agreements are commonly called installment agreements or plans.
There are various types of IRS installment agreements including:
- A guaranteed 3 year plan if the debt is less than $10,000.00
- A streamlined plan for debts less than $250,000.00/$50,000.00/$25,000.00 that is typically paid over time and doesn't require the submission of detailed financial information.
- A full pay plan that allows the taxpayer to use his or her actual/reasonable budget to determine ability to pay if the debt is paid over 6 years and;
- A partial pay installment agreement.
The partial pay plan allows the taxpayer to pay only what he or she can afford each month even if the amount paid doesn't pay the debt in full before the statute of limitations runs out on the collection of the debt. Again, a “poor man's” offer in compromise. (see above)
Installment agreements stop levies as well, but they don't necessarily prevent the recording of the notice of federal tax lien (unless the debt is less than $50,000 and the payment plan is set up in a certain way) or stop the assessment of penalties or accrual of interest. Partial pay agreements also don't prevent the IRS from demanding the use of assets to pay down the debt.
Offer in Compromise
26 U.S.C Section 7122 provides the basis for the settlement or one-time reduction of the tax debt. In essence, you would be making an offer to compromise and settle the back tax liability. But this isn't horse-trading.
The amount that the law requires the IRS to settle for is based on objective criteria. This criterion is called the “reasonable collection potential” or the RCP.
In theory, the RCP is the amount that the IRS could collect from you before the statute of limitations period on collection runs out.
The vast majority of offers filed with the IRS fail primarily because the RCP calculation is rigged a bit in the IRS' favor. They are allowed to use as a starting point for calculation purposes or a budget that is based on averages they have created.
For instance, they may have pre-determined that a family of four only needs $1650.00 per month to pay for all housing and utilities expenses. That family may be actually spending $2100.00 per month. If in the end, the IRS is able to use the $1650.00 figure to determine the RCP, then the amount of extra income per month by their calculation would be at least $450.00 per month.
If the statute of limitations period remaining on collections is 8 years than the RCP, just based on this number could be as high as $43,200.00
Successful Offers in Compromise, require much thought and planning as a result. They shouldn't be entered into lightly.
There are two other types of Offers. One is used to dispute the underlying debt typically called an Offer in Compromise based on a doubt as to the liability. The other is made when the taxpayer may be able to afford the tax debt payment but it would be unfair to make him or her do so.
Some side notes about the Offer Process:
a. It stops IRS levy and other seizures.
b. The taxpayer is on probation for 5 years following the acceptance of the Offer. He or she must file all returns timely and pay all the tax due or else the offer is revoked.
Currently Non-Collectible Status
If the IRS is levying or otherwise, and the collection is causing an actual hardship on the taxpayer, the collection activity is supposed to stop. If the taxpayer can convince the IRS of the hardship status, a code can be placed on the account to designate the account as non-collectible.
The main benefit is obvious. There is a secondary benefit that is less obvious and that is that the statute of limitations period on collections continues to run while the status is in place.
The downsides of non-collectible status are that interest continues to accrue and if the change in circumstance is to the taxpayer's benefit, i.e. income goes up, the status can be revoked.
If you filed a return jointly with your spouse or ex-spouse, and a large tax debt exists as a result, you need to be at least aware of your potential rights as an innocent spouse.
There are three types of relief:
a. Innocent Spouse Relief – Where your former spouse filed to report income correctly or claimed improper credits or deductions.
b. Separation of Liability – The additional tax that exists as a result of the spouse or ex-spouse's decision to not report something properly on the return may be allocated to that spouse.
c. Equitable Relief – If you do not qualify under one of the theories above, the IRS may agree to relieve you of the debt based on fairness and equity.
The basic requirements to file for innocent spouse relief are these:
a. The taxpayer filed a joint return which has an understatement of tax due to erroneous items.
b. The taxpayer can establish that at the time he or she signed the return he or she did not know and had no reason to know that there was an understatement of the tax.
c. Taking into account all of the facts and circumstances, it would be unfair to hold the taxpayer liable for the understatement of the tax.
Collection Due Process
When a tax debt is assessed or entered into the government's records as a debt, the IRS doesn't need a Judge's permission to collect. They can simply start the collection process. However, there are some limits on this ability. The most important are that you are entitled to due process . Therefore, the IRS must send you a notice of it's intent to levy and give you thirty days to appeal it and ask for some alternate arrangement.
This appeal is called a collection due process appeal and using it stops the collection process. Although the statute of limitations on collections stops running while the appeal is pending, the appeal typically provides the taxpayer the time to find a solution to the tax debt.
An offer in compromise can be made via this process and judicial review attaches to the process as well.
Collection Appeals Process (CAP)
Collection activities can be appealed at any time. These types of appeals have different names like equivalency hearing, and can in less powerful ways forestall the collection process. They do not come with the right to seek judicial review.
Bankruptcy and it's relation to tax debt is misunderstood. Many people including attorneys believe that bankruptcy can't resolve tax debt. Nothing could be further from the truth.
In fact, unless the IRS is able to prove that a taxpayer attempted to evade a tax or filed a false return, the treatment of the tax debt is not up to them. It is governed by the Bankruptcy Code.
Filing a bankruptcy petition will stop all tax collection activity by the IRS and erase taxes that meet the Bankruptcy Code's definition of dischargeability.
I have helped many taxpayers rid themselves of tax and other debt through bankruptcy especially where one of the other solutions in this article didn't make complete sense.
Pay and Sue for Refund
The U.S. District Court and the Court of Federal Claims hear tax cases only after the taxpayer has paid the tax (or a portion of it in district court) and filed a claim for a refund.
A taxpayer can file a claim for a refund if he or she believes that the tax paid was incorrect. Once the claim is disallowed by the IRS, the taxpayer can bring the suit.
The suit must be brought within a certain time period after the rejection of the claim.
As a taxpayer, you have the right to request the cancellation of any IRS penalty. There are more than 140 penalty provisions and they all have a good faith exception.
If you have been penalized for something like a failure to pay the tax on time, but you acted in good faith and there exists some reasonable basis for the failure then the penalty can be removed along with interest. This removal often makes it easier for you to deal with the underlying debt.