Editor: John L. Miller, CPA
In these economic times, more taxpayers are not able to fully pay their federal income taxes when due. There are several methods that may be used to pay tax liabilities in this situation, one of which is an offer in compromise (OIC).
Sec. 7122 permits the IRS to compromise a tax liability on one of the following grounds:
- Doubt as to liability;
- Doubt as to collectability; or
- To promote effective tax administration because either collection of the full amount would cause economic hardship for the taxpayer or compelling public policy or equity considerations provide a sufficient basis for compromising the liability.
This item focuses on offers when there is doubt as to collectability.
Submitting an Offer
A taxpayer makes an offer by filing Form 656, Offer in Compromise. Form 656-B, Collection Information Statement for Businesses, contains detailed instructions for completing the Form 656. In addition to the application, the taxpayer must send a $150 application fee with the offer. This fee can be abated if the monthly household income is not more than the IRS’s low-income guidelines. Moreover, other than for the low-income exceptions, if the taxpayer makes a lump-sum cash offer, 20% of the amount offered must be included with the offer. The payment is not refundable even if the IRS denies the offer. This payment rule has been in effect since 2006 and has resulted in a decline in the number of submitted offers. One of the current administration’s legislative proposals is to repeal this requirement.
If the taxpayer makes an offer to pay the tax liability using installments, the first payment must be paid with the offer, and the installment payments must be made while the offer is being evaluated. The IRS will return the offer without any appeal rights if the taxpayer does not make the payments as outlined.
The IRS has to act on an offer within two years. If it does not accept or reject the offer within two years, the offer is considered to be accepted. The statute of limitation is suspended while an offer is under consideration.
The IRS offers three types of payment plans:
- Lump-sum cash offer: The offer amount is paid in five or fewer installments;
- Short-term periodic payment option: Payment is made within 24 months from the date the offer is submitted; and
- Deferred periodic payment: Payment is made over the remaining statutory period (normally a maximum of 10 years) for collecting the tax.
Observation: To increase the chances of acceptance, a taxpayer should offer to pay all the money at once, if possible, because the IRS usually does not want to wait two years to get full payment. If full payment is not possible, a taxpayer should attempt to pay at least half of the total offer shortly after the IRS has accepted it and pay the remainder in monthly installments.
An individual taxpayer uses Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, to list required financial information. Form 433-B, Collection Information Statement for Businesses, is for use by a partnership, a limited liability company, or a corporation.
Calculation of the Amount to Offer
The minimum offer amount that the IRS will accept, except in certain special circumstances, is based on the taxpayer’s reasonable collection potential (RCP). The RCP is the total net value of the taxpayer’s assets minus allowable exemptions for certain assets, plus the difference between monthly income and expenses multiplied by a factor based on the type of plan and the time period in which payments will be made. Taxpayers calculate this amount on a Form 656-B worksheet using financial information taken from Forms 433-A and 433-B to determine the current fair market value of all assets less any loan balances thereon and the difference between monthly income and monthly living expenses.
Note: As discussed in more detail below, when investigating the offer the IRS is free to adjust the RCP calculated by the taxpayer upward or downward based on the taxpayer’s specific facts and circumstances.
The IRS will reject an offer immediately if it is not processable. The IRS considers offers to be processable when received unless one or more of the following problems exist:
- The taxpayer or tax liabilities are not properly identified;
- An out-of-date Form 656 is used (or the terms on the printed Form 656 are changed);
- No amount of money is offered;
- Required financial statements are not provided or are otherwise incomplete or missing required signatures;
- The amount offered is less than the value of the taxpayer’s assets;
- A Social Security or employer identification number is missing, incomplete, or incorrect;
- The offer is not properly signed; or
- The offer is submitted to delay or impede IRS collection efforts.
Investigation of an Offer
The IRS recently announced that its employees will be allowed to consider a taxpayer’s current income and potential for future income when investigating an offer in compromise and negotiating an offer amount. The usual practice is to judge an offer amount based on a taxpayer’s earnings in prior years. The agency may require that a taxpayer entering into an offer agree to pay more if his or her financial situation significantly improves.
Section 126.96.36.199.1 of the Internal Revenue Manual provides that IRS investigators may consider assets held by the taxpayer, earning power, amounts collectible from third parties, and assets available to the taxpayer that are beyond the reach of the agency in determining the collection potential.
In a doubtful collectability case, the investigator must consider the taxpayer’s ability to pay in calculating the taxpayer’s reasonable collection potential. The taxpayer’s ability to pay is determined using an estimation of the taxpayer’s allowable expenses (i.e., the taxpayer’s basic living expenses). Unless there are special circumstances, allowable expenses for purposes of the ability to pay calculation are based on national standards for food, clothing, and out-of-pocket health care expenses and on local standards for housing, utilities, and transportation.
The IRS will also consider other factors, including the taxpayer’s age, health, education, and occupation, in determining the taxpayer’s RCP. Here the agency is trying to determine whether future income may increase. Therefore, a taxpayer may want to make a Freedom of Information Act request to see his or her collection administrative file to make sure the file contains accurate information.
If an Offer Is Rejected
If the IRS investigator decides to reject the offer, Sec. 7122(d)(1) requires the IRS to perform an independent administrative review of the rejection before notifying the taxpayer that the offer has been rejected. If the rejection is sustained on review, the IRS will notify the taxpayer by mail that the offer has been rejected. The taxpayer may request an Appeals hearing within 30 days of the date of the rejection letter. An appeal is the last chance to get the offer accepted. A taxpayer cannot contest a rejected offer in the courts; however, if the Appeals officer sustains the rejection of the offer, the taxpayer can submit another offer.
If an Offer Is Accepted
After an offer is accepted, a taxpayer must:
- Promptly pay any unpaid amounts due under the terms of the agreement;
- Notify the IRS if not able to comply with the agreed-upon terms; and
- Timely file all tax returns for the next five years and pay all taxes in full.
The IRS will not refund any overpayments shown on a return during this period and will instead apply them toward any outstanding assessment.
Failure to follow these requirements can result in a previously accepted offer being terminated and a taxpayer being required to pay the remaining balance in full.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Joe Marchbein is with Jack P. Fitter, CPA, APC, in Chesterfield, MO, and is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at email@example.com.