You see them of television and hear them on the radio: “We’ll reduce or eliminate your back tax liabilities.” “You’ll pay as little as 15 cents on the dollar for your back taxes.” So what’s the catch? What secret knowledge do these promoters possess that allows them to reduce your tax liability so drastically?
The Mysterious Technique Revealed:
When taxpayers cannot pay their back taxes, IRS allows them to submit an “offer-in-compromise” (“Offers”), using Form 656, for the amount owed, plus the promise to timely file all tax returns and pay all taxes for the next 5 years. An Offer is a contractual offer to pay less than 100% of the taxes owed, which, if accepted by IRS, becomes a binding contract. The policy behind the Offer concept is to give taxpayers a fresh start by allowing them to settle on back taxes.
In the Northern California district, last year approximately 6,000 Offers were submitted of which 55% were accepted, compromising about $145,000,000 in back taxes. The average accepted Offer settled taxes at 11 cents on the dollar. IRS also sees the Offer process as a way to bring back to the system a certain “universe of taxpayers” that have landed in tax trouble.
In the past, IRS was reluctant to accept an Offer without making the taxpayer jump through a number of procedural and technical hoops. Arbitrary minimum offers were established by some IRS districts. Other statistical misuses caused many Offers to fail, or become “unprocessable” in IRS-speak. Now, IRS states that its offer specialists will act more like bank loan officers and work with taxpayers to package and accept Offers.
The Offer in Compromise Process
IRS has stated that it wants to reduce the number of unprocessable Offers and will work with taxpayers and their representatives to make submitted Offers processable (i.e. IRS must analyze the Offer on the merits of the taxpayer’s situation). Under this new policy, all Offers will be processed, with two exceptions:
(1) If the taxpayer is currently in bankruptcy; or
(2) The taxpayer has not filed all required tax returns for prior years.
Because all other Offers are now processable, should a later rejection occur, they will automatically become subject to the appeal rights and other taxpayer protections afforded under the Taxpayer’s Relief Act of 1998. This is a new and important taxpayer protection that an unprocessable Offers did not enjoy.
Usually an Offer is accompanied by a good-faith deposit of 5% to 10% of the Offer amount. However, IRS is considering the elimination of the deposit requirement because many of the deposits are nominal and a majority are refunded. IRS has also found no correlation between the deposit and the amounts actually paid on accepted Offers.
Changes in the IRS Reform Act of 1998 and the Impact on Offers
IRS is permitted to accept an Offer for two distinct reasons: (1) doubt as to liability (it is doubtful the taxpayer owes the tax in the first place) and (2) doubt as to collectibility (even if the taxpayer owes the taxes, the taxpayer does not have the financial assets or earning capacity to pay the amount owed). About 99% of all Offers are based on doubt as to collectibility.
No Minimum Dollar Requirement
Congress found that IRS discriminated against low income taxpayers by sometimes requiring a minimum Offer ($500 or $1,000) regardless of the taxpayer’s financial inability to pay that amount. The Reform Act requires IRS to consider each Offer based on the taxpayer’s facts and circumstances and ability to pay, rather than relying on an artificial minimum floor.
When an Offer is based on doubt as to collectibility, the inquiry is limited to the taxpayer’s ability to pay. The amount of the outstanding tax is not considered. Thus, in extreme circumstances, a $100 offer might suffice to extinguish a $1 million tax liability.
Doubt as to Liability
The Reform Act of 1998 prevents IRS from requesting a financial statement (Form 433-A Statement of Financial Condition) when an Offer is based on doubt as to liability. Congress concluded that IRS unfairly used financial statements to determine whether a taxpayer had the ability to pay the taxes, rather than focusing on whether the taxpayer actually owed the money.
On occasion, IRS rejected Offers based on doubt as to liability because it could not locate the administrative file. The Reform Act prohibits rejection of Offers because IRS cannot find the pertinent administrative files.
Doubt as to Collectibility
Doubt as to Collectibility exists when a taxpayer clearly owes the taxes, but does not have the financial capability to pay them within the foreseeable future. Doubt as to collectibility involves a financial analysis of a taxpayer’s assets and earning capacity. These are two distinct financial considerations. IRS calculates the value of a taxpayer’s assets and the taxpayer’s excess earnings after “necessary living expenses,” then combines the two as the minimum acceptable Offer.
Financial statements must accompany Offers based on collectibility. Form 433-A is a statement of financial condition for an individual. If the taxpayer owns a business, he or she must also complete Form 433-B. These forms require that the taxpayer list assets and liabilities as well as income and current expenses. To verify expenses, taxpayers may be required to provide between 3-6 months of bank statements and cancelled checks, and contracts or leases.
Offer Proposals Must Be Consistent With Taxpayer’s Ability to Pay
IRS Policy Statement P-5-100 (“Policy Statement”) states that “the success of the compromise program will be assured only if taxpayers make adequate compromise proposals consistent with their ability to pay … Taxpayers are expected to provide reasonable documentation to verify their ability to pay.” Therefore, IRS must be able to determine and verify what a taxpayer is able to pay.
Consider the following example: A foreign resident and citizen owes U.S. income taxes of $100,000 but has no assets in the U.S. He has, however, $1,000,000 in a foreign bank, but IRS cannot levy those funds in satisfaction of the taxes owed. The foreign taxpayer wants to make an offer of $20,000 but does not want to disclose his foreign assets.
According to the Policy Statement, IRS will reject the proposed Offer on two grounds: first, the taxpayer must provide documentation to verify his ability to pay, and secondly, the taxpayer has the ability to pay the full taxes, even though IRS cannot levy and collect those funds.
Now consider this example: Taxpayer owes $100,000 in taxes, but his entire net worth is comprised of $5,000 in fuel (gas and oil), furniture, food, medicine and personal effects (“Personal Effects”) and another $1,000 in basic clothing. Taxpayer plans to make an Offer of $100.
IRS should consider this Offer because the taxpayer has an exemption against IRS collection on the first $6,250 in value for Personal Effects. Also, basic clothing is exempt. These exemptions should be applied when valuing the equity in assets. Therefore, the net equity in the taxpayer’s assets would be zero.
Note: Self-employed individuals have an additional $3,125 exemption for tools-of-the-trade, including books. The full list of property under Section 6334(a) exempted from levy is as follows:
• School books and wearing apparel (excluding expensive, luxury apparel);
• Fuel, provisions, furniture, and personal effects not exceeding $6,250 in value;
• Books and tools-of-a-trade, business or profession with a value not greater than $3,125;
• Unemployment benefits;
• Undelivered mail;
• Certain annuity or pension payments under the Railroad Retirement Act, benefits under the Railroad Unemployment Insurance Act, special pension payments received by a person whose name has been entered on a military honor roll under 38 USC Section 562 and annuities based on retired or retainer pay under chapter 73 of 10 USC;
• Worker’s compensation payments;
• An amount of the taxpayer’s wages, salary or other income sufficient to comply with a judgment to contribute to the support of the taxpayer’s minor child;
• The minimum exemption amount for wages, salary, and other income;
• Certain payments made for a service-connected military disability;
• Certain public assistance payments;
• Certain payments relating to social security, state and local welfare, and the Job Training Partnership Act; and
• The taxpayer’s residence (when the taxes owed are less than $5,000) or business assets, in certain cases.
Valuation of Assets
Assets are valued at their “quick sale” value which is usually 80% of their fair market value. For example: Suppose a taxpayer who owes $100,000 in taxes has cash of $2,000, a car worth $3,000 with no debt, a residence worth $200,000 with a $150,000 mortgage (in addition to $5,000 in personal effects and $1,000 in basic wearing appeal, which are automatically exempt from collection):
(1) The equity in the home under a fair market value analysis would be $50,000 ($200,000 FMV – $150,000 mortgage). But under a quick sale valuation, the equity is reduced to $10,000 ($200,000 FMV less 20% = $160,000).
(2) The car’s value would be $2,400 (80% of $3,000); and
(3) The cash is not subject to a quick sale valuation and is worth $2,000.
The taxpayer’s assets would be worth $14,400 for Offer purposes.
Valuation of Excess Earnings
The most difficult part of the financial analysis for an Offer involves the determination of how much, if anything, from a taxpayer’s current earnings and income can be paid towards his or her tax liability. The formula is as follows: Gross income from all sources, less “necessary” living expenses = excess monthly income. Excess monthly income X 60 months (IRS is considering lowing this to 48 months) = Total excess earnings. Total excess earnings discounted by the current discount rate (assume 6%) = Excess earnings.
To illustrate: Suppose a taxpayer had $3,000 of income from all sources and $2,500 of necessary living expenses, leaving $500 in excess monthly income:
Step One: $500 x 60 = $30,000
Step Two: 30,000 x 94% = $28,200
Excess Earnings = $28,200
The amount acceptable to IRS will be Assets of $14,400 + Excess Earnings of $28,200 = $42,600.
Note: If the excess earnings was based on 48 months, the calculation would be:
Step One: $500 x 48 = $24,000
Step Two: 24,000 x 94% = $22,560.
The Excess earnings would be $22,560 and the minimum Offer would be $22,560 + $14,400 = $36,960.
Necessary Living Expenses
Clearly the most important variable in the financial analysis is the determination of necessary living expenses. For instance, if the necessary living expenses were $2,800 instead of $2,500, then only $200 a month would be excess earnings and the excess earnings would drop to: $200 x 60 = $12,000; $12,000 x 94% = $11,280. The minimum offer would then be $11,280 + $14,400 = $25,680. This example illustrates how critical the necessary living expense determination is to the entire Offer amount. For every $1.00 increase in necessary living expenses, the Offer amount drops $56.40. A $100 increase therefore drops the Offer amount by $5,640.
IRS has been criticized for adopting artificial statistics and tables to determine necessary living expenses that were unduly low for the geographical area in which the taxpayer lived. IRS must now use national and local allowances to determine basic living expenses; however, IRS must also consider the unique facts and circumstances of the individual taxpayer with respect to necessary living expenses.
IRS uses the Bureau of Labor Statistics data for the median cost of housing in each of the counties throughout the U.S. as its standard. But housing throughout a county can vary greatly. This approach may discriminate against middle-class taxpayers since the actual cost of housing in their neighborhood may be greater than the county median. The American Bar Association has recommended adopting housing standards based on ZIP codes, rather than county-wide statistics, to correct this distortion.
Under the new standard, IRS cannot use national or local standards if those standards would not provide the taxpayer enough money to meet basic living expenses. The two major areas of concern have been the cost for housing and private school expenses for minor children. For instance, the cost of local standards uses the average cost of housing. This standard would be inappropriate for a taxpayer who just bought a home and is paying the market rate for housing.
Equity and Hardship Factors
In addition to the financial analysis, IRS is instructed to consider equity, fairness and hardship when considering an Offer. IRS is supposed to work with taxpayers who in good faith are trying to meet their tax obligations, by possibly eliminating penalties and interest during the time a taxpayer’s liability is under IRS consideration.
Hardship, fairness and equity might evolve into a third category for Offers, in addition to the current doubt as to liability and doubt as to collectibility. Currently, 99% of the Offers fall into the doubt as to collectibility sphere and are handled by IRS Collections division. The 1% of Offers based on doubt as to liability are handled by IRS Examination division.
A new category for hardship, fairness and equity would prove useful to taxpayers who owe taxes, despite IRS collection efforts. For instance, if IRS or another government agency seized and sold assets, but failed to apply the proceeds to the taxpayer’s account, this could meet the fairness test. Also, if a taxpayer is incapacitated and unable to work, this could meet the hardship test.
In some circumstances, taxpayers become liable for taxes through “transferee liability.” If a taxpayer receives a gift of raw land valued at $1,000,000 and the donor fails to pay gift taxes of $400,000, the donee (receiver of the gift) as the transferee of the property becomes liable for the gift tax. Suppose the property’s value subsequently drops to $300,000, the value of the property received is now less than the taxes owed. Under these circumstances, an Offer based on the proceeds from the sale of the property should be accepted on the basis of equity.
Offers in the Real World
Taxpayers cannot Offer an amount IRS can otherwise collect. In other words, a taxpayer with $10,000 in the bank cannot Offer that amount since IRS can already seize it through its levying powers. Instead, an Offer is usually made by borrowing funds from a third party (almost always a friend, relative or significant other) and making a cash Offer from the borrowed funds. Often, Offers are made in contemplation of marriage and the funds come from the fiancée.
Tricks of the Trade:
It is better to lease than own. IRS cannot levy or sell leased property, so lease your automobiles and furniture. Rent an apartment. If you are not married, but are living with a significant other, assets should be titled in that person’s name, although do not transfer your assets to that person in order to make yourself appear poor. You’ll run afoul of the fraudulent transfer prohibitions.
If you are contemplating marriage, consider a pre-nuptial agreement (pre-marital agreement) specifying that your future spouse’s assets are his or her separate property.
If you own assets, attempt to value them at the lowest supportable value. Remember, used furniture, equipment, and clothing are usually worth about 10 cents on the dollar. Use low blue book for your automobile and then reduce its value further for needed repairs, excess mileage or other damage.
If you own a home, reduce the equity by property taxes that have accrued or could be owing. Also, reduce the value by the cost of needed repairs. Hire a contractor to provide you with a independent valuation of its condition and the cost of repairs.
If you have cash, consider purchasing personal effects or basic clothing. Both categories are exempt from levy ($6,250 is exempt for personal effects), whereas cash is not. Remember, once purchased personal effects could be valued at 10% of the original purchase price. To illustrate: You could purchase $35,000 worth of furniture and other personal effects and then value them between 10-20% of retail ($35,000 x 20% = $7,000 – 20% forced-sale value = $5,600), which brings the value well under the exemption of $6,250. Note: You should investigate the price a used furniture store would pay for the items and use that amount as the value. Remember, you are entitled to a 20% discount for forced sale value.
IRS can no longer levy (seize) a taxpayer’s property while an Offer is pending and for a 30-day period after an Offer is rejected. If the rejected Offer is appealed, the prohibition against a levy continues. An Offer is “pending” once it has been accepted for processing. This prohibition also applies to taxpayers who have an installment agreement for the payment of taxes.
The restriction against an IRS levy does not apply if: (1) the taxpayer signs a written notice waiving the levy restriction; (2) the levy predates the Offer; and (3) when collection of taxes is in jeopardy under Code Section 6331(i)(3)(A)(ii).
The levy restriction also prevents IRS from filing a court action with respect to property that is subject to the Offer.
Note: The 10-year statute of limitation against collection is suspended during the time IRS is prohibited from levying or filing court action against property. In other words, if IRS cannot pursue collection action because a taxpayer has filed an Offer, the 10-year period it has to collect taxes is suspended.
Under circumstances when a taxpayer has no assets that could be subject to a levy and the statute of limitations for collections is due to expire shortly, the taxpayer may want to waive the restriction against levy and keep the statute running.
For instance, assume the statute of limitations will expire in about 18 months and taxpayer has no property which can be affected by a levy (property is owned by taxpayer’s spouse). The taxpayer should consider waiving the levy prohibition, thereby allowing IRS to continue its collection action for the remaining 18 months. This strategy puts pressure on IRS to accept the Offer, since it will lose the ability to collect taxes altogether in 18 months.
IRS is required to establish administrative procedures for an independent review of any Offer (or installment agreement) that is rejected. This internal review must be completed before the Offer is formally rejected and communicated to the taxpayer.
The taxpayer has the right to appeal any Offer rejected to IRS Office of Appeals. Also, taxpayers are to be notified: (1) of the advantages of telling IRS about any changes in address (burden of providing proper notices were sent to the taxpayer at his last known address shifts to IRS); (2) that when Offers are submitted jointly by spouses, a breach of the Offer conditions by one spouse will not constitute a breach by the innocent spouse; and (3) of their right to appeal a rejected Offer or installment agreement.
With respect to the innocent spouse protection, Offers require that in addition to compromising the amount due with a specific payment, taxpayers must properly file and pay taxes due for the ensuing 5 years, or the Offer is rejected. In divorce or separation situations, one spouse may violated this covenant and in the past, such a breach caused the Offer to expire as to both parties, even though the other spouse maintained his or her side of the bargain. Now, the innocent spouse may apply to have the Offer remain in effect.
The amendments are generally effective as to Offers processed after the date of enactment, July 22, 1998. The provisions suspending IRS ability to levy property while an Offer is pending, however, applies to Offers made or pending after December 31, 1999.
Where to File Your Offer
Offers are filed within your IRS district. If you reside in the Northern California District, send your Offers to IRS at 1301 Clay St. #1040 – S, Oakland, CA 94612.
You may obtain forms by clicking below, by calling 1-800-Tax Form, or by visiting the IRS Website http://www.irs.ustreas.gov/prod/forms_pubs/index.html.
Form 656 Offer in Compromise and Instructions.
Form 433-A Financial Information for Individuals.
Form 433-B Financial Information for businesses.
Caution: Don’t blindly follow these forms. The Offer form tricks you into making an Offer which is higher than necessary, because it does not reduce the asset valuation 20% for the forced-sale value and does not eliminate exempt assets from the calculation. IRS claims its Offer specialists will make these adjustments, but don’t rely on IRS to do it. Make your Offer based on the forced-sale valuation and full use of your exemptions.
Offers in Compromise can be effectively used to greatly reduce one’s outstanding tax liabilities, provided the taxpayer’s total assets and excess earnings are less than the taxes owed. Since Offers are based on financial information which is subject to interpretation and valuation, it often pays to have an expert assist you in the Offer process. This is especially true when there are assets which are difficult to value or your necessary living expenses are outside the national and local standards. Remember, for every dollar increase in necessary living expenses, approximately $56.40 can be saved in the Offer amount.
Also, you’ll need a third party source for the Offer money since IRS will not accept your current assets in payment (because it can already seize those assets for payment). If the statute of limitations for collection (usually 10 years from the date the taxes were assessed) is running out, consider waiving the prohibition against IRS levying against your assets. Remember, as long as IRS is prevented from levying your assets, the statute of limitations for collection is tolled (stops running).
In the end, having a third party source for the Offer payment, making shrewd calculations as to your necessary living expenses or creatively using the new “hardship, fairness and equity” premise are the keys to a successful Offer.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**