IRS debt can be a life-changing burden. But for some taxpayers, an offer in compromise may be an avenue to get rid of that tax debt and to receive a fresh start. When a taxpayer qualifies for an offer in compromise, the IRS agrees to settle the tax debt for less than is actually owed. The IRS then wipes the rest of the tax liability off the books—as long as the taxpayer complies with the requirements that come with an offer in compromise.
An offer in compromise is a settlement, or an agreement, between the taxpayer and the IRS to settle the tax debt for less than the amount that is owed. The authority for an offer in compromise derives from Internal Revenue Code (IRC) § 7122, which authorizes the IRS to accept less than the full amount due in the form of an offer in compromise (OIC).
Presenting a successful offer in compromise is both an art and a science. The IRS requires that certain information be reported in a required format. An offer to compromise a tax liability should set out the legal grounds for compromise and should provide enough information for the IRS to determine whether the offer fits within its acceptance policies. The Internal Revenue Manual specifies many of the precise rights and requirements relevant to an offer in compromise.
The IRS can accept an offer in compromise based on any one of the following grounds:
- Doubt as to Liability
- Doubt as to Collectability
- Effective Tax Administration
Doubt as to Liability
That is, the IRS can accept a compromise if there is doubt as to liability. A compromise meets this criterion when there is a genuine dispute as to the existence or amount of the correct tax debt under the law. This generally requires that a tax attorney make a compelling demonstration to the IRS that the tax is not owed.
Under IRS standards, doubt as to liability exists where there is a genuine dispute as to the existence or amount of the correct tax liability under the law. Doubt as to liability does not exist, however, where the liability has been established by a final court decision or judgment concerning the existence of the liability.
An offer to compromise based on doubt as to liability generally will be considered acceptable if it reasonably reflects the amount that the IRS would expect to collect through litigation. This analysis includes consideration of the hazards (or risks) of litigation that would be involved if the liability were litigated.
Doubt as to Collectability
Second, the IRS can accept a compromise if there is doubt that the amount owed is fully collectible. Doubt as to collectability may exist where the taxpayer’s assets and income cannot satisfy the full amount of the tax liability. Offers based on doubt as to collectability are the most common form of offer in compromise. In some cases, the tax debt can be settled for a fraction of the amount owed. Notably, IRC 7122(d)(3)(A) mandates that “the Internal Revenue Service shall not reject an offer-in-compromise from [certain] taxpayer[s] solely on the basis of the amount of the offer.”
An offer to compromise based on doubt as to collectability generally will be considered acceptable if it is unlikely that the tax can be collected in full and the offer reasonably reflects the amount the Service could collect through other means, including administrative and judicial collection remedies. See IRS Policy Statement P-5-100. This amount is known as the reasonable collection potential. In determining the reasonable collection potential, the IRS takes into account the taxpayer’s reasonable basic living expenses. In some cases, the IRS may accept an offer of less than the total reasonable collection potential if there are special circumstances.
Effective Tax Administration
Third, the IRS can accept a compromise based on effective tax administration (ETA). An offer may be accepted based on effective tax administration when there is no doubt that the tax is legally owed and that the full amount owed can be collected, but requiring payment in full would either create an economic hardship or would be unfair and inequitable because of exceptional circumstances. This provides an avenue for many taxpayers that do not fit under one of the two prior categories.
The IRS Regulations provide several examples of situations that may justify relief under the Effective Tax Administration’s economic hardship prong. These examples are not exhaustive, can help demonstrate where an offer in compromise may be available on the ETA basis. The examples that may indicate an offer in compromise based on ETA would be acceptable are set forth below:
The taxpayer has assets sufficient to satisfy the tax liability. The taxpayer provides full time care and assistance to her dependent child, who has a serious long-term illness. It is expected that the taxpayer will need to use the equity in his assets to provide for adequate basic living expenses and medical care for his child. The taxpayer’s overall compliance history does not weigh against compromise.
The taxpayer is retired and his only income is from a pension. The taxpayer’s only asset is a retirement account, and the funds in the account are sufficient to satisfy the liability. Liquidation of the retirement account would leave the taxpayer without an adequate means to provide for basic living expenses. The taxpayer’s overall compliance history does not weigh against compromise.
The taxpayer is disabled and lives on a fixed income that will not, after allowance of basic living expenses, permit full payment of his liability under an installment agreement. The taxpayer also owns a modest house that has been specially equipped to accommodate his disability. The taxpayer’s equity in the house is sufficient to permit payment of the liability he owes. However, because of his disability and limited earning potential, the taxpayer is unable to obtain a mortgage or otherwise borrow against this equity. In addition, because the taxpayer’s home has been specially equipped to accommodate his disability, forced sale of the taxpayer’s residence would create severe adverse consequences for the taxpayer. The taxpayer’s overall compliance history does not weigh against compromise.
The IRS regulations also provide several examples where relief may be warranted under the Effective Tax Administration’s public policy and equity provisions:
In October of 1986, the taxpayer developed a serious illness that resulted in almost continuous hospitalizations for a number of years. The taxpayer’s medical condition was such that during this period the taxpayer was unable to manage any of his financial affairs. The taxpayer has not filed tax returns since that time. The taxpayer’s health has now improved and he has promptly begun to attend to his tax affairs. He discovers that the IRS prepared a substitute for return for the 1986 tax year on the basis of information returns it had received and had assessed a tax deficiency. When the taxpayer discovered the liability, with penalties and interest, the tax bill is more than three times the original tax liability. The taxpayer’s overall compliance history does not weigh against compromise.
The taxpayer is a salaried sales manager at a department store who has been able to place $2,000 in a tax-deductible IRA account for each of the last two years. The taxpayer learns that he can earn a higher rate of interest on his IRA savings by moving those savings from a money management account to a certificate of deposit at a different financial institution. Prior to transferring his savings, the taxpayer submits an e-mail inquiry to the IRS at its Web Page, requesting information about the steps he must take to preserve the tax benefits he has enjoyed and to avoid penalties. The IRS responds in an answering e-mail that the taxpayer may withdraw his IRA savings from his neighborhood bank, but he must redeposit those savings in a new IRA account within 90 days. The taxpayer withdraws the funds and redeposits them in a new IRA account 63 days later. Upon audit, the taxpayer learns that he has been misinformed about the required rollover period and that he is liable for additional taxes, penalties and additions to tax for not having redeposited the amount within 60 days. Had it not been for the erroneous advice that is reflected in the taxpayer’s retained copy of the IRS e-mail response to his inquiry, the taxpayer would have redeposited the amount within the required 60-day period. The taxpayer’s overall compliance history does not weigh against compromise.
Doubt as to Collectability – Reasonable Collection Potential
The IRS’s policy is not to reject an offer in compromise solely on the basis of an asset and income evaluation—instead, it looks to whether the offer reasonably reflects collection potential. IRS Policy Statement P-5-100 (1-30-92), at IRM 22.214.171.124.17; IRM 126.96.36.199.4 (7-18-17). The first step that the IRS undertakes in this process is to determine the net realizable equity in the taxpayer’s assets. Net realizable equity is defined as the “quick sale value” (QSV) of the assets less any amounts owed to secured lien holders with priority over the federal tax lien and applicable exemptions. There are a number of detailed rules that come into play in this context. For example:
- Normally, QSV is calculated at 80% of FMV. But a higher or lower percentage may be applied in determining QSV when appropriate.
- When taxpayers submit separate offers but have jointly owned assets, the IRS generally allocates equity in the assets equally between the owners.
- The cash value of a whole life insurance policy is generally included.
- Funds held in a retirement or profit sharing plan are considered an asset and must be valued for offer purposes.
The IRS will also generally include “dissipated assets” in the calculation where the taxpayer sold, transferred, encumbered or otherwise disposed of assets in an attempt to avoid the payment of the tax liability, or used the assets or proceeds (other than wages, salary, or other income) for the payment of items that were not necessary for the production of income or the health and welfare of the taxpayer or their family.
Next, the IRS calculates the value of the taxpayer’s future income. This analysis largely tracks the analysis used for determining eligibility for an installment agreement. Future income is defined as an estimate of the taxpayer’s ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future.
The IRS will also give consideration to the taxpayer’s overall general situation including such facts as age, health, marital status, number and age of dependents, level of education or occupational training, and work experience.
An expert tax attorney can help a taxpayer present an accurate and effective picture and analysis of the taxpayer’s assets and their reasonable collection potential. This process is critical in order to maximize the taxpayer’s chances at a successful Offer in Compromise.
Know Your Rights—An Offer in Compromise Generally Suspends IRS Collection Activity
The submission of an Offer in Compromise request generally suspends IRS collection. IRC section 6331(k) generally prohibits IRS levies on a taxpayer’s property or rights to property:
- during the period that the offer is pending,
- for an additional 30 days after the offer is rejected, and
- during the time any appeal of the rejection is pending.
An Offer in Compromise must propose a payment method. An offer based on Doubt as to Collectability can be made as a Lump Sum Cash Offer or as a Periodic Payment Offer. The offer terms and associated initial partial payment requirements are set forth below in more detail:
- Payment Option 1 – Lump Sum Cash Offer: Payable in five or fewer installments beginning on or after notice of acceptance. The Form 656 must be accompanied by payment of 20% of the amount of the proposed offer, unless Low Income Certification Guidelines are met.
- Payment Option 2 – Periodic Payment Offer: Payable in more than five installments, beginning with the date the offer is received by the Service. The Form 656 must be accompanied by the first proposed installment payment unless Low Income Certification Guidelines are met. Additional installments must be paid in accordance with the taxpayer’s proposed terms while the offer is being considered, unless the offer is based upon DATL or the taxpayer meets the low-income exemption under Section 4 of Form 656.
The Right to Appeal
Treasury Regulation 301.7122-1(f)(5) provides that a taxpayer may administratively appeal the rejection of an offer to the IRS Office of Appeals if, within the 30-day period commencing the day after the date on the letter of rejection, the taxpayer requests such an administrative review in the manner provided by the Secretary.
Under IRC 7122(f) and Notice 2006-68, an OIC is deemed to be accepted if it is not rejected, returned, or withdrawn before the date that is 24 months after the date of the submission of the offer.
IRC 7122(b) requires an opinion from Chief Counsel on all offers recommended for acceptance in which the unpaid liability (including tax, penalties and interest) is $50,000 or more. Counsel’s review of a proposed acceptance has two separate and distinct components:
- Certification that the legal requirements for compromise were met.
- Review of the proposed compromise for consistent application of the Service’s acceptance policies.
There are a number of other avenues available to taxpayers to resolve outstanding tax collection issues. Those opportunities may include:
- Suit Against the IRS/Federal Government
- Installment Agreement
- Lien Removal
- Currently Not Collectible Status
- Extension of Time to Pay