By Deborah J. Weber

The Government, like other creditors, encounters situations where an account receivable cannot be collected in full (especially in the current economic climate) or there is a legitimate dispute as to what is owed. The IRS, with the permission of Congress, has accepted the business practice of compromise of liability in certain circumstances with the creation and implementation of its Offer in Compromise program.

The Offer in Compromise program includes four types of offers:

1. Doubt as to Collectibility
2. Doubt as to Liability.
3. Effective Tax Administration.
4. Doubt as to Collectibility with Special Circumstances

This article is intended to give a brief overview of the type and purpose of each Offer and to discuss recent developments and issues with the Offer program.

Doubt as to collectibility offer

The quick sale value of the taxpayer’s equity in assets plus the present value of a future installment payment agreement between the taxpayer and the Service equals the minimum amount necessary to offer the IRS to compromise a tax liability for less than the full amount owed (referred to by the Service as its reasonable collection potential).

Assets

The Service looks at all of the assets belonging to the taxpayer. Some assets, such as cash, bank accounts and investment accounts are valued at 100%. Non-cash items, such as a house, car, etc., are discounted by 20% since the IRS realizes that they will not obtain full value if they force the sale of the asset. Therefore, 80% of the fair market value, minus any senior encumbrance is used to determine the taxpayer’s equity in the asset for purposes of the Offer analysis. This 20% discount is referred to as the quick sale value.

Many practitioners are not aware that retirement accounts, such as IRAs or 401(k)s, are not exempt from collection by the IRS and as such must be included in the Offer computation. However, the Service will allow credit for the tax consequences of the dissipation of pre-taxed funds including the early withdrawal penalty if the retirement account is going to be liquidated to fund the Offer if accepted.

PVFIPA – Present Value of a Future Installment Payment Agreement

To determine the present value of a payment agreement between the IRS and taxpayer, the Service queries the taxpayer’s household income and expenses. The IRS divides all expenses into two categories; necessary and conditional. Only necessary expenses are allowed when evaluating an Offer in compromise. As part of this analysis the Service further divides necessary expenses into 3 types: national, local and other.

National expenses are food, clothing, personal care products and miscellaneous expenses. The amount for the national expense is the same across the nation and requires no substantiation to claim it.

Local expenses differ depending on taxpayer’s residence. Local expenses are for transportation and housing, and although these amounts are also standardized, unlike the National expense, the taxpayer only receives the allowable amount or the actual amount spent on these items, whichever is less.

Other Expenses

The third type of necessary expense is referred to as “other” because it consists of all of the other expenses that are necessary for the health and welfare of the taxpayer or his or her family or for the generation of income. Other expenses include medical expenses, taxes, life insurance, child care and court-ordered payments. The taxpayer must substantiate all “other” expenses, but there are no pre-set caps on the amounts.

Allowable necessary expenses subtracted from the taxpayer’s gross income equals “disposable income.” The disposable income is then multiplied by a factor. The amount of the factor depends on the payment terms of the Offer. The PVFIPA is then added to the quick sale value of all assets and this is the minimum amount that must be offered to compromise the liability. Other than the level of review (acceptance of Offers for liabilities in excess of $50,000 require approval by the Office of Chief Counsel), the amount of the liability is irrelevant. Further, if an analysis of the taxpayer’s financial circumstances indicates that the taxpayer could full pay the tax liability over the remaining life of the statute, the IRS will reject the Offer.

Given the above, advertisements that make blanket statements that tax liabilities can be settled for “pennies on the dollar,” are often misleading. Although the calculation may often result in a compromise that is “pennies on the dollar,” as demonstrated above it is more a coincidental evaluation after the fact than a function or part of the process.

Doubt as to liability offer

In a situation where the taxpayer can establish real doubt as to the assessed tax liability, the taxpayer should consider submitting an Offer in Compromise based on Doubt as to Liability. Offers submitted based solely on Doubt as to Liability do not involve an evaluation of the taxpayer’s financial circumstances. Rather, the Doubt as to Liability Offer is based on the substantive law that applies to the particular facts.

The Doubt as to Liability Offer is most useful in circumstances where the taxpayer has missed his or her opportunity to challenge the assessed tax liability. For example, if the Internal Revenue Service issued a 60 day letter asserting the trust fund recovery penalty against a potentially responsible officer of a corporation who failed to file a timely appeal, and if the taxpayer can argue that he or she should not be held liable, then a Doubt as to Liability Offer can be submitted.
An additional circumstance where a Doubt as to Liability Offer may be useful is where the Internal Revenue Service issued a Notice of Deficiency (90 day letter) and the taxpayer failed to timely petition the Tax Court. In that circumstance, if the taxpayer can establish that the substitute for return prepared for the taxpayer by the IRS is incorrect, a Doubt as to Liability Offer may be appropriate.

Offer in compromise based on effective tax administration

The IRS Restructuring and Reform Act of 1998 added §7122(c) of the Internal Revenue Code which provides that the Service shall set forth guidelines for determining when an Offer in Compromise should be accepted. Items that must be considered by the Internal Revenue Service include:

1. Hardship
2. Public policy
3. Equity

Effective Tax Administration Offers are appropriate where the tax is legally owed and the taxpayer has the ability to full pay, however, the taxpayer can establish that, nevertheless, there is a very good reason why the taxpayer should not be forced to full pay. Unlike Doubt as to Liability Offers, Effective Tax Administration Offers involve a review and evaluation of the taxpayer’s financial circumstances.

Factors taken into consideration by the Internal Revenue Service that impact the taxpayer’s financial condition include:

1. The taxpayer’s ability to provide for basic living expenses;
2. A taxpayer’s age and employment status;
3. The number, age and health of the taxpayer’s dependents;
4. The cost of living in the area in which the taxpayer resides and any extraordinary circumstances such as special education expenses;
5. Medical catastrophe, natural disaster, etc. that apply to the taxpayer.

Factors that support an economic hardship determination may include:

1. Taxpayer is not capable of earning a living because of a long term illness, medical condition or disability and it is reasonably foreseeable that the financial resources will be exhausted providing for care and support during the course of the condition.
2. Taxpayer may have a set monthly income and no other means of support and the income is exhausted each month in providing for the care of dependents.
3. Taxpayer has assets, but is unable to borrow against the equity in those assets and liquidation to pay the outstanding tax liabilities would render the taxpayer unable to meet basic living expenses.

Doubt as to collectibility offer with special circumstances

A little known type of Offer in Compromise that pre-dates RRA 98 is Doubt as to Collectibility with “Special Circumstances”. This type of Offer is appropriate where the taxpayer’s assets are in excess of the amount offered, but less than the outstanding tax liability. Keep in mind, an Effective Tax Administration Offer is an Offer where the taxpayer has sufficient assets to full pay, but there is a very good reason why he or she should not. The Doubt as to Collectibility Offer with Special Circumstances is a situation where the taxpayer does not have sufficient assets to full pay, but does have assets in excess of the amount being offered.

When evaluating a Doubt as to Collectibility Offer with Special Circumstances, the Internal Revenue Service will determine its reasonable collection potential and the taxpayer must then establish the circumstances forming the basis of the “special circumstances”. Factors similar to those listed above under Effective Tax Administration are those that can be used by a taxpayer to establish “special circumstances”.

Centralization

The local Offer Review Unit in Buffalo was one of the last in the country to be disbanded and that occurred in the summer of 2006. Thus, most Offers in Compromise are submitted and worked through a Central Processing Unit with the Unit location depending on where the taxpayer resides. If an Offer in Compromise is submitted based solely on Doubt as to Liability, after processing, the Offer is forwarded to the Exam Function. The majority of offers submitted are Doubt as to Collectibility and are worked at a Centralized Processing Unit.

Twenty Percent Deposit

On May 17, 2006, then President Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005. This legislation added the requirement that a taxpayer make a 20% nonrefundable deposit with the submission of any Offer in Compromise based on Doubt as to Collectibility that will be paid in installments of 5 or less. This deposit is due in addition to the $150 processing fee.

If a taxpayer submits an Offer in Compromise which will be paid in periodic installments of six or more, instead of a 20% deposit, the taxpayer must begin making the periodic installment payments with the submission of the Offer and continue making the installment payments throughout the processing and evaluation of the Offer in Compromise.
Since the 20% deposit is considered a voluntary payment the taxpayer can designate the application of the 20% lump sum deposit or installment payments. The designation is not relevant if the Offer is ultimately accepted, but if the Offer is not ultimately accepted, the designation could be useful to the taxpayer. For example, if the type of tax in issue is an income tax liability which includes years that could be dischargeable in a bankruptcy and years that could not be dischargeable in a bankruptcy, the taxpayer should consider designating the payment to the priority taxes that would not be discharged.

Alternatives

In some circumstances, an Offer in Compromise can be a fabulous resolution for a client. However, the Offer in Compromise program has become more difficult as the rules are applied to certain taxpayers. The 20% non-refundable down payment is a problem for some taxpayers, especially those submitting hefty Offers as some taxpayers are unwilling or unable to make a large non-refundable deposit. Additionally, although it does not apply in every circumstance, the retirement of debt rule does affect the acceptability of some Offers.

For those taxpayers who are unable to submit and negotiate a successful Offer in Compromise, alternatives for resolving their outstanding tax liabilities include partial payment installment payment agreements, full pay installment payment agreements, non-collectibility status and, in some circumstances, bankruptcy. The appropriate “Plan B” to be applied to a case obviously depends on the particular circumstances of each and every particular taxpayer. Although a detailed discussion of the various alternatives is outside of the scope of this outline, recommendation of the most appropriate alternative is the job of the competent tax professional.