Why IRS offers in compromise fail

Problems-with-Hiring-a-Third-Party-Software-Selection-Consultant1-425x241

WHY IRS OFFERS IN COMPROMISE FAIL

Thousands of Americans have serious tax debt.  They are often taken in by the promise of an easy solution via the IRS offer in compromise (OIC) program.  The problem is that most people aren’t good candidates for the OIC program.

In an OIC the IRS is empowered to accept less than what they are owed if:

1. The debt amount is incorrect
2.  The debt isn’t reasonably collectible
3. The debt is collectible but there is some other reason that would make it unfair for the IRS to collect the debt.

Most OIC cases are those that are based on #2 – the debt isn’t reasonably collectible.  Most people don’t try an OIC and of those that try, most fail.

Here’s why.

Reason 1 – The debt is collectible

The IRS is allowed to use a “formula” to determine whether a debt is collectible before the 10 year statute of limitations (SOL) on collection runs out.  The formula is theoretically simple.

  • Average Income – “necessary” Budget = Excess Income
  • Excess income multiplied by time left in SOL + asset value = amount collectible over remaining time in SOL
  • If amount collectible over remaining SOL is less than the debt:
  • Cash Offer – Excess income x 12 plus asset value = OIC amount
  • Payment Offer – Excess income x 24 plus asset value = OIC Amount

The formula is simple on it’s face and for those that make little money and have few assets the formula often works well.  The problem and the reason why so many OIC’s fail,  is found in the details of the formula.

How does the IRS calculate income?   If you have had a down year income wise, will the IRS limit it’s calculation of your income average to that year?

How does the IRS calculate your budget?   It uses a standard budget with variations.  Not your budget.  If your house payment is $2500 per month and the standard for your household size is $1500 per month, it will usually use the lower number creating a larger excess income amount and phantom income.

The formula usually results in a failed OIC based on one of two things:

  1. The IRS sees the ability to pay the entire debt before the statute of limitations runs out
  2. The formula works but the taxpayer can’t afford to pay the settlement amount

Reason 2 – The process can be difficult

The IRS purposefully makes the process difficult. It initially rejects many cases and many do not have the funds or desire to continue the fight.

Reason 3 – Large amount paid upfront 

The taxpayer must typically pay 20% of the debt with the offer (in a cash offer) or start making monthly payments equal to the offered monthly payment amount and loses those funds if the offer is unsuccessful.

Reason 4 – Full compliance is often a problem after acceptance

IF the offer is successful, the taxpayer must file tax returns and pay tax obligations for 5 years, if not, the offer is over, the money paid is lost, and the total original debt with it’s accrued interest, continues to be owed, minus what has been paid.

Reason 5 – Offer in Compromise is not a complete solution

Often, the taxpayer proposing the OIC has medical bills, credit card debt, personal loans, state tax debt etc. all of which must still be dealt with outside of the offer in compromise. The payments on these debts aren’t always allowed as part of the budget in calculating the reasonable collection potential of the taxpayer, making it difficult to comply with the requirements of the OIC.

OIC’s have other problems as well

1.  When an OIC is rejected, the taxpayer still owes the entire debt with interest, while the statute of limitations period on the collection of the debt has been stopped.  The taxpayer is right back where he or she began.

2.  The taxpayer who has been rejected, has provided every detail about his or her financial life to the IRS making it easy for it to collect the debt.  They’ve provided a detailed roadmap.

3.  The OIC stops certain time-period(s) from running for purposes of bankruptcy requiring a payment plan to be negotiated post rejection in order to run out the time.

BANKRUPTCY – is it really an alternative?

Believe it or not many people with tax debt use bankruptcy to reduce, eliminate or control tax debt.

A quick review of bankruptcy in relation to tax debt will help to explain why:

There are two types of bankruptcy that pertain primarily to consumers. Chapter 7 and chapter 13.

A chapter 7 bankruptcy is the more commonly filed, and is a liquidation case. In a chapter 7 bankruptcy, the debtor loses all assets not protected by statute and is forgiven his or her dischargeable debt.

Chapter 13 bankruptcy is a “reorganization” bankruptcy. The debtor attempts to keep his or her assets and pay some or all of the debt depending on income and budget amounts. The plan length varies between 3 and 5 years depending on a number of factors.

Tax debts as alluded to above, are classified in either a chapter 7 or chapter 13 as either dischargeable or non dischargeable on the date the bankruptcy petition is filed.

Non-dischargeable tax debts include:
1. collected and unpaid sales tax (of the trust fund nature)
2. trust fund recovery penalty (employment tax unpaid by a business assessed against a “responsible party”).
3. Trust fund tax
4. Income tax related to a return that was not filed or filed but within 2 years of filing the bankruptcy.
5. Income tax related to a return that was due including extensions within the last three years
6. Income tax related to a return for which fraud was involved
7. Income tax for a tax liability that was assessed by the taxing authority within 240 days prior to the date of the bankruptcy filing.

Dischargeable tax debt includes:
1. Those income and certain other non “trust-fund” taxes that meet the following criteria:
A “return” was filed
It was filed more than two years ago
It was due more than three years ago including extensions
The tax was assessed more than 240 days ago
There was no civil or criminal fraud nor did the taxpayer willfully evade or defeat the payment of the tax debt.

In essence, a tax motivated bankruptcy is a bankruptcy case that takes into account filing issues, timing and taxpayer history in a way to take maximum advantage of bankruptcy law in relation to the tax debt.

Or in other words, what may be a non-dischargeable tax debt today may become a dischargeable tax debt tomorrow.

The other benefits in comparison to an offer in compromise are as follows:

1. OIC’s factor in the taxpayer’s income while chapter 7 bankruptcies usually don’t. In a chapter 7 if the majority of the taxpayer’s debt is tax debt, then the income is irrelevant as to whether the taxpayer qualifies to file a chapter 7. The bankruptcy means testing shouldn’t apply.

2. OIC’s factor in future income potential while most bankruptcies don’t. It may not matter in bankruptcy that the taxpayer may be making more next year. Many offers are rejected on that basis alone.

3. OICs factor in asset equity. Bankruptcies do not. Equity in bankruptcy has little to do with ability to file or the dischargeability of the debt itself. Certain assets may be liquidated in a chapter 7, most consumer assets are safe.

4. The largest benefit of bankruptcy over the Offer in Compromise is that a bankruptcy can be crafted to deal with all of the other taxpayers debts at once. State tax, credit card, medical bill, personal loans and other consumer debt.

IRS Offer In Compromise – 4 Reasons Most Offers Fail

bag-of-money-dropping-out-bottomAn “offer in compromise” is simply an offer to settle tax debt made by the taxpayer to the IRS that may result in a settlement agreement between the two.

The driving force behind the process is that…like most creditors, the IRS is smart enough to know when a “bird in the hand” is worth more than “two in the bush”, i.e. if it really believes that it will get less in the end, it will agree to take what it can now, and call it a day.

The initial standard used to determine the “bird in the hand” value is whether the amount being offered by the taxpayer to settle the debt once and for all, is greater than or equal to the “reasonable collection potential” of that taxpayer. (RCP)

So…first question:

How Does The IRS Determine One’s “RCP”?  The most common way stated generally is as follows:

The equity value of taxpayer assets PLUS The difference between the taxpayer’s income and budget when multiplied by 12.

An example: Fanny Fictitious

Fanny has the following:
$30,000.00 Equity in home (“Market value” of home – loan amount)
$5000.00 Equity in car (“Market value” of car – loan amount)
$10,000.00 “Value” of Retirement Fund
$45,000.00 Total Equity
$5,500.00 (gross monthly income)
$5,300.00 (gross monthly living expenses including proper tax withholding)
$200.00 (Remainder) X 12
$2400.00 Ability to pay from income
$45,000.00 PLUS $2400.00 = $42600.00
$42,600.00 = Reasonable Collection Potential

Fanny’s RCP would be $42,600.00.

If she owes more than $42,600.00, than in theory, it’s a good settlement, i.e. the IRS is getting…the bird… and Fanny is paying less than she owes.

Great right? Now the catch.

The payment would have to be made by sending 20% of it as a lump sum with the filing of the offer proposal and the remainder within a very short period of time following the agreement. (by the way if the offer doesn’t pan out, the IRS keeps the 20%)

What…?

Yes, this type of offer in compromise requires the amount to be paid in full, very quickly following acceptance.

So what if Fanny doesn’t have access to such a large sum of money?

She could convince the IRS to try and calculate the RCP another way. She would multiply the remainder number by 24 instead of 12 thereby increasing the RCP but also thereby creating a payment plan of sorts. A payment plan that requires the RCP be paid over what is typically a two year period.

There are exceptions, but you are getting the idea.

This RCP thing seems simple enough…

So, Why Do So Many Offers In Compromise Fail?
How many? Nationwide you can count on about a 65% to 80% failure rate each year.

A few reasons:

1. The Relationship Between 12 and Fannie’s Lifestyle

It’s a bad one. The IRS is able to “impose” a budget on Fanny, at least to start. That budget is usually not the same as Fannie’s actual budget. It is lower. Every dollar that the IRS can remove from the budget is 12 dollars added to the cash offer and at least 24 to a “payment plan” offer.

Many people that file offers in compromise don’t fully understand this relationship and the IRS’ ability to use budget numbers different than their own.

Of course, this basic budget can be challenged in different ways, and an experienced practitioner will understand some of the ins and outs related to convincing the IRS to agree to a more reasonable number.

2. Inability to Pay Offer Amount

Assume that Fanny owes the IRS 1 million dollars. The above RCP is only $42,600.00. A savings of…alot.

Holy smokes. That is really a fantastic settlement. Amazing.

Fanny doesn’t have $42,600.00 though. She can’t borrow it because no one she knows has that kind of dough.

She switches to the payment plan but the monthly amount needed to pay the settlement over a limited period of time leaves her too little income to pay her actual bills.

3. Unclear Standards

The law surrounding what constitutes an acceptable offer in compromise is a bit..fickle. You know, uncertain, flighty, gray etc.

An example of this is found in a 2008 Tax Court Case,Leslie B. Bennett v. Commissioner.

Ms. Bennett owed some money to the IRS. She calculated her RCP and submitted the offer.

Although the IRS admitted that the offer amount she submitted was more than “ten times” the RCP based on it’s own calculations, it rejected the offer.

Some of the reasoning:

  • Internal Revenue Manual (IRM) Part 5.8.7.6(5)(Sept. 1, 2005), says that a rejection can be based on a determination that an acceptance of the offer is simply not in the government’s best interests.
  • In other parts of the IRM the IRS is allowed to reject the offer if the taxpayer had a bad history of filing returns on time and there was some belief that she would continue in that manner.
  • The doubt as to collectability i.e. the RCP amount above only determines whether the offer should be “considered for acceptance”.

Quoting from the case.

“This language…doesn’t require that the Commissioner accept an offer in compromise whenever the amount exceeds the collection potential. Rather, it only establishes grounds for winning consideration”.

What this case really stands for is that RCP is really just the beginning of the process.You don’t have the right to appeal the denial of the offer and win just because the numbers make sense. The IRS can deny the offer for a whole host of reasons including quite possibly…just because.

You don’t have the right to appeal the denial of the offer and win just because the numbers make sense. The IRS can deny the offer for a whole host of reasons including quite possibly…just because.

4. I Just Can’t Hack It

It takes an organized and dedicated individual to put together the information necessary to submit with a compromise offer.

In the more complicated case, the amount of paperwork kills a few trees.

Not only that but in order to make the RCP work, to the taxpayer’s advantage, some planning i.e. changes must often be made.

Many people bail out during this process. It is just too much work, and the inability to keep up dooms the case from the start.