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In depth OIC information
The IRS Offer in Compromise program OIC is authorized by federal tax law. The program is older than the income tax, allowing revenuers in the 1800s to compromise excise tax liabilities. The Internal Revenue Service takes the offer program seriously and to be successful, the taxpayer must also. Preparing an offer goes far beyond filling in the blanks. The offer must present an overall picture of a deserving taxpayer. Today, there are three ways to compromise income tax liability under federal law.
If the taxpayer does not believe he or she owes the tax and wants to settle by compromise, the taxpayer can file an IRS Offer in Compromise based on doubtful liability. If the taxpayer simply does not have the resources to pay the outstanding obligation, the taxpayer can file an Offer in Compromise based on doubtful collectibility. Since 1998, the taxpayer can also seek to compromise the tax obligation on the basis that it is good public policy or that it is simply equitable.
To successfully compromise a tax liability based on collectibility, it is the taxpayer’s job to convince the Internal Revenue Service that they will receive more by acceptance of the offer than they will obtain by proceeding with collection remedies. However, some assumptions applied by the IRS in reviewing an offer are actually more liberal than the results should the Internal Revenue Service attempt collection. For example, a taxpayer who collects his salary on a monthly basis may have only $800 in take home pay after garnishment of his wages. The Internal Revenue Service therefore allows the taxpayer an amount equal to his or her (hereafter “his”) reasonable expenses, assuming that the taxpayer will not stay at the job if the taxpayer is not allowed enough money to live on.
If the offer is location sensitive (valuation of real estate), it will be sent back to a local IRS group. The information is initially reviewed for processability. If the taxpayer a) hasn’t filed all required returns, b) is in bankruptcy, or c) is in business with employees and has not been in compliance with 940/941 filing and depositing requirements for the two preceding quarters and the current quarter, then the offer will be returned as non-processable.
If, from the information provided by the taxpayer, it is obvious that the offer is less than the IRS would otherwise collect, the offer is also returned non-processable. Unfortunately, the IRS has taken the position that incomplete offers (such as omitting the vehicle mileage) are returned. Offers may also be returned if the government determines that the sole purpose of the offer is to delay collection.
Once the offer is found to be processable, it is “processed” and freeze codes are input into the computer to stop collection action. The IRS must cease all collection activity, unless collection of the tax liability is determined to be in jeopardy (which is a rare event). If the taxpayer receives any notices during the offer process, a follow up should be made to ensure that the offer has been properly coded in the system.
The offer then awaits assignment to an offer specialist. The goal of the IRS is to process offers within a six-month time frame and it appears that most offers are being processed within that time frame. A new law that just went into place last year, states that the IRS has 24 months to process an Offer or it is automatically deemed accepted. Offers that present no novel issues may be accepted without further communication, or after a rather simple request for additional information or clarification.
If the case is referred to a local IRS office, the taxpayer will receive a letter notifying him of an assignment to a revenue officer who will be contacting the taxpayer, or their representative in the near future. Once the revenue officer begins working the case, the case will again lie dormant until the offer reaches the top of the pile. The process will then move very rapidly.
If the revenue officer feels the amount offered is inadequate, he will usually supply his calculations that will lead to a minimum offer amount. In effect, this is a counter-offer. Counter-offers are based upon the IRS’s ability to collect, not upon the amount owed.
Counter-offers will arise from differences in opinion between the offer specialist and the taxpayer as to the value of assets (usually the house or car), as to the actual income of the taxpayer, and as to the necessity of the taxpayer’s expenses.
Each rejection is given an independent review by an independent administrative reviewer, a position created as a result of Section 3462 of the 1998 act. The independent administrative reviewer must review all offers prior to communicating such rejection to the taxpayer. The taxpayer can appeal the rejection in most cases and may have more luck with the appeals officer. Likely areas of appeal are valuation problems and issues having to do with the necessity of expense items, such as cost of travel to work. Today, nearly 70% of all valid Offers are rejected by clerks failing to give the Offer a thorough review, leading to more and more appeals.
If the revenue officer recommends acceptance, it goes to his group manager for review. Upon acceptance, the taxpayer receives a letter outlining the terms and a copy of the offer executed by the Internal Revenue Service.
In determining the Offer amount, the offer specialist is charged with determining the amount of unpaid tax liability that can be collected by (1) liquidating taxpayer’s assets (Valuation Issues) and (2) through an installment plan with respect to taxpayer’s income (Income Issues).
Valuation Issues – In the case of assets, the issue is how much the Internal Revenue Service will realize if the IRS seizes the assets and auctions them rather than how much the taxpayer can get through careful marketing.
First, you are going to have to offer an amount exceeding the cash the IRS could raise if they come in and sell all your assets (current IRS valuation is 80% of FMV). Therefore, you have to have some outside source for obtaining the offer funds. This would generally be a loan or gift. However, the IRS cannot make you borrow from your credit cards, life insurance or 401k plans, so these may also be sources of funds.
The IRS requires the last three months of personal bank statements. The offer specialist will determine the average personal checking balance and subtract one month’s necessary living expenses from it. Any excess will be considered a cash asset. Total balances in all savings accounts will be added to that to determine total cash assets available. It is imperative that the bank statements tell the same story as the financial statements submitted with your Offer. If the deposits on the bank statements exceed the income figure, this needs to be explained (loans, inheritances or the like).
If the taxpayer is self-employed, the business will be considered an asset. However, if the hard assets of the business (accounts receivable, equipment, operating capital) are liquidated, the resulting income will disappear. Therefore, where the primary source of income is the business, do not count the accounts receivable as an asset and also count the money coming in from those receivables as income.
If the taxpayer is self-employed, the business will be considered an asset. However, if the hard assets of the business (accounts receivable, equipment, operating capital) are liquidated, the resulting income will disappear. Therefore, where the primary source of income is the business, do not count the accounts receivable as an asset and also count the money coming in from those receivables as income. If the business is profitable, it should continue. If not, it should be liquidated. The value of the business then becomes the net value of the assets in the forced sale scenario. Accounts receivable can either be, allocated to the business, or to future income, but not both.
When collecting, the Internal Revenue Service steps into the shoes of the taxpayer. If the taxpayer cannot liquidate his retirement plan without terminating employment, the asset has no value to the IRS. However, it must be listed and should include an explanation as to why it cannot be liquidated.
The IRS can levy retirement vehicles such as IRAs. Since voluntary liquidation will generate a tax and penalty, the IRS will allow a discount to reflect the payment of tax and penalty upon liquidation, but only if you are going to liquidate the IRA to pay the offer amount. You must include the entire amount.
At this point, the potential for bankruptcy should be mentioned. Income taxes that are due at least three years before filing the bankruptcy, if the returns were actually filed at least two years before the petition and the taxes were assessed at least 240 days before the petition, may be dischargeable. In the case of IRAs, bankruptcy courts will weigh the needs of the creditors against the needs of the bankrupt in determining whether the IRA is protected. The IRS should, and often will weigh the bankruptcy option in valuing the offer. If the taxpayer is a candidate for bankruptcy, he should probably begin with a bankruptcy analysis. The offer program is often referred to as the IRS bankruptcy equivalent.
Automobiles seem to be the hardest asset to reach agreement over. The IRS rarely realizes the value of an automobile at auction and it is extremely unlikely that the IRS will realize low blue book value. However, the offer specialist is likely to argue that the correct value should be somewhere between low blue book and retail. It is essential that all automobiles be listed because the offer specialist will check with the DMV for all vehicles registered in the taxpayer’s name. This includes vehicles recently transferred out of the taxpayer’s name (there is a box that requires disclosure of any recent transfers for less than full value).
The Internal Revenue Service has historically allowed a 20% discount from the fair market value of real property, i.e. your home. This is called “quick sale value.” It means that a home for which a taxpayer recently paid 20% down will be reflected as having zero equity.
If the taxpayer owns a home he should obtain an appraisal or a good market analysis. The IRS will sometimes ask for backup documentation if the taxpayer resides in an area with increasing home values. The form asks for the amount that the taxpayer could sell the property for “today,” which suggests quick sale vale. We believe that this allows the 20% discount from true market value that is based upon presenting the home in its most favorable circumstances to be taken.
Under the community property law of some states, all community property is responsible for the debts of either spouse. However, a house held in joint tenancy, if in fact it is a true joint tenancy, is deemed held one-half by each spouse and presumably would support the same type of discount that fractional interest holders claim. A prenuptial or even post nuptial agreement separating property, if executed at a time in which no fraudulent conveyances are occurring, can equally separate the property. Therefore, review of title to property and of marital agreements may be productive.
The statute provides exemptions from levy and these exemptions apply when valuing the assets. A taxpayer may exclude a certain amount in tools and equipment used in a trade or business, and a certain amount in furniture and household belongings. The IRS will apply these exemptions. However, the taxpayer may want to address the exemptions. For example, in some cases it may be possible to argue that an automobile should be eligible for the exclusion as a tool required in a trade or business.
Income Issues – Most taxpayers that fail to qualify for an offer, fail because they are able to pay from income that they have offered. The offer specialist determines the monthly amount that the Internal Revenue Service will receive under an installment agreement from the taxpayer’s financial information submitted. To arrive at the offer amount, the offer specialist merely multiplies the monthly income times 48 months. If the taxpayer can make payments of $100 per month, the offer amount must be at least $4,800 (plus that value of the taxpayer’s assets).
Historically, the 48 multiplier is approximately the present value of five years of collection. The time frame arises from the old six-year statute of limitations, less one year to reflect the average time it took a taxpayer to file the offer. Since the present value of a five-year stream of income was approximately equal to 48 times the monthly amount available under an installment agreement, the current practice is to calculate the amount available to the IRS for offer purposes by multiplying the monthly income available by 48 if the taxpayer can pay the offer amount within 90 days of acceptance. A new law currently in place, will allow the taxpayer to pay over 5 months. For longer payout periods, the multiplier goes up.
For the wage earner, the income side of the equation is fairly easy. For self-employed individuals, net income is supposed to be a realistic projection. Last year’s net income is acceptable. If the projection differs from the taxpayer’s previous year’s schedule C (or E in the case of a partnership or S Corporation), the taxpayer needs to attach an explanation.
In most cases, this explanation of projected income is the single most important attachment to the offer. In it the taxpayer can explain the trends in the industry, problems internal to the company, contingent liabilities and a host of other limiting factors.
The taxpayer is allowed by the Internal Revenue Service to apply certain National Standards as expenses related to transportation, household goods, and housing allowances. These are derived from IRS charts and vary by income level and the number of persons in the household. The amounts are updated periodically and can be found on the IRS website.
The taxpayer is always able to offer information that will allow a variation from the standard, but variation is rare. This expense category is based on national averages and is a substitute for actual monthly expenditures. An individual with no dependants earning $3,000 per month is entitled to $556 per month, while a family of four earning $6,000 per month is entitled to $1,546 per month.
Unlike the national standard expenses, housing and utility expenses are not automatically granted. The expense allowed will be the lesser of (1) the taxpayer’s actual expenses and (2) the median expense of living in the county of residence. In other words, for a family of four in Contra Costa County, the housing expense will be the lesser of the median expense in the county, which is $2,434, or the actual expense incurred by the taxpayer. However, there is again room for argument here.
Household and utilities include rent or mortgage payments on the taxpayer’s principal residence, property taxes, property insurance, necessary maintenance and repair, parking, homeowner’s dues, gas and electricity, telephone, garbage, water and any other expense associated with home ownership or renting. In the case of shared living (taxpayer lives with fiancé), the revenue officer will usually allocate the expenses between a taxpayer and the person sharing the residence on the basis of actual contribution to the household, if by agreement. If there is no agreement, allocation will probably be proportional to income (if taxpayer earns $10,000 and fiancé earns $20,000, taxpayer gets one-third of the household and utilities expense).
There is room for argument where the housing cost can be tied to income or health and welfare issues. If employment is dependant upon living close to the job, higher costs can be justified. In the case of the elderly, cost of relocation can justify higher living expense.
The IRS asks that proof of car payment, lease, fuel, oil, insurance, parking and registration fees to be submitted with the Offer. These are requested for the non-business use of the car, assuming that business use will be netted out in the net income statement. As in the case of household and utilities, there is a cap on the amount of transportation expense. The cap has two components, namely the monthly ownership cost (lease or monthly loan payment) and operating costs. Operating costs are based on average transportation cost determined by metropolitan statistical area while ownership costs are determined nationwide. The cap on car payments for the first car for the San Francisco Bay Area is $471, while the cap on the second car is $332 per month. The balance of the monthly operating expenses (gas, oil, necessary maintenance, insurance, parking and tolls and registration) cap out at $401 for one car, and $484 for two cars. If the taxpayer has no car, the cap for public transportation is $325 per month.
The Healthcare expense category consists of (1) the monthly average of out-of-pocket expenditures (not reimbursed by insurance) for medical expenses, and (2) the cost of maintaining medical insurance, averaged over some period (such as six months). The form requires supporting data for the last three months and this is another area where there seems to be extreme scrutiny. A statement as to the reason for the expenses may be advantageous.
Revenue officers will generally look to the rate at which taxes are actually being paid currently (withholding for wage earners and estimated taxes for non-wage earners). Taxes should include federal and state withholding, SDI, FICA, and Medicare.
Court ordered payments and child support require the attachment of the court order and proof of payment (checks).
The IRS will accept Life Insurance payments, but only if it is for term insurance equal to 3 times the taxpayer’s average salary. Additional cost will have to be justified by statements.
Other expenses allowable generally fall into two categories. Any expenses incurred in the production of income, these would include excess gasoline expenditures for taxpayers living far from their job, bridge tolls, parking expense, union dues, home office expense where warranted and any other expense which, if not incurred, would adversely impact the taxpayer’s earning ability. In the case of self-employed individuals, these expenses will probably be netted out in the net income statement.
Other expenses can also include any item for which there is a compelling argument. Tithing has been accepted (and rejected) depending on the circumstances. The IRS does not consider sending a child to college more important then paying taxes.
Common sense will tell you that a family unit cannot spend more than it takes in. Therefore, the taxpayer will need to explain why expenses exceed income. If this is the result of subsidy by parents or the borrowing against credit cards, a statement to that effect will go a long way.
If the taxpayer finds that he is unable to pay the amount offered in full within ninety days of acceptance (recently changed to 5 months), taxpayer can opt to pay over a period of 24 months. However, the offer price will be higher because a 60 multiplier will be applied to the income realization instead of the 48 multiplier. This calculates out to an interest rate of up to 15%. Alternatively, the taxpayer can have the IRS determine how much the taxpayer can pay on a monthly basis and the taxpayer can agree to pay that amount monthly through the period that the statute of limitations runs. The statute of limitations for collection is ten years from the date of assessment and can be determined from an Internal Revenue Service transcript on which it is coded as CSED. These transcripts are available at any IRS office and the officer on duty will usually be glad to determine the collection statute for the taxpayer.
If there are special circumstances, the Internal Revenue Service can use an alternate set of rules that look to the fairness of accepting the offer. The IRS refers to the offer as based upon the need for effective tax administration. The IRS can accept an offer based upon the fact that collection of the tax would create an economic hardship on the taxpayer or that collection of the full tax would be detrimental to voluntary compliance.
Regulations released in July, 1999, give four examples of situations in which compromise is appropriate. These include the mother with a child having a long-term illness if liquidation of her assets would leave her without the ability to provide for her child, a retired person that would not have sufficient assets to provide for basic living expenses if his retirement plan were liquidated, and a disabled taxpayer with a home that has been specially equipped to accommodate his disability and where liquidation of the home would render him unable to get these facilities elsewhere. In each case, the fact pattern includes the fact that the taxpayer’s overall compliance history does not weigh against compromise.
The fourth example represents a complete reversal of IRS policy and results from some of the testimony given at the Congressional hearings in 1997. In the case of corporate Trust Fund taxes (withholdings of payroll 940/941 taxes), if there has been an embezzlement of funds of which a corporation was unaware and should not have known of, and if the company is profitable, but not profitable enough to pay the liability, the IRS will consider settlement.
Secondly, the IRS will compromise a liability where exceptional circumstances exist such that collection of the full liability will be detrimental to voluntary compliance by taxpayers. This is a standard hard to comprehend. It appears that the intention is that if the overall story is compelling enough, taxpayers in general would lose faith in the system if the liability were not compromised.
The two examples start with a taxpayer incapacitated for several years and, when he becomes able to care for himself, finds he owes more than three times the original tax. The second example is that of a taxpayer that has been misled by IRS advice (in response to his E-mail, etc.), as often as this happens, most taxpayers do not obtain this advice in writing, therefore no action can be taken.
One thing is clear. The equitable offer is the far more uncertain road to travel, and may well take far longer than the well-defined offer in compromise based upon doubtful collectibility.