This panel discussed the pros and cons of declaring bankruptcy versus entering into an offer in compromise (OIC) when confronted with a large tax debt. Topics included how to prepare the OIC, the appeals process, and bankruptcy as it relates to tax liabilities.
Preparing an Offer in Compromise
Sklarz began the panel by asking Engelhardt to cover the steps for preparing an OIC. Prequalifying the client is extremely important, Engelhardt said, as is advising the client that the attempt may fail. An initial consultation can reveal whether the client is a good candidate in the first place, although he also noted that the process of filing and receiving approval or rejection can buy time for the case no matter the outcome. In addition, the engagement letter should contain a clause giving the practitioner the right to terminate the engagement if the client provides false information or pressures the practitioner to do so.
Engelhardt continued by stressing that the proposed payment plan must be formally documented. He also explained the formula used to determine the payment amount under an OIC, which incorporates the taxpayer’s net assets, future income potential, and various exclusions and expenses allowed by the IRS.
Engelhardt also advised CPAs to remain in contact with the IRS collections department during the OIC process to avoid levy action. Even though credit card bills are not among the allowed exclusions, a credit report can help “show a story” to the IRS regarding the taxpayer’s financial straits. He also advised applying for a low-income certification “when it’s appropriate.”
If the taxpayer also has a significant New York State tax debt, Engelhardt said, paying off that amount as fully as possible can allow a tax deduction on the federal amount and lower the available income for the IRS. In addition, there is “a good chance” that the taxpayer will lose net operating loss deductions going forward; “you can’t double dip,” he said. He also advised making any necessary amendments to outstanding tax returns before beginning the OIC. Furthermore, self-employed taxpayers should not overpay their estimated taxes in the year of the OIC.
Engelhardt warned against hiding assets and noted that agents may look at the taxpayer’s standard of living and suggest adjustments rather than accept the OIC. It is important to establish a rapport with the examiner and lay out the economic reality of the taxpayer’s situation; humanizing the taxpayer can go a long way.
The OIC Appeals Process
Sklarz then turned to the OIC approval process, saying that the initial assessor, called campus OIC, is notoriously strict and has not approved an OIC he submitted in a decade. “The good news,” he said, “is after it comes out of there, we get to go to IRS appeals.” Brooks described the official rejection letter, which gives the taxpayer 30 days to file a formal appeal. He also noted that rejection is often the result of discrepancies on the asset equity table (AET) or income expense table (IET). Once the appeal is filed, the matter goes to a settlement officer.
The panel explained that the appeals office will generally only review the specific issues raised in the appeal, unless other issues are raised later. Brooks raised the issue of bankruptcy, asking what happens if the taxpayer files for bankruptcy after the OIC process has started. The government panelists said that in such a case, the OIC is returned without possibility of appeal. Brooks noted, however, that a taxpayer whose OIC is returned can request reconsideration within 30 days as a last resort. One advantage of an OIC is that certain items can be abated that cannot be discharged in bankruptcy. “Maybe an offer-in-compromise is your best collection alternative and the IRS can make a decision on that,” he said. “They cannot make a decision on a bankruptcy, because they have no jurisdiction.”
“Maybe an offer-in-compromise is your best collection alternative and the IRS can make a decision on that,” Brooks said. “They cannot make a decision on a bankruptcy, because they have no jurisdiction.”
Brooks said that not enough emphasis is placed in the preparation of Form 433A or B, which serves as the starting point for the IRS to evaluate what the client can pay. “Appeals will not just overlook something just because the taxpayer is in dire straits,” he said. While the office does consider some extenuating circumstances, such as age or other considerations that might affect the taxpayer’s ability to pay over the life of the collection statute.
Brooks then asked whether an appeals officer would review the OIC against a potential bankruptcy settlement. The IRS generally does not accept an offer for less than what it could collect through the bankruptcy. But if the issue is raised and the Appeals officer thinks it’s something that might be followed through on, then it will be considered.
Sklarz then asked which types of matters are worth fighting the IRS over when negotiating an OIC. Brooks replied that the calculation of income is a sticking point with him, especially the disallowance of expenses. “I want to ensure that my client is allowed all of their allowable deductions before it gets to Appeals,” he said. Practitioners, having been involved with OIC longer than the appeals officer, would have an advantage in knowing which matters are most critical to the taxpayer. Brooks then raised the question of whether items are able to be excluded if they are considered to be income-producing assets.
Filed tax liens ride through the bankruptcy. They remain attached to the property, and even if the personal liability of the individual taxpayer is discharged, the lien will remain on the property.
Sklarz then asked about the particulars of business OICs. Brooks said that while the forms differ, the process and criteria for inclusion are substantially the same. The IRS looks at the value of assets versus the income they produce. The issue of whether the analysis of a possible bankruptcy outcome factors into a business OIC, and the panelists agreed that it does.
The Alternative of Bankruptcy
Sklarz then turned the discussion to bankruptcy. The government panelists began by describing the bankruptcy court process, noting that cases are technically referred to the bankruptcy court by the district courts, and that in some cases it renders a recommendation that the district court considers when making its own judgment. In general, he advised taking into consideration the tax status of the client. When a petition is filed, a new taxpayer is created, and this requires tax planning as if it was a new corporation.
The government panelists then spoke about the appropriateness of bankruptcy in tax cases. They laid out for criteria for consideration of whether a tax liability is dischargeable in bankruptcy: the time periods set forth in the bankruptcy code for the discharge of taxes, the question of payroll trust fund taxes, whether the taxpayer has fraudulently understated any taxes or otherwise evaded payment, and the effect of any existing tax liens.
On the subject of time requirements, they noted the three-year rule, which requires the return in question to have been due more than three years before the filing of the bankruptcy case; the 240-day rule, which requires the tax to have been assessed at least 240 days before the filing; and the two-year rule, which requires a late-filed return to have been filed at least two years before the filing. They also noted that the 5th, 10th, and 1st Federal Circuits have recently overturned the two-year rule, barring all tax liabilities from late-filed returns from being discharged in bankruptcy; however, a bankruptcy appellate panel in the 9th Circuit rejected the arguments in those cases and allowed discharge, a decision the 11th Circuit later agreed with. In short, the status of the two-year rule is currently uncertain.
The panel then turned to the other three criteria. They repeated the firm rule that payroll trust fund taxes are not dischargeable in bankruptcy, nor are public trust fund sales taxes. The government panelists also quoted a provision of the bankruptcy code that excludes from discharge any debt with respect to which the debtor willfully attempted to evade or defeat taxation, noting that the government bears the burden of proof in such situations. They noted that filed tax liens ride through the bankruptcy. They remain attached to the property, and even if the personal liability of the individual taxpayer is discharged, the lien will remain on the property. An audience member asked whether this includes state taxes, and Sklarz said that it does, with the caveat that several states have declared that liabilities from late-filed returns are non-dischargeable; the IRS does not hold to this view.
The panel also noted that the IRS may take refunds from a pre-bankruptcy year and offset them against pre-bankruptcy liabilities, even if the pre-bankruptcy taxes are discharged. But the IRS cannot offset refunds for a post-bankruptcy period against discharged pre-bankruptcy tax liability. The panelists also discussed challenging the liability for the trust fund portion of payroll taxes by utilizing a disconnect in the rules to get the responsible person off the hook for the taxes.
The comments below represent below represent the speakers’ own views and do not necessarily represent those of their partners, affiliates, or employers, nor do they represent official policy of the government or any government agency.