In situations where a taxpayer has a greater tax liability than funds, there are several options available. The taxpayer can, of course, borrow the money from a third party to satisfy the debt to the IRS, or even arrange for an installment payment agreement with the IRS. When the debt is so substantial with respect to a taxpayer’s overall financial position that he may not be able to satisfy the debt in full, or there is a real risk of financial ruination, the taxpayer can seek to compromise that debt, resulting in payment of a lower amount than the total due.
A compromise is an agreement between the taxpayer and the IRS that is a result of the taxpayer making an Offer in Compromise (OIC) under Internal Revenue Code (IRC) section 7122 (Preamble to TD 9007, July 18, 2002). For the IRS to enter into a compromise agreement with the taxpayer, the following conditions must be met:
- Doubt as to liability [Treasury Regulations section 301.7122-1(b)(1)];
- Doubt as to collectability [Treasury Regulations section 301.7122-1(b)(2)]; or
- A need to promote effective tax administration because either 1) collection of the full amount would cause economic hardship for the taxpayer [Treasury Regulations section 301.7122-1(b)(3)(i)] or 2) compelling public policy or equity considerations provide a sufficient basis for compromising the liability [Treasury Regulations section 301.7122-1(b)(3)(ii)].
Doubt as to Liability
Contrary to the other grounds for granting an OIC, the doubt as to liability regarding the taxpayer’s debt does not hinge upon the financial resources of the taxpayer to meet the tax obligation. In effect, the taxpayer is saying that either the debt is not owed or is less than asserted by the IRS, as opposed to that the debt cannot be paid. Thus, taxpayers offering to compromise a liability are not required to provide financial statements or personal financial information [IRC section 7122(d)(3)(B)(ii); Treasury Regulations section 301.7122-1(d)(1)]. A situation arising under this provision might include, for example, a disagreement between the taxpayer and the IRS on either the facts or the law concerning the taxpayer’s position. As in a civil matter, the parties might agree to settle the dispute by way of a compromise for an amount somewhere between their respective positions.
Doubt as to Collectability
By far, the most common grounds for submission of an OIC is doubt as to collectability. In this situation, the taxpayer claims that personal finances do not provide the ability to pay the liability in full, and seeks to pay a lower amount (or even nothing). In evaluating a taxpayer’s financial condition and ability to pay, the OIC provisions provide for the analysis of income, expenses, assets, and liabilities. The goal is to determine what is commonly referred to as the reasonable collection potential (RCP), that is, the amount the IRS could reasonably expect to collect through litigation considering the uncertainties of the process (Revenue Procedure 2003-71, section 4.02(2), 2003-2 CB 517). The IRS will most likely accept an offer based on doubt as to collectability if it is unlikely that the tax can be collected in full and the offer reasonably projects the amount the IRS could collect through other means, including both administrative and judicial collection efforts.
The determination of a given taxpayer’s RCP comes largely from stipulations in the Internal Revenue Manual (IRM). The stated purpose of these provisions is to provide instructions for securing, verifying, and analyzing financial information; this data provides the basis for determining a taxpayer’s ability to pay delinquent tax liabilities and enables collection personnel to make appropriate collection decisions to resolve cases (IRM 184.108.40.206).
A taxpayer’s gross income generally includes wages, business income, and investment income (e.g., interest, dividends, capital gains, rental income). After the taxpayer’s gross income is determined, the allowable expenses are separated in several categories: 1) allowable living expenses, which are based on national and local standards; 2) other necessary expenses that meet certain criteria regarding their necessity; and 3) other conditional expenses that may be allowable under the circumstances of the particular taxpayer (IRM 220.127.116.11.1).
The allowable living expense standards provide for the taxpayer and his family’s health and welfare or production of income (IRM 18.104.22.168.2). These standards must be reasonable based on the size of the family and the geographic location of the taxpayer, considering any unique circumstances, with the total establishing the minimum amount that the taxpayer and his family require to provide for themselves (IRM 22.214.171.124.2).
National standards are established for food, clothing, housekeeping supplies, and personal care services, as published by the Bureau of Labor Statistics Consumer Expenditure Survey. The amounts of these specific expenses are allowable as deductions to the taxpayer according to the amounts of the national standards, even if the actual amount spent by the taxpayer is lower (IRM 126.96.36.199.3).
Local standards are used to determine allowable expenditures for 1) housing and utilities and 2) transportation costs. Housing and utilities are based on county of residence and family size and include expenses for mortgage (including interest) or rent, property taxes, insurance, maintenance, repairs, gas, electricity, water, heating oil, and similar items (IRM 188.8.131.52.4.A). Transportation costs include car loan or lease payments and operating costs such as maintenance, repairs, insurance, fuel, and similar items (IRM 184.108.40.206.4.B). Generally, unlike expenses measured by national standards, taxpayers are allowed the actual amount spent for these expenditures, unless the amount exceeds local standards, in which case they are limited to such standards (IRM 220.127.116.11.4).
Other necessary expenses meet the necessary expense test and normally are allowed. The amount allowed must be reasonable considering the taxpayer’s individual facts and circumstances. Other conditional expenses may not meet the necessary expense test, but may be allowable based on the circumstances of an individual case (IRM 18.104.22.168.1). Examples of necessary expenses, each needing to meet the required standard of necessity, are professional fees, child care, charitable contributions, education of the taxpayer (if required as a condition of employment), alimony, child support, taxes, secured debts, and similar items (IRM 22.214.171.124.3). The allowance of conditional expenses depends on the length of time the taxpayer will take to satisfy the debt to the government; the shorter the time, the greater the chance the expenses will be allowed.
The final component of RCP is the valuation of the taxpayer’s assets. Here, the fair market value of an asset is the starting point, and follows the general definition as the price set between a willing and able buyer and seller in an arm’s-length transaction with full knowledge of the relevant facts (IRM 126.96.36.199.3). Based on the need to value the asset as part of the taxpayer’s readily available resources, the RCP provides for the use of the quick sale value (QSV) of an asset. This is an estimate of the price a seller could get for the asset in a situation where financial pressures motivate the seller to sell in a short period of time, usually 90 days or less. Generally, the QSV is calculated at 80% of the fair market value; a higher or lower percentage may be appropriate depending on the type of asset and current market conditions (IRM 188.8.131.52.4). The value so determined must be reduced by encumbrances and tax liens (IRM 184.108.40.206.5).
The final basis for the filing of an offer in compromise is that it would promote effective tax administration, which can be exhibited in one of two ways: collection of the full liability is possible but would cause the taxpayer severe economic hardship, or there is a compelling public policy or equity consideration which provides sufficient reason for the government to compromise the claim.
Economic hardship can be shown if the collection of the liability would render the taxpayer unable to pay reasonable basic living expenses when taking into consideration the taxpayer’s age, employment history, ability to earn, number of dependents and other similar factors [Revenue Proceeding 2003-71, section 4.02(2), 2003-2 CB 517]. The IRS also considers the reasonable amount required by the taxpayer for basic necessities such as food, clothing, housing, and transportation, as well as any other extraordinary circumstances such as special medical or education expenses (Chief Counsel Advice 200130041). In determining a reasonable amount for basic living expenses, the IRS will consider an individual taxpayer’s unique circumstances, but not the maintenance of a luxurious standard of living (Chief Counsel Advice 200126003). Other possible factors include the taxpayer being incapable of earning a living because of a long-term illness, medical condition, or disability that would likely cause the taxpayer’s financial resources to be exhausted during this period [Comm’r v. Holmes (309 B.R. 824 (M.D. Ga. 2004); Macher v. U.S. 303 B.R. 798 (W.Va. 2003)], or the taxpayer’s monthly income is exhausted each month in providing for the care of dependents who have no other means of support [In re 1900 M Restaurant Associates, Inc., (352 B.R. 1 (D. D.C. 2006)].
Economic hardship can be shown if the collection of the liability would render the taxpayer unable to pay reasonable basic living expenses.
Examples are also provided in the regulations. Hardship has been found when the taxpayer is retired and only has income from a pension, and the value thereof is sufficient to satisfy the liability, but doing so would leave the taxpayer without adequate means to support basic living expenses (Chief Counsel Advice 200126003). The bar for hardship in this case can, however, be quite high. In Fargo v. Comm’r, T.C. Memo 2004-13, the U.S. Tax Court upheld an IRS determination that denied application for an offer in compromise. In that case, the taxpayers had substantial wealth and an expected substantial retirement income, but might at some point in the future have had to pay for 24-hour nursing care for the husband, who had been diagnosed with a progressive neurological condition. The court found that the taxpayers’ claimed future expenses were based on general information readily available to the public and were not specific to the husband, and thus the expenses were speculative. Furthermore, given the taxpayers’ substantial assets, it was highly unlikely that their ability to pay basic living expenses would be impaired even if the husband did require such care (Form 656-B, January 2014).
Public Policy and Equity Considerations
The second way to promote effective tax administration requires compelling public policy or equity considerations related to the taxpayer. These considerations are highly case-specific and apply only under unusual circumstances where the collection of the full amount owed would undermine public confidence that the tax laws are being administered in a fair and equitable manner. This rule is so specific that one would have to show circumstances that justify the granting of a compromise even though similarly situated taxpayers may have been able to pay their tax liabilities in full (Preamble to TD 9007, July 18, 2002). The taxpayer’s burden thus justifies compromise, even though this might be inherently inequitable with respect to other taxpayers who might not qualify for such relief (Fowler v. Comm’r, TC Memo 2004-163).
The IRS has provided the following examples of cases in which it might compromise under the public policy and equity provisions [IRM 220.127.116.11.2(1), par. 9608, Sept. 23, 2008].
- In October 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 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 bill was more than three times the original liability. The taxpayer’s overall compliance history does not weigh against compromise [Treasury Regulations section 301.7122-1(c)(3)(iv), Ex 1].
- Where the taxpayer relied on erroneous advice from the IRS web inquiry service and suffered an additional tax burden directly attributable to this advice, compromise was warranted given the taxpayer’s history of compliance with his tax obligations [Treasury Regulations section 301.7122-1(c)(3)(iv), Ex 2].
The application of the above rules and principles may be illustrated by a case study that reflects the financial position of taxpayers, a married couple with substantial tax debt (Eric L. Green, Esq., “Offers in Compromise: Initial Call to Acceptance Letter,” material for training course provided by Eli Financial).
The initial facts concerning background, monthly expenses, and assets are as follows: Joe (45) and Mary (43), of New Haven, Conn., owe $187,000 in back income taxes from 2009 to 2014. Joe used to be self-employed, but is now a W-2 employee. He earns $75,000 a year, and Mary earns $40,000 a year; they have two sons, ages 17 and 14. Their assets are a home worth $280,000, carrying a mortgage of $197,000 and $25,000 of home equity debt; a 2011 Cadillac Escalade with no loan attached and a book value of $12,000; a 2011 Honda Accord with no loan attached and a book value of $4,500; Mary’s pension, worth $78,000; and combined savings and checking account balances of $1,750.
Exhibit 1 contains an analysis of Joe and Mary’s total expenses by category, the starting point for the analysis. Based on the facts presented above, Joe and Mary have a monthly income of $9,583, and expenses of $10,562, giving them a monthly deficit of $979.
Case Study—Monthly Expenses (Actual)
Exhibit 2 shows the same expenses, adjusted, modified, or limited by the rules discussed above regarding allowable expenses in the computation of RCP. Thus, with a monthly income of $9,853 and allowable expenses, Joe and Mary have an available monthly income, according to the IRS, of $694. Note that their expenses for a timeshare, credit card payments, and charitable giving to their church are not considered by the IRS at all and are not included in the Exhibits.
Case Study—Monthly Expenses (Allowable under RCP Rules)
The IRS’s analysis takes the available monthly income ($694), extrapolates it over 12 months ($8,328), and adds that figure to the house’s available equity after the mortgage and loan ($2,000) and the equity of the vehicles ($6,300), for a total of $16,628. This is Joe and Mary’s initial offer to the IRS for extinguishment of their outstanding tax debt of $187,000—a very favorable position.
Consider, however, the following changes made to Joe and Mary’s lifestyle: Needing life insurance, Joe and Mary purchase a $500,000 term life policy costing $120 a month for both of them. In addition, Joe trades in his Cadillac for a new Ford pickup truck with monthly payments of $400. Finally, Mary’s mother loans them $4,500 to pay for the legal fees surrounding the OIC, which they agree in writing to pay back over 25 months (with interest) at $188 per month. With these changes, Joe and Mary can now adjust their offer because they have increased their allowable expenses, as shown in Exhibit 3. The new allowable expenses of $9,597 are greater than their income of $9,583, and thus their future income is reduced to $0. Thus, the amount of their offer consists solely of the RCP on their assets (the house and Mary’s Honda), which equals $2,150. By making three small changes, Joe and Mary have reduced their payment to the IRS by $14,478.
Case Study—Monthly Expenses (Allowable under New Facts)
A Tricky Needle to Thread
Offers in compromise represent an opportunity for taxpayers to extinguish large tax debts without becoming destitute in the process. The criteria for determining such offers, however, are complex. CPAs advising individuals entering into this process should be well versed in the intricacies of the applicable tax laws and regulations in order to maximize the benefit to those individuals—by minimizing the amount paid in compromise.