The Fundamentals of the IRS Offer in Compromise Program
“Settle Your Back Taxes for a Fraction of What You Owe – Tax Evaluation Waiting! Stop IRS Collections Now.”
–Google search ad results, September 2018
What’s true is that the IRS has a program that allows taxpayers to settle their tax debts for less than the amount they owe. The formal name for this tax debt settlement program is the IRS Offer in Compromise.
That brings us to what’s false.
Despite ads that imply the OIC is a common and reasonable solution for many people, the reality is that few people qualify for this program. In fact, while more than 16 million people and 3 million businesses owe the IRS, only 25,000 settled their tax debts using the OIC last year.
The reason is simple: From the IRS perspective, most taxpayers can afford to pay their taxes with their current assets or over time or with a payment plan — so those people wouldn’t qualify for an OIC. Every year, millions of taxpayers pay their taxes on monthly payment plans.
The OIC program is geared toward a narrow segment of taxpayers — people who will never be able to pay all of the debt with their future income or assets before the IRS runs out of time to collect it (generally, 10 years from the date the tax was assessed). For most people, there are IRS alternatives to the OIC that work out much better for their situation.
Next year, it will be more important than ever for taxpayers to understand their IRS payment options. In 2019, the IRS projects that 3 to 4 million new taxpayers (on top of the 30 million who already file with a balance due) will owe taxes due to tax reform and a growing gig economy. These basics will help taxpayers choose the right option with the IRS.
Most people file for a certain kind of OIC
There are actually three types of OICs. The most common one is called “Offer in compromise, Doubt as to Collectibility,” or OIC-DATC. This OIC is appropriate for people who can’t pay their taxes and want to settle for a payment that is less than the amount they owe.
The two other types of OICs are:
— “Doubt as to Liability,” when taxpayers don’t think they owe the tax in question.
— “Effective Tax Administration,” which is reserved for taxpayers who can pay the tax they owe, but it would cause undue hardship, or there are other extenuating circumstances.
Taxpayers file few of the last two types of OICs. Most people simply owe and can’t pay — so they need a Doubt as to Collectibility OIC.
All returns need to be filed
The IRS will accept an OIC only if taxpayers are in filing compliance, meaning they’ve filed all required past returns. How far back? In most cases, the IRS requires the past six years (this little-known rule comes from IRS Policy Statement 5-133).
If taxpayers have lots of past debts and unfiled returns, it’s a good idea to file any past returns and wrap all past tax debts into an OIC. A word of caution: If the OIC applicant voluntarily files more than the past six years of tax returns, and the OIC application isn’t successful, the taxpayer will still owe any new balances, plus penalties, to the IRS.
Withholding and/or estimated tax payments need to be current
Notice a pattern? This is called payment compliance.
When taxpayers file an OIC, they must prove to the IRS that they have enough withholding or estimated tax payments so that they won’t owe when they file the next year’s return. Without payment compliance, the IRS will reject the OIC.
It may be better to contest the taxes and penalties owed
Before considering an application to settle taxes, taxpayers should analyze their past returns and balances owed to potentially reduce the amount they owe. This is where a good tax professional can help. Taxpayers should also request penalty abatement if their circumstances fit.
In the end, a good look at past tax returns may reveal that taxpayers owe a lot less than they thought they did — and they don’t even need an OIC.
It’s math
The formula is simple: Can taxpayers pay the taxes they owe with their net equity in assets, plus any future disposable income (that could be paid monthly) before the collection statute of limitations expires? The IRS calls this “reasonable collection potential.”
Here’s a simple example to illustrate:
— A taxpayer owes $25,000 on April 15, 2018, for a timely filed 2013 return (filed April 15, 2014) and submits an OIC application on that date.
— The taxpayer has net equity in assets of $1,000 and monthly disposable income of $200.
— The collection statute expiration date is April 15, 2024 (six years, or 72 months, remain on the collection statute).
Over 72 months, that $200 adds up to $14,400; add the $1,000 in net equity and you get a RCP of $15,400 – almost $10,000 less than the tax owed. This taxpayer would qualify.
The formula is straightforward. What’s difficult is determining asset values, assets to be included in an OIC, average monthly income, and regular necessary and allowable monthly living expenses. The IRS limits allowable living expenses, meaning the IRS will scrutinize and potentially limit a taxpayer’s actual expenses in an OIC application.
Taxpayers have to be able to actually pay the offer amount
If taxpayers qualify for a DATC-OIC, the IRS will settle the amount owed based on the OIC payment method:
— The lump sum payment method requires taxpayers to offer the IRS their net equity in assets, plus 12 months of their future monthly disposable income.
— The periodic payment option requires taxpayers to offer the same net equity in assets, but include 24 months of their future monthly disposable income.
For people with substantial monthly disposable income, the lump sum option can be much more beneficial if they can meet the IRS payment terms. From the qualification example above, the lump sum payment option would be just $3,400 — $1,000 in assets, plus 12 months’ worth of available monthly income of $200.
If the taxpayer has correctly accounted for asset values and necessary income and expenses, they can settle the taxes for $3,400 using the lump sum payment option. The taxpayer would be relieved of the remaining $21,600 ($25,000 less the $3,400 paid as the offer amount) in taxes, penalties, and interest owed.
Consider extenuating circumstances
If taxpayers don’t qualify for the DATC-OIC, they’ll need to consider whether they have extenuating circumstances and may qualify for an Effective Tax Administration OIC.
For example, a person has equity in his home that would allow him to pay the tax in full. But he has an illness, and he’ll need to use all his home equity to pay for care. In this case, the IRS may consider his circumstances in an ETA offer.
ETA-OICs are rare and require careful consideration about whether the taxpayer’s circumstances qualify, calling for the services of an experienced tax professional.
Taxpayers can’t file and owe for the next five years
For some taxpayers, this is a big obstacle to getting the benefit of an OIC.
If they owe taxes in the next five years, the OIC will be canceled. That means the taxpayer would owe the entire amount of taxes, penalties, and interest again. Taxpayers who can’t withhold enough or make required estimated tax payments often have their OICs canceled when they can’t meet future tax obligations. This also happens with business owners who can’t make their estimated tax payments each quarter.
The OIC application can come with a significant fee and down payment
The fee to file a DATC-OIC is $186. Also, depending on the OIC payment method, taxpayers will have to start paying the offer amount with their OIC application — and maybe while the IRS is investigating and making a determination on the OIC.
— Lump sum payment OICs require a 20 percent down payment of the offer amount with the application. In our example above, unless the taxpayer met the low-income guidelines, the initial out-of-pocket costs would be $866 ($186 application fee, plus 20 percent of the offer amount, or $680).
— Periodic payment OICs require taxpayers to make 24 installment payments of the offer amount while the IRS is investigating the OIC.
— Low-income OIC applicants can avoid the fee and the down payments/installment payments of the offer amount while the IRS investigates the application.
However, if the IRS rejects the OIC, the IRS keeps the fee and the down payments/installments, and puts them toward the tax liability. Taxpayers should understand the financial costs of applying for an OIC. They could suffer significant financial hardship if they pay these upfront amounts and the IRS doesn’t accept their OIC. This is a real risk: In 2017, only 40 percent of IRS OIC applications were accepted.
Taxpayers must prove they qualify for the OIC
In all DATC-OICs, taxpayers must prove their ability to pay (the reasonable collection potential). They’ll have to prove everything: asset values, debts owed on assets, monthly income, and necessary living expenses.
Unpaid bills are not allowed. Unnecessary expenses, such as payments for recreational assets and charitable contributions, are not allowed. It’s critical to get these values and amounts correct to determine whether taxpayers qualify, and determine the proper offer amount.
The IRS often disputes these amounts and can disqualify an OIC or ask for a higher offer amount. If taxpayers can’t pay the higher offer amount to settle, the IRS rejects their OIC.
The IRS will investigate taxpayers’ finances
OIC investigations can last up to two years. Most OIC investigations (about 80 percent) conclude within nine months after taxpayers apply. By law, OIC investigations never last more than two years.
If taxpayers owe less than $50,000, the average time is usually about 6 to 7 months. If they owe more than $50,000, the OIC may take a little longer, depending on the complexity of the applicant’s finances.
A special OIC examiner at the IRS reviews taxpayers’ filing and payment compliance, and all of the components that go into the qualification and offer amount. The OIC examiner goes in-depth into the taxpayer’s financial history, even looking into old transactions to see whether the taxpayer has tried to hide assets. If the taxpayer owes more than $100,000, it’s common for the examiner to pull a credit report. If the taxpayer has a business, examiners will commonly ask local IRS collection personnel to review the case.
Be prepared to appeal disagreements with the IRS
About 14 percent of all OICs are appealed to a higher level at the IRS to resolve disputes between the applicant and the OIC examiner who initially investigates the application. Why? Common reasons are:
— Asset values and dissipated assets
— The amount of income to be included in average monthly income
— Which expenses should be allowed as necessary living expenses
— Any expenses above IRS-allowed averages
Applicants should be prepared to document and argue all of their assets, income and expenses. Taxpayers should also be prepared to explain why they dissipated any assets before the OIC application. The IRS looks to see whether the dissipated assets should have been used to pay the tax liability before the OIC was submitted.
No matter what — if taxpayers believe they may want to apply for an OIC (or need a better option), it’s best to engage a professional to help. The first step is to understand whether they qualify — and if they do — they’ll need to figure out the amount they’d have to pay to settle the tax bill.
An experienced tax professional can help taxpayers avoid pitfalls, set up the right collection option with the IRS, and ultimately save them a lot of grief and money, by evaluating all the alternatives in relation to their specific circumstances.
If you or a client need help fighting off the IRS, call Jeffrey R. Siegel, your Kansas City tax attorney. We help with IRS liens, wage garnishments, levies, offers in compromise and installment agreements. Bring back some stability to your life, and call.