Offers in Compromise Under IRS Fresh Start Program
by N. Dean Hawkins
The recent economic downturn significantly increased the number and amounts of outstanding tax liabilities. As a result, many taxpayers are interested in submitting an offer in compromise, particularly if they know about the IRS Fresh Start program. Major changes have been made to the manner in which the amount of an offer in compromise is determined under this program, thereby making submission of an offer in compromise a viable option for more taxpayers.
Before submitting an offer in compromise, taxpayers and their counsel need to understand its effect, how it compares to an installment payment agreement, and when its use is appropriate. Unlike an installment payment agreement, which still requires the taxpayer to pay the full amount of the outstanding tax liability (albeit over a period of time), an offer in compromise is a settlement of the taxpayer’s tax debt for less than the amount of the currently outstanding liability. Contrary to many radio and TV ads, this procedure is not new and has been statutorily authorized for many years. Determining whether to submit an offer in compromise or enter into an installment payment agreement is a logical process. After all, the taxpayer is attempting to settle his or her tax debt for less than the actual amount of the debt. Thus, it is logical that an offer in compromise would be appropriate only when the taxpayer’s “reasonable collection potential” (i.e., the taxpayer’s resources) is less than the actual amount of the taxpayer’s outstanding tax liability. The taxpayer does not qualify to submit an offer in compromise if his or her resources exceed the amount of the debt. However, many taxpayers who previously would not have qualified to submit an offer in compromise now qualify due to the Fresh Start program.
In general, the taxpayer’s resources are the taxpayer’s net equity plus the amount that the taxpayer can afford to pay to the IRS over a future period of time. The taxpayer’s total resources are computed on Form 433-A (OIC). There are, however, special rules that must be followed in computing the taxpayer’s resources and, ultimately, the amount of the offer in compromise.
The taxpayer’s net equity is generally computed by valuing assets other than cash at a liquidation value of 80 percent of estimated fair market value, valuing retirement assets (such as 401k accounts and IRA’s) at 70 percent, and only taking into account loans against the asset accounts (e.g., investment accounts) and secured debt in computing the taxpayer’s net equity. Unsecured debt (e.g., credit card debt) is not considered in computing the taxpayer’s net worth.
The second element of the taxpayer’s resources is the monthly amount that the taxpayer can afford to pay to the IRS over a future period of time. This available monthly amount is determined using the IRS Collection Financial Standards, which are available at www.irs.gov.
While the Fresh Start program made changes that are beneficial to the taxpayer to the expense limitation rules, the major changes of the Fresh Start program are the substantial reductions in the number of months taken into account for purposes of calculating the amount of the offer. Those changes substantially reduce the required offer amounts. These changes were announced in IR-2012-53 on May 21, 2012.
In determining the amount of an offer:
1. If the offer will be paid in 5 or fewer months, the IRS will consider 1 year of income, rather than 4 years of income; and
2. If the offer will be paid in 6 to 24 months, the IRS will consider 2 years of income, rather than 5 years of income.
As illustrated by the following example, the effect of these changes can be quite dramatic. Assume the following:
1. The taxpayer has an outstanding liability of $225,000;
2. Under the IRS rules, the taxpayer’s net worth is $90,000 and the taxpayer has monthly income of $3,000 to apply towards the debt; and
3. The taxpayer is considering submitting an offer in compromise pursuant to which the taxpayer will make payments over a period of 5 months (using borrowed funds).
Prior to the issuance of IR-2012-53, the taxpayer would not qualify to submit an offer in compromise because the taxpayer’s total resources would be $234,000 ((48 months x $3,000 income/month) + $90,000 net worth = $234,000), more than the hypothetical outstanding liability. Under the Fresh Start rules, the taxpayer qualifies to submit an offer in compromise in the amount of $126,000 ((12 x $3,000) + $90,000 = $126,000).
N. Dean Hawkins is a sole practitioner in Dallas. He can be reached at email@example.com.