Eliminating IRS tax debts - why bankruptcy may be better than an OIC to resolve your client's tax debts.

• Author: Heinkel, Larry

Does your client owe taxes to the IRS? If so, you probably think the solution to your client's nightmare is simply to file an offer in compromise to reach a settlement with the IRS. Must be easy, too, because everywhere you look nowadays, someone is touting "pennies-on-the-dollar" settlements for IRS tax debts with "guaranteed results." Surely that's the way to go, right? But think about it. Does it sound too good to be true? Of course, it does--and it usually is.

This article is designed to explain in simple terms how the offer in compromise (OIC) process works, how income tax debts can be discharged in bankruptcy, and why a "tax bankruptcy" is usually the better way to go, rendering the filing of an OIC a waste of time and money.

The IRS is authorized to settle or compromise tax debts if it determines that there is "doubt as to liability" for the debt or "doubt as to collectability" of the debt. OICs based on "doubt as to collectability" may be appropriate when the taxpayer admits he or she owes the tax debt, but contends he or she does not have the financial ability to ever pay the amount owed. OICs based on "doubt as to liability" may be appropriate when the taxpayer has the financial wherewithal to pay the liability claimed as due by the IRS, but contends he or she does not legally owe the amount claimed. OICs based on liability issues will not be discussed in this article.

The policy behind the OIC program is that there are some taxpayers who owe more in taxes, penalties, and interest than they could ever repay before expiration of the (generally 10 years) statute of limitations on collections. The OIC program is a mechanism whereby a taxpayer can present financial information to demonstrate his or her "reasonable collection potential." Once the IRS verifies the financial information submitted by the taxpayer, the IRS may agree that it is in the government's best interest to accept less than what is owed if the amount offered is more than the IRS determines it would otherwise ever collect. But if the IRS determines that the liability can be paid in full, in most cases, an OIC will not be accepted.

A taxpayer's "reasonable collection potential" is the sum of 1) the present value of the taxpayer's ability to make continuous monthly payments to the government, and 2) the net realizable equity in the taxpayer's assets. To determine the "reasonable collection potential" of a taxpayer, the taxpayer must complete and file form 656 (offer in compromise) with supporting documentation to substantiate the taxpayer's assets, liabilities, income, and "necessary" living expenses.

The taxpayer's ability to make continuous monthly payments is determined by subtracting from his or her average monthly income the taxpayer's average monthly "necessary" living expenses. In determining a taxpayer's "necessary" living expenses, the IRS uses published "national standards" of what it will allow for food, clothing, and other items as well as for out-of-pocket health care costs. It uses "local standards" for housing and utilities and for transportation expenses. The IRS uses these calculations regardless of the taxpayer's actual living expenses (the figures are available at www.irs.gov/individuals/ article/0,,id=96543,00.html). The resulting net figure is also reduced by the amount of any court-ordered child support and alimony payments. The final figure constitutes the amount the IRS determines the taxpayer can afford to pay on a monthly basis toward the unpaid liability. The present value of that stream of income is calculated by multiplying the monthly figure by 48. (Note that with short-term and deferred periodic payment offers (discussed below) the monthly ability to pay amount is multiplied by 60 instead of 48.) The product comprises the first part of the taxpayer's "reasonable collection potential."

Realizable equity is determined, roughly speaking, by taking the asset's fair market value and reducing it by 20 percent (to arrive at the quick sale value). This figure is then reduced (but not below zero) by the amount of secured debt. Once the positive equity is so calculated for all the taxpayer's assets, they are added together to determine the second part of the taxpayer's "reasonable collection potential."

The two components determined above (present value of monthly ability to pay and net realizable equity) are added together to arrive at the minimum amount a taxpayer must offer for the OIC to be eligible to process. A completed Form 656 with attachments including Form 433-A (financial statement for an individual) and, when appropriate, Form 433-B (financial statement for a business) are to be filed along with a $150 nonrefundable application fee. This starts a suspension of the running of the statute of limitations on collections until such time as the OIC is either accepted or rejected (and if the OIC is rejected but the taxpayer appeals that determination, the suspension continues).

OICs can be submitted with one of three different payment options. With the "lump sum" offer, the taxpayer agrees to pay the entire balance offered within five installments of acceptance. The "short-term periodic payment" offer is one in which the balance will be paid within two years. Finally, the "deferred periodic payment" offer...