Dealing with IRS Collection Problems

By Jack Angel

Dealing with the IRS when a taxpayer has a problem with coming up with the necessary cash can be a difficult and frustrating experience. However, there are a number of options available and the author explains and provides practical guidance on their use.

Taxpayers may find themselves owing more money to the IRS than they can pay. This article discusses various aspects of dealing with IRS collection problems including such techniques as Form 911, installment payment agreements, offers in compromise, and bankruptcy proceeds. Also included is a discussion of the most recent IRS policy regarding "necessary expenses" and "conditional expenses" the IRS will recognize for collection purposes.

IRS Options

The IRS has awesome powers to enforce collection, which it will not hesitate to use if the taxpayer is not liquidating the debt as quickly as the taxpayer's circumstances permit. For example, the IRS can--

* file a Notice of Federal Tax Lien against the taxpayer's assets thereby notifying the public of money owed to the government. It attaches to all the taxpayer's assets whenever acquired. While it does not divest the taxpayer of title to any property, the taxpayer may not sell any of his or her property without first satisfying the lien.

* serve a Notice of Levy that permits the IRS to take property to satisfy the debt. Levies can be served on third parties holding assets of the taxpayer (e.g., funds on deposit at a bank, securities held by a stockbroker, certain retirement accounts, monies owed to the taxpayer including accounts receivable, and wages due from an employer). Levies can also be served on property held by the taxpayer (e.g., a house, boat, vehicle).

* seize and sell the taxpayer's property to satisfy the tax debt. Seizure of a primary residence, however, generally requires the approval of an IRS district director.

Full Payment

While full payment may appear to be an obvious solution, its advantages to the taxpayer are so beneficial that every effort should be made to pay the IRS off as soon as possible. Some of the advantages include stopping additional interest and penalties that are generally nondeductible, eliminating IRS intrusion into the taxpayer's financial affairs, avoiding injury to the taxpayer's credit standing, and minimizing additional professional fees.

Full payment may be achieved by sale of liquid assets, cashing in or borrowing against life insurance or pension funds, borrowing from friends or family, or collateralized loans including mortgaging the personal residence. A home mortgage can provide the additional benefit of deductible interest.

Form 911

Taxpayers should be aware of the existence of Form 911, Application for Taxpayer Assistance Order to Reduce Hardships. The filing of this form causes an immediate review of an intended IRS action where the taxpayer is suffering or is about to suffer a "significant hardship" as the result of the manner in which laws are being administered by the IRS.

Significant hardship may include severe emotional stress, potential damage to a taxpayer's credit rating resulting from an erroneous enforcement action, possible eviction, and other similar situations. Significant hardship does not include mere economic or personal inconvenience to the taxpayer.

Form 911 must be filed by mail or fax with the Problems Resolutions Office for the district in which the taxpayer resides.

Installment Payment Agreement

If the taxpayer does not have the ability to pay the debt in full, the IRS has the authority, at its discretion, to enter into a written installment payment arrangement with the taxpayer.

Although the taxpayer does not have an absolute right to such an agreement, the IRS manual instructs collection personnel to consider an installment agreement if it will facilitate the collection of the liability. Disadvantages of such agreements are that interest and penalties will continue to run until the liability is paid in full and the IRS may insist on extending the 10-year period of time in which it can collect the debt.

Most installment payment arrangements are entered into only after the taxpayer has submitted financial statements establishing inability to pay in full. "Streamlined" installment agreement procedures, however, exist for certain types of liabilities under $10,000 whereby written financial statements are not required.

The financial statements required by the IRS mandate disclosure of assets and liabilities and monthly income and expenses. The IRS has recently initiated a policy of dictating the amounts that will be accepted as reasonable monthly living expenses, irrespective of the taxpayer's actual monthly living expenses. Numerous practitioners have expressed concern that this new policy can force taxpayers into significant lifestyle changes to the point of requiring the taxpayer to move to less expensive living quarters, require children to attend public instead of private schools, and, in general, require taxpayers to conform their living expenses to modest allowances as dictated by the IRS.

More specifically, in determining disposable income, effective September 1, 1995, the IRS will consider two categories of expenses, "necessary expenses" and "conditional expenses."

Necessary expenses are defined as those essential to the family's health and welfare and the production of income that are reasonable in amount. For the first time the IRS has established national and local standards as to what is considered reasonable for this purpose. The new manual alarmingly excludes from necessary expenses such things as--

* charitable contributions, except if required as a condition of employment;

* education expenses, except for a
physically or mentally challenged child where no public educational facilities are available;

* high option health insurance premiums where a low option is available, unless the taxpayer can establish that, given the family situation, the change to the low option will ultimately cost more;

* all life insurance premiums except for term policies that are nonexcessive;

* any pet expenses unless required, e.g., guide dog for the visually challenged.

* transportation expenses in excess of the national or local standard, whichever is applicable. Furthermore, only transportation expenses required to produce income or ensure health and welfare are considered necessary; and

* unreasonable housing expenses as established by IRS local standards for middle class living.

Conditional expenses are defined as those living expenses that do not meet the necessary expense test. Conditional expenses are allowed, however, only if they are reasonable in amount and
the entire liability will be paid within three years.

If the liability cannot be paid within three years, taxpayers will be given one year in which to adjust excessive conditional expenses. For example, a taxpayer living in luxury housing, leasing a luxury car for personal use, or sending a child to private college, will have one year to moderate these expenses. In any event, the IRS urges that, when the taxpayer's maximum ability to pay permits, taxes should be collected in less than three years.

The IRS manual states that if an analysis of the taxpayer's financial condition reveals the liability cannot be realistically collected in full through an installment agreement, the possibility of an offer in compromise should be discussed with the taxpayer.

Offers in Compromise

In February 1992, the IRS announced a new policy statement that amounted to a complete shift in attitude toward accepting, rather than rejecting, offers in compromise. Because of that new policy shift, there has been a noticeable improvement in the acceptance rate.

An offer in compromise (OIC) is essentially a contract under which the taxpayer agrees to pay the IRS a specific sum of money that is less than the total amount owed, in complete satisfaction of the taxpayer's tax liability, including penalties and interest. It requires the submission of Form 656, Offer in Compromise, financial statements, and documentation to verify asset values, encumbrances, and income and expenses shown on the financial
statements.

Most OICs are based on doubt as to collectability, i.e., the liability cannot be collected in full or can only be collected over a protracted period of time, or at an unreasonable cost. In addition, doubt as to liability can be used where the taxpayer believes the total assessed liability is incorrect. In unusual situations the IRS will reject an otherwise adequate offer where it believes it will be perceived by the public as an improper action (e.g., known criminal involved); or where it believes it is better off waiting (e.g., taxpayer is the beneficiary of a nonliquid estate).

If the offer is accepted, it becomes a matter of public record for one year after acceptance. In addition, there is a five-year compliance requirement obligating the taxpayer to be current with respect to filing returns and paying taxes due. Breach of terms of the OIC by the taxpayer not meeting the five-year compliance requirements or by not making timely payments as stipulated in the offer authorizes the IRS to terminate the OIC and reinstate the original liability.

Advantages. The use of an OIC to resolve a collection problem has certain advantages. These include the stopping of collection activities during the period of consideration, unless the IRS concludes the offer was submitted to delay collection activities or a delay would jeopardize the IRS's ability to collect. Other advantages are that upon acceptance of the OIC the taxpayer's liability is fixed by the terms of the offer, and upon full payment the IRS will issue releases of tax liens thereby improving the taxpayer's credit standing.

Disadvantages. The disadvantages associated with an OIC include the
following:

* The taxpayer is required to disclose the amount and location of assets and income. In the event the OIC is not accepted, the IRS has a road map to those assets and income.

* The statute of limitations for assessment and collection is suspended "for the period during which the offer is pending, or the period during which any installment remains unpaid, and for one year thereafter."

* The taxpayer must waive the right to any tax refunds for the calendar year in which the offer is accepted as well as all prior years, and must also waive the right to contest the original liability.

* The taxpayer may be required to sign a collateral agreement as discussed later.

Preparation of Forms. Form 656 is essentially a contract that sets forth the terms of the agreement between the taxpayer and the IRS. This form contains blank spaces for identifying the taxpayer, the type of tax and periods covered by the offer, the amount being offered and method of payment, and the reason for acceptance of the offer.

Detailed instructions are attached to the back of Form 656 and should be followed carefully. In this regard, it is important to note--

* the taxpayer is not required to set forth the amount of tax, penalty, and interest being compromised;

* the amount offered cannot include any amounts already collected by the IRS;

* the amount offered may be paid immediately, or may be paid over a period of time not to exceed two years. If a deferred payment arrangement is elected, the IRS prefers monthly payments.

How Much to Offer. One difficult problem is how much to offer. The stated IRS policy is that an acceptable offer must reflect collection potential, giving consideration to net forced or quick sale value of assets and the taxpayer's future income.

In valuing assets, only encumbrances that have priority over Federal liens must be taken into consideration (i.e., mortgage on realty filed before Federal tax lien). Assets that are readily marketable (e.g., publicly traded securities) are valued at fair market value; assets that are not readily marketable (e.g., real estate, closely held stocks, collectibles, etc.) would be valued at fair market value less a discount of roughly 25%. This 25% discount is not an official IRS figure but appears to be an acceptable ball park figure based upon the experience of this author.

Real estate and other related property owned by husband and wife as tenants in the entirety require special consideration in valuation where only one of the spouses is liable to the IRS. Due to the legal complexities in determining the value of the taxpayer's ownership interest, the IRS is willing to accept not less than 20% of the net equity in the property based on quick sale value. Property held by tenants in common or joint tenants, where the assessment is only against one owner, is valued using that taxpayer's proportionate interest of the quick sale value.

Pension plans and other related retirement accounts require special consideration. The IRS manual states that if a taxpayer is required under the terms of employment to contribute to a retirement plan, and withdrawals are not permitted prior to separation, retirement, demise, etc., this asset will be considered as having no equity. Conversely, for all other pension plans where the taxpayer voluntarily contributes [e.g., IRA, Keogh, 403(b), 401(k), SEP, etc.], the equity for OIC purposes is the gross value of the assets in the plan reduced by 1) the employer's contribution to the plan 2) the penalty, if any, for early withdrawal, and 3) the additional tax that must be paid on withdrawal.

Future income is a factor in determining the amount of an acceptable offer. The IRS will consider the taxpayer's past, present, and potential earnings to determine the present value of the disposable income the taxpayer will have over the next five years to pay back taxes. The dollar amount of this present value, when added to the taxpayer's equity in assets, constitutes what the IRS considers to be an acceptable offer.

In determining disposable income, the IRS will consider earnings as less necessary expenses. As discussed, the IRS has very recently released a new manual section defining necessary expenses as those essential to the family's health and welfare and production of income that are reasonable in amount. Conditional expenses are not considered for purposes of an OIC.

Practical Considerations. Upon receipt of the offer, the revenue officer will review it to ascertain if it is "processable." An offer will be considered not processable if there are one or more technical deficiencies, e.g., taxpayer or the liability is not properly identified, financial statements are not provided, or the amount offered does not equal or exceed the taxpayer's "equity in assets" as reflected on line 37 of Form 433-A or line 27(d) of Form 433-B. If the offer is determined to be processable, the revenue officer within 30 days of receipt of the offer will request the taxpayer submit any information deemed necessary to evaluate the offer and will then conduct an investigation to determine whether the amount offered reasonably reflects collection potential.

If the offer is accepted, cash deposited with the offer will not be returned. Conversely, if the offer is rejected, the taxpayer is entitled to a refund of the deposit but will be requested to sign Form 3040 authorizing the government to keep the money and apply it against the amount owed. If the deposit is returned to the taxpayer, logic dictates the revenue officer will probably levy on the bank account in which the funds are deposited. As an alternative, the taxpayer should borrow the money from a third party who should issue the check directly to the IRS with the understanding it will be returned if the offer is rejected. Another alternative is to specify in the offer that payment will be made shortly after (e.g., 30 days) notice of acceptance of the offer.

Taxpayers should be aware of the occasional insistence by the IRS on the execution of a collateral agreement. A collateral agreement is a written agreement whereby the taxpayer agrees to give more than the amount offered in the OIC. This additional offering could be in the nature of a waiver of tax benefits (i.e., net operating losses, capital losses, suspended passive activity losses, basis of assets, or other tax attributes) or a future income agreement.

A future income agreement generally provides that the taxpayer will pay to the service approximately 20% to 50% of his or her's next five years' "annual income" less applicable Federal income tax, in excess of the taxpayer's necessary living expenses. Annual income generally includes all income, earnings, gifts, inheritances, etc.

The IRS manual specifically states that collateral agreements should be secured only when a significant recovery can be reasonably expected (e.g., taxpayer expects a substantial increase in real income or a large inheritance) and that collateral agreements should not be entered into because of speculative or improbable future income. The manual also states that collateral agreements should not be routinely obtained and should be the exception and not the rule.

In lieu of a proposed collateral agreement, the taxpayer should consider increasing the amount of the offer.

If the offer is accepted, the taxpayer will receive a pattern acceptance letter, a copy of Form 656 signed by an IRS official, and a copy of the collateral agreement if any. Upon acceptance, the agreement is binding on both parties and may be reopened only in limited situations, i.e., mistake or misrepresentation of a material fact, or if the taxpayer cannot meet the terms of the accepted offer because of a significant change in his or her financial circumstances. Upon full payment of the offered amount, the taxpayer should request that Special Procedures in the Collection Division issue a Certificate of Discharge of Property from Federal Tax Lien and should follow up to assure the liens have been released. If the terms of the OIC are breached (e.g., taxpayer fails to meet the five-year compliance requirement), the IRS may reinstate the original liabilities, and probably will.

The Appeals Process. If the offer is considered insufficient, IRS personnel are under instructions to attempt to negotiate a higher offer. If the offer is ultimately rejected, the taxpayer will receive a rejection letter and have 30 days in which to file a protest for a hearing before the Appeals Division.

Upon receipt of such a protest, the Appeals Division may request additional information, return the case to the district director for further consideration of the additional information received, or consider the case on its merits. In considering an OIC, the Appeals Division will not resolve the case on litigating hazards because there is no provision to take into court an OIC rejected because the amount offered was too small. Most OICs settled in appeals involve asset valuations, although other issues will be considered such as priority of liens, the need for a collateral agreement, the amount of annual income or necessary expenses, etc.

Bankruptcy

Bankruptcy, as a means of solving a taxpayer's financial tax problem, is often overlooked. It should be considered early in the collection process, and only recommended after consultation with a qualified bankruptcy attorney. Under certain circumstances, many taxes can be discharged in bankruptcy.

Where the taxpayer cannot work out a satisfactory installment payment agreement or OIC, certainly bankruptcy should be considered, particularly if the IRS has planned or is planning, to seize taxpayer assets or income and the taxes are dischargeable in bankruptcy.

Advantages. One of the advantages of filing a petition under any bankruptcy chapter is an immediate automatic stay imposed on assessments, as well as on collection activity by all creditors to protect the debtor. Representatives should notify the revenue officer assigned to the case that a petition in bankruptcy has been filed and a copy should be sent to the revenue officer. This will serve to avoid any inadvertent collection action by the IRS.

Another major advantage is the possibility to have taxes owed discharged by the Bankruptcy Court. Whether the debtor uses Chapter 7 (liquidation of assets by individual, partnership, or corporate debtor), Chapter 11 (reorganization and rehabilitation of individual, partnership, or corporate debtor), or Chapter 13 (adjustment of debts of an individual with regular income, e.g., wage earner, sole proprietor, pensioner, etc.), taxes can be discharged. Chapter 13, however, may be a better medium in that it provides a greater opportunity for the discharge of taxes, penalties, and interest over Chapters 7 and 11.

Disadvantages. Some of the disadvantages of bankruptcy are--

* certain taxes may not be discharged;

* there is a limit as to the frequency in which bankruptcy proceedings can be instituted voluntarily;

* bankruptcy is a matter of public record, and may adversely affect credit; and

* the filing of a petition in bankruptcy extends the statute of limitations for assessment of tax for the period of time measured by the date the petition is filed through 60 days after the automatic stay on assessment terminates. Similarly, the filing of a petition extends the statute of limitations for collection for a period measured by the date the petition is filed through six months after the automatic stay on collection terminates.

Practical Considerations. The discharge of taxes in bankruptcy is dependent on the nature of the taxes involved and when the petition was filed. As to income taxes, while the general rule is that discharge will be granted where the due date of the income tax return (including extensions) is more than three years prior to the petition filing date, certain exceptions to this discharge rule apply, namely--

* no return was filed; or

* the return was filed within two years of the filing of the petition; or

* the taxpayer filed a fraudulent return or willfully attempted to evade payment.

* the tax was assessed within 240 days preceding the filing of the petition. This 240-day period is extended if the taxpayer filed an OIC within 240 days after the tax was assessed.

Under a Chapter 13 proceeding, the court may disregard one or more of the foregoing exceptions and discharge tax liability. An IRS prepared return ("substitute for return") does not constitute a return filed by the debtor.

There are special considerations where the bankrupt is a corporation and is liable for unpaid withholding taxes. Most Bankruptcy Courts believe they do not have authority to prevent the IRS from asserting the 100% penalty against the corporation's responsible persons even after a petition in bankruptcy has been filed with respect to the corporation. However, the normal statute of limitations for assessment of the 100% penalty against any responsible person continues to run and is not extended by bankruptcy proceedings of the corporation.

While a taxpayer can direct the IRS to apply voluntary payments against the trust fund portion of the employment tax liability, the taxpayer cannot so direct monies obtained from the taxpayer involuntarily (e.g., by IRS levy of taxpayer's bank account). A fairly recent decision of the Supreme Court held that a trustee in bankruptcy of a corporate debtor involved in a Chapter 11 proceeding had the authority to order IRS to apply tax payments to the bankrupt corporation's trust fund tax liability first and then to the non-trust fund portion.

A Word to the Wise

Dealing with the IRS collection personnel can often be a difficult and frustrating process. Revenue officers' personalities may range from reasonable to aggressive to completely unreasonable, and they have a lot of discretionary authority. It always helps to be forthright with them and maintain close telephone contact. It also helps to know your rights and options and to use them wisely.