IRS introduces new offer in compromise procedures. (includes related article)by Keiser, Laurence
IRC Sec. 7122 authorizes the Secretary of the Treasury to compromise any civil or criminal case. With that section as background, over the years the IRS has developed a compromise policy. The process generally begins with the taxpayer making an "offer in compromise." The procedure is often a satisfactory alternative to dealing with revenue officers and entering into installment payment arrangements.
The offer in compromise procedure, however, has not been the IRS bargain basement. The IRS has always been cautious about the types of offers it accepts, especially in light of the fact that offers are a matter of public record. In addition, every accepted offer must be approved by IRS Chief Counsel to be finally accepted.
Despite the existence of the statute and IRS guidance, to date the offer in compromise has been a little used procedure. One reason the compromise is not used often may be the poor acceptance rate on offers. For instance, the last published statistics by the IRS indicate that 8,000 offers had been made and 2,000 accepted. However, with the economy presenting new collection problems and dilemmas, the IRS is looking to the compromise procedures to help it collect unpaid tax. The IRS recently issued new guidelines IRM 57(10) to publicize the compromise procedures, to encourage the making of offers, and to educate revenue officers as to the types of offers that may be acceptable.
The guidelines state that the objectives of compromise are as follows: 1. To resolve accounts receivable that cannot be collected in full or on which there is a legitimate dispute as to what is owed; 2. To effect collection of what could reasonably be collected at the earliest time possible and at the least cost to the government; 3. To give taxpayers a fresh start to enable them to voluntarily comply with the tax laws; and 4. To collect funds that may not be collectible through any other means.
The new guidelines have been communicated to all collection field function personnel in a memo from the Assistant Commissioner (Collection) in which he states: "We will accept an offer if the amount offered reasonably reflects collection potential."
Tax liabilities that place severe payment burdens on taxpayers may arise in several ways. For example, audits of prior years may result in deficiencies, or a taxpayer whose income has declined may have committed available resources to personal expenditures without setting aside money for taxes. A taxpayer who cannot pay an IRS liability has several options, none of which are particularly attractive.
If there is no question as to the amount involved, the taxpayer may try to negotiate an installment payment arrangement. This is usually done with a revenue officer but can also be done through ACS, the automated collection system. Sec. 6159 was added to the IRC in the Taxpayer Bill of Rights section of TAMRA 88. The section codifies the installment payment agreement (previously a creature of IRS administrative rules) to facilitate collection of a tax liability.
The IRS will not agree to an installment payment arrangement without the taxpayer submitting a detailed financial statement. The statement is submitted on IRS Form 433, and it must be signed "under penalties of perjury." The form is reviewed carefully, and the IRS will generally scrutinize items of cash and liquidity to see whether a down payment can be made on the liability. It will also study potential equity in assets to see if the taxpayer might be able to borrow elsewhere. The IRS will study the taxpayer's income and expenses to determine how much of the net income would be available to pay the tax liability.
Bankruptcy is also an option available to the taxpayer. Certain taxes, however, (as well as additions to tax) are not dischargeable in bankruptcy. For instance, income taxes assessed within three years of the bankruptcy are not discharged (as well as interest and penalties on those items). In addition, the IRC Sec. 6672 penalty (the 100% penalty) asserted against a person responsible for withholding and remitting payroll taxes has been held not to be dischargeable in bankruptcy In re Slodov, 436 U.S. 238 (1978).
Cross Fingers and Wait
A third option is simply to do nothing and wait out the liability until the statute of limitations on collection has run out. Pursuant to legislation in RRA 90, the statute of limitations on collection for items assessed after November 5, 1990, has been extended from six to 10 years. The IRS also has the option of reducing its liability to judgment before the expiration of the statute of limitations period. Collection of a judgment has an independent statute of limitations under the laws of most states. In New York, for example, a judgment is enforceable for 10 years and can be further renewed for another 10 years.
In the past, the IRS did not often take advantage of the judgment procedure, and many liabilities went uncollected when statutes expired. It is not known whether the IRS will expand its efforts in this area.
When an item is determined to be uncollectible, the collection division will record it as such and terminate its efforts at active collection. It will, however, periodically contact the taxpayer for filings of up-to-date financial statements to determine whether circumstances have changed which might cause the item to become collectible.
Offer in Compromise
A fourth option and the one explored in greater detail in this article is the offer in compromise procedure. The IRS views the compromise procedure as viable means of collection (see Sidebar for the new IRS policy statement on the acceptance of an offer in compromise).
SUGGESTION OF OFFER
If no evidence of criminality exists and an evaluation of his or her financial condition raises serious doubt that collection in full is practicable, a taxpayer should consider making the IRS an offer in compromise. The taxpayer will be advised as to procedures and forms, but not on the amount of the offer. The first specific proposal must come from the taxpayer. That proposal should be realistic. An offer that is considered a delaying tactic will be rejected out of hand. There should be a "legitimate compromise proposal based on ability to pay."
Under prior rules, an inadequate offer would simply be rejected on the ground that "a greater amount appears to be collectible." A counter- proposal would not be made. The new procedure implies that if the initial offer is deemed insufficient, the IRS might suggest an acceptable amount to the taxpayer.
It is expected (though not required) that the taxpayer will make a deposit with the offer as a sign of good faith. If the offer is not accepted, the deposit will be returned.
In evaluating an offer, the IRS will be looking beyond assets it can already seize (cash, securities, equity in real property) to assets to which only the taxpayer has access. Friends, relatives, or business associates may be willing to lend money to the taxpayer if a compromise can be reached. Or property may be jointly held with another. Funds such as these are beyond the ability of the IRS to pursue.
Types of Offers
Offers may be made on the grounds of 1) doubt as to liability or 2) doubt as to collectibility.
Doubt as to Liability. A taxpayer's options involving doubt as to liability are somewhat narrow. Where the offer is based on doubt as to liability, the taxpayer must explain why the amount is not due. A questionable liability might arise for example from an IRS assessment because no response was made to an audit contact, 30-day letter, or statutory notice. The taxpayer could not normally ask for an Appeals Office review, because appeal is not a matter of statute. It is an IRS procedure. Another possible avenue to pursue would be submit a petition to the Tax Court. But if such a petition is not filed on a timely basis, prepayment judicial review is eliminated. The other normal channels to resolve the question of liability would involve paying the assessment and filing a claim for refund (and subsequent civil suit for refund). Such claims cannot be made absent full payment Flora v. U.S., 357 U.S. 63 (1956). A taxpayer facing an assessment, but without the funds to make full payment, might seek to make an offer based on doubt as to liability. If the taxpayer can prove his or her position, the offer (or some compromised amount) will be accepted.
A spouse may use an offer in compromise based on doubt as to liability by putting forth an innocent spouse claim under IRC Sec. 6013(e). in that event, the question must be referred to the District examination function for determination.
Offers may also be made to compromise penalties. Penalties that can be abated for reasonable cause (delinquency, negligence) can be compromised for doubt as to liability. This part of the IRS procedure indicates fraud penalties and responsible officer (Sec. 6672) penalties will be considered for compromise. Experience has shown, however, that compromises have generally not been accepted in fraud and failure to pay over trust fund situations based on public policy.
Doubt as to Collectibility. Where an offer is filed for doubt as to collectibility, the collectibility has to be proven as part of the compromise proceeding. The collection division must make this determination, based upon the facts and circumstances.
The new guidelines state that offers can be rejected where public knowledge of acceptance would be seriously detrimental to voluntary compliance. Rejection on this ground should be rare, however, and should be made only where a clear and convincing case.can be made for the detrimental effects of acceptance.
PREPARING THE OFFER
Offers are made by filing Form 656. The offer must specify the amount the taxpayer is offering to pay, the method and terms of payment, the liabilities covered by the offer, and a detailed statement of the grounds for the offer. The offer must be accompanied by a financial statement (Form 433-A for individuals and Form 433-B for businesses). The taxpayer should receive an acknowledgment from the IRS within 30 calendar days. Any other required information will normally be requested from the taxpayer at that time.
Collection activity will be suspended if it is determined the offer merits consideration and there is no reason to believe that collection will be jeopardized. Also, the offer must not have been made for the purpose of delay. If the taxpayer already has an installment payment arrangement in effect, these payments must be continued.
When an offer is filed, the statutory period of limitations on collections is suspended for the period that the offer is pending plus one year. This is accomplished by a provision on the offer form. This is an important factor when there is little time remaining before the statutory period expires. A taxpayer might consider deferring any action to see if the IRS will let the statute expire rather than voluntarily extending it.
EVALUATING THE OFFER
In evaluating the offer, the IRS will first determine collectibility of the liability. Is anything collectible based on the excess of fair market value of assets over liabilities? In valuing assets, ordinarily the quick sale or liquidating value would be used. Liquidating value is normally somewhat less than fair market value and is the amount that would be realized if financial pressures caused the taxpayer to sell in a short amount of time.
Next, the IRS will determine future income potential taking into account the taxpayer's education, profession or trade, age and experience, health, and past and present income.
If the IRS concludes that the taxpayer's offer is too low (since more appears to be collectible), it will give the taxpayer the opportunity to increase the offer to an acceptable amount. If the taxpayer does not, he or she may withdraw the offer or have the IRS formally reject the offer.
In evaluating whether to accept the offer, cash and marketable securities are taken at their current value, although cash balances should be averaged over three months. Closely held stock has to be valued. If the taxpayer holds only a nominal interest, has no control, and his or her interest can't be liquidated, the interest will be considered to have no value.
The cash loan value in a life insurance policy, i.e., what the taxpayer could borrow, is a collectible asset. As to balances in pension plans, apparently the IRS considers all employer contributions to qualified retirement plans as exempt. Employee contributions are collectible assets if employee contributions are voluntary but exempt if contributions are required by the terms of employment. IRA and Keogh accounts are collectible as assets.
Personal property should generally be considered at appraised value. Real property should be appraised at its highest and best use. Jointly owned real estate (especially residences) present some problems. If the offer is a joint offer, the total quick sale value of the entire property would be considered. Where the liability is that of only one spouse, "It is reasonable to expect that if a taxpayer wishes to compromise a liability, the taxpayer should be asked to include in the amount offered at least a portion of the amount accessible to the taxpayer but unavailable to the IRS for collection action." Indeed, the guidelines indicate that not less than 20% of the net equity in the property should be included. The amount of the expected inclusion could vary based on the parties' respective contributions to the property.
The procedure is silent with respect to a residence in which the taxpayer has no interest. Legally, the IRS has no collection rights. However, it must be remembered that acceptance of an offer is totally discretionary, and there is no right to judicial review. The IRS may not be motivated to accept a nominal offer based on doubt as to collectibility where a residence owned by a wife has considerable equity. This would especially be the case if there has at some time been a transfer to the wife, and transferee liability can be established.
Future income is also considered. An evaluation must be made of the likelihood that any increase in real income will become available to pay the delinquent taxes. The IRS will consider the present value of a stream of future payments. The procedure states that the IRS considers any installment payment agreement that requires more than five years to complete to have a high probability of not being completed. The IRS would likely accept the present value of the payments in compromise.
Prior to the new procedure, it was rare for the IRS to accept an offer without a collateral agreement - an agreement to pay over percentages of "income" in excess of threshold amounts. For instance, the taxpayer might agree to pay to the IRS 30% of income in excess of $50,000, 40% in excess of $75,000, and 50% in excess of $100,000.
The new procedure indicates that collateral agreements should be the exception, not the rule. Collateral agreements should not be a matter of routine, but should be obtained only when a significant recovery is involved or where the IRS seeks to protect an expected substantial increase in the taxpayer's real income.
Future income collateral agreements usually run for five years. Income for purposes of an offer in compromise agreement includes many items that are excluded for income tax purposes, such as tax-free bond interest, gifts and bequests, sick pay, insurance proceeds, and unrecognized gains on condemnations and involuntary conversions. Keogh and IRA deductions are not allowed. Income for purposes of an agreement with the IRS is reduced by federal income tax and payments on the offer.
Where the taxpayer is a shareholder in a closely held corporation, his or her individual income is increased by his or her percentage interest in corporate income in excess of $10,000. Obviously, this is to prevent amounts from being accumulated in closely held corporations.
In addition to a future income collateral agreement, taxpayers may also agree to reduce basis in assets (thus reducing current depreciation expense or increasing the gain on future sale) or to waive available capital loss or net operating loss carryforwards or unused credit carryforwards.
A future income collateral agreement is made on Form 2261, which outlines all the terms. Payments due must be submitted on or before the 15th day of the 4th month following the close of the taxable year, along with a computation of the amount due and a copy of the tax return. There are also forms for collateral agreements on losses and credits (Form 2261-C) and basis reduction (Form 2261-B).
If the IRS wants to accept the offer, it must be reviewed and accepted by the Chief Counsel's office. For a period of one year, all accepted offers are available for inspection in the district office. If the offer is to be rejected, the taxpayer has a right to appeal. If the amount of the liability exceeds $2,500, a written protest must be filed. As noted earlier, appeal is the taxpayer's last recourse. There is no right to judicial review.
If the offer is accepted, a binding contract is created between the taxpayer and the IRS. However, if there has been a mistake of fact or misrepresentation of a material fact (e.g., the taxpayer omits assets in the financial statement), the, contract may be rescinded or set aside.
Form 656 is presently being redrafted, and the IRS has indicated that the new form will also contain a provision requiring the taxpayer to make all current payments of tax for the five-year period following acceptance of the offer. Failure to stay current would cause any compromised balance to again become due and payable (subject to whatever time remains on the statute of limitations).
The guidelines also contain provisions for a compromise of a compromise. If the taxpayer is unable to pay the balance of an accepted offer, the IRS may adjust the terms of the offer or otherwise compromise the amount. The IRS will apply all the factors outlined above to determine whether, in light of present facts and conditions, it is in the best interest of the Government to accept the taxpayer's proposal. Without adjusting the terms of the compromise, the IRS may also grant an extension of time of a payment for not more than six months. Ultimately, if there is a default, the IRS has the right to pursue the full amount of the original liability
AN ALTERNATIVE MORE
The IRS's past reluctance to accept offers in compromise man, have been counterproductive. The IRS was known to turn down offers hoping to get more but often ending up with less. The new guidelines lend flexibility and judgment to the process and should, if administered properly, result in net gains to the Treasury. They also provide taxpayers with an alternative more palatable than bankruptcy or living their lives with IRS liens threatening to attach any assets that they may acquire.
WHEN AN OFFER WILL BE ACCEPTED
The IRS will accept an offer in compromise when it is unlikely that the tax liability can be collected in full and the amount of the offer reasonably reflects collection potential. An offer in compromise is a legitimate alternative to declaring a case currently not collectible or to a protracted installment agreement. The goal is to achieve collection of what is potentially collectible at the earliest possible time and at the least cost to the government.
In cases where an offer in compromise appears to be a viable solution to a tax delinquency, the IRS employee assigned to the case will discuss the compromise alternative with the taxpayer and, when necessary, assist preparing the required forms. The taxpayer will be responsible for initiating the first specific proposal for compromise.
The success of the compromise program will be assured only if taxpayers make adequate compromise proposals consistent with their ability to pay and the IRS makes prompt and reasonable decisions. Taxpayers are expected to provide reasonable documentation to verify their ability to pay. The ultimate goal is a compromise which is in the best interest to the taxpayer and the IRS. Acceptance of an adequate offer will also result in creating for the taxpayer an expectation of and a fresh start toward compliance with all future filing and payment requirements.
Laurence Keiser, LLM (tax), CPA, is a Partner in the New York City and White Plains, NY, law firm of Greenfield Eisenberg Stein & Senior, specializing in tax planning and litigation, and estate planning and administration.
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