The last major change to the IRS’s Offer in Compromise system occurred in July 2006, when Section 509 of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) amended IRC §7122 of the Internal Revenue Code. Those changes were detailed in a previous article in this series. A new Form 656 was issued at that time. Now the Form 656 has been changed again, this time due to new administrative policies announced by the IRS on May 21, 2012. This article will explain the changes.
The new offer policies are presented as part of the IRS’s recent efforts to help taxpayers hurt by the perfect storm created by the collapse of the real estate market, stagnant economic growth, and high unemployment. IRS touts it as “. . . another expansion of its “Fresh Start” initiative by offering more flexible terms to its Offer in Compromise program that will enable some of the most financially distressed taxpayers to clear up their tax problems and in many cases more quickly than in the past.”
The previous and much welcomed IRS “Fresh Start” change was an increase in the limit on “streamlined installment agreements” from $25,000 to $50,000, with a simultaneous extension of the maximum payment period from 60 months to 72 months. Simple. The changes to the Offer in Compromise program, however, are anything but simple. And contrary to the IRS press release, not all of the changes will make it easier for taxpayers to compromise their tax liabilities. Indeed, some will make is significantly harder. The changes are to be implemented through new provisions in the Financial Analysis section of the Internal Revenue Manual, at IRM 5.8.5 et. seq.
Deferred Payment Offers.
The common notion of an Offer in Compromise is a “lump sum” settlement. But many offers submitted to the IRS are in fact “deferred payment” arrangements, in which the taxpayer proposes monthly payments totaling something less than the full amount owed. Lump sum offers are still available. However, the range of deferred payment offers permitted has been considerably narrowed.
Nothing with the IRS is simple, of course, and words rarely mean what you would expect. Thus, a “lump sum” offer has heretofore been one to be paid in five or fewer payments (plus the deposit), over a maximum of 5 months. This has been “Option 1″ on the current version of the Form 656, and it will still be available.
Payment “Option 2,” however, has been changed. Previously, the taxpayer could offer a stream of payments over any period of time up to and including payments over the full remaining life of the collection statute of limitations. Under the new regime, the maximum term of a deferred payment offer will be 24 months. This will make it considerably more difficult for taxpayers who do not have access to a lump sum to compromise what they owe. Those who can’t pay in 24 months, and who in the past might have proposed offers with payments over the remaining life of the statute of limitations, will now have to look to “part pay installment agreements.”
Paying the amount of an accepted offer, of course, is the last step, not the first. Most of the changes to the IRS’s Offer in Compromise policy have to do with how the taxpayer’s “ability to pay” is calculated, and how this ability to pay is then used to determine the minimum acceptable offer amount. But the focus on these issues can lead the taxpayer or the representative to ignore two crucial threshold issues: (1) current compliance, and (2) ability to pay in full.
Current compliance is required before the IRS will even review an offer on its merits. Current compliance means that all required returns have been filed, and that the taxpayer is fully and properly participating in the pay-as-you-go tax system by having an adequate amount of tax withheld from his wages, or by making timely and adequate current period estimated tax payments. Failure to meet either part of this current compliance test will result (after a short opportunity to correct the problem) in the return of the offer package with no appeal rights.
Second, no offer will be acceptable if the IRS determines in its administrative wisdom that the taxpayer can pay the liability in full over the remaining life of the collection statute of limitations. In general, the statute of limitations is a period of ten years starting with the date of assessment. Many things, however, can extend that ten year period, including appeals, prior offers, bankruptcy, and voluntary extension agreements. This is in fact where most offers fail; the IRS simply determines that the sum of the liquidation value of the taxpayer’s assets, and the taxpayer’s ability to make monthly payments over the remaining life of the collection statute of limitations, would permit the tax to be paid in full. It is only those fortunate few who pass these gatekeeper tests who have any chance of seeing their offers accepted.
Ability to Pay.
The IRS’s new policies involve changes to both parts of the ability to pay analysis: (1) the liquidation value of assets, and (2) the ability to make payments to the IRS from the “excess” of the taxpayer’s future income over allowable living expenses. We will discuss each of the changes below.
In the past, the IRS’s financial analysis standards have been less than clear about how to treat income-producing assets. To include the liquidation value of such an asset, while at the same time including the future income that it would produce, is plainly double counting. But as a practical matter it has sometimes been hard to convince IRS Offer Examiners of this. Examiners are now admonished that “(w)hen considering equity in income-producing assets and the effect on income streams and expenses, you must exercise sound judgment consistent with the unique facts of each case.” That’s nice, but to back it up the new IRM provisions include a series of six examples. The examples illustrate several concepts, the outer limits of which are easy to see: First, if a business isn’t using the asset, what it would bring if sold will be included in the analysis of the IRS’s collection potential. Second, at the other extreme, if a business asset is contributing substantially to the ability of the business to produce a significant amount of income that can be devoted to the payment of tax, the equity in the asset will be excluded from the computation. Thus, in the examples the liquidation value of an asset worth $100,000 and producing income of $5,000 per month is excluded, but if the same asset produces only $500 per month in income, the asset’s liquidation value would be included and the future income projection reduced accordingly. So the IRS assumption about selling the asset versus keeping it and using it to produce future income turns on how much income the asset produces, compared to what would be realized by liquidating it. Of course, determining how much income any particular asset produces is exceedingly difficult. Taxpayers with accounting systems sufficiently sophisticated to make this determination on an asset by asset basis are unlikely to be in tax trouble in the first place. But this at least opens a basis for negotiating with the Offer Examiner in an appropriate case about the asset component of the ability to pay analysis.
Heretofore, cash and bank balances were simply included in the “asset equity” analysis. Cash in the typical household checking account, however, is often just there momentarily, waiting for checks to clear or for the next bill to show up in the mailbox. The new IRS rules permit a limited amount of cash to be excluded from the computation of the taxpayer’s ability to pay. Cash up to $1,000 is now excluded entirely. Cash over $1,000 can also be excluded to some extent if the Offer Examiner has “reason to believe the money will be used to pay for the taxpayer’s monthly allowable living expenses.” In that case, the examples in the new IRM provision illustrate reducing the balance by $1,000 and one month’s worth of living expenses. Cash in excess of this is to be included in the determination of the IRS’s reasonable collection potential.
Similarly, the new IRS rules exclude a portion of the taxpayer’s equity in automobiles (or aircraft or boats) “used for work, the production of income, and/or the welfare of the taxpayer’s family, up to two cars per household.” The amount excluded is $3,450 of the net equity per vehicle, for a maximum of two vehicles. Like the exclusion of a portion of the cash discussed above, this will tend to reduce the computation of the liquidation value of the taxpayer’s assets, and thus the taxpayer’s ability to pay for purposes of evaluating the offer, first as to whether the taxpayer can full pay the liability, and if not, the minimum acceptable Offer amount.
Finally, in the past the offer analysis would look at the loan on a car and would “retire” it as an allowable expenditure as of the last scheduled payment. In other words, the monthly payments would be allowed as a monthly living expense as part of the IRS’s standard for vehicle ownership costs, but only up to the time the car loan would be paid in full. We have always argued that this was inappropriate, because by the time the loan was paid it wouldn’t be too long before the taxpayer had to replace the car, whereupon he would once again have monthly payments. The new rules seem to have adopted this logic by now providing that $400 per month will not be retired (thus effectively assuming that the loan will be replaced by another one at $400 per month).
Perhaps the most complicated aspect of the rule changes involves so-called “dissipated assets.” In a marvel of semantic gymnastics, IRS policy in the past has included the value of dissipated assets in the computation of the IRS’s “reasonable collection potential.” This is usually raised when the Offer Examiner has some personal objection to how the taxpayer got himself into the financial pickle that requires the filing of the offer. For example, we’ve had this raised in cases in which the taxpayer was a recovering drug addict who spent money from the exercise of stock options on his drug habit; the Offer Examiner insisted on including the amounts thus spent in the reasonable collection potential calculation. Where the IRS could actually go to collect on this element of its presumed “collection potential” was something of a mystery. And the obvious problem with this is that it causes the analysis to depart from a review of what the taxpayer has now and is likely to have in the future, and instead opens the question of what the taxpayer may have done with his money in the past. In most cases where taxes are owed, an Offer Examiner would have little trouble pointing to funds that could have been used to pay taxes, but that were instead spent in some other way. This made the entire offer analysis process rather arbitrary, though fortunately few Offer Examiners bothered with this.
Now, however, the Internal Revenue Manual will include a lengthy provision on how and when such dissipated assets are to be included to either increase the minimum acceptable offer amount, or perhaps to reject the offer altogether.
If it is determined inclusion of a dissipated asset is appropriate and the taxpayer is unwilling or unable to include the value of the dissipated asset in the offer amount, the offer should be rejected as not in the government’s best interest.
The change is phrased in the Manual as though it is a liberalization. But since the whole dissipated assets issue was rarely raised, the practical effect is that this provision will probably cause it to be raised in many more cases than it was before:
Inclusion of dissipated assets in the calculation of the reasonable collection potential (RCP) is no longer applicable except in situations where it can be shown the taxpayer has sold, transferred, encumbered or otherwise disposed of assets in an attempt to avoid the payment of the tax liability or used the assets or proceeds (other than wages, salary, or other income) for other than the payment of items necessary for the production of income or the health and welfare of the taxpayer or their family, after the tax has been assessed or within six months prior to the tax assessment.
The updated Manual provision then explains that the time period to be reviewed for possible dissipation of assets is generally three years (the year of submission and two prior years). That would be bad enough. But it then provides an exception that in many cases will swallow the rule:
Even if the transfer and/or sale took place more than three years prior to the offer submission, it may be appropriate to include the asset in the calculation of RCP if the asset transfer and/or sale occurred either within six months prior to or within six months after the assessment of the tax liability. In these instances, a determination on whether the funds were used for health/welfare of the family or production of income would be appropriate . . .
Since tax returns are filed annually, a period encompassing six months before and six months after each assessment would typically cover the entire period of time during which the tax liabilities were accruing. Thus, for an offer filed in 2012 for unpaid income taxes for 2003 through 2010 resulting from timely filed returns, the period of examination for possible dissipation of assets would extend all the way back to six months prior to the assessment of the 2003 tax. And for that entire period, the taxpayer could be asked to justify everything that was spent. If any of it exceeds what, in the IRS’s view, was necessary for allowable living expenses, it could be added into the computation of the IRS’s “collection potential,” thus making an offer impossible.
The new Manual provisions include a list of examples, clearly drawn from specific cases, in which the IRS believes that the taxpayer fully deserved to be hit with the “dissipated assets” argument in considering an Offer in Compromise:
The taxpayer dissolved an IRA or other investment account to pay for specific non-priority items, i.e. child’s wedding, child’s university tuition, extravagant vacation, etc.
The taxpayer refinanced their (sic) house and used the funds to pay off credit card and non-secured debt. The credit cards were NOT used for payment of necessary living expenses and/or the production of income.
The taxpayer inherited funds and used the funds for non-priority items (other than health/welfare of the family or production of income).
The taxpayer closed bank/investment accounts and will not disclose how the funds were spent or if any funds remain.
A taxpayer filed a CAP to avoid the filing of a NFTL and insisted the lien would impair his credit and his ability to successfully operate his business. After the non-filing was granted, the taxpayer fully encumbered his assets, used the funds for non-priority items (items not necessary for the production of income or the health and welfare of the taxpayer and/or their family) and then submitted an OIC.
The taxpayer sold real estate and gifted the funds from the sale to family members.
Perhaps its just me, but the author of this language sounds just a wee bit angry about these examples.
To balance this, at least a little, some examples of situations in which the dissipated assets should not be included in the computation of the IRS’s reasonable collection potential are listed:
When it can be shown through internal research or substantiation provided by the taxpayer that the funds were needed to provide for necessary living expenses, these amounts should not be included in the RCP calculation.
Dissolving an IRA during unemployment or underemployment. Review of available internal sources verified the taxpayer’s income was insufficient to meet necessary living expenses. In this case, do not include the funds up to the amount needed to meet allowable expenses in the RCP calculation.
Substantial amount withdrawn from bank accounts. Taxpayer provided supporting documentation that funds were used to pay for medical or other necessary living expenses. This amount will not be included in the RCP calculation.
Disposing of an asset and using the funds to purchase another asset that is included in the offer evaluation. Do not include the value of the asset disposed of as a dissipated asset.
Clients who want to submit offers usually have great difficulty simply documenting their current assets, liabilities, income and living expenses. Pushing this analysis back to cover the entire period during which the tax liabilities were accruing will place a huge additional burden on taxpayers and their representatives, and on the IRS itself. This hardly seems designed to facilitate easier access to the kind of financial fresh start touted by the IRS’s press releases. The lesson is that in helping a client prepare an Offer in Compromise, you will now have to pay much more attention to how the taxpayer got himself into the mess in the first place, and what he did with his money during the entire time the tax liabilities were accruing. In this regard it makes the bogus promises of the TV infomercial “settle your taxes for pennies on the dollar” crowd even more preposterous.
Allowable Living Expenses.
Some parts of the new offer rules liberalize the IRS’s famously miserly standards for determining “allowable” living expenses, and thus in turn the taxpayer’s ability to make payments against the tax from future income. The more notable changes are as follows:
Previously, an additional operating expense allowance was available for vehicles with over 75,000 miles, but only after the monthly payments had ceased. That limitation has now been lifted:
When the taxpayer owns a vehicle that is six years or older or has reported mileage of 75,000 miles or more, allow an additional operating expenses of $200 or more per vehicle. The additional operating expense will be allowed on any vehicle meeting the criteria, up to two cars per household.
Payments on federally insured student loans are allowable:
Minimum payments on student loans guaranteed by the federal government will be allowed for the taxpayer’s post-high school education. Proof of payment must be provided. If student loans are owed, but no payments are being made, do not allow them, unless the non-payment is due to circumstances of financial hardship, e.g. unemployment, medical expenses, etc.
State tax payment agreements.
In the past, the IRS has not allowed state tax installment agreements unless the money is being taken from the taxpayer by a wage levy. Now, however, payments on state tax delinquencies will be allowed in calculating the taxpayer’s ability to make payments to the IRS from future income, but subject to some unusual limitations. If the state agreement predates the earliest IRS assessment, the full amount will be deemed an allowable expense. But if the state tax agreement came after the earliest IRS liability, the amount allowable by the IRS will be limited to a percentage of the monthly excess of income over living expenses equal to the ratio of the state tax to the total federal and state tax owed. In other words, if the taxpayer owes $80,000 to the IRS and $20,000 to Maryland, the Maryland tax is 20% of the total. The IRS will “allow” a state tax payment agreement of no more than 20% of the otherwise available “excess income.” If the taxpayer’s disposable income after allowable expenses is $1,000, the allowable amount of any state tax payment agreement would be limited to 20% of $1,000, or $200. If the state tax agreement calls for larger payments, the excess will not be considered an allowable living expense for purposes of the IRS’s ability to pay calculation as used in the evaluating the Offer in Compromise. And while this limitation my be harsh in some cases, it is better than the IRS’s previous position of simply ignoring state tax payment agreements. The new more realistic and reasonable approach seems to be “share and share alike.”
Projection of Ability to Pay.
The above-described changes in the allowability of certain living expenses impact the Offer in Compromise analysis process in two ways: First, they have a bearing on the gatekeeper test of whether the taxpayer can full pay the liability within the remaining life of the collection statute of limitations. Greater allowance of living expenses reduces the computed ability to pay, and may allow more taxpayers to pass this initial test.
Second, once the taxpayer is in the door, the revised ability to pay figure is used to project the minimum acceptable offer amount. In the past, a lump sum offer (i.e. one paid with a single check or in payments over five months or less) had to be at least equal to the sum of (a) the liquidation value of the taxpayer’s assets, and (b) what the taxpayer could pay from future income over 48 months. That 48 month projection has now been dramatically reduced to 12 months. Who will this help? If the taxpayer’s income is low and the minimum acceptable offer amount is based solely on the liquidation value of assets, it will make no difference. But if the taxpayer’s assets are negligible and his “excess” income is substantial (though still insufficient to pay the liability in full), using only 12 times that excess income instead of 48 times could make a major difference. At a computed ability to pay of $1,000 per month, it would require the inclusion of only $12,000 in a lump sum offer, rather than $48,000. Similarly, in the past an offer to be paid over more than five months required the inclusion of an amount equal to 60 times the taxpayer’s monthly ability to pay. That has been reduced to 24 times the monthly excess income. It won’t help everyone, but given the right combination of assets and income, it could make a large difference in some offers.
These new IRS Offer in Compromise “Fresh Start” rules will help some clients but will hurt others. And for all new offers, we as representatives will have to review the reasons for the delinquencies and the taxpayer’s handling of assets and income over the entire time the tax debts were accruing. This will be necessary in order to anticipate and withstand an effort by the IRS to include “dissipated assets” so as to make the proposed offer unacceptable or unaffordable. Finally, the heightened risk of a dissipated asset argument, and the 24 month limitation on deferred payment offers, may increase the usefulness of part pay installment agreements, or even bankruptcy in appropriate cases.
1Mr. Haynes is a tax lawyer in Burke, Virginia. From 1973 to 1981 he served as a Special Agent with the IRS Criminal Investigation Division. His firm specializes in civil and criminal tax disputes and litigation, tax collection cases, the tax aspects of bankruptcy and divorce, and the defense of individuals accused of financial crimes. Many of his previous articles for the Maryland Society of Accountants are posted on the Society’s website, as well as on his firm’s website at www.bjhaynes.com.
2A previous article titled “Offers in Compromise After TIPRA” was published in the October-November 2006 issue of The Freestate Accountant.
4New IRM 18.104.22.168.
5See the author’s article on Part Pay Installment Agreements in the October-November 2005 issue of The Freestate Accountant.
6See the author’s article on the Statute of Limitations, published in the August-September 2002 issue of The Freestate Accountant.
7New IRM 22.214.171.124.1(4).
8New IRM 126.96.36.199(1).
9New IRM 188.8.131.52.
10New IRM 184.108.40.206.
11New IRM 220.127.116.11.
12See Mr. Haynes’ article “Dealing with Tax Debts in Bankruptcy after BAPCPA” published in the November/December 2006 issue of the Maryland Bar Journal, Volume XXXIX, Number 6.