You have likely heard stories about people settling their tax debts for far less than they owe. Is the IRS really in the business of wheeling and dealing with taxpayers? The answer is of course no, and as in all tax matters, no one should ever approach a tax problem with a mindset of outsmarting the feds. When individuals and businesses reach an agreement with the IRS to settle a debt for a reduced amount, they do so by following a very specific procedure called an offer in compromise (OIC).
It Is an Offer, Not the Opening of Negotiations.
An offer in compromise is an offer from the taxpayer to the IRS, not the other way around. Upon reviewing a taxpayer’s application, the IRS will take one of three actions:
- Accept the offer
- Reject the offer
- Return the offer due to an incomplete application or circumstances (such as active bankruptcy proceedings) that make the taxpayer ineligible to apply
Note that receiving a counter-offer from the IRS is NOT one of the possible outcomes of the application process. An OIC is not a prelude to haggling.
A key factor in the IRS’s evaluation of an offer is Reasonable Collection Potential.
In any situation of outstanding tax debt, the IRS has formulas to calculate the reasonable collection potential (RCP)—an estimate of the greatest amount of the debt that the agency can expect to recover through collection procedures over a reasonable time.
The main factors that determine the RCP for a tax debt are the value of the taxpayer’s current assets and the taxpayer’s current and anticipated income. Only in rare circumstances will the IRS accept an offer in compromise for an amount below the RCP for the debt.
Circumstances Under Which OICs Are Accepted
As explained in IRS publications, any of the following may be considered appropriate grounds for the IRS to accept an OIC:
- Doubt regarding the amount of the taxpayer’s liability. In a case where plausible reasons exist to question whether the tax debt has been correctly determined under the law, an OIC can provide an opportunity for the taxpayer and the IRS to reach an agreement without a lengthy legal dispute.
- Doubt regarding the collectability of the full amount owed. The most common basis for accepting an OIC is that based on its analysis of the taxpayer’s assets, income, and reasonable living expenses, the IRS deems that it would be unrealistic to expect full payment of the tax debt. In other words, the RCP is significantly less than the amount owed.
- Fair and efficient tax administration. Underlying all tax laws are basic principles of fairness and economic justice. In some cases, even though the amount of tax debt is clearly established under the law and full collection would be possible, the IRS may accept an OIC because full payment would cause unreasonable hardship due to exceptional circumstances.
How to Apply
Filing an application for an OIC requires completion of one or more current versions of IRS Forms 656 and 433. The application must be accompanied by payment of a non-refundable $186 fee, along with the first payment required under the proposed offer. The complete procedure is outlined in the IRS’s Offer in Compromise Booklet, also known as Form 656-B.
There are two cases under which the $186 application fee may be waived:
- The basis for applying for an OIC is doubt about the taxpayer’s actual liability
- An individual taxpayer (not a business entity such as a partnership or LLC) qualifies for an exemption based on low income.
As of March 27, 2017, the IRS will not review any OIC application from a taxpayer who has not filed all required returns. This is the one case in which the application fee is refunded, since the application is not even considered. However, the IRS will keep any additional payment included with the application and apply it to the tax debt.
The application process is lengthy, and as noted above, acceptance usually hinges on how the offer compares with the RCP for the debt. It is therefore essential to seek the advice of a qualified tax advisor before submitting an OIC application.
Payment Options for an OIC
An OIC must include a specific schedule for the amount offered to the IRS to be paid. A payment plan involving five or fewer payments in a timespan of five months or less is classified as a “lump sum cash offer.” An application for a lump sum OIC must include payment for 20% of the offer amount. A schedule of six or more (up to 24) monthly payments is classified as a “periodic payment offer,” and the application must be accompanied by payment of the first installment. In both cases, if the application is rejected or returned, the IRS retains the included payment and applies it to the tax debt.
Make Them an Offer They Won’t Refuse
In short, an offer in compromise is not a way to weasel out of trouble or take advantage of loopholes. It is a way to honestly make things right with your taxes in a manner consistent with the IRS’s mission. Take the process seriously and follow the advice of experienced tax professionals.