by Larry Heinkel
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 must be paid within the time remaining on the statute of limitations on collections. With lump sum offers, the offer must include a nonrefundable check for at least 20 percent of the amount offered; the other two offers must include the first payment with the offer and the installment payments offered must continue throughout the time the offer is under consideration.
Several months after the OIC is submitted and it has been accepted for processing, the file will be sent to a local revenue officer to be thoroughly investigated. If rejected, the taxpayer still owes the entire debt and the statute of limitations on collections has been extended. Only worse, the taxpayer has now provided the IRS with everything about his or her financial situation, which is simply a roadmap for the IRS to now take (better) enforced collection action.
If the offer is accepted, the taxpayer must satisfy the terms offered and the taxpayer is on “probation.” The taxpayer must remain compliant with his or her tax obligations for the longer of five years or for however long it takes to finish making payments due under the accepted offer. This means the taxpayer must file all tax returns on a timely basis and pay all tax liabilities in full. Failure to live up to this challenge means the accepted OIC is then terminated, the IRS keeps all monies previously paid under the OIC, and the taxpayer owes the rest of the original tax amount as well as the new tax amount.
Even if a taxpayer successfully submits an OIC, makes all required payments, and completes the entire “probation” period, all is not necessarily well with that taxpayer. For example, in nearly all cases for which a taxpayer has an insurmountable tax debt for which the OIC is desired, the taxpayer also owes 1) state income taxes, 2) credit card debt, 3) civil judgments, and 4) other financial obligations. The OIC will do nothing for the taxpayer/debtor having these issues.
How can an OIC be a good solution for this person? It can’t be a complete solution as post-acceptance the taxpayer still has his or her other debts with which to contend. But wouldn’t it be great if there was another option that could eliminate the federal tax debts as well as the other financial problems the taxpayer is facing? Well, there is — bankruptcy! Yes, filing for protection under the federal bankruptcy laws may absolve the taxpayer not only of his or her federal income tax debts, but also of any state tax income debts, credit card debts, business debts, and other financial problems as well.
When discussing whether a taxpayer can discharge (eliminate) tax debts by filing for protection under the federal bankruptcy laws, one must remember that, generally speaking, a debtor loses almost all his or her assets when filing Ch. 7 bankruptcy. What we are really exploring then is whether the tax debt in excess of the equity in the debtor’s assets is large enough for the bankruptcy to be a benefit. We are not saying that bankruptcy can eliminate the tax debts while the taxpayer/debtor keeps his or her assets. But in order to understand how bankruptcy can discharge tax debts, certain terms and concepts must be understood.
• The Impact of Federal Tax Liens
A lien for unpaid taxes arises as soon as the tax debt exists. This is important when assets of the taxpayer are transferred in a manner other than to a bona fide purchaser for value. The lien follows assets that are given away or sold for less than full and adequate consideration and the IRS can pursue those assets after the transfer. This explanation can be given to a client who wonders why he or she cannot give away his or her assets or sell them “for a dollar” before the IRS starts trying to collect for unpaid tax debts.
Once a notice of federal tax lien (FTL) is filed in the public records, the world is put on notice and the tax debt is “secured.” Thereafter, with a bona fide purchaser for value, the issue is when and where it has been filed, and what impact the filing has.
The FTL attaches to all the taxpayer’s personal property “everywhere” that property is located, but only to the taxpayer’s real property located in the county where the FTL is filed. As a planning technique, if the tax debts are dischargeable (discussed below) and the FTL is not filed in the county where the homestead is located, then the tax debt is not a lien on the homestead and the taxpayer will emerge post-discharge without tax debts but retain his or her homestead; otherwise he or she would emerge without personal liability for the tax debts, but the lien would attach to the home.
It is important to know the U.S. Supreme Court held in United States v. Craft, 535 U.S. 274 (2002), that “homestead” is a creature of the Florida Constitution and law, and is not recognized by federal law. Therefore, you must make it clear to clients that their homes are not protected just because they may qualify as “homestead” under bankruptcy and other law.
Although a homestead is not protected as a result of Florida’s homestead law, half of it can be protected based on how title to the property is held and whether the tax debt is a joint debt or the debt of just one of the owners. The tax debt may be the debt of one and not both owners where, for example, the debt is a civil penalty assessed under I.R.C. §6672 (when responsible for unpaid payroll taxes), or where married persons filed separate rather than joint income tax returns. Prior to the Craft decision, a tax lien of just the husband did not attach to any part of a husband and wife’s property owned by them as tenants by entireties. Now thanks to the Craft decision, a lien for such a debt attaches to half the property owned by the husband and wife as tenants by the entirety.1
• Trust Fund Liability
Trust fund taxes are those taxes that are withheld from a payee by a person or entity and are to be held “in trust” to be paid over to the government. Examples include income taxes and Social Security (FICA) taxes withheld from the paychecks of employees, and sales taxes collected by vendors from their customers. Trust fund taxes do not include the employer’s matching Social Security (FICA) taxes, employment, or sales taxes not actually collected but due as the result of an audit, or related penalties and interest (those that are not trust fund taxes are, not surprisingly, called nontrust fund taxes).
The employer can be a sole proprietor, a general or limited partnership, or a corporation or limited liability company. When the owners do not enjoy limited liability, the IRS can pursue them for the entire unpaid payroll tax liability — trust fund and nontrust fund alike. But when the employer is a defunct corporation or other entity which affords its owners limited liability from the unpaid debts of the corporation, I.R.C. §6672 is needed to pierce the corporate veil and does so by imposing a civil penalty against those shareholders, officers, directors, and other persons who are determined to have been “responsible” for collecting, accounting for, and paying over the trust fund taxes and who have “willfully” failed to do so. The penalty is called the trust fund recovery penalty. As explained later, neither the TFRP nor personal liability for collected sales taxes is dischargeable in a bankruptcy.
• Ch. 7 or Liquidation Bankruptcy
A Ch. 7 bankruptcy is the type most frequently thought of by the public. Generally speaking, in this liquidation-type bankruptcy, the debtor loses all his or her assets and is forgiven all his or her debts and is, thus, rewarded with a “fresh start.”
• Ch. 13 or Reorganization Bankruptcy
Ch. 13 bankruptcies are becoming a more frequently used option for debtors and are almost the opposite of Ch. 7 bankruptcies. For example, with this type of bankruptcy the debtor keeps all his or her assets and repays most debts by adopting a plan of reorganization. The debtor proposes a plan whereby he or she devotes “disposable income” (take home pay less necessary living expenses) to the repayment of his or her debts based on the priority each debt is assigned. The plan payments are paid for a certain period of time, usually five years. Certain debts (such as the trust fund recovery penalty and “newer” income taxes) are classified as “priority” and must be paid in full over the life of the plan. After those priority debts are provided for, the other (non-priority) debts (such as older income taxes, credit card debts, and other general unsecured debts) share what is left over on a pro rata basis. From a creditor standpoint, therefore, it is better to be classified as priority debt rather than nonpriority debt. From a debtor’s standpoint the non-priority creditors may receive as little as one percent (even zero) of their claims — an inexpensive way for debtors to eliminate their debts and yet keep their assets (some would call it a pennies-on-the-dollar bankruptcy).
• Consequences of Dischargeable Versus Nondischargeable Tax Debts
Tax debts are classified as either dischargeable or nondischargeable on the date the petition is filed (how the classification is made is explained below). The classification of a tax debt on that date is important, because if the tax debt is dischargeable then it will be eliminated in a Ch. 7 bankruptcy or fall in the “pennies-on-the-dollar” repayment category if Ch. 13 is elected. Those tax debts that are not dischargeable cannot be eliminated in a Ch. 7 bankruptcy and survive to torment the debtor once the proceedings are concluded. In the case of a Ch. 13 bankruptcy, nondischargeable tax debts must be paid in full during the course of the Ch. 13 repayment plan. Thus, it is important to a debtor that the tax debts have dischargeable status. Note from the explanation below that some tax debts may be classified as nondischargeable only because some period of time has not yet elapsed. In that case, it may be prudent to allow the requisite time period to elapse before filing bankruptcy to allow the tax debt in question to change from nondischargeable to dischargeable — and this author believes it may constitute malpractice not to offer the client the option of waiting.
• Nondischargeable Tax Debts
A tax debt is not dischargeable on the petition filing date if:
1) In the case of nonincome taxes:
a) It is a liability for collected and unpaid sales taxes; or
b) It is a trust fund recovery penalty; or
c) It is a trust fund tax or related penalty or interest (such as owed by a sole proprietorship);
2) In the case of income taxes:
a) It relates to a return that has not been filed or was filed within the last two years; or
b) It relates to a return that was due (including extensions) within the last three years; or
c) It relates to a return for which there was fraud involved; or
d) It is a liability that was assessed within the last 240 days.
• Dischargeable Tax Debts
It is easier to state what is dischargeable than it is to state what is not dischargeable. A tax debt is dischargeable if all of the following tests are satisfied on the bankruptcy petition filing date:
1) A return2 was filed3 for the year in question;
2) The return was filed more than two years ago;4
3) The return was “due” (including extensions) more than three years ago;5
4) The tax was assessed more than 240 days ago;6 and
5) There was no civil or criminal fraud nor did the taxpayer willfully evade or defeat the payment of the tax debt.
• Practice Pointers
Determining whether a filing constitutes a “return” for bankruptcy purposes, when or whether it was “filed,” when the return was “due,” and whether there was a subsequent assessment to take into consideration, are all issues best not left up to the client to decide. The prudent practitioner would secure an IRS power of attorney (Form 2848) and request official transcripts from the Internal Revenue Service. Only after thoroughly analyzing these transcripts should the practitioner render a considered opinion on when (or whether) to file bankruptcy and which chapter of the bankruptcy code should be utilized.
Benefits of a Tax Bankruptcy Over an Offer in Compromise
A tax bankruptcy is just a regular bankruptcy, the timing of which is geared toward relieving the debtor of his or her tax obligations as well as other debts. If the debtor owes federal income taxes and/or state income taxes in addition to the “usual” mix of debts (credit cards, judgments, loans, etc.), the wise bankruptcy practitioner should focus first on the severity of the tax debts to determine if the tax debts are large enough that failure to discharge them would render the taxpayer/debtor no better off after the bankruptcy than he or she was before. There generally is no concern about when to file bankruptcy for purposes of discharging the “usual” type of debt. Conversely, the timing of the bankruptcy is critical to discharge tax debts. Failure to take timing into consideration probably constitutes malpractice. After all, how is the debtor better off, how does the debtor get his or her “fresh start,” if post-discharge the debtor no longer owes the usual debts, but still owes taxes to the Internal Revenue Service, arguably the toughest debt collector in the world? The answer is he or she is not better off.
In such a situation, the debtor is only better off if the attorney advises him or her to wait on the filing of a petition in bankruptcy until sufficient time has elapsed to render otherwise non-dischargeable tax debts dischargeable. Of course, the debtor may wonder what to do about the IRS and the other creditors in the meantime. The answer is he or she is just going to have to face the IRS and work out as small a monthly payment as possible until the right time to file, and to simply ignore the other creditors via changing telephone numbers or other evasive actions. Although not pleasant, it is a small price to pay to also obtain relief from the IRS.
Remembering that the amount to be offered in an OIC is based on equity in assets and the present value of one’s monthly ability to make payments, it stands to reason that one cannot save up money to file an OIC. Why? Because the amount saved then becomes an asset and is added to the amount required to be offered. It becomes a vicious circle. Therefore, OIC’s are best suited for those of very low income and little or no assets who have family or friends (or maybe an employer) willing to advance the money necessary to make an offer. On the other hand, one’s income is not usually a factor in determining whether a tax debt is dischargeable in a bankruptcy.
Contrary to popular belief, OICs are rarely accepted, although the public is lead to believe the opposite by the advertising of unscrupulous OIC mills. For example, in fiscal year 2006, IRS statistics show that 59,000 OICs were “filed.”7 Of the 59,000 filed OIC’s, only 15,000 were actually “accepted” by the IRS and these generated $283,746,000 in collected revenue; leading one to conclude that the average accepted OIC was for just under $19,000.
In the final analysis, filing for bankruptcy protection is usually a better course of action for clients with large tax debts than is the filing of an OIC because:
1) OICs factor in the debtor’s income while bankruptcies generally do not.
2) OICs factor in future income potential while bankruptcies do not.
3) OICs factor in asset equity including equity to which the IRS has no legal claim, such as equity of the taxpayer/debtor’s spouse, while bankruptcies do not.
4) OICs do not resolve state income tax debts while bankruptcies do.
5) OICs do not help with the “usual” nontax debts while bankruptcies do.
In conclusion, given all the advantages that a properly filed tax bankruptcy can have over an accepted OIC, why would you ever recommend your client file an OIC rather than a bankruptcy?
1 In the author’s opinion, a claim for malpractice could be made against a tax preparer who has married clients file joint income tax returns when the facts show that one of the spouses would have had little or no tax debt had they filed separately rather than jointly (except in those cases where the tax is to be paid in full). By filing jointly, all of the income and assets of that spouse who would otherwise not have a tax debt are exposed needlessly to the IRS. A better course of action is to file separate returns because, even after Craft, one-half of the homestead would be protected from IRS.
2 What is a “return”? It includes not only the Form 1040, but also any other legal IRS document that the taxpayer signed signifying his or her agreement with the liability after participating in a meaningful way with the determination of the liability. A “return” does not include a substitute for a return (a/k/a “SFR”) prepared by the IRS under 26 USC §6020(b) which allows the IRS to assess a liability based on information known to it (via Forms W-2 and 1099). With this liability, IRS can commence collection actions, but these are treated as tax debts arising from an unfiled return for dischargeability purposes under bankruptcy law. But see 11 USC §523(a)(1)(B)(ii) added by BAPCPA which seems to state that the “return” requirement is also met by the filing of an “equivalent report or notice.” A case addressing this issue is currently before the U.S. Bankruptcy Court, Middle District of Florida, Orlando Division.
3 “Filing” a return means that delivery was accomplished. Filing is not accomplished by placing the return in the mail. That is why hand delivery or certified mail with return receipt requested is preferable. It can save the day when IRS loses a return.
4 Recent legislation and case law says that the various time periods stated above are “tolled” for any time the IRS was precluded from taking collection action against the taxpayer, such as due to having filed a previous bankruptcy or by exercising certain appeals rights under the Internal Revenue Code. Add to this tolling period an additional 90 days.
6 The “240-day rule” asks whether the assessment was made within the 240 days prior to the petition date, but you must also add to the 240 days both 1) the entire time an offer in compromise was pending or in effect if the offer was filed within the 240 days, plus 30 days, and 2) if a prior bankruptcy case was in effect during the 240 days, then add in the entire time a stay was in effect against the IRS during that 240 day period, plus 90 days.
Part two in the preceding sentence was added by BAPCPA. Prior to that see In re Collins that states all of the time periods are extended by the amount of time the IRS was held at bay by the filing of a prior bankruptcy. Further, that case added 180 days (roughly six months), not 90 days.
- One can only assume that such a figure is misleadingly low as it cannot include the number of OICs submitted by taxpayers that were not determined to be processible.
Larry Heinkel is a tax and bankruptcy attorney with R. Lawrence Heinkel, P.L., based in St. Petersburg, but representing businesses and individuals with state and federal tax problems throughout the state of Florida. Mr. Heinkel received degrees in accounting, law, and an LL.M., all with honors, and all from the University of Florida.
This column is submitted on behalf of the Tax Section, Edward E. Sawyer, chair, and Michael D. Miller and Benjamin A. Jablow, editors.