The offer in compromise

We prepare a lot of returns for people who stopped filing years ago, usually because they knew they would owe and could not pay. Getting those returns filed is the first step, and it is the step we do. The second step, for the ones who qualify, is the offer. Here is what it is, why the IRS does it, who qualifies, and why we send that part to an attorney.

Why the IRS would ever take less

It is a fair question. The answer is that the IRS is a collector, not a punisher, and a collector’s job is to bring in what can actually be collected. A tax debt that will never be paid produces nothing: no payments, years of notices and levies, a taxpayer who stops filing altogether because filing only adds to a number that is already hopeless, and a file that eventually expires when the ten-year collection statute runs out. Congress gave the IRS authority to compromise so that it could take what a person can pay, close the account, and get that person back to filing and paying every year. The IRS says so itself: the program’s stated goal is collection of what is reasonably collectible at the earliest possible time and at the least cost, and a “fresh start” for the taxpayer.

Our own view of it is simpler. The offer in compromise is a backstop. It exists so that a person who got into a hole — a failed business, a divorce, an illness, years of 1099 income with nothing set aside — can get out of it and go back to being a contributing taxpayer instead of someone hiding from the mail. That is good for the person and it is good for the system, and it is why the program has survived every administration since it was written into the Code.

What an offer actually is

An offer in compromise is a written proposal, on Form 656, to pay a specific amount in full settlement of specific tax years. If the IRS accepts it and you keep the terms, the rest of the debt is forgiven — tax, penalties and interest. There are three grounds:

• Doubt as to collectibility. You owe it, but you cannot pay it. This is almost every offer, and it is the one this page is about.
• Doubt as to liability. You have a real argument that you do not owe the amount assessed. This is a different form and a different process, and it is usually handled by audit reconsideration or appeal instead.
• Effective tax administration. You could technically pay, but collecting would cause economic hardship or would be unfair in a way the IRS recognizes — a retiree whose only asset is the home, a person whose medical condition makes the future income number meaningless. Rare, and harder.

The IRS does not have any other program that reduces the tax itself. Payment plans spread it out; currently-not-collectible status pauses it; penalty abatement trims the penalties. Only the offer reduces the principal.

Who qualifies

The IRS does not accept an offer because the balance is large or because paying would be painful. It accepts an offer when the amount offered is at least what it calculates it could collect from you anyway — what it calls reasonable collection potential. That number has two parts:

• Net equity in what you own. The quick-sale value of your assets (the IRS generally uses 80% of fair market value) minus the loans against them, with some allowances — a modest amount of equity in a vehicle, ordinary household goods, the tools of your trade up to a limit. A paid-off house, a brokerage account, a second car, cash in the bank, and the cash value of life insurance all count. Retirement accounts count too, net of the tax and penalty it would cost to get at them.
• Future income. Your monthly income minus allowable living expenses, multiplied by 12 if you will pay the offer in five or fewer payments within five months of acceptance, or by 24 if you will pay it over six to twenty-four months. The allowable expenses are not your actual expenses; they are the IRS’s national and local standards for food, housing, utilities, transportation and health care, with your actual figures used only where the standards allow it.

Add the two together. If the result is less than what you owe, you are a candidate, and the result is roughly the floor for your offer. If the result is more than what you owe, the IRS will expect full payment — through a payment plan if it has to be — and will reject the offer.

In plain terms, the people who qualify look like this: someone with little or no equity, income that covers a modest life and not much more, a tax debt that is several times what that income could pay toward it, and no realistic prospect of a windfall. A self-employed person whose business failed and who now earns wages. A retiree on Social Security and a small pension with a debt from a decade ago. A person who went through a divorce or a long illness and came out the other side with a balance from the years when nothing got paid. The people who do not qualify are the ones with equity in a home, a solid income with room in the budget, or a balance that a five- or six-year payment plan would clear. For them, the answer is a payment plan, and an offer would be a waste of the fee and a year of waiting.

The conditions that come first

• All required returns filed. The IRS will not evaluate an offer with unfiled years behind it. This is where most of our clients start, and it is the part we do: the last six years at a minimum, prepared from the wage and income transcripts and whatever records exist. See unfiled and overdue returns. Filing often lowers the balance, because the IRS’s own substitute returns allow no deductions, no dependents and the worst filing status.
• Current on this year. Withholding adjusted, or estimated payments being made, so that the current year is not becoming a new debt while the old one is being settled.
• Not in an open bankruptcy. A bankruptcy case has its own process for tax debts; the IRS will return an offer filed during one.
• The fee and the down payment. A $205 application fee, plus 20% of the offer amount with a lump-sum offer or the first monthly installment with a periodic offer. Both are waived for households under the IRS’s low-income line (250% of the poverty guideline). The payments are not refundable if the offer is rejected; they are applied to the debt.

How it goes

The application is Form 656 plus a complete financial statement — Form 433-A (OIC) for an individual, 433-B (OIC) for a business — with bank statements, pay stubs, vehicle and property valuations, and proof of every expense claimed. An offer examiner reviews it, asks for more, and often comes back with a number higher than the one offered. There is a negotiation. Collection action generally pauses while the offer is pending, but interest keeps running, and the ten-year collection clock is suspended for the time the offer is under review. The IRS’s public figures put the wait at six to twelve months. By law an offer the IRS has not acted on within two years is deemed accepted, which almost never happens.

If the offer is accepted: you pay the agreed amount on the agreed schedule, and for the next five years you file every return on time and pay every balance on time. Miss either and the offer defaults, the full original debt comes back less whatever was paid, and the IRS can collect it. The accepted offer is also a public record, in a limited form, for a year. The federal tax lien, if one was filed, is released once the offer amount is paid.

If the offer is rejected: you have thirty days to appeal to the IRS Independent Office of Appeals, which is where a good many offers are actually settled. The payments made along the way stay applied to the debt. And a rejected offer does not prevent a payment plan or currently-not-collectible status afterward.

A word about the ads

You have heard the radio ads: settle your tax debt for pennies on the dollar, call now. The IRS puts “offer in compromise mills” on its Dirty Dozen list of scams every year, and for good reason. The program is real. The guarantee is not. Nobody can know whether you qualify, or for how much, until the financial statement is done and the arithmetic above is run, and anyone who promises a result before that is selling you the application fee. The IRS’s own Offer in Compromise Pre-Qualifier is free and takes ten minutes; it is a reasonable first look before paying anyone anything.

Why we send the offer to an attorney

We could prepare offers. We generally do not, and the reason is that an offer is a negotiation with a collector over a financial statement, and the difference between an accepted offer and a rejected one is usually in how the assets are valued, which expenses are defended, and how the examiner’s counter is handled. That is lawyer’s work, and it is work someone should be doing all the time to do well. For our clients that someone is Tyler Murray of Murray & McCarthy Law in Denver — former chair of the Tax Law Section of the Colorado Bar Association, an LL.M. in taxation, and very good at offers. We get the returns filed and the balance established; he takes it from there. We get nothing for the referral except a client who comes back the next year with a return that is current.

You are not obliged to use him. An offer is your case and your money, and you can and should look at more than one attorney before choosing: ask how many offers they have filed and how many were accepted, whether they handle the appeal if the first answer is no, and what the fee covers. Any licensed attorney, CPA or enrolled agent can represent you before the IRS on an offer; what matters is that the person does this work regularly. The IRS also funds Low Income Taxpayer Clinics that handle offers at no charge for people under the income limit, and the IRS lists them by state. Whoever you choose, we will hand over the file with the returns done and the balance established.

What we do, in order: pull the IRS transcripts to see what years are open and what the IRS already thinks you owe; prepare and file the missing returns; adjust this year’s withholding or set up estimates; and then, if the numbers say you are a candidate, make the introduction with the file ready to go. If the numbers say you are not, we say so, and help with the payment plan instead.