Offer in Compromise Programs Provide Taxpayers with Options to Settle Federal, State Tax Debt

Part 2 of a 2-Part Series

The Internal Revenue Service (IRS) offers two important collection alternatives for individuals seeking freedom from tax debt.  They are known as the “Offer-in-Compromise” (OIC) and the status known as “Currently Not Collectible.” These programs allow taxpayers to settle their balances, often for far less than what is owed if they satisfy the terms of the programs.

In part one of this series, we discussed the IRS collection alternative called the installment agreement. We discussed how the IRS uses installment agreements as a structured payment plan that taxpayers can use to pay back most or all their tax balance. But what options are available for taxpayers who lack the financial ability to make even the smallest of payments towards their balances due to financial hardship?

In this second part of the series, we examine in more detail the Offer-in-Compromise. We will outline the OIC program and the way it can be used to settle tax balances for taxpayers. We will also walk through the OIC qualifying process and what taxpayers can expect once an OIC is accepted by the IRS.

What is an Offer-in-Compromise?

An OIC is an option that allows taxpayers to settle their tax balance for less than the amount owed, under certain circumstances. In addition to the initial tax assessed by the IRS, penalties and interest are added to the balance every month. Over time, the tax balance can grow to be very large.

Taxpayers who are approached by the IRS, or a state, about unpaid taxes commonly have very little discretionary money or assets available to pay back their taxes. Compounding this problem can be that a taxpayer’s financial circumstances may have worsened, leaving little or no money to make the installment agreement payments we discussed in Part One of this series.  Confronted with such circumstances, the OIC may be the next best option.

Also described in Part 1 of this series, and is worth repeating here, is that one of the main goals of the IRS is to collect money. The IRS is motivated to collect what can be paid by the taxpayer before the 10-year collection statute expires and the tax debt is gone forever. With this goal in mind, the IRS allows taxpayers to make a lump sum payment, often for far less than the total tax balance, in exchange for fully resolving any outstanding tax claims against the taxpayer.    

What are the different types of Offers-in-Compromise?

There are two main types of OICs available to settle outstanding tax balances. The type of OIC that a taxpayer ultimately applies for will depend on whether the taxpayer simply cannot pay the amount owed or because the taxpayer claims the underlying tax is not owed.

In addition to these two main OIC types, taxpayers who can demonstrate that there were special circumstances that impacted their ability to file or pay their taxes can also apply for an offer called a doubt as to collectability with special circumstances or an OIC based on effective tax administration.

These special OIC types allow the IRS to deviate from the normal formula used to determine OIC eligibility and the overall offer amount that can normally be accepted if the taxpayer can demonstrate financial need

Doubt-As-To-Collectability Offer (DATC)

A DATC OIC offer is one where the underlying tax balance is not disputed. Instead, the offer is based on the taxpayer’s demonstrated inability to pay the tax debt before the statutory 10-year collection period expires. To make a DATC offer, the taxpayer must propose a lump sum payment based on documented personal financial circumstances, demonstrating a need for the DATC.

Doubt-as-to-Liability Offer (DATL)

A DATL OIC offer is one where the taxpayer denies owing some or all of the underlying tax balance. The underlying tax balance may be incorrect because of an IRS calculation error or when the taxpayer believes the debt is owed by some other party. A DATL is similar to an audit reconsideration where the validity of the tax assessed is challenged because it asks the same questions regarding the validity of the tax attributed to the taxpayer. To support a DATL the taxpayer must provide documentation to the IRS plausibly showing that the tax is not owed.  

Effective Tax Administration Offer (ETA)

An OIC based on effective tax administration is an agreement between a taxpayer and the IRS that settles a tax debt for less than the full amount owed, even when the taxpayer can pay the full amount.

This type of OIC is designed for taxpayers who might not otherwise qualify for a DATL or DATC, but requiring full payment of the debt would create economic hardship or be inequitable. The IRS splits potential ETA offers into two situational categories—economic hardship and public policy or equity grounds.

Economic hardship is a consideration for those able to pay the tax debt but doing so would impair their ability to cover typical and necessary household and living expenses.

For example, a taxpayer might be able to pay their tax bill in full by selling their home, but they would then incur unaffordable housing expenses due to high rental prices in their area.  In such a case, the IRS would not require that the taxpayer to sell their home because doing so could result in the taxpayer qualifying for federal or state financial living assistance. Put another way, little may be gained if collecting the full amount of the tax debt places the taxpayer in need of governmental support to cover basic necessities.  

Public policy or equity offers are most often accepted when “collection in full would undermine public confidence that the tax laws are being administered in a fair and equitable manner.” For an ETA to be accepted based on public policy grounds, the taxpayer must have acted reasonably, remained in compliance, and must demonstrate that the criminal or fraudulent act of a third party is directly responsible for the tax liability. Additionally, the compromise must not place the taxpayer in a better position than they would have been by timely and fully meeting their filing and payment obligations. Offers of this type are commonly for any tax balance that would have been owed if the taxpayer had filed their tax return and paid any tax balance due on time.

For example, assume that a taxpayer has historically paid all taxes timely and in full. However, for the prior year the taxpayer discovers that a third-party payroll service wrongfully failed to withhold and pay all required payroll taxes and misappropriated the money. Upon learning of the payroll service’s wrongful actions, the taxpayer immediately took steps to calculate and pay the missed tax payments but was unable to do so.

An offer based on public policy to waive penalties and interest for the missed payments may be appropriate because the taxpayer’s actions were reasonable, and the taxpayer would not be in a better financial position if the offer were accepted. In other words, the taxpayer would still need to pay the same taxes owed as though they filed their return and made the tax payment on time.  

Doubt-as-to-Collectability with Special Circumstances Offer (DCSC)

A DCSC OIC is a specific type of agreement proposed to the IRS by a taxpayer who cannot fully pay their tax liabilities. This type of OIC is based on the premise that the taxpayer's income and assets are insufficient to cover the total amount owed, and there are additional extenuating circumstances that further impact the taxpayer's ability to settle their tax debt.

Special circumstances that are typically considered for this type of OIC include:

  • Serious illness or disability that impacts earning capacity or causes significant medical expenses;
  • Advanced age that may affect income potential and financial resources; or
  • Other factors that would make full payment of the tax liability cause significant hardship, such as situations that affect the taxpayer’s ability to earn a living or meet basic living expenses.

The IRS will consider special circumstances when determining the taxpayer’s Reasonable Collection Potential (RCP), which is the amount the IRS believes it can reasonably collect from the taxpayer’s assets and income. If the RCP, considering the taxpayer’s special circumstances, is less than the full amount of the tax liability, the IRS may accept the OIC.

What is the process for establishing an Offer-in-Compromise?

Establishing an OIC involves several steps including:

  1. Determine Eligibility: Before applying, ensure that you have filed all required tax returns and have received a bill for at least one tax liability included in the offer. You cannot be in an open bankruptcy proceeding.
  2. Choose the Type of OIC: Decide if your OIC will be based on doubt as to collectability, doubt as to liability or effective tax administration. If you're considering a doubt as to collectability with special circumstances offer, be prepared to demonstrate those circumstances.
  3. Complete the Necessary Forms: For most taxpayers, this includes Form 433-A (OIC) for individuals or Form 433-B (OIC) for businesses and Form 656. If disputing the tax debt’s validity, Form 656-L may also be necessary.
  4. Calculate Your Offer Amount: This involves determining your reasonable collection potential, which is based on your assets, income, expenses and future earnings potential. Any offer must represent the most the IRS can expect to collect before the remainder of the 10-year collection statute expires.
  5. Submit Your Offer Package: Include the completed forms, your calculated offer amount, the application fee (if applicable), and the initial payment towards your offer amount. The application fee is $205, which may be waived for low-income taxpayers, and the initial payment will vary depending on the payment option chosen: lump sum or periodic payment.
  6. Wait for IRS Review: The IRS will review your offer, which includes verifying the information provided, assessing your ability to pay, and considering your overall compliance history. This process can take several months and often exceeds 8-10 months before the IRS issues a decision.
  7. Respond to IRS Requests: The IRS may request additional information or documentation during their review. Promptly responding to these requests is crucial to ensure that the IRS does not return the offer.
  8. IRS Decision: If your offer is accepted, you must comply with all the terms of the offer, including staying current with all filing and payment requirements for the next five years. If rejected, you have the right to appeal the decision within 30 days.
  9. Payment: Upon acceptance, follow through with the payment terms as outlined in your accepted offer. This will either be a lump-sum payment or periodic payments based on what was selected during the application process.

It’s important to note during the review processes discussed above the IRS will typically suspend collection actions, but penalties and interest will continue to accrue until the tax liability is fully settled. Given the complexity of the OIC process, taxpayers should seek the assistance from tax professionals.

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