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IRS: offer in compromise.

The effects of the economic downturn of the past several years have been felt in all sectors of the economy. Businesses and workers have seen a decline in income, an increase in unemployment and a generally difficult business environment.

Apparently no one is immune, not even the Internal Revenue Service. In an effort to increase collection of outstanding tax liabilities--liabilities that have steadily grown over the last several years--the Service has issued new guidelines concerning the little-known Offer In Compromise procedures. The new guidelines are intended to increase the use of these procedures to partially collect unpaid taxes under certain circumstances.

As part of this effort, the IRS Collection Division has developed a four-day training program for its revenue officers to increase awareness of these procedures and to encourage the processing of more acceptable offers. The following is a discussion of the new Offer in Compromise guidelines and the potential relief they may provide.

Offer in Compromise -- What is it?

As most experienced business people know, they will encounter situations where an accounts receivable cannot be collected in full or there is a dispute as to the amount owed. At times, it is prudent business practice to resolve these receivable issues through a compromise or partial collection. The creditor receives at least part of the amount due while allowing the debtor a "fresh start."

Generally, the Internal Revenue Service has shied away from actively encouraging delinquent taxpayers to settle disputes or potentially uncollectible accounts by making an offer of partial payment in lieu of the full balance. Standard procedure has been to have Collection Division personnel determine if the liability was collectible. If collectibility exists, the Collection Division is empowered to take the necessary steps to collect the account in full. In addition to standard efforts at collection (requests for payment by the revenue officer), the Collection Division may resort to liens, levies and seizure of assets.

If the taxpayer lacks the ability to pay in full immediately, revenue officers are encouraged to resolve the liability using a long-term installment agreement. To secure a long-term installment agreement, the taxpayer will have to submit detailed financial statements. The revenue officer will review the financial statements to initially determine if, in fact, immediate full payment is not possible and if there is potential for collection of the liability by way of the installment agreement.

Although on the surface this may seem to resolve the issue, this procedure often involves disadvantages for both parties. For the Service, an installment agreement does not represent full collection; in fact, the downpayment on an installment agreement usually represents a small portion of the total liability. The potential for future default of the agreement still remains. The taxpayer often signs this agreement as a last resort with the subsequent payment schedule protracted and burdensome, often resulting in delinquencies of future tax liabilities. If, however, the Service determines that the taxpayer lacks the ability to pay in full and an installment agreement is not feasible, the Collection Division will discontinue collection activity, in effect "writing off" the account.

An alternate procedure is the Offer in Compromise. An Offer in Compromise is a formal offer by the taxpayer to make a partial payment in lieu of the full tax liability. If accepted by the Service, the taxpayer is relieved of all past tax liabilities covered by the offer. As stated previously, the Service has not publicized or otherwise encouraged this avenue of settlement. However, with the dramatic increase in the number of delinquent accounts coupled with the decline in the ability of businesses and individuals to settle accounts in full, the Service is instructing its field collection personnel to be receptive to offers to settle liabilities via partial payment. To convey this new philosophy to collection personnel and the public, the Service has issued Policy Statement P-5-100

There are several points in this statement that should be stressed:

* The statement declares that Collection personnel will accept offers when tax cannot be collected in full and the offer "reasonably reflects collection potential." Taxpayers should keep in mind that there is no judicial review for Offers in Compromise. Therefore, to decrease the potential for rejection, the offer should not be frivolous and should be a "best effort" to resolve the liability in light of the amount of the debt and the ability to pay.

* The Statement highlights the point for collection personnel that Offer in Compromise is an acceptable collection procedure.

* The statement directs collection personnel to assist in preparing the required forms and documentation. Although the taxpayer is responsible for the first offer, the statement implies that if this initial offer is rejected, further negotiation will occur. This is a departure from the past, when offers were rejected without explanation or negotiation.

* The statement encourages collection personnel to make "prompt and reasonable" decisions.

* The taxpayer, once the offer is accepted, is expected to comply with all "future filing and payment requirements." Violation of this provision could result in withdrawal of the acceptance and collection action for full payment.

Offer in Compromise Procedures

IRC Sec. 7122 allows the Secretary of the Treasury to compromise any "civil or criminal case arising under the internal revenue laws prior to reference to the Department of Justice." Under Sec. 7122 and the guidelines developed by the Collection Division, a taxpayer can make an "Offer in Compromise" as a full settlement of an outstanding liability. The payment may be immediate or on a deferred basis. The liabilities could have arisen as a result of an audit or from a delinquency of tax payment, such as estimated taxes or employment taxes. The Service receives unpaid taxes it might not otherwise collect. The taxpayer gets a "fresh start," with prompt resolution of their tax problems. Taxpayers are given the opportunity to move past tax problems into voluntary compliance.

The taxpayer initiates the offer process by executing Form 656, Offer In Compromise. To be processable, an offer must contain the following:

* Full identification of the taxpayer: Liabilities arising from joint returns should include the names of both spouses.

* Identification of the liability: All unpaid tax liabilities must be listed and can involve more than one type of tax.

* Amount and terms of offer: The actual amount being offered along with terms of payment should be specifically stated.

* Appropriate signatures: All parties named in the offer must sign. A designated agent may sign for the taxpayers.

* Basis for compromise: The taxpayer is encouraged (though not required) to provide a written, detailed statement of the facts and reasons that support the acceptance of the offer. These facts must relate to doubt as to the liability, the collectibility or both (to be discussed in detail later in this article).

* Complete financial statements: A completed collection information statement, Form 433A, 433B or any other financial statement, as long as it conforms with information required, must be included.

* Amount of offer: The offer must reasonably reflect collection potential or it will be rejected.

As stated previously, there are two acceptable grounds for the offer: 1) doubt as to liability, or 2) doubt as to collectibility.

Doubt as to Liability

In an offer based on doubt as to liability, the taxpayer must show that the calculation of the liability itself is not correct. This is not an easy argument to sustain, as one would assume that pertinent facts questioning the liability would have been brought forward prior to collection action. Situations that could give rise to doubt as to the liability are:

* A tax deficiency arising from old years where records are not available to rebut the Service's tax calculations.

* An assessment arising where the taxpayer failed to respond to a statutory notice of deficiency, thus forfeiting appeal rights.

* Where the taxpayer has insufficient funds to pay the tax but failed to timely file a petition for tax court (thus limiting judicial review to court of claims where full payment is required prior to legal action).

* 100% penalty cases where there is a valid doubt as to responsibility and willfulness. In all cases where there is doubt as to liability, the Collection Division will consult with the Examination Division in evaluating the offer.

Doubt as to Collectibility

Doubt as to collectibility is a basis for compromise when the taxpayer presents evidence that raises doubt as to the ability to pay the liability in full, either currently or in the foreseeable future. The revenue officer will evaluate the taxpayer's ability to pay, taking into consideration the taxpayer's financial condition. Assets will be evaluated as to market and liquidation value and ownership interest (joint with others). Interest in partnerships, closely-held corporations and trusts as well as assets available to the taxpayer that are beyond the reach of the Service will also be considered.

With respect to the last item, it is important to keep in mind that if the Service determines there are sources of funds that, while not directly owned by the taxpayer, are yet available, the Service is likely to reject the offer. In this instance the Service will take the position that the taxpayer could pay in full with the available funds. An example cited in the guidelines is where a married taxpayer has a separate liability and his or her spouse has extensive personal assets.

Among the assets that will be considered available to satisfy the liability are:

* Bank accounts, including security deposits and escrow funds;

* Interest in real estate;

* Stocks, bonds and other investments;

* Cash value of life insurance;

* Voluntary contributions to pension plans (401K plans);

* IRA and Keogh plans (the value will be reduced by any penalties and taxes);

* Furniture and fixtures and personal effects;

* Machinery and equipment (including autos); and

* Receivables.

If any assets were transferred by the taxpayer to a third party, the Service will take into consideration the amount collectible from the transferee. Therefore, the offer should include a sum substantially equal to the amount collectible from the transferee. The tax advisor should keep in mind that the burden of proof in a transferee case rests with the government.

The following items are exempt from levy in determining reasonable collection potential:

* Wearing apparel;

* Fuel, provisions, furniture and personal effects allowed by statute;

* Books and tools;

* Unemployment benefits;

* Certain pension benefits;

* Workmen's compensation;

* Child support (but not alimony);

* Disability payments;

* Public assistance payments.

In determining collection potential, the revenue officer will consider the taxpayer's current and future income. There are no guidelines fixing the percentage of a taxpayer's income that must be accounted for in deciding the acceptability of an offer. The Service will attempt to determine how much a taxpayer can realistically pay on a monthly basis. It will then perform a present value calculation to determine the present value of the stream of payments that it determines a taxpayer can make.

Example 1

A taxpayer owes $50,000 and is able to pay $500 per month based upon future income calculations (monthly income of $3,000 less expenses of $2,500). The current interest rate is 9%. In five years (the Service will consider any installment agreement greater than five years to potentially be defaulted) the taxpayer will make 60 payments of $500 for a total of $30,000. Using present value tables for 9% for 60 months, the present value of these payments is $24,285. The Service has indicated in its guidelines that an offer of $24,285 under these circumstances would be accepted.

Under the Offer in Compromise procedures, the taxpayer is responsible for making the initial offer. If the offer is rejected, it will be because the Service believes more can be collected. At this point, the revenue officer will prepare a narrative outlining the reasons for the rejection. If the offer is being rejected on collectibility issues, the narrative will contain a statement of the amount and terms of an acceptable offer.

Advisors should consider that the Service is looking to close these cases as fairly and expeditiously as possible. The Service seems willing to negotiate in order to resolve these liabilities. The guidelines specifically state that, "Rejection of an offer based solely on narrow asset and income evaluation should be avoided. Our goal should be to negotiate a settlement that is in the best interest of all parties while at the same time collecting as much as possible of what is due the Service."

Collateral Agreements

A collateral agreement is a contract executed by the taxpayer with the Service as part of the offer pledging to pay part of the taxpayer's future income above a certain amount agreed to the Service. Generally, the Service is not looking to secure collateral agreements in lieu of immediate payment in the offer itself. However, if the offer is deemed insufficient and the Service feels that there is potential for recovery of significant additional amounts, they will attempt to secure a collateral agreement. This is a departure from past practice where the Service routinely looked to collateral agreement to secure additional tax in the offer. The fact that a collateral agreement is contingent on some future event may explain the Service's reluctance to pursue this avenue of remedy. However, this alternative within the offer process may be advantageous to the taxpayer.

Typical instances that may give rise to a collateral agreement are:

* Evidence of potential substantial increase in a taxpayer's earnings;

* A taxpayer is the only child of wealthy parents and the surviving parent is advanced in years and in poor health;

* A corporate taxpayer has large NOL carryforwards and the current years are profitable (Waiver of Loss agreement).

There are five types of collateral agreements:

1. Future Income; 2. Reduction of Basis; 3. Waiver of Loss; 4. Co-obligor; and 5. Waiver of Bad Debt.

The most common are the Future Income, Reduction of Basis and Waiver of Loss agreements.

A future income collateral agreement creates a potential obligation for the taxpayer to pay a graduated percentage of future income for a specified number of years. The obligation is contingent on the taxpayer's income exceeding a negotiated annual income exclusion. For example, the taxpayer agrees to pay 20% of income in excess of a $60,000 annual exclusion, 30% in excess of $65,000 and 50% in excess of $70,000.

Obviously, the annual exclusion figure is the most significant provision of the future income agreement. This is a negotiated figure taking into consideration such factors as the taxpayer's age, health, occupation, current income, foreseeable trends impacting the taxpayer's profession and an estimate of reasonable expenses. Again, it is important to keep in mind that the annual exclusion figure is negotiable and the advisor should be prepared to support future income and expense calculations and assumptions.

The income figure will include non-taxable items, such as insurance proceeds, gifts, tax exempt interest and inheritances. If the taxpayer is a shareholder in a closely-held corporation, the annual income figure will be increased by the percentage of the taxpayer's interest in corporate income that exceeds $10,000. The usual inclusion brackets are 30% of income above $10,000 but less than $20,000 and 50% of corporate income above $20,000.

Example 2

A is a 50% shareholder in AB Corporation. AB's net income for 1990 is $100,000. Since A is 50% shareholder, $50,000 of AB Corporation's net income will be subject to inclusion in A's annual income calculated as follows:
Income above $10,000 but not exceeding
$20,000 ($10,000 x 30%) $ 3,000
Income above $20,000 ($30,000 x 50%) 15,000
Total $18,000

A figure of $18,000 will be added to A's income for 1990.

A future income agreement is a direct payment agreement. That is, if the taxpayer's annual income exceeds the exclusion amount, a percentage of the excess will be paid to the Service as part of the Offer in Compromise.

Reduction of Basis and Waiver of Loss are indirect payment agreements. By agreeing to reduce basis of assets, the taxpayer will recognize a larger gain on disposition, which will result in a higher tax liability. Waiver of Loss operates in much the same manner. The taxpayer agrees to waive the benefit of net operating losses, capital losses or unused business credits. Again, the potential result is a higher tax liability for the taxpayer in the years covered by the agreement.

Generally, collateral agreements are for a period not to exceed five years. Unlike an installment agreement, a collateral agreement is a contingent obligation dependent on some future event (increased future income, gain on sale of assets, etc.) for payment to be realized. Advisors should keep this avenue in mind, especially in situations where an initial offer has been rejected and the ability to increase the current offer amount is limited.

Accepted Offers

Accepted offers become a binding contract between the parties. The Service will prepare Letter P-673 with copies of the Form 656 and any collateral agreements attached. The terms of the offer payment will be included, specifying dates of payment, interest charges, waiver of losses, etc. Rejected offers may be appealed administratively. However, there is no judicial review of rejected offers.

All accepted offers will require the taxpayer to remain current for all tax liabilities arising subsequent to acceptance of the offer. Failure to do so will result in termination of the offer agreement and immediate collection action.


The new Offer in Compromise guidelines are an attempt by the Service to close out numerous outstanding liabilities in a fair and expeditious manner. This presents an opportunity for the taxpayer to resolve troublesome tax assessments for a fraction of the debt. However, by no means should one believe that the Service will accept any offer merely to close the case. As stated in the guidelines, the offer should "reasonably reflect collection potential." If used properly, the Offer in Compromise procedures will allow the taxpayer a "fresh start" and remove the often-felt anxiety of a potentially troublesome IRS collection action.

Policy Statement P-5-100

The Service will accept an Offer in Compromise when it is unlikely that the tax liability can be collected in full and the amount offered reasonably reflects collection potential.

An Offer in Compromise is a legitimate alternative to declaring a case as currently not collectible or to a protracted installment an agreement.

The goal is to achieve collection of what is potentially collectible at the earliest possible time and at the least cost to the Government.

In cases where an Offer in Compromise appears to be a viable solution to a tax delinquency, the Service employee assigned to the case will discuss the compromise alternative with the taxpayer and, when necessary, assist in preparing the required forms. The taxpayer will be responsible for initiating the first specific proposal for compromise.

The success of the compromise program will be assured only if taxpayers make adequate compromise proposals consistent with their ability to pay and the Service makes prompt and reasonable decisions. Taxpayers are expected to provide reasonable documentation to verify their ability to pay. The ultimate goal is a compromise which is in the best interest of both the taxpayer and the Service. Acceptance of an adequate offer will also result in creating for the taxpayer an expectation of and a fresh start toward compliance with all future filing and payment requirements.

James B. Rosa, CPA, MBA, is an assistant professor of accounting at Queensborough Community College of the City University of New York. Before joining Queensborough, he was employed at the Internal Revenue Service as a revenue agent training manager. He is a member of the AICPA and the New York State Society of CPAs.
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Author:Rosa, James B.
Publication:The National Public Accountant
Date:Jun 1, 1993
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