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When your client receives notices from the Internal Revenue Service ("IRS") regarding their outstanding tax liabilities they will typically contain a demand for full payment These notices create a lot of stress and intimidation for your client Accordingly, it is important that you understand that there are several alternatives available to your client, depending upon their economic and financial status, which do not require them to make full payment of the total outstanding liability.
For example, the client may consider filing bankruptcy if his/her financial woes meet the requirements for a bankruptcy filing. It is imperative when counseling a client with regards to a bankruptcy filing to ensure that all outstanding liabilities are dischargeable pursuant to 11 U.S.C. §523 and §507. Additionally, the taxpayer may make a request to the IRS to delay the collection of the outstanding tax liability based upon his/her inability to make payments on the outstanding liability. Examples of hardship recognized by the IRS include terminal illness or large medical bills; incarceration of the taxpayer or primary wage earner, receipt of welfare payments or unemployment; or where the taxpayer's income does not exceed their necessary living expenses It is important to remember that although the collection of the outstanding liability is temporary placed on hold; the interest and penalties associated with the liability still continue to accrue Additionally, the IRS can reevaluate the taxpayer's ability to make payments and reinstitute the normal collection procedures if they determine that the taxpayer's financial circumstances have improved. Examples of hardship recognized by the IRS include terminal illness or large medical bills; incarceration of the taxpayer or primary wage earner, receipt of welfare payments or unemployment; or where the taxpayer's income does not exceed their necessary living expenses
It is important to remember that although the collection of the outstanding liability is temporary placed on hold; the interest and penalties associated with the liability still continue to accrue Additionally, the IRS can reevaluate the taxpayer's ability to make payments and reinstitute the normal collection procedures if they determine that the taxpayer's financial circumstances have improved. Alternatively, the taxpayer may enter into an installment agreement with the IRS wherein monthly payments are made against the total outstanding liability Finally, the taxpayer has the option of entering into an offer-in-compromise whereby the IRS agrees to comprise the total outstanding liability for less than the total amount due
The installment agreement and the offer-in-compromise programs are the most widely applicable and common payment alternatives Accordingly, these two payment alternatives and the applicable procedures for entering into these arrangements are discussed in more detail below.
Internal Revenue Code ("IRC") Section 6159 provides authorization for the IRS to enter into installment agreements with taxpayers Specifically, Section 6159 provides that the IRS may enter into an installment agreement with a taxpayer if the IRS determines that the agreement will "facilitate full or partial collection" of the total outstanding liability. 26 U.S.C. § 6159(a) (2006) However, there are many procedural steps that must be taken in order to enter into an installment agreement Additionally, in most circumstances the IRS has full discretion in determining whether to accept a taxpayer's request to enter into an installment agreement.
In certain circumstances, however, the IRS is required to enter into an installment agreement Specifically, I.R.C. § 6159(c) provides that the IRS must enter into an installment agreement if the taxpayer's total outstanding liability does not exceed $10,000 and the taxpayer has not, during the last five years, failed to file returns or pay tax shown on the return, or entered into another installment agreement. 26 U.S.C. §6159(c)(2). Additionally, the taxpayer must also have the ability to make full payment of the total outstanding liability within three years and must agree to comply with all provisions of the I.R.C. while the agreement is in effect. Id. at (c)(3)-(5) Installment agreements entered under the provisions of I.R.C. §6159(c) are called Guaranteed Installment Agreements.
Additionally, the Internal Revenue Manual ("I.R.M.") Section 220.127.116.11 provides that the IRS will enter into an installment agreement when the taxpayer owes $25,000 or less so long as the taxpayer can fully pay the total outstanding liability within 60 months (5 years) Installment agreements entered under these provisions are called "streamlined installment agreements".
Accordingly, except in cases where the total outstanding liability is $25,000 or less, the IRS has complete discretion in determining whether to accept a taxpayer's request for an installment agreement Accordingly, it is essential that the advisor and the taxpayer understand the information the IRS will need to make its decision, as well as the procedures that the IRS is likely follow when evaluating a request for an installment agreement.
Current with Reporting and Filing Obligations
The IRS will generally not accept an installment agreement if the taxpayer is not current with all reporting and payment obligations for the current year. I.R.M. §18.104.22.168.1 Accordingly, an advisor should ascertain the taxpayer's filing status before requesting an installment agreement If the advisor becomes aware of the taxpayer's failure to make required estimated tax payments or failure to file a return, the advisor must advise the client to get into compliance before requesting an installment agreement
Preparation of Financial Information
The IRS will require that a taxpayer provide financial information regarding their assets and liabilities before the IRS will enter into an installment agreement The IRS will request that the taxpayer furnish this financial information on IRS Form 433-A, Collection Statement for Individuals and/or IRS Form 433-B, Collection Statement for Businesses Generally speaking, a self-employed or independent contractor should prepare both the IRS Forms 433-A and B.
These forms are very detailed and may take a taxpayer a great deal of time to prepare In addition to the information requested on the actual form, the taxpayer must also supply substantiation for each of the assets and liabilities reported on the forms Specifically, the taxpayer must provide statements for all their expenses, such as electric bills, telephone bills, insurance bills, etc Additionally, the taxpayers must also provide the IRS will at least three months of bank statements for each of their checking and savings accounts
Once the IRS receives these forms, they will analyze them to determine whether the taxpayer has the ability to full pay the liability by borrowing against the equity in any of their assets; whether the taxpayer can sell any extravagant assets to satisfy the outstanding liability, and also the taxpayer's cash flow If the IRS determines that the taxpayer has the ability to borrow against some equity in their assets, or to sell assets, they may be less likely to accept the taxpayer's request for an installment agreement, and may demand full payment On the other hand, if the IRS's analysis of the financial information reveals that the taxpayer does not have adequate equity to borrow against their assets, the IRS will analyze their cash flow to determine the monthly installment amount.
Calculation of Monthly Installment Amount
The IRS will analyze the information prepared by the taxpayer on IRS Forms 433-A and/or B and determine the taxpayer's cash flow The cash flow analysis includes the comparison of the taxpayer's monthly expenses against the monthly income to determine a reasonable amount for the monthly installment agreement Generally, the IRS will not allow the installment agreement to be based upon the taxpayer's actual monthly expenses Rather, the IRS will base the installment agreement on the IRS's national standard living expenses These national standards are broken down by different geographic locations and provide for the standard living expense for taxpayer's and their families (The IRS provides the charts illustrating the national standards on the IRS website, http://www.irs.gov). Accordingly, the IRS will determine the national standards expenses applicable to a taxpayer and subtract them from the taxpayer's monthly income The difference between the income and expenses will be the monthly installment agreement.
However, the use of national standards for expenses is not a hard and fast rule Specifically, the IRS will allow the taxpayer's actual monthly expenses if the taxpayer can show that they can full pay the total outstanding tax liability within five years and still stay current in all paying and filing requirements and the expense amounts are reasonable. I.R.M. §22.214.171.124(5) Additionally, the IRS will give taxpayers one year to modify or eliminate excessive necessary expenses, such as a high mortgage payment, if the taxpayer cannot pay their total outstanding liability within five years It is important that an advisor understand these provisions because it is my experience that the IRS will not voluntarily apply the one year rule when determining the installment agreement amount.
Once the IRS determines the proposed installment agreement amount they will generally present the proposed amount to the taxpayer for pre-approval Once the taxpayer consents to the proposed installment agreement amount, the IRS will review the taxpayer's credit report to ensure all information reported on the IRS Forms 433-A and B was accurate Lastly, the installment agreement will be submitted to an IRS manager who will review the installment agreement and determine whether the monthly payment was accurately calculated After the manager has approved the installment agreement, the IRS will send the taxpayer a written notice indicating the approval of the installment agreement The taxpayer will then decide how the installment payments will be made (i.e. direct debit from taxpayer's account, payroll deductions, or direct payment)
If the IRS denies the taxpayer's request for an installment agreement, the taxpayer can appeal this decision within thirty (30) days of the denial During the pendency of the appeal, the IRS is forbidden from issuing levies against the taxpayer 26 U.S.C §6331(k).
Advantages and Disadvantages of Installment Agreement
When advising a client with respect to the installment agreement it is important to convey both the advantages and disadvantages of an installment agreement A few of the major advantages and disadvantages are discussed below.
One of the major advantages of an installment agreement is that the taxpayer does not have to make full payment of the total outstanding liability Additionally, the IRS may not levy on the taxpayers wages or accounts while the request for an installment agreement is pending, while the installment agreement is in effect, for thirty days after the agreement is rejected, for thirty days after the agreement is terminated, and while an appeal of a default, termination or rejection is pending or unresolved. I.R.M. §126.96.36.199(1) Furthermore, I.R.C. §6651(h) provides that the failure to pay penalty for taxpayers who filed a return on or before the due date for the return will be halved while the installment agreement is in effect
The major disadvantage of the installment agreement is that the interest and penalties associated with the underlying tax liability still continue to accrue despite the existence of the installment agreement Additionally, the IRS will typically always file a Federal Tax Lien prior to entering into an installment agreement in order to protect its interest in the total outstanding liability. I.R.M. §188.8.131.52.2(1) Finally, the IRS has the ability to review the installment agreement periodically and increase the payment amount if the taxpayer's financial circumstances have improved.
An offer-in-compromise ("OIC") is a binding agreement between the taxpayer and the IRS in which the IRS agrees to compromise the total outstanding liability of the taxpayer for a decreased amount I.R.C. Section 7122 provides authority for the IRS to enter into these types of agreements Similar to the general installment agreement, the IRS has complete discretion when deciding whether to grant a taxpayer's request for an offer-in-compromise
I.R.C. Section 7122 provides three grounds for which the IRS may grant an OIC: (1) doubt as to liability of the tax owed, (2) doubt as to collectability of the full amount, and (3) promotion of the effective tax administration. Treas. Reg. §301.7122-1(b) (2006) The procedures for applying for an is discussed fully below.
Current with Reporting and Filing Obligations
Similar to installment agreements discussed above, the IRS will not grant an OIC unless the taxpayer has filed all tax returns that he/she was required to file including all income tax, employment tax, excise tax, along with all required Partnership, Limited Liability Corporations, or closely held Sub-Chapter S Corporation returns
IRS Form 656-Offer-in-Compromise
Regardless of the grounds for the offer-in-compromise, the IRS will require the taxpayer to submit the request for an OIC on IRS Form 656-Offer-in-Compromise This form must indicate the grounds for the offer-in-compromise request (i.e. doubt as to liability, doubt as to collectability, or effective tax administration) The taxpayer is required in input the offer amount and indicate whether they will pay the offer in one of the three possible payment plans, (1) cash offer where the total offer amount is paid within 90 days, (2) Short-Term Deferred Payment Offer wherein the taxpayer agrees to pay the offer in more than 90 days but less than 24 months from the acceptance of the offer, or (3) Deferred Payment Offer in which the taxpayer agrees to pay the offer amount over the remaining life of the collection statute
For OICs submitted based upon the doubt as to collectability or for effective tax administration, the IRS requires that the taxpayer also include an IRS Form 433-A and/or 433-B Similar to the installment agreement, the taxpayer must include substantiation for each of the expenses and income items listed on the 433-A or B The IRS will review the 433-A and/or B in order to determine the reasonableness of the offer amount
Explanation of Circumstances
If the taxpayer is submitting the OIC on grounds of doubt as to liability the taxpayer must also include an explanation as to why they believe they do not owe the tax The IRS Form 656 provides space for the taxpayer to make this statement.
Amount of Offer
The calculation for an OIC offer amount is different depending on the type of OIC For example, a doubt as to collectability OIC must include an offer amount that equals or exceeds the reasonable collection potential amount The doubt as to liability OIC offer amount should be based upon the taxpayer's calculation of the correct tax, penalty, and interest Finally, the effective tax administrative OIC offer amount should be based upon the actual amount of tax the taxpayer is able to pay
Reasonable Collection Potential Amount
The IRS will not accept an OIC based upon doubt as to collectability that is not at least equal to the reasonable collection potential amount The reasonable collection potential amount equals the net equity of the taxpayer's assets plus the amount the IRS could collect from the taxpayer's future income
Total value of taxpayer's assets
The offer amount takes into account the quick sale value of the taxpayer's assets including automobiles, real estate, and personal assets such as jewelry and furniture The quick sale value of these assets is determined by multiplying the current value of each asset by 80% and subtracting out the loan balance for each asset The total quick sale value of the taxpayer's assets along with any cash or savings (including IRAs and insurance policies) are included within the reasonable collection potential amount as the net equity of the taxpayer's assets.
Taxpayer's income available for payment
The offer amount, similar to the installment agreement calculation, also includes the difference between the taxpayer's income and necessary living expenses The IRS will typically only apply the national standard expenses when determining whether to accept an OIC However, the IRS does have some discretion in determining whether to allow the taxpayer's actual expenses Specifically, I.R.C. §7122(d)(2)(B) provides that IRS may use the taxpayer's actual expenses if the officer or employee determines that the use of the national standards will result in the taxpayer not having adequate means to provide for basic living expenses
The total amount of income is then multiplied against either 48 months (three years) or 60 months (five years) depending on the payment option selected by the taxpayer for payment of the offer amount Specifically, if the taxpayer has the ability to make a cash offer in which he/she makes full payment of the total offer amount within 90 days of acceptance, then the total income is determined based upon three years However, if the taxpayer chooses the short-term deferred offer, in which the taxpayer pays the offer in full within 24 months, the income is determined based upon five years
The calculation for the reasonable collection amount can be illustrated with the following example Taxpayer A is an individual residing in Columbus, Ohio with two children Taxpayer A has a total outstanding tax liability of $120,000 The taxpayer has the following assets:
Taxpayer A also has the following income and expenses.
Short-Term Deferred Offer
Liquidation of Assets
Liquidation of Assets
Total Living Expenses
Total Living Expenses
Reasonable Collection Potential Amount
Reasonable Collection Potential Amount
Accordingly, based upon the example set forth above, the reasonable collection potential amount for a cash offer would be $36,700 and for a short-term deferred offer would be $43,900
Application Fee & Down payment
All OICs submitted to the IRS must be accompanied by both an application fee of $150 as well as a down payment equal to 20% of the total offer for all cash or lump-sum offers, or a payment equal to the first proposed offer amount for the short-term deferred offer indicated on the IRS Form 656 These down payment requirements were enacted pursuant to the Tax Relief Extension Reconciliation Act of 2005, which became law May 17, 2006 This down payment requirement was enacted in order to ensure that taxpayer's submitting OICs had the actually ability to make full payment of the offer and to ensure that the OIC was not being used as a tool to defer collection
A taxpayer may appeal a rejection of an OIC if the taxpayer files a request for review within 30 days of the rejection of the OIC The appeals process is an administrative review
Advantages and Disadvantages of the OIC
There are many advantages to entering into an OIC with the IRS, including the reduction of the total amount of outstanding tax liability owed Another significant advantage is the hold on all collection enforcement actions such as levies and garnishments while the OIC is being processed
Alternatively, there are notable disadvantages associated with the OIC Specifically, the newly enacted down payment requirements make it nearly impossible for many taxpayers to qualify for the OIC due to their inability to secure that much money without assurances that that IRS will accept the OIC Additionally, the IRS is not fond of the OIC program, and more often than not rejects taxpayer's attempt to get into an OIC, accordingly, the costs associated with applying for an OIC often outweigh the perceived benefits Furthermore, when a taxpayer submits an OIC the statute of limitations for collections is tolled during the period in which the IRS is prohibited from levying against the taxpayer. Treas. Reg. §301.7122-1(i)(1). Accordingly, if the IRS takes an entire year to evaluate the OIC the normal ten year statute of limitations is extended for an additional year.
The client's financial circumstances, their ability to borrow against any equity in their home or business, and their ultimate goals with respect to handling of their outstanding tax liabilities are all important factors in determining what payment options is the best alternative Based upon the typical taxpayer who doesn't have the ability to borrow against equity in their home or business, and who does not have a financial safety net in a savings account or insurance policy, the installment agreement most likely provides the best alternative However, the OIC is advantageous to those taxpayers who have low liquidation value of their assets and low income available for payments but who have enough of a reserve to make the requisite down payment and application fee Once you understand the application process and the necessary information required for both the installment agreement and the OIC you can better advise your client as to the appropriate payment option.
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About the Author
Ms. Herron, Esq., is an associate at Terrence A. Grady & Associates Co., LPA in Columbus, Ohio, where she focuses primarily on civil and criminal tax controversy and white collar defense Ms. Herron is admitted to practice in the State of Ohio, the United States Tax Court, and the United States District Court of the Southern District of Ohio Ms. Herron is an active member in the American Bar Association in both the Young Lawyers Division and the Tax Section and the Ohio and Columbus Bar Associations.