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Does your client owe taxes to the IRS? If so, you probably think the solution to your client’s
nightmare is to simply 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.

OFFERS IN COMPROMISE

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. OIC’s based on
“doubt as to collectability” may be appropriate where the taxpayer admits he owes the tax debt,
but contends he does not have the financial ability to ever pay the amount owed. OIC’s based on
“doubt as to liability” may be appropriate where the taxpayer has the financial wherewithal to
pay the liability claimed as due by the IRS, but contends he does not legally owe the amount
claimed. OIC’s 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 “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, then in most cases an OIC will not be accepted.
A taxpayer’s “reasonable collection potential” is the sum of (i) the present value of the
taxpayer’s ability to make continuous monthly payments to the government, and (ii) 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 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; and 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 http://www.irs.gov/individuals/artic...=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 that 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”.
-2-
Realizable equity is determined, roughly speaking, by taking the asset’s fair market value
and reducing it by 20% (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, where appropriate, Form 433-B (financial
statement for a business) are to be filed along with a $150 (non-refundable) 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).
OIC’s 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 (5) installments of
acceptance. The “short-term periodic payment” offer is one in which the balance will be paid
within two (2) 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 non-refundable check for at least 20% 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 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” whereby he must remain compliant with his tax obligations for the longer of five (5)
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 (i) state income taxes, (ii) credit card debt, (iii) civil
judgments, and (iv) 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 other debts to contend with. 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 federal income tax debts, but
also of any state tax income debts, credit card debts, business debts, and other financial problems
as well.

volcom579

BANKRUPTCY

When we talk about 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 assets when filing chapter 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 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 can’t give away his 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
homestead; otherwise he would emerge without personal liability for the tax debts, but the lien
would attach to the home).
It is important to know the United States Supreme Court held in United States v. Craft,i
that “homestead” is a creature of 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
it 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 Section 6672 of the IRC (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.

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 non-trust 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 non-trust 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, Section 6672 of the Internal Revenue Code imposes 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.

Chapter 7 or Liquidation Bankruptcy

A chapter 7 bankruptcy is the type most frequently thought of by the public. Generally
speaking, in this liquidation-type bankruptcy, the debtor generally loses all his assets and is
forgiven all his debts and is thus rewarded with a “fresh start.”

Chapter 13 or Reorganization Bankruptcy

The Chapter 13 bankruptcy is becoming a more frequently used option for debtors and is
almost the opposite of a chapter 7 bankruptcy. For example, with this type of bankruptcy, the
debtor keeps all his assets and repays most of his debts by adopting a plan of reorganization.
The debtor proposes a plan whereby he devotes his “disposable income” (take home pay less
necessary living expenses) toward the repayment of his debts based on the priority each debt is
assigned. The plan payments are paid for a certain period of time, usually five years. Certain
higher priority debts 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) tax 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 non-priority debt.
Consequences of Dischargeable versus Non-Dischargeable Tax Debts
Tax debts are classified as either dischargeable or non-dischargeable 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 chapter 7 bankruptcy. Those tax debts that are not dischargeable cannot be eliminated in a
chapter 7 bankruptcy and survive to torment the debtor once the proceedings are concluded. In
the case of a chapter 13 bankruptcy, non-dischargeable tax debts must be paid in full during the
course of the chapter 13 repayment plan. Thus, it is important to a debtor that the tax debts have
dischargeable status. Note that some tax debts may be classified as non-dischargeable 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 non-dischargeable to dischargeable.
A tax debt is not dischargeable on the petition filing date if:
1. In the case of non-income 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.
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 returniii was filediv for the year in question;
2. The return was filed more than two years agov;
3. The return was “due” (including extensions) more than three years agovi;
4. The tax was assessed more than 240 days ago;vii and
5. There was no civil or criminal fraud nor did the taxpayer willfully evade or defeat the
payment of the tax debt.
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 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 was before. That is, there
generally is no concern about when to file bankruptcy for purposes of discharging the “usual”
type of debt. But how is the debtor better off, how does the debtor get his “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 is not better off.
In such a situation, the debtor is only better off if the attorney advises him to wait on the
filing of his petition in bankruptcy until sufficient time has elapsed to make the 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 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 actions. Although not pleasant, it is a small
price to pay to also obtain relief from the IRS.

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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 make an OIC. This is so 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 a factor in determining whether a tax debt is dischargeable in a
bankruptcy.
Further, OIC’s 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 OIC’s were “filed.”viii 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 (BK) protection is usually a better course of
action for clients with large tax debts than is the filing of an OIC because:
1. OIC ’s factor in the debtor’s income while bankruptcies do not. Advantage BK
2. OIC’s factor in future income potential while bankruptcies do not. Advantage BK
3. OIC’s 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.
Advantage BK
4. OIC’s do not resolve state income tax debts while bankruptcies do. Advantage BK
5. OIC’s do not help with the “usual” non-tax debts while bankruptcies do. Advantage BK
So, 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?

Mad Finance

thanks for the post! good read.

ken7700

Great information in this article. Many things I did not know that will make me makes much better decisions. Thanks for posting it.

Rabscuttle

is this information still releivent? Does it include the new BK laws?

ken7700

I thought under no conditions you were allowed to put in federal taxes. Or am I missing something here. Could someone explain more details to me and the new bankruptcy laws how different are they now than from the past.

DianaR

I heard the same thing. Federal taxes, along with federally insured student loans, can't be included in a bankruptcy.

Rabscuttle

I've heard that taxes that are so many years old (three/four?) can be cleared with a BK. Considering all the penalties and interest paid on deliquest taxes, after a point the real tax is already paid and the rest is just institutional greed...

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