Given enough time, a federal tax debt can reach astronomical levels. And for taxpayers who are already swimming in the deep end, dealing with a hefty debt to the government might not be in the cards anymore.
While debt forgiveness may be an option, most taxpayers will find that it’s harder to get rid of your outstanding tax liabilities than most other debts. The IRS is a tough creditor, and they have a large toolkit to coerce cooperation.
Thankfully, there are ways out of your debt problem. Under certain circumstances, taxpayers in financial difficulty can try to apply for an offer in compromise to reduce the size of their tax debt, and simultaneously negotiate a payment plan to facilitate the repayment of this new, smaller debt load.
However, qualifying for an offer in compromise is easier said than done. Approval is never guaranteed, and while the IRS has lowered the threshold for approving offers in compromise in recent years through the Fresh Start Initiative, it is still meant as a last resort, rather than a widespread debt resolution method.
What Is an Offer in Compromise?
An offer in compromise is an altered payment plan wherein the debtor to the IRS proposes a smaller debt load that they can manage and pay off within a set period – usually a few years, and no more than the debt’s statute of limitations (10 years from the assessment date, in the case of federal tax debt). The exact number must be proposed by the debtor.
This is your first hurdle as a taxpayer – while you’re free to decide how much you’ll be paying back, the IRS is also free to reject all non-serious offers. Under most circumstances, the IRS expects you to match or exceed your reasonable collection potential (RCP).
To keep things short, your RCP boils down to what you can afford to pay within a given period (say, the next 24 months) based on: your current pay after taxes; the total quick sale value of non-exempt assets and property; and the contents of your bank accounts, minus some money for current day-to-day living expenses. In other words, your RCP would equal your net equity plus your future remaining income.
If your offer to the IRS does not match what they determine to be your RCP based on the information you’ve provided, your offer is likely to get rejected. If your RCP is higher than what you owe to begin with, you’re likely to be asked to fill out the paperwork for a regular installment agreement instead.
If you try to lie about what your equity or income is looking like, the IRS will find out by cross-referencing your information with information reports from financial institutions and income averages for people with similar backgrounds, careers, and living situations.
If your offer matches or exceeds your RCP, however, and all other requirements for an offer in compromise are met (such as being unable to pay off your debt within the next few years with your current income and net equity, being up to date on your current and past tax returns, and continuing to pay your taxes), you may be approved for an offer in compromise.
How Does an Offer in Compromise Work?
An offer in compromise begins with the realization that your tax debt is too great to pay off within the next 72 months, or less. While the collection statute on federal tax debt is 10 years (plus tolling periods), most installment agreements are shorter.
If you figure that your current income is not enough to cover basic living costs and continue to pay your tax debt before it expires, or within five to six years, you may want to talk to a tax professional about your chances of qualifying for an offer in compromise.
At this point, you will need to calculate what you can afford to pay on a monthly basis. Following the changes made to tax relief through the Fresh Start Initiative, qualified taxpayers may pay off their debt in as little as five months, or as long as 24 months – but typically not more.
Obviously, the better the deal for the IRS, the better your chance of getting your offer accepted. Yet even so, it takes time for your offer to be deliberated. The IRS may even continue to apply collection actions against your account until your offer is accepted or rejected.
It’s important to note that, regardless of whether your offer is accepted or rejected, your tax debt continues to grow in the form of penalties and interest while the IRS deliberates your offer.
If the IRS rejects your offer, you have the right to appeal the rejection. It is highly recommended only to do so with the assistance of a legal professional, and under counsel. Otherwise, you may want to consider heading back to the drawing board and drafting an offer with the help of an experienced tax professional.
Once your offer is accepted, you must avoid defaulting on it. This means making your payments on-time – or better yet, agreeing to have the money wired to the IRS automatically each month. The IRS will require you to continue to stay up to date on all taxes and tax returns as you make your payments. Entering a payment plan with the IRS usually also softens your interest rate and penalties.
What Is the Difference Between a Partial Payment Plan and an Offer in Compromise?
Offers in compromise are not the only way to reduce your debt with the IRS. The other method is to avail a partial payment installment plan.
A partial payment installment plan similarly requires filling out a Collection Information Statement and proving that your financial situation cannot sustain your current debt to the government.
The difference is that a partial payment plan requires annual check-ins to determine whether your financial situation has improved. In the case of an offer in compromise, once your offer is accepted and payment begins, your debt is effectively reduced to whatever your RCP was when your offer was first deliberated. With a partial payment plan, your monthly obligations to the IRS may change if your finances improve.
What If You Can’t Pay?
One way or the other, the IRS wants to see taxpayers pay their debts, even if they can’t do so fully. In the rare case that a taxpayer cannot put forward a dime without financial destitution, however, the IRS does offer the ability to file as currently not collectible, until matters change.
A taxpayer who is currently not collectible will have their collection statute halted, and all collection actions stopped, but their debt will continue to grow with interest. The IRS will periodically revisit your case to determine whether you’re capable of entering into a payment plan – if yes, they may place a lien or issue a warning of a levy to encourage payment.