Editor: Mark G. Cook, CPA, MBA
Procedure & Administration
Since 2008, with the decline in the U.S. economy, the IRS has seen an increase in requests for offers in compromise from financially strapped taxpayers. An offer in compromise (OIC) is a form of administrative relief offered to financially distressed taxpayers with outstanding tax liabilities who are unable to satisfy their obligations to the government. Taxpayers who can demonstrate an inability to pay their tax liabilities in full may qualify for an OIC, which will settle the outstanding taxes for a fraction of the original amount owed. While an OIC may seem like a dream come true, the reality is that most taxpayers do not meet the requirements to qualify. Out of approximately 57,000 OICs received by the IRS in 2010, roughly 14,000 were accepted (IRS Publication 55B, Internal Revenue Service Data Book, 2010, Table 16). This item addresses the rules and requirements for an OIC, focusing on the importance of maintaining a strict accounting of one’s assets.
Qualifying for an Offer in Compromise
Under Sec. 7122(a), taxpayers may request a compromise with the IRS to settle outstanding tax liabilities for less than the full amount owed. To qualify for an OIC, taxpayers must prove that the outstanding tax liabilities exceed the amount of income and assets available to satisfy such liability during the time remaining in the collection period (i.e., statute of limitation). This is known as establishing the taxpayer’s reasonable collection potential (RCP), which is how the IRS measures a taxpayer’s ability to pay and includes the value that can be realized from the taxpayer’s assets.
The IRS may accept an OIC under one of three bases:
- There is doubt that the taxpayer will be able to satisfy the full amount of the tax liability within the statutory collection period;
- There is doubt about the accuracy of the assessed tax liability; or
- The taxpayer demonstrates exceptional circumstances such that collecting the full tax liability would create economic hardship or would be unfair and inequitable.
OICs are administrative “safety valves” that release the economic pressure of burdensome tax liabilities on financially distressed taxpayers. They are typically encouraged when it is in the best interests of both the taxpayer and the government to promote equity and voluntary compliance with the tax laws.
Reasonable Collection Potential and Dissipated Assets
Notwithstanding the IRS’s willingness to cooperate with legitimately afflicted taxpayers, it denies more than 75% of claims filed. The low rate of acceptance is typically due to taxpayers having a high RCP in relation to their outstanding tax liability. The RCP and the tax liability have an inverse correlation: the higher the taxpayer’s RCP, the lower the taxpayer’s chances of qualifying. In calculating the RCP, the IRS takes into account current and potential earnings, as well as the value of assets exceeding those needed for necessary living expenses. The sum of the taxpayer’s income and assets is treated as available to satisfy the taxpayer’s federal tax liability.
Many taxpayers have ventured to dispose of their assets for purposes of qualifying for an OIC. However, a number of federal and Tax Court cases support the IRS’s practice of including dissipated assets in the RCP calculation. A dissipated asset is defined as any asset (liquid or nonliquid) that has been sold, transferred, or spent on nonpriority items or debts and that is no longer available to pay the tax liability. IRS examiners have the authority to include dissipated assets in an RCP calculation to advance the government’s interest in tax administration and policy.
The Tax Court recently decided two cases upholding the IRS’s rejection of OICs where it was shown that the taxpayers had disposed of assets that would otherwise have been available to satisfy their outstanding tax liability. In Tucker, T.C. Memo. 2011-67, the individual taxpayer’s request for an OIC was denied when the examiner included dissipated assets, which resulted in an RCP sufficient to satisfy the outstanding tax liability within the statutory collection period. The taxpayer was aware of his unpaid tax liabilities when he transferred funds into an online brokerage account to engage in day trading. The IRS determined, and the Tax Court held, that the money was lost in disregard of the taxpayer’s outstanding liability. But for the failed investments, the taxpayer’s RCP exceeded his outstanding tax liabilities, and the court held that the settlement officer did not err in determining that the taxpayer could fully pay his federal income tax liabilities.
Dissipated assets are not limited to those lost through negligence or disregard of one’s tax liabilities. In Layton, T.C. Memo. 2011-194, the taxpayer’s request for an OIC was rejected after the IRS examiner included the excess balance of an IRA distribution in the RCP calculation. The taxpayer had been unemployed for several years and had liquidated an IRA account to help pay her necessary living expenses. The remaining balance of the taxpayer’s IRA distributions, however, went to pay other nonessential debts. The taxpayer was not able to demonstrate that the debts she liquidated were necessary living expenses, so the Tax Court ruled in favor of the IRS.
The taxpayer in the Tucker case challenged the IRS’s rejection of the OIC, alleging that the examiner abused her discretion in considering the money lost on investments for purposes of the RCP. The Tax Court ruled in favor of the IRS, holding that “when an Appeals officer has followed IRS administrative guidelines to ascertain a taxpayer’s reasonable collection potential and has rejected the taxpayer’s OIC on that ground,” the Tax Court has generally found no abuse of discretion.
The IRS has issued guidelines for all examiners evaluating OICs. Internal Revenue Manual Section 184.108.40.206 provides the following factual considerations or queries that examiners must analyze to determine whether the taxpayer has dissipated an asset and it is includible in the RCP:
- When an asset was dissipated in relation to the OIC submission (generally, the value of assets dissipated more than five years before the OIC submission will not be included in the RCP);
- If an asset was used by the taxpayer to pay for existing ongoing business operating expenses, the funds should not be considered to be a dissipated asset;
- When the asset was dissipated in relation to the liability;
- How the asset was transferred;
- Whether the taxpayer realized any funds from the asset transfer;
- How any funds realized from the disposition of assets were used; and
- The value of the assets and the taxpayer’s interest in them.
Offers in compromise are important taxpayer safeguards that preserve the integrity of our system of taxation. Through adherence to strict guidelines and regulations, such as those discussed above, the general constituency can be assured that every taxpayer is bearing his or her fair share of the cost of government. As the court stated in Tucker, “conscientious taxpayers would object—and the system would suffer—if a noncompliant taxpayer with overdue taxes and with money in hand could spend his money on ‘non-priority items’ and nonetheless effectively obtain forgiveness of his liability simply by proving in the collection context that he really did reduce his collection potential by wasting the assets.”
Mark Cook is a partner at SingerLewak LLP in Irvine, CA.
The editor would like to offer a special thanks to Christian J. Burgos, J.D., LL.M., for his assistance with this column.
For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.