Editor: Valrie Chambers, Ph.D., CPA
Procedure & Administration
In May 2012, the IRS published new guidelines for its offer in compromise (OIC) program (IR-2012-53) as part of its expansion of the “Fresh Start” program. The Fresh Start initiative, first announced by former Commissioner Douglas Shulman in February 2011, has consisted of a series of initiatives designed to help taxpayers resolve delinquent federal tax liabilities and is a response to the current difficult economic climate.
In addition to new OIC guidelines, other changes in IRS collection processes have included easier access to installment agreements, increased thresholds for federal tax liens, and improved processes for removing liens. The new OIC guidelines, which are focused on the financial analysis used in determining a taxpayer’s eligibility, should significantly increase the number of taxpayers who qualify for an OIC.
The major guideline changes included:
- Revising the calculation of the taxpayer’s future income;
- Allowing taxpayers to pay student loans and delinquent state and local taxes;
- Expanding the types of allowable living expenses; and
- Narrowing the parameters for including dissipated assets in calculating future income.
Calculation of Future Income
Before the new guidelines were issued, the IRS would look at four years of future income in calculating a taxpayer’s reasonable collection potential for offers that would be paid in five or fewer months. Under the new guidelines, this has been reduced to one year of future income. For offers paid in six to 24 months, the future income period has been reduced to two years, down from five years. This change in future income periods could result in a reduction of 60% to 75% in the amount required to be paid, depending on the time period in which the OIC will be settled.
Example 1: Taxpayer A has monthly income of $5,000, allowable expenses (also expanded under the new guidelines) of $4,500, and no assets of any value. If all other OIC qualifications were met and the OIC was paid within five months, A would have had to pay $24,000 ($500 × 48) under the old guidelines. The required payment amount using the new calculations would be only $6,000 ($500 × 12).
Changes in Allowable Expenses
In determining a taxpayer’s ability to pay, income is reduced by allowable living expenses. The calculation of allowable living expenses employs national standards that are designed to provide consistency and fairness in collection proceedings. However, in many cases, the national standards have resulted in unrealistic financial analysis and overstated the taxpayer’s true ability to pay. In recognition of this issue, the revised guidelines have changed the calculation and greatly expanded the definition of allowable living expenses.
Monthly payments for delinquent state and local taxes are now allowed in determining reasonable collection potential. However, the amount of these delinquent taxes that is permitted is a ratio of taxes owed (including penalties and interest) to the state and the IRS. Generally, the calculation works as follows:
Example 2: Taxpayer B owes delinquent income taxes (including penalties and interest) of $100,000 to the IRS and $20,000 to a state. Of the combined total liabilities ($120,000), 83% is owed to the IRS (100,000 ÷ 120,000), and 17% (20,000 ÷ 120,000) is owed to the state. Further assume that, after calculating B’s reasonable collection potential without regard to the outstanding state tax liability, the IRS has determined that B has $300 per month in disposable income. The IRS would allow monthly payments of $51 to the state (17% of $300) with the remainder ($249) going toward the federal tax liability.
Additionally, minimum payments on student loans guaranteed by the federal government for post-high school education are now allowable living expenses. However, such payments will only be considered if they are actually being made. Hardship exceptions for nonpayment of student loans are permitted.
A miscellaneous allowance is also provided for in the national standards. Taxpayers are now allowed to include credit card payments as well as bank fees and charges when calculating the miscellaneous allowance.
Dissipated assets are no longer included in calculating a taxpayer’s reasonable collection potential. A dissipated asset is an asset that has been sold, transferred, encumbered, or otherwise disposed of and, therefore, is no longer available to pay delinquent federal taxes. However, a dissipated asset will be included in determining reasonable collection potential if it can be shown that the asset was disposed of within six months before or after the tax assessment in an attempt to avoid payment of taxes or was used for purposes other than to pay items necessary for the production of income or the health and welfare of the taxpayer or the taxpayer’s family.
For example, if a taxpayer withdrew assets from an IRA or other investment account to pay for items such as a vacation or child’s tuition, the value of that asset may be included when determining reasonable collection potential. The IRS will generally use a three-year lookback period from the date the OIC was submitted to determine whether a dissipated asset should be included in the reasonable collection potential calculation.
In addition to the above changes, equity in income-producing assets will generally not be included in calculating reasonable collection potential. However, to be excluded, the assets must be critical to the operations of a viable and ongoing business. Obviously, income from business assets will continue to be included in reasonable collection potential. The IRS provides two examples in the Internal Revenue Manual (IRM) that demonstrate the interplay between using the equity or the income from business assets in calculating reasonable collection potential.
Example 3: Trucking company C has 10 trucks. Eight of the trucks are fully encumbered, and two trucks have no encumbrances and $30,000 in equity. The two trucks with no encumbrances generate net income of $12,000 per year. The income from these two trucks would be added in calculating the taxpayer’s reasonable collection potential, but the equity would not be included (IRM §22.214.171.124.1).
However, if in the above example, the two unencumbered trucks generated only $1,000 per year in net income, the calculation of the taxpayer’s reasonable collection potential might produce a different result. If the business could successfully operate without these two trucks, the IRS would consider including the equity of these trucks and excluding the income in determining reasonable collection potential (IRM §126.96.36.199.1).
OIC Acceptance Rates Improve
The above changes in financial analysis for OICs should increase the number of financially troubled taxpayers qualifying for relief from delinquent federal taxes. In her Fiscal Year 2013 Objectives Report to Congress, National Taxpayer Advocate Nina Olson acknowledged improvements in the IRS acceptance rate of OIC cases. According to her report, the IRS accepted 26% more offers in March 2012 than in March 2011, and the number of accepted offers doubled when compared with the first two quarters of 2010. She further noted that as of March 2012, “the offer acceptance rate of 38 percent is the highest we have seen in many years.”
The IRS, as part of its Fresh Start program, has made many changes and improvements to the OIC process. Significantly more taxpayers will qualify for OIC relief under these new procedures.
Many CPAs, discouraged by the historically low acceptance rate of OICs, restrictive national standards, and length of time to resolve cases, have avoided representing taxpayers in the OIC process. With the expansion of allowable expenses and other taxpayer-friendly improvements to the calculation of reasonable collection potential, practitioners who represent financially troubled clients with delinquent federal tax liabilities should look to the OIC as a truly viable relief option.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, Texas. Danny Snow is managing director with CBIZ MHM Thompson Dunavant in Memphis, Tenn. Prof. Chambers is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. Mr. Snow is a member of the AICPA Tax Executive Committee. For more information about this column, contact Prof. Chambers at email@example.com.