Eliminating IRS
Tax Debts -
Why Tax Bankruptcies
are better than Offers in Compromise to eliminate
tax debts
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 IRS determines that there is "doubt
as to liability" for the debt or "doubt
as to collectibility" of the debt. OIC's based
on "doubt as to collectibility" 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 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 IRS verifies the financial information submitted
by the taxpayer, 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 IRS determines
it would otherwise ever collect. But if 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. IRS uses these calculations
regardless of the taxpayer's actual living expenses
(the figures are available at http://www.irs.gov/individuals/article/0,,id=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 IRS determines
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 not by 48). The product comprises the first part
of the taxpayer's "reasonable collection potential".
Realizable equity is determined, roughly speaking,
by taking the asset's fair market value and reducing
it by 20% (at 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 "processible".
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; 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 IRS with everything about his financial
situation which is simply a roadmap for IRS to now
take (better) enforced collection action.
If the offer is accepted, he 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 liabilities
in full. Failure to live up to this challenge means
the accepted OIC is then terminated, IRS keeps all
monies previously paid under the OIC, and the taxpayer
owes the rest of the original problem as well as
the new tax problem.
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 problems. 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 were another
option that can 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.
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 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
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 the impact
of the filing is.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
keeping his homestead; otherwise he would emerge
without personal liability for the tax debts but
the lien would attached 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 returns. Prior to
the Crafts decision, a tax lien of just the husband
did not attach to any part of a husband and wife's
property owned by the entireties. Now thanks to the
Crafts decision a lien for such a debt attaches to
half the property owned by the husband and wife as
tenants by the entirety.ii
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, 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. For example, with this type of bankruptcy,
the debtor keeps all his assets and repays most of
his debts by adoption 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 rather than non-priority.
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. 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 nondischargeable to dischargeable.
A tax debt is not dischargeable on the petition
filing date if:
- In the case of non-income taxes:
- It is a liability for collected and unpaid sales
taxes; or
-
It is a Trust Fund Recovery Penalty; or
-
It is a trust
fund tax or related penalty or interest (such as
owed by a sole proprietorship);
- 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:
- A return iii was
filed iv for
the year in question;
- The return was filed more than two years ago
v;
- The return was "due" (including extensions)
more than three years ago vi;
- The tax was assessed
more than 240 days ago; vii and
- 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
they tax debts are large enough that failure to discharge
them would render the taxpayer/debtor is 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 obtain relief from IRS as well.
FINAL ANALYSIS
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
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 protection
is usually a better course of action for clients
with large tax debts than the filing of an OIC because:
- OIC's factor in the debtor's income while bankruptcies
do not.
Advantage BK
- OIC's factor in future income potential while
bankruptcies do not.
Advantage BK
- OIC's factor in
asset equity including equity to which IRS has
no legal claim, such as equity of the taxpayer/debtor's
souse, while bankruptcies do not.
Advantage BK
- OIC's do not resolve
state income tax debts while bankruptcies do.
Advantage BK
- 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?
i United States v. Craft, 535 U.S. 274 (2002).
ii In the author's opinion, a claim for malpractice
could be made against a tax preparer who has married
clients file joint income tax returns when the facts
show that one of the spouses would have had little
or no tax debt had they filed separately rather than
jointly (except in those cases where the tax is to
be paid in full). By filing jointly, all of the income
and assets of that spouse who would otherwise not
have a tax debt are exposed needlessly to IRS. A
better course of action is to file separate returns
because, even after Craft, one-half of the homestead
would be protected from IRS.
iii What is a "return"? It includes
not only the form 1040 but also any other legal IRS
document that the taxpayer signed signifying his
or her agreement with the liability after participating
in a meaningful way with the determination of the
liability. A "return" does not include
a substitute for return (a/k/a "SFR")
prepared by IRS under 26 USC §6020(b) which
allows IRS to assess a liability based on information
known to it (via forms w-2 and 1099). With this liability,
IRS can commence collection actions but these are
treated as tax debts arising from unfiled return
for dischargeability purposes under bankruptcy law.
But see 11 USC §523(a)(1) (B)(ii) added by BAPCPA
which seems to state that the "return" requirement
is also met by the filing of an "equivalent
report or notice." A case addressing this issue
is currently before the US Bankruptcy Court, Middle
District of Florida, Orlando Division.
iv "Filing" a return means that delivery
was accomplished. Filing is not accomplished by placing
the return in the mail. That is why hand delivery
or certified mail with return receipt requested is
preferable. It can save the day where IRS loses a
return.
v Recent legislation and case law says that the
various time periods stated above are "tolled" for
any time the IRS was precluded from taking collection
action against the taxpayer, such as due to having
filed a previous bankruptcy or by exercising certain
appeals rights under the Internal Revenue Code. Add
to this tolling period an additional 90 days.
vi See the previous endnote.
vii The "240-day rule" asks whether
the assessment was made within the 240 days prior
to the petition date, but you must also add to the
240 days both (i) the entire time an offer in compromise
was pending or in effect if the offer was filed within
the 240 days, plus 30 days, and
(ii) if a prior BK case was in effect during the
240 days, then add in the entire time a stay was
in effect against IRS during that 240 day period,
plus 90 days.
Part (ii) in the preceding sentence was added by
BAPCPA. Prior to that see In re Collins that states
all of the time periods are extended by the amount
of time IRS was held at bay by the filing of a prior
bankruptcy. Further, that case added one hundred
eighty (180) days (roughly 6 months), not 90 days.
viii One can only assume that such figure is misleadingly
low as it cannot include the number of OIC's "submitted" by
taxpayers that were not determined to be "processible".
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