The Time May Be Right for an Offer in Compromise

In ordinary times, an offer in compromise is rarely in a taxpayer’s best interests.  Most offers in compromise are ultimately not accepted by the IRS.  During the pendency of an offer in compromise, the 10-year collection statute of limitations is suspended on the subject tax assessments.  The IRS is taking upwards of a year to respond to an offer in compromise, and process it.  If the IRS rejects the offer, and the taxpayer appeals the rejection, the IRS Appeals Office will take upwards of a year to process the appeal.  An offer that is not ultimately accepted thus significantly prolongs the time the IRS has to collect the subject tax.  And the taxpayer is out the professional fees incurred in making the offer.

But these are not ordinary times.  An offer in compromise is not about making a deal.  The IRS has no interest in making a deal.  An offer in compromise is about the IRS collecting the maximum it can from a taxpayer—the net value of the taxpayer’s assets.  Many taxpayers’ net worth has dropped precipitously in the coronavirus pandemic. 

An offer in compromise is about the taxpayer’s balance sheet.  The IRS will not accept an offer in compromise in an amount less than the fair market value of the taxpayer’s assets.  The fair market value of a bank or brokerage account is the account’s current balance, except that the IRS allows an individual taxpayer to exclude the first $1,000 in cash.  The fair market value of a retirement account is the account’s current balance, less tax and penalties which the taxpayer would incur on receiving distribution of the balance.

For this purpose, the fair market value of a tangible asset, such as real property or a vehicle, is the forced sale value of the asset, less the amount of any security interest or mortgage encumbering the asset with priority to the Federal tax lien.  The forced sale value of a tangible asset equals 80 percent of the asset’s fair market value. 

The IRS adds a phantom asset to the taxpayer’s balance sheet.  It is the excess of the taxpayer’s actual monthly income, over the taxpayer’s allowable monthly expenses, multiplied by a factor.  The factor depends on how long the taxpayer plans to take to pay the offer if it is accepted.  If the offer is a cash offer, i.e., if the taxpayer commits to pay it in five monthly installments, or faster, after the offer is accepted, the factor is 12.  If the taxpayer plans to take up to 24 monthly installments to pay the offer, the factor is 24.

IRS collection financial standards determine the taxpayer’s allowable monthly expenses.

For example, assume that Husband and Wife have not had enough income tax withheld from their wages, and have not paid in enough estimated taxes, over the years, and that they owe Federal income tax totaling $400,000.  Husband and Wife have two minor children.  Husband and Wife own one car.  The monthly payment on the car is $550.  The balance due on the car exceeds the value of the car. 

Husband and Wife lease a second car.  The monthly payment on the lease is $600.

The mortgage balance on Husband and Wife’s home exceeds the house’s fair market value.  The monthly payment on the mortgage is $3,500.

Husband and Wife have $3,000 in a joint checking account.  Husband has a vested balance of $10,000 in an account with his employer’s 401(k) retirement plan.

Husband and Wife nave monthly household gross income of $15,000.

Husband and Wife’s monthly expenses, both actual and as limited by the IRS collection financial standards, follow:

Food, clothing, miscellaneous$1,935$1,740
Housing and utilities4,1002,267
Automobile operation1,1001,042
Automobile ownership1,150628
Out-of-pocket health care240224
Health insurance900900
Accountant/attorney fees300300
Retirement plan contribution450450
Monthly minimum payments on credit cards  600  600
Current taxes (Federal and State income tax and FICA tax withheld from wages)  
                                                        Total   $10,401

Tuition or costs for attendance at college or private school are not expenses allowed by the IRS.

The IRS should not include a modest retirement account balance in a taxpayer’s net worth for offer in compromise purposes, but it does.  However, the taxpayer should reduce the retirement account balance by the Federal and State tax and penalties the taxpayer would incur upon receiving distribution of the retirement account balance.

The minimum acceptable offer in compromise from Husband and Wife is $64,888, as follows:

Bank account balance, $3,000, less $1,000$2,000
Vested balance in 401(k) account, $10,000, less estimate of tax and penalties that would be incurred on receiving distribution of same, $3,000    $7,000

Excess of monthly actual gross income, $15,000, over allowable monthly expenses, $10,401, or $4,599, multiplied by 12

Minimum acceptable offer$64,888

If household income were cut in half or worse, Husband and Wife’s allowable expenses would remain constant, except that current taxes would be proportionately reduced.  As a result, there would be no excess of monthly actual gross income over allowable monthly expenses, and Husband and Wife’s minimum acceptable offer would be $9,000.  Husband and Wife could pay it in five monthly installments or faster.

Surely the flood of offers in compromise induced by the coronavirus pandemic will further slow IRS responses.  Employment regained by the time the IRS works an offer in compromise could vitiate the offer.  The employment reductions we are seeing in the wake of the pandemic appear to be of indefinite duration, i.e., the recovery will be “U”-shaped rather than “V”-shaped.  It is in the best interests of such a taxpayer to strike while the iron is hot, and file an offer in compromise and have it worked by the IRS and accepted before regaining full employment.  A taxpayer certainly should file an offer in compromise, or otherwise act to avert IRS collection action, before the IRS resumes collection action on July 15, 2020.   

Stephen J. Dunn

Tax and Estate Planning Attorney and Author