An Offer in Compromise (OIC) is a powerful tool that allows taxpayers to settle their tax liabilities for less than the full amount owed. But how does it work, and can you really qualify? Let's explore this opportunity for tax relief.

What is an Offer in Compromise?

An Offer in Compromise (OIC) is an agreement between a taxpayer and the Internal Revenue Service that settles a taxpayer's tax liabilities for less than the full amount owed.

Why Would the IRS Accept Less Than the Full Amount Owed?

Congress passed a law requiring the IRS to have a program to assist taxpayers who are unable to pay the full amount of their tax liability. If you do not have the ability to pay the full amount of the tax, the IRS will accept an amount offered that is equal to or greater than the Reasonable Collection Potential (RCP). RCP is the amount a taxpayer is required to offer, and it is how the IRS measures the taxpayer's ability to pay.

How is Reasonable Collection Potential Determined?

The RCP calculation includes the value that can be realized from the taxpayer's assets, such as real property, automobiles, bank accounts, and other property. In addition to property, the RCP also includes anticipated future income less certain amounts allowed for basic living expenses. So, the formula for reasonable collection potential is equity plus future income (or excess net monthly income).

Understanding Your Equity

There are many nuances in determining RCP. Three of the numerous nuances will be mentioned below. Don't worry, you do not have to sell your home or any other assets. Equity in assets is only used to determine the amount you must offer; you don't need to sell the assets. After this amount is determined you can take a loan from family or friends to pay the IRS and keep the assets.Remember to account for the discount for assets. The value of assets is determined by using what IRS calls "Quick Sale Value" (QSV), which is an estimate of the price a seller could get for the asset in a situation where financial pressures motivate the owner to sell in a short period of time, usually 90 calendar days or less. QSV is usually calculated at 80 percent of fair market value. A higher discount may be applied if the value chosen represents a fair estimate of the price a seller could get for the asset in a situation where the asset must be sold quickly (usually 90 calendar days or less). In this case, an independent appraisal would be required.

1. Real Estate

Pay close attention to real estate, like your home. For real estate and other related property held as tenancies by the entirety (generally, a married couple) when the tax is owed by only one spouse, the taxpayer's portion is usually 50 percent of the property's Net Realizable Equity (NRE). Real Property acquired by married people is usually held as tenants by the entirety but be sure to check that out.Here is why even if you have equity in your home, you may still qualify for an offer. When the property does not appear to have been transferred into the tenancy to avoid tax collection, a determination may be made to reduce the taxpayer's NRE to less than 50 percent based on the difficulty in liquidating or borrowing against the taxpayer's share of the asset. So, if one cannot borrow due to bad credit and a hypothetical sale of the real estate will lead to an economic hardship, then the equity may be reduced or eliminated completely.

2. Retirement Plans

Funds held in a retirement plan are considered assets and must be valued for offer purposes. Here is a huge benefit:If the plan may not be borrowed against or liquidated until separation from employment and the taxpayer has no ability to access the funds within the terms of the offer, and the taxpayer is not eligible to retire until after the period for which future income value is being calculated, then the plan has no equity for OIC purposes. That is correct, the equity is excluded from consideration.

3. Business Interests as a Going Concern

The value of a business may be worth more than the sum of its individual assets when sold as a going concern. The difference between what an ongoing business would realize if sold on the open market as a going concern and the traditional RCP analysis of its individual assets is attributable to intangible assets, which must be included in the computation of RCP.But there are two exceptions which may exempt the value or part of it from the computation of RCP:A. Generally, the value of a business as a going concern would not be included in RCP of a viable, ongoing business, unless the value is substantially greater than the income produced by the business. For example, the taxpayer operates a business which holds a liquor license which is transferable and valued at $100,000. The net income from the business is $1,000 per month. The value of the liquor license must be included in RCP, but the taxpayer's net income must be adjusted and/or anticipated additional expenses allowed.B. When determining the equity to include in RCP for an individual taxpayer who has an interest in a business entity, consideration should be given to the taxpayer's control over the business.The value of a business may be substantially decreased or even eliminated as a result of the above two provisions.

How Much of Your Future Income Can You Offer?

Generally, future income is gross income, minus necessary living expenses for a specific number of months into the future. The number of months depends on the payment terms you choose:

1. If you choose to pay the offer in 5 months or less, then the future income will be the gross income less necessary living expenses for 12 months into the future.

2. If you choose to pay the offer in 6 to 24 months, the future income will be the gross income less necessary living expenses for 24 months into the future.

Note: If you have no equity or a low amount of equity, do not choose to pay in 6 to 24 months, because you will be extending the payment for a longer period, and multiplying excess income by 24, not 12.Tip: There are many ways to determine monthly gross income, including 3-year averaging if your income fluctuates, or the current year's income in which you file the OIC if there has been a change in circumstances, such as a new job or other event affecting your income earning capacity.

Necessary Living Expenses

Necessary Living Expenses are those that are necessary for the health and welfare of the taxpayer's family or for the production of income:

1. Food, clothing and miscellaneous household expenses, called National Standard Expenses, are limited by table depending on family size. There is no need to substantiate the amount spent.

2. Housing expenses, including rent or mortgage payment, utilities and other housing payments, are allowed but they too are limited by a table amount. The housing and utilities standards are derived from U.S. Census Bureau, American Community Survey and Bureau of Labor Statistics data, and are provided by state down to the county level. The standard for a particular county and family size includes both housing and utilities allowed for a taxpayer's primary place of residence.

3. Transportation expenses, including ownership costs and operating costs are allowable against gross monthly income. Ownership costs are limited by table and are based on the national costs of ownership. Operating costs are limited by table but are (local) based on region of the country.

Tip: The National and local expense standards (tables) are guidelines, and deviations are allowed, but reasonable substantiation must support the deviation.

1. Other expenses may be allowed in determining the value of future income for offer purposes. The expense must meet the necessary expense test by providing for the health and welfare of the taxpayer and/or their family or must be for the production of income. This is determined based on the facts and circumstances of each individual case.

2. Health insurance and other out of pocket costs are allowed deductions.

   
   

Three Main Types of Offers in Compromise (OIC)

1. OIC based on doubt as to collectability by IRS.

2. OIC based on Hardship.

3. OIC based on the Effective Administration of the tax system.

Doubt as to Collectibility Offer

Notice: An offer may be accepted for less than the RCP when special circumstances are present. Generally, special circumstances are:

1. Economic Hardship

2. Equity grounds

3. Public policy consideration

Economic Hardship Offer

Economic hardship occurs when a taxpayer is unable to pay reasonable basic living expenses. The determination of a reasonable amount for basic living expenses will vary according to the unique circumstances of the individual taxpayer.Note: Because economic hardship is defined as the inability to meet reasonable basic living expenses, it applies only to individuals (including sole proprietorship entities).

1. An economic hardship means that the taxpayer's income does not provide for payment of basic living expenses.

2. In addition to the basic living expenses, consider other factors that impact the taxpayer's financial condition which may include:

   
   

   A. The taxpayer's age and employment status

   B. Number, age, and health of the taxpayer's dependents

   C. Cost of living in the area the taxpayer resides

   D. Any extraordinary circumstances such as special education expenses, a medical catastrophe, or natural disaster

In economic hardship cases, an acceptable OIC amount is determined by analyzing the financial information, and the hardship that would be created if certain assets, or a portion of certain assets, were used to pay the liability.

Effective Tax Administration Offer

Major Tip: Don't give up because you can qualify for an OIC even if you can fully pay the tax liability. This OIC is called an Effective Tax Administration offer (ETA).The IRS may compromise a tax liability to promote effective tax administration where the taxpayer can identify exceptional circumstances that are so unfair that collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner.The ETA OIC is allowed where tax liabilities should not be fully collected even though:

1. The tax is legally owed, and

2. The taxpayer has the ability to pay it in full.

Generally, a physical or mental disability or illness where the taxpayer was unable to attend to financial matters during the time of the illness would qualify one for an ETA OIC.Due to the complex nature of the subject matter involved in this type of OIC, it is recommended that a tax professional be contacted to assist you.

Basic Requirements to Qualify

• All tax returns must be filed.

• All required estimated tax payments, if any, for the current year must be made.

• A business with employees must be current with federal tax deposits for the current and two preceding quarters.

• File Form 656 and pay application fee.

Should You Use the IRS Offer in Compromise Pre-Qualifier?

1. The quick answer is to be aware that in many instances the Pre-Qualifier will not provide an accurate result, informing you that you do not qualify when you in fact do.

2. This is because there are many instances where exceptions to the usual rules to determine RCP apply. These exceptions frequently are deciding factors. For example, the pre-qualifier does not take into account deviations from standard allowable expenses, if the table limits are insufficient for you to pay your basic living expenses. If you own a primary residence jointly with your spouse, under certain circumstances, you could exclude 50% of the amount that could be realized from that asset.

Can You Afford an Offer in Compromise?

Yes! Because you are only required to pay what you can afford (or have the ability to pay, called RCP).

Payment Options

The amount calculated as your ability to pay can be paid either as a:

1. Lump-sum offer which must be paid within five months of the offer acceptance.

2. Periodic payment offer which must be paid within six to 24 months.

3. In a lump sum offer, twenty percent (20%) of the amount offered must be paid with the application.

4. In a periodic payment offer, an initial periodic payment installment must be paid with the application, and subsequent periodic payments must be made based on ability to pay.

You Will Have a Continuing Obligation

You must remain current by filing future tax returns and paying taxes timely for five years after acceptance of the offer.

Tips

• "Offer in Compromises are a viable means of resolving a tax liability depending on the circumstances present in your financial life."

• "There are many special circumstances that will qualify you even when it appears in the first instance that you do not qualify."

• "It is a misnomer that if you have equity in an asset, such as your home or business, that you will not qualify for an offer, because you may be able to exclude that equity from RCP due to an economic hardship."