GUTIERREZ , CPA, PhD, is associate professor of
accounting, University of Northern Colorado, Greeley. |
MYRON HULEN , PhD, is associate professor of accounting, Colorado State University, Fort Collins.
T he Internal Revenue Service introduced its compliance 2000 program in 1990 to reduce taxpayer burden, increase voluntary compliance and improve overall IRS productivity. One specific goal was to increase collections on accounts receivable, which had grown to $111 billion by the end of fiscal year 1991. To this end, the IRS revamped its offers in compromise (OIC) policy (acceptance by the IRS of less than full payment when it is unlikely a tax liability can be collected in full) in March 1992 to make it a more viable collection tool. The new policy simplified the process for both taxpayers and the IRS. Although the number of offers made by taxpayers and accepted by the IRS has increased significantly since 1992, the acceptance and recovery rates varied considerably from district to district. One reason for the variance was taxpayer uncertainty in how to determine the amount of allowable living expenses. In 1995, the IRS revised its manual to provide guidelines of ranges and amounts allowed as necessary living expenses to make it easier for taxpayers to make acceptable OICs. This article reviews the guidelines and discusses the practical implications for tax practitioners.
HOW OFFERS WORK
When a taxpayer is unable to pay his or her tax liability in full, the IRS has several collection alternatives from which to choose. It prefers to encourage taxpayers to convert available assets to cash to pay taxes. If a taxpayer is unwilling or unable to transform assets to cash, the IRS typically initiates enforcement actions. Its choice of collection tool depends on the facts and circumstances of a particular case. The IRS may accept OICs when accounts cannot be collected in full but still have some collection potential from existing assets, future income or both. The IRS uses OICs when installment agreements are not a viable option and it believes there is still some potential to collect something from the taxpayer.
Taxpayers use of OICs increased dramatically after the IRS simplified the application process in 1992. However, taxpayers remained uncertain about acceptable living expenses and the IRSs inflexibilities in life-style change expectations, which continued to make the OIC program an unacceptable option for many who could not fully pay their tax liabilities. The 1992 IRS guidelines were intended to alleviate some of these problems and expand OIC use to a broader range of delinquent taxpayers. Taxpayers can make OICs for tax liabilities, penalties and interest when there is doubt about collectibility or liability. Most cases involve doubt about collectibility. It is the taxpayers responsibility to initiate the offer and to determine how much to offer.
An adequate offer has four components:
1. The amount payable from the taxpayers assets.
2. The amount payable from the taxpayers current and future income.
3. The amount payable from third parties, such as amounts collectible from a transferee to whom assets were given for less than adequate consideration after a tax liability was incurred.
4. The amount the taxpayer should reasonably be expected to
raise from assets he or she has an interest in but that are beyond the
reach of the government, such as property located outside the United
The 1992 guidelines relate to the first two elements and are described in greater detail below.
Amount payable from assets. In determining the amount payable from a taxpayers assets, CPAs should consider the value of all assets less encumbrances—such as home mortgage debt—that have priority over the federal tax lien. The liquidation or quick sale value of an asset should be used—the amount that would be realized if financial pressures cause a taxpayer to sell an asset in a short period of time.
The IRS made a major improvement in the guidelines when it established a one-year rule for changes in a taxpayers life-style after it accepts an offer. Previously, the IRS expected taxpayers to change their life-styles immediately to live within the confines of what it allowed as necessary living expenses. This was not always practical or even possible. For example, a taxpayer whose house payment exceeded a "reasonable amount" would be expected to move to less expensive lodging. The requirement to move was not necessarily unreasonable but the expectation that it happen immediately was. Houses often cannot be sold or rented immediately.
The 1995 guidelines provide a list of expenses the taxpayer may have to modify or eliminate within the one-year period. Transportation is one such expense. Excessive purchase or lease payments for luxury cars that do not meet the necessary expense test of providing for health and welfare or the production of income may be modified or eliminated within the one-year period. Unnecessary private school or university education expenses normally are allowed until the end of the current school year. Taxpayers have one year to reduce excessive housing expenses. In determining whether housing expenses are excessive, the IRS considers the costs involved in breaking or acquiring new leases, moving and selling a house. The one-year rule provides time for an orderly liquidation of the taxpayers assets to pay debts and to adjust ones life-style downward.
Amount payable from current and future income. In determining the amount a taxpayer can pay from future income, the IRS allows him or her to deduct necessary living expenses—the expenses that provide for the taxpayers (and his or her familys) health and welfare or for the production of income. The old guidelines did not provide dollar amounts to be used in determining what was reasonable. As a result, significant variations in OIC acceptance and recovery rates occurred from district to district. For example, in 1993 the acceptance rates ranged from a low of 19% in the California Laguna Niguel district to a high of 79% in the Mississippi district, with a nationwide average of 53%. Compromise recovery rates ranged from $.03 on the dollar in the Utah district to $.31 on the dollar in the New Hampshire district, with a nationwide average of $.15. Because of the variations between districts and a General Accounting Office report that the IRS was permitting high-income taxpayers excessive amounts of necessary living expenses, the IRS provided new guidelines to determine such expenses.
Necessary living expense guidelines. The Internal Revenue Manual was revised on August 29, 1995, to provide IRS collection personnel with more specific guidelines to analyze a taxpayers financial condition and determine the appropriate collection tool to use in resolving a case when immediate collection is not possible. This involves calculating the amount of disposable income available to apply to the tax liability.
The guidelines provide standards that must be used to determine monthly amounts of allowable necessary expenses. Three categories of necessary expenses are included: national standards, local standards and other necessary expenses. National standards include necessary expenses for food, housekeeping supplies, apparel and services, personal care products and services and miscellaneous. Specific dollar amounts for the first four expenses come from the Bureau of Labor Statistics consumer expenditure survey and are stratified by income level and family size. The IRS established the amounts for miscellaneous expenses as discretionary amounts of $100 per month for one person and $25 for each additional person. It allows taxpayers the maximum amount for their income levels unless they can substantiate and justify larger amounts as necessary. Monthly national standards for a family of four are included in exhibit 1, page 58.
Local standards vary geographically and include necessary expenses for housing and transportation. The IRS national and district offices developed these monthly standards, which allow taxpayers the local standard or the amount actually paid, whichever is less. Exhibit 2, page 59, contains the local transportation standards for the Northeast region and a sample of the local housing standards established for Colorado.
No standards exist for other necessary expenses. Taxpayers and their CPAs must determine and justify the expenses necessary for their health and welfare and/or production of income. The IRS employee responsible for a case decides whether the expense is necessary and reasonable in amount. Exhibit 3, at right, includes a list of the national and local standards and other necessary expenses that are defined in the Internal Revenue Manual.
The manual defines the other necessary expenses listed in exhibit 3. For example, charitable contributions must be a condition of employment or provide for a taxpayers (or his or her familys) health and welfare to be considered necessary. Education is deemed necessary only if it is a condition of employment or is for a physically or mentally handicapped dependent who cannot be educated in public schools. The IRS also may consider other expenses for health and welfare and/or production of income not described in the manual.
A final necessary expense discussed in the manual is unsecured debts. Minimum payments on unsecured debts are allowed if they meet the necessary test. For example, payments to suppliers and on lines of business credit required for the production of income are necessary payments. Also, payments on debts incurred to pay a federal tax liability also are necessary unless the payments are to friends or relatives. Payments on other unsecured debts are not considered necessary and the IRS will disallow them.
THE PRACTICAL IMPLICATIONS
The revised guidelines make the OIC process less onerous. They reduce some of the uncertainty about what the IRS will allow as an acceptable amount of necessary living expenses and perhaps offer a viable alternative to bankruptcy if taxpayers are willing to make some life-style changes. Tax practitioners can play an important role in advising clients of their options when they become delinquent in paying their federal taxes. Practitioners should recommend an OIC when taxpayers cant fully pay within a reasonable period of time.
CPAs should advise taxpayers of some of the pitfalls and negative
aspects of OICs.
1. Taxpayers must comply fully with all filing and paying requirements for five years. This means that in addition to making all payments on the OIC for delinquent liabilities, taxpayers have to stay current with all other taxes. If they do not, the IRS will treat their offer as in default and reinstate the balance of the original delinquent liabilities.
2. The IRS will suspend the statute of limitations on collection for the periods of time the offer is under consideration, the time the amount offered remains unpaid and for one year after the amount offered is fully paid. When the statute of limitations for collection is about to expire, the OIC may not be the best payment alternative. For example, if the IRS has classified a taxpayers account as currently uncollectible, that taxpayer would benefit from allowing the statute of limitations to expire rather than initiate an OIC.
3. All accepted OICs are available for public inspection for one year after acceptance in the district office where the taxpayer resides. A taxpayers name, amount of tax debt compromised and amount of offer accepted are made public. If confidentiality is an issue, an OIC may not be a viable alternative.
4. If the IRS accepts an OIC, neither the IRS nor the taxpayer can reopen the case to further protest the amount of liability unless the taxpayer has falsified or concealed assets or there is a mutual mistake of a material fact. Taxpayers should not file OICs if they intend to file amended returns with regard to any tax, interest or penalties.
5. Payments on unsecured debt are limited. Minimum payments are allowed if a taxpayer substantiates and justifies the payment as necessary for health and welfare and/or production of income. Such a restriction renders payments on most unsecured debt as unnecessary and not allowable. Taxpayers risk further deterioration of their credit ratings if they cannot make payments on unsecured debt.
For most taxpayers, perhaps the largest obstacle to making an OIC is the often dramatic life-style change they must make before the IRS will accept an offer. Even though taxpayers are allowed one year in which to modify their standards of living, they often find such a downward adjustment in life-style unpalatable. See exhibit 4, above, for examples of allowable national and local standards for a family of four in Denver. If a family earns gross income of $2,500 to $3,329 per month, the total allowable expenses equals $2,696. With monthly gross income of $5,830 or more, the same family of four would be allowed a maximum of $3,224. This is an increase of only $528 relative to an increase in income of $2,501 or more. The larger the income, the larger the downward adjustment in the allowed standard of living.
Is the revised OIC process working? While it is still too early to know whether the revised standards are having the desired effect, the number of offers increased significantly from 52,127 in 1994 to 133,598 in 1996. To further improve the process and increase the number of processible offers, the IRS revised Form 656, Offer in Compromise, and its instructions in February 1997. These revisions should make OICs more user-friendly and further increase the programs effectiveness.
A MORE VIABLE OPTION
The IRS guidelines on acceptable living expenses make OICs far more attractive than previously. What once was a little-used payment tool by taxpayers is now a much more viable option. Both the IRS and taxpayers should benefit from the changes. IRS collections should increase as taxpayers who cannot pay their taxes in full find it less painful to make acceptable OICs. Tax professionals should be aware of the new standards and should advise clients of the availability of OICs in appropriate cases.