Howard's IRS and the Law Blog

It is complicated enough to understand when taxes can be discharged in a bankruptcy.  But once it is determined that your taxes can be done away with in bankruptcy, another potential hurdle rears its ugly head:  Bankruptcy means testing.

Means testing determines what type of bankruptcy you qualify to file – Chapter 7, which eliminates debts (including taxes) without repayment, or Chapter 13, which forces you to repay a percent of your debt through a payment plan approved by the bankruptcy court.

Means testing is a financial calculation that “tests” whether your income is higher than the median income for a family of your size in your state.  The purpose of the test is to determine if you make too much money to eliminate your debts without repayment (Chapter 7), and if repayment is appropriate, what the minimum amount should potentially be.  If you “flunk” the test – meaning you make more than the average family – there is a presumption that you can afford to repay your debts (Chapter 13) rather than wipe the slate clean (Chapter 7).

The good news is that a tax debt to the IRS can help you avoid the effects of means testing (yes, owing the IRS can be a good thing).  Here’s why:

The means test applies only to what is known as consumer debts.  Consumer debt is defined in Section 101(8) of the bankruptcy code to be a debt that is primarily incurred by an individual for personal, family or household purposes.  This typically includes debts such as credit cards, home mortgages and car loans.  But not taxes.

If over half of your debt is not consumer debt (taxes), the means testing calculations do not apply. Pass go, collect $200.  You are not subject to bankruptcy means testing.

Example:  You have a mortgage on your house with $120,000 owed, $25,000 of credit cards and a car loan with an unpaid balance of $5,000.  This is $150,000 of consumer debt.  But you also owe the IRS, say, $175,000.  This is not consumer debt.   Your total debt is $325,000, and over half ($175,000) is non-consumer debt.  You can check the box on your bankruptcy petition that the means testing does not apply because the majority of your debt is not from consumer purchases.  (Business debt, like guaranteed loans, are also non-consumer debt.)

There are three distinguishing factors that makes tax debt a non-consumer debt:  Consumer debt is considered to be voluntary; taxes are not.  Taxes are for the public welfare, and consumer debt is for personal and household purposes.  And taxes are imposed on earnings, while consumer debt is based on consumption.  A good court decision on this is In re Westberry, 215 F.3d 589 (6th Cir. 2000).

Tax debt for bankruptcy means testing purposes includes money owed to the IRS and state and local taxing authorities.  When considering bankruptcy, know that your tax debt can help you avoid jumping through hoops.

There are many options to resolve an unpaid tax liability – you can agree with the IRS to make monthly installment payments, reach a settlement with an offer in compromise, eliminate the taxes in bankruptcy, or have the IRS place your account in currently not collectible status.

Let’s focus on currently not collectible.

Currently not collectible status occurs when the IRS agrees that you cannot afford to repay the debt, and doing so would create an economic hardship on you.  It is forbearance by the IRS, a break from enforcement that can last years.

To obtain currently not collectible status, a financial statement must be provided to the IRS listing your household income and monthly living expenses.  If the IRS agrees that – after paying expenses like rent, a car payment or medical expenses – you have no money left to pay them, they will mark your account as uncollectible.

Yes, the IRS will take a back seat to your necessary living expenses, but the expenses have to be reasonable for the IRS to consider you to be in hardship.  The IRS applies internal expense guidelines that limit your living expenses – for example, car payments are capped at $517/month; housing and utilities for a family of four in Hamilton County, Ohio are capped at $1,910/month;  food, clothing and supplies for a family of four is limited to $1,450; no allowance is usually provided for credit card payments in your budget.  The IRS calls this Collection Financial Standards.

On the asset side, the IRS will consider you in hardship if your seizing your assets would either not result in any money paid (i.e, no equity in your property) or doing so would create a hardship (seizing your car means you cannot get to work, go to the grocery store, etc.).

If, after applying the IRS expense guidelines (Collection Financial Standards) it can be shown that there is no money left to pay the IRS and doing so would put you in a hardship to pay reasonable living expenses – food, rent, gas, car payment, child support, day care – and seizing your assets would also create a hardship – the IRS will place your account in currently not collectible status and, yes, leave you alone.

The IRS sends a letter out confirming you are uncollectible and that they will not bother you.  This is IRS Letter 4223 – at the top, in bold print, it has the words “Case Closed – Currently Not Collectible.”

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Deciding whether it is best to submit an offer in compromise or file bankruptcy on your taxes involves thoughtful consideration of many factors.  Those factors include how long each can take, which option will have the lowest settlement payment, which is most likely to be successful, and post-settlement terms (like tax lien releases in bankruptcy or future compliance in compromises).

Each of these factors is worthy of their own post.  For now, let’s focus on how long each option takes – when should you expect to get to the finish line in an offer in compromise vs. the filing of bankruptcy?

1.    Offer in compromise – how quickly does the IRS work?

An offer in compromise is not necessarily a quick fix.  It can take the IRS, on average, 6-9 months at a minimum to complete its initial investigation.  But here’s the catch:  many offers are not initially accepted.  That means an appeal of the errors the IRS made in the initial review is usually necessary.  An appeal of a rejected offer can take another 6-9 months.  With the initial review and appeal, go into an offer in compromise presuming a 12 -18 month time frame to completion.

If you get a “yes” on the compromise, then you have to pay the amount offered to the IRS. The IRS will give you up to two years to pay the settlement to them.  But your “yes” is conditioned on the final payment being made – meaning you still owe the IRS and have not been given your fresh start until then.  If you want your tax lien released and credit cleared, presume it stays on until final payment is made.   It is not until final payment of the compromise settlement that the IRS makes an entry into their database to reduce your account balance to zero (yes, they really do that).

So, 12-18 months for investigation (and appeal), then up to two years for payment.  Yes, it can be shorter if appeal is not necessary, or if you can pay in the settlement quickly, but there is a wide time range to completion.

Let’s compare that to bankruptcy.

2.     Chapter 7 bankruptcy – quick relief without IRS passing judgment.

A Chapter 7 bankruptcy is a swift and efficient way to eliminate an IRS debt.  (Yes, bankruptcy can eliminate IRS tax debt.)  A Chapter 7 should be completed within 4 months of filing.

Here is what happens in a Chapter 7 bankruptcy:  Approximately 5 weeks after the filing, a hearing is scheduled with a bankruptcy trustee.  This trustee is employed by the Department of Justice – generally speaking, his or her job is to make sure that you have  been honest in your bankruptcy filing, and to determine if you have any assets available to sell to pay your creditors (rest easy, most assets are protected from creditors by state and federal law, very few Chapter 7 bankruptcies on the IRS result in loss of any property).  After your hearing with the trustee, your creditors – and the trustee – then have 60 days to object to your bankruptcy.  This is also rare – usually in cases where the bankruptcy laws are being “abused.”   If no one objects, the court issues you what is known as a “discharge”.

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There is an uncanny consistency in the returns that I see the IRS auditing. The process that the IRS goes through to determine whether to audit a tax return is far from random.  The IRS knows what to look for, and can spot a return that is prone to having mistakes in it, making you vulnerable.

Keep this in mind about your tax return:  it is a map of your finances.  And the IRS know the map quite well – after all, they created the map (tax forms).  You are filling the map in.

Let’s get into the mind of the IRS.  Here is a list of of five items that are red flags to an IRS audit:

1.     Returns that are self-prepared.  My only evidence of this is what I see – my clients that are audited usually prepared their own tax return.   I do not know if the IRS strategically and purposefully targets self-prepared returns, but it sure seems that way.  And thinking about it, it makes sense.  CPAs. attorneys, enrolled agents – professionals who are well-versed in the tax code and return preparation – may have less errors on a return.

2.     Returns that are illogical.   Remember that a tax return is a map of your finances  and the IRS is the map reader.  Here is an example:  If your household income is $46,000 a year, but you deduct $18,000 in mortgage interest, $4,000 in real estate taxes and $2,000 in charitable contributions – a total of $24,000 in expenses – the IRS could likely wonder how these expenses are being paid.  The income to debt ratio is too high.

Think about it.  That $46,000 of income is pretax – you actually brought home, say, $36,000 after taxes and deductions (equal to $3,000/month).  The expense deductions on the return for mortgage interest, real estate taxes and charity totals $2,000/month.  That leaves $1,000 for food, clothing, utilities, car payments, medical expenses, gas, insurance…and possibly an IRS audit because that budget may be appear unreasonable to the IRS.  To an IRS auditor, something is illogical on the tax return – are you making more and not reporting it, or deducting expenses you did not pay? Now, there may be explanations, and they can be provided – but you could be on the IRS’s radar.

3.     Schedule C losses.  This can go hand-in-hand with the tax returns not being logical.  If you are self-employed and show a loss on your tax return on Schedule C, questions can arise in the mind of the IRS:  How are you funding the loss?  How are you paying living expenses if you are losing money?  Schedule C losses offset other income on a tax return, lowering taxes and creating what can often be a significant tax benefit.  It makes the IRS curious.

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Resolving your tax debt often involves providing a financial statement to the IRS that discloses what you own, who you owe, what you make, and how much you spend.

Your financial disclosures are required to be made on forms designed by the IRS.  There are three forms that the IRS uses:  The 433A, which you will use if you are self-employed or a wage earner, the 433F, which is a shortened version of the 433A, and the 433B, which is used by businesses.

But what you put on the 433A, 433F or 433B is not enough.  Expect the IRS to request documents that back-up what you list – in other words, proof of how you report your financial situation.

IRS collection officers often appreciate their job being made easier – and that means providing documents that verify what is listed on the 433A, 433F or 433B.   More importantly, documents verifying your financial situation permits a Revenue Officer to move closer to making a recommendation to resolve and close your file.

Be prepared in advance – here is a list of 10 items IRS collections is most likely to request from you:

1.     Bank statements, usually at a minimum the last three months leading up to the date of the financial statements.  If you are self-employed and have both business and personal accounts, both will likely be required.

2.     Recent paystubs or proof of other income, like social security benefits, usually covering the last three months.

3.     A statement from your bank verifying the amount you owe on your home and car loans.

4.     A statement verifying the value of whole life insurance, stocks, brokerage accounts.

5.     Verification of any balances in a retirement account.  Information should also be obtained detailing indicating any inability to access the funds (age, separation from employment, etc.).

6.     Verification of certain monthly living expenses.  This can include housing and utilities, car payments, child care, child support, out of pocket medical expenses if the monthly expense is greater than $60 per dependent, health insurance premiums and payment of old state and local tax debts.

The IRS should not request verification of your expenses for food, clothing and entertainment – the IRS has a standard amount that it allows for these expenses regardless of what you spend.  Only in unusual circumstances will the IRS allow more than their standard monthly allowances for food, clothing and entertainment.

7.     If you are divorced and paying child support, a copy of your decree showing that a court requires you to make the payment and verification of the payments (usually three months).

8.     If you are self-employed, the IRS can request verification of your business expenses (this should be consistent with the profit and loss provided as part of the financial statement).

9.     If you are self-employed and are required to make estimated tax payments, expect the IRS to ask for proof that you are making your quarterly deposits.

10.   Verification of the valuation of your home and car.

Keep in mind this is intended to be a laundry list – what is actually requested is on a case-by-case basis.

Also remember that Revenue Officers need to document their case file and report to their manager that their recommendation for the case resolution (i.e., installment agreement, uncollectible) is backed up by records.  And if you are working with Automated Collection Service, I recommend having everything that could be possibly requested available when you place the call – if you are fortunate enough to have found a sympathetic IRS case worker, you do not want to have to call back and start again with someone else because documents are missing.  That someone else could be something else.

Any way you cut it, it pays to be prepared in advance and have records available that supports your IRS financial statement.

Falling behind on filing your taxes can be scary, filled with questions and doubt about how to make it right with the IRS.  Fortunately, there are steps that can be taken to satisfy the IRS and get you back into the system.

Here are 10 things you should know about getting current with your unfiled returns:

1.     In most cases, the IRS requires the last six years’ tax returns to be filed as an indicator of being current and compliant.  The reference is IRS Policy Statement 5-133 and Internal Revenue Manual  This is the starting point – preparing the last six years’ returns for filing.

2.    Gather your records.  It is important to do your best to pull together your records for the years where you did not file.  This can include 1099s or W2’s you received for work your performed, mortgage interest you paid, or interest, dividends and stock sales.  Don’t worry if you are missing records, this is just a starting point.

3.    Your records are supplemented by securing internal IRS transcripts that will show what has been reported to the IRS – this will be a comprehensive listing of the 1099s and W2s that were sent to you.  This cross-checks against your own records, filling in for anything that is missing.

4.    The IRS transcripts are a checking point – if there is income you earned that is not on the transcripts, best efforts need to be taken to determine that income and include it on your return.

5.    If you are self-employed, business income and expenses need to be determined.  Income can be pieced together by several methods, including 1099 reporting to the IRS (supplemented by any income not reported), or your total bank deposits.  Working backwards, determining what you spent to live (food, housing, utilities, auto expense) can cross-check your income on the presumption that you at least earned what you spent and saved.

6.    Before preparing the returns, a financial review should be completed to determine how any taxes can (or cannot) be repaid to the IRS.  Unfiled returns are really a two-step process, consisting of (1) getting the returns prepared and filed and (2) negotiating solutions to balances due with IRS collections.  This involves a review of your current income, living expenses, property and debts.  It is often the case that the amount owed on unfiled returns cannot be repaid – you may qualify for an offer in compromise, or may be considered in financial hardship – in those cases, the IRS puts collection of the debt in forbearance (known as uncollectible).   Bankruptcy could eventually eliminate the tax debt.

If you cannot pay either way, spending time piecing together every business expense for the returns might be an effort in futility – you will owe more than can be paid with or without the receipts.  In that case, it may be best to file a “gross” return, listing your income but not the expenses, and focusing on collection solutions.

7.     If you are married but only one spouse earned income, strong consideration should be given to filing a separate return for the spouse that caused the liability.  Filing separately can limit who the IRS can collect from – protecting your innocent spouse.

8.     If you were employed with wages and had taxes withheld from your paycheck, it is possible that you may not owe the IRS at all.  This will depend on the amount withheld from your wages and any other deductions you may have (mortgage interest, etc.).

The IRS charges interest and penalties only on balances due – so there are no penalties if you do not owe.  And if you have refunds, you should actually receive those for the last three years’ returns (but note the refunds will be applied to any balances due for other years).

9.     Sometimes, when you don’t file a return, the IRS files one for you.  In IRS-speak, this is called a Substitute for Return (sometimes known as an SFR).  Most times, an IRS substitute for return gets it wrong, charging you for income that was reported on W2s and 1099s but not giving you any deductions or exemptions.  You may already have a bill from the IRS from a Substitute for Return.  These estimated returns can be corrected – and the tax lowered – by filing an original return.

10.     If possible, the unfiled returns should be hand-filed at an IRS walk-in center – bring an extra copy to get it stamped by the IRS as proof of filing.  If you are working with an IRS Revenue Officer, the returns should be filed direct with that person.  It can take the IRS several months to process the returns – watch for billing notices in the mail that will indicate the IRS processed the returns and you are back in the system.  If you owe money, the next step is solutions to the balances due -usually consisting of compromise, installment agreement, uncollectible and bankruptcy.

You can get current on your on unfiled tax returns and get back into the system.  Your goals should be the same as the IRS’s – get the returns filed and provide financial disclosures to arrive at a solution for the balances owed.

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