Howard's IRS and the Law Blog

If you owe the IRS and have a refund on your tax return, the IRS will keep the refund and apply it to your unpaid taxes.  The problem is not repaying the debt – you would if you could – but that you simply cannot afford to lose the refund.  The refund is needed to pay bills, repair a car, or see the doctor.

The solution to any lost refund issue:  Review your withholding to eliminate the IRS refund and put the cash in pocket for necessary expenses.

If you are losing your refunds to the IRS, change your withholding.   Take your refund, divide it by the number of your paychecks, and tell your employer to lower your withholding by that amount each pay period.  You can also change the number of exemptions you are claiming, although I prefer making a specific dollar change.  You will probably need to complete a new W-4 for the change.

If you are married, file jointly and only your spouse owes the IRS, it is important to attach an Injured Spouse Allocation (Form 8379) to your return.

You are being injured by the IRS taking your refund and applying it to your spouse’s tax liability. You can still file jointly – there are benefits to you over filing separately –  but use the injured spouse allocation – it permits the IRS to calculate how much of the refund was generated by you, and pay it to you, rather than apply it to a debt that is not yours.

Most tax refunds are generated from too much withholding.  In essence, this means you are making a loan to the IRS of your money by overpaying the current year’s taxes.  While for some this is a good way to accelerate paying the IRS back, if it is more than your budget can take, change your withholding or file a injured spouse claim.

When you make a payment to the IRS, it will be automatically applied to your account in a manner that is in the IRS’s best interest.

But what is best for the IRS in handling your payment can be different from what is best for you.

In some situations, it is in your best interest to make a designated IRS payment, which tells the IRS how you would like them to handle and apply your payment.

Designated payments should be considered in the following situations:

1.     If you owe income taxes, it may be beneficial to designate your payment to pay a more recent tax liability off before paying an older liability.  This is recommended due to the 10 year IRS statute of limitations on collection.

Example:  If you owe taxes for 2001 – 2008, collection of the 2001 liability should expire well in advance of the 2008 debt.  If you are about to make a payment that will pay some – but not all – of your taxes, you could be best served by designating the payment to be applied to the most recent debt (2008) first.  This allows the older taxes a greater chance to expire from the statute of limitations on collection.

Without the designation, the IRS will apply the payment to the oldest tax year first (the one in which collection is set to expire).

If you are considering bankruptcy, voluntary payments can also be designated to pay nondischargeable taxes.

2.    If you owe employment taxes, a designated payment can help reduce exposure to the trust fund recovery penalty.  The IRS uses the trust fund recovery penalty to hold owners and employees of a business personally responsible for a portion of unpaid employment taxes.

If your business is set to make a payment on a past due employment tax liability, consider designating the payment to the trust fund portion of the employment taxes. This strategy reduces the exposure of the operators of the business to the IRS while simultaneously paying down the business debt.

You can make a designated payment only if your payment is submitted voluntarily. Payments made by installment agreement or by enforced IRS collection action (i.e., levy) are not considered voluntary and cannot be designated.  A payment is voluntary even if you are working with a Revenue Officer or Automated Collection Service provided it is made by your own choice and without an installment agreement or levy.

To properly make a designated payment, you need to specifically tell the IRS how to earmark it.  To accomplish this, first, in the memo portion of your check, insert your tax identification number, the tax form to which your payment relates (i.e., “Form 1040″) and the tax year or period you want to pay (i.e, “Tax Year 2003″).  Second, a cover letter should accompany your check stating the same information.  Keep a copy of the cover letter and your cancelled check as proof of the designation.

It is important to understand why, how and when IRS payments can be applied to your benefit.  Designating payments to the IRS is a right that should not be overlooked when voluntarily paying down your account.

My clients with IRS collection problem come to me with different ideas about what will happen to them because they did not pay their taxes.  Is the IRS going to show up one day and seize my house?  Levy on my income so I cannot provide for my family?  Shut down my business?  When do I get my life back?

IRS problems often happen from what  life throws at us – divorce, failed businesses, medical problems.  Most IRS problems do not reflect any bad intent, but they can be all-consuming.

Owing money to the IRS is serious, but most of what you hear from friends, the media, even the IRS – can be more myth than reality.

My recent article in the Journal of Enrolled Agents – IRS Collection Threats: Myth vs. Reality – is intended to enhance your understanding of the IRS collection process.  Hopefully, you will find it as a road map to the IRS and the collection of back taxes. Solutions are best reached knowing the realities of the IRS collection process, not the myths.

Feel free to browse through the article here.

The best way to get relief from an IRS collection problem is to consider the complete picture before jumping in.  A quick way out may be desired, but it is important to look carefully before you leap.

Here are three things that I recommend that you carefully consider before taking on an IRS problem:

(1)     How do you wish to resolve your IRS problem, and is it obtainable?

The best known option to resolve an IRS problem is an offer in compromise.  If your goal is settlement, it is important to carefully consider whether you are a good candidate before plunging in.

The IRS has specific formulas for calculating what they will settle for.  You will find the formulas are often different from your real world situation.  The most disputed item in an offer in compromise is the difference between what your living expenses are and what the IRS will allow you.

Anticipate the issues your compromise could present before jumping in with it – understand in advance how the IRS will apply their guidelines to your situation.

And always make sure that just because you can accomplish a compromise, the settlement value is obtainable for you.  If you owe $150,000 but the settlement value is projected to be $75,000 – due in part to the IRS formulas – does that work for you?  That is a 50% settlement, but still a significant payment.  If it is not realistic other options should be considered – maybe bankruptcy, where the IRS formulas are not necessarily as rigid, or an installment agreement over the remaining collection timefram.

(2)    What property can the IRS take from you?

Every IRS collection case involves understanding what your risk of levy and property seizure is. Know that IRS seizures of real and personal property are serious, but actually quite rare.  It is important to negotiate based on the real risk of levy, not perceptions or myths.

Some assets – like everyday household goods – are exempt from IRS seizure by law.  Additionally, the IRS cannot take property if it does not result in an economic recovery to them.  That means that the IRS is not interested in your car with a bank loan.  Same for your house.  Those assets have no equity for the IRS.

The IRS prefers taking liquid assets, like cash in a bank account and wages. But even to do that, the IRS must first provide you with important rights of notice and appeal to permit you to resolve the account before they can levy.   Before jumping in, it is important to know what the IRS can take, and whether they procedurally are able to do so.

(3)     How much time is left on the statute of limitations on collection?

In most every situation, the IRS has 10 years to collect an unpaid tax liability. The 10 years starts when the IRS puts your liability on its books – this should be when you filed your return.  The statute of limitations on collections provides an end date to IRS problems.

But what you do during the 10 years can impact your end date.  For that reason, it is important to look before you leap.

Take an offer in compromise, for example.  An offer in compromise extends the time the IRS has to collect by the timeframe it is pending.  Most offers can take up to a year.  If your offer does not work, you have just given the IRS more time to collect – you are actually worse off.

If the IRS has one or two years left to collect from you, pursuing an offer in compromise may not be in your best interest.  It would likely be better to hold the IRS off with an installment payment or hardship/uncollectible claim, especially since the compromise can take a year to investigate and finalize.

All three of these points fit together – your goals/options, your collection risk and the end date under the statute of limitations on collections.  The best approach to solving IRS problems is careful consideration of your situation as a whole before jumping in.

The trust fund recovery penalty can cause financial havoc for anyone involved in a business that did not pay over its employee withholdings to the IRS.  Internal Revenue Code Section 6672 allows the IRS to investigate those in the business who were part of the decision not to pay the IRS and hold them personally responsible for repayment.

The amount of the trust fund recovery penalty charged to the individuals is equal to the taxes deducted from employee paychecks but not paid to the IRS.

Usually, the trust fund recovery penalty involves defending on the basis of liability – developing facts to indicate you had no control over company finances.

But even if you had control, an inability to personally repay the taxes can be a procedural defense to the trust fund recovery penalty.  The investigating IRS Revenue Officer has discretion not to hold you responsible if it can be proven that you are – and will continue to be – uncollectible.

Uncollectible is defined by the IRS as being financially unable to pay – doing so would create a hardship for you and your family, leaving you unable to pay for basic necessities.  Uncollectible status also requires that your assets be of minimal value to the IRS.

The basis for using collectibility, not liability, as a method of defense in trust fund investigations can be found in the Internal Revenue Manual Sections and

The IRS will consider many factors in determining whether they should withhold assessment of the trust fund recovery penalty based on financial hardship.  Factors include whether you have had IRS troubles in the past, your age, occupation, family size, amount of income tax refunds, future earning potential and the probability of an increase in the value of your assets.

The future ability to pay should not be overlooked as a defense to the trust fund recovery penalty. It is important to recognize the right situation where personal financial disclosure during the IRS investigation could make a difference to the defense. If there will be problems paying the trust fund taxes later, considering asking the IRS to eliminate the problem early.

I received a great question from a reader about whether Veteran’s disability benefits should be included in the value of an IRS installment agreement or offer in compromise.

Although the question is directed to Veterans’ disability benefits, my answer also applies to those with unemployment and workers’ compensation benefits.  Here is the question:

I owe the IRS over $50,000 and my only source of income is my 100% service-connected disability compensation.  I was set-up on an installment agreement of $428/month.  I listed my service-connected disability as income on my 433A financial statement. Shouldn’t it be listed as $0?  I have no other income but the service disability.

Internal Revenue Code Section 6334 lists the income sources that are protected from an IRS levy.  The protected list includes unemployment benefits, workers’ compensation, and service-connected disability benefits.

But the Section 6334 limitations on IRS levies are slightly unraveled by another part of the Internal Revenue Code, known as Section 6331.

Section 6331(h) gives the IRS discretion to make a continuous levy of up to 15% of benefits including unemployment, workers’ compensation and service-connected disability.  Even though the IRS can take 15% of these benefits, it is cautious in doing so.  And to that end, current IRS guidelines state that the IRS collections is not to levy these benefits.   See Internal Revenue Manual

Recommendation for completing an IRS financial statement in cases of veterans, unemployment and workers’ compensation benefits:  The IRS should be put on notice that you receive these benefits – you should make a full disclosure of your income.  Attach a statement to your 433A or 433F disclosing the income and the legal position that it is exempt from IRS collections and, therefore, excluded from an IRS collection analysis.  Do not confuse the issue by listing the benefits as income on the face of the 433A or 433F – rather, direct the IRS to see your attached explanation.

Even if the IRS did have a policy of levying veterans, unemployment and workers’ compensation benefits, only 15% would be available for application to your collection potential.

The payment you propose to the IRS – or the value of your offer in compromise – should be consistent with your collection potential.  Take the position that exempt income sources are not part of your collection potential.

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