Howard's IRS and the Law Blog

On more than one occasion I have used the possibility of bankruptcy as leverage in reducing the value of a offer in compromise.  The possibility of bankruptcy can have a big impact on an IRS compromise.

Here’s why:

1.     A Chapter 7 bankruptcy can “discharge” a tax liability.

2.     Any taxes that could be discharged by a potential bankruptcy cannot be collected against the future income of the taxpayer.

3.      A critical component of an offer in compromise is an IRS calculation of how much can be collected from future income.

4.     If bankruptcy is “Plan B” to an offer in compromise, the IRS may reduce the value of future income to account for the limited collection potential.

The Internal Revenue Manual 5.8.5.6(5)) on reducing the value of a compromise from bankruptcy states as follows:

“Some situations may warrant placing a different value on future income than current or past income indicates…if a taxpayer will file a petition for a liquidating bankruptcy (Chapter 7)…consider reducing the value of future income.”

It is important to know when bankruptcy can discharge taxes to do this – it often will need to be explained in detail to the IRS offer investigator, who may not be familiar with taxes and bankruptcy.  The taxes being compromised would need to have been (1) due to be filed three years prior (2) filed two years prior and (3) the tax assessed 240 days prior to the potential bankruptcy filing.

When properly inserted into the compromise negotiations, Internal Revenue Manual 5.8.5.6(5) can have a significant impact on the value of a compromise. It can also avoid a bankruptcy filing by pushing a compromise over the goal line.

For more on taxes and bankruptcy, see my article in the Journal of the National Association of Enrolled Agents, presentation outlines and my other tax bankruptcy related posts.

I received this question about using an offer in compromise on interest and penalties:

I owe $25,000 in tax, but the interest and penalties have made the amount I owe almost double.  Won’t the IRS be happy just to get the principal I owe back and forgive the interest and penalties?

In an offer in compromise, the IRS considers all of your liabilities – tax, penalty, interest – as being of equal stature.   The amount you owe in penalties is as equally important to the IRS in an offer in compromise as the tax.  Although it may seem logical to assume that the penalties and interest are “extras” and more easily forgiven, this is simply not true with the IRS.

To the IRS, the tax, penalty and interest all bear equal weight.  There is no formula to abate interest and/or penalties in an offer in compromise.  It is purely a collection formula.  If the IRS believes they can collect it, they will not compromise it.  The IRS does not consider “tax only” offers unless for some reason that is the exact amount that can be collected.

If you believe the IRS should not have charged you penalties, then the proper course is to request abatement outside of the compromise process.  This involves an administrative decision of the IRS to forgive penalties they have already determined you are responsible for.  Penalty abatement involves proving to the IRS factors that there were beyond your control that prevented timely payment or filing.  Interest can be abated if the IRS unreasonably fails to perform a ministerial or administrative function.  The additional interest can be abated during the period of delay.

A better option on eliminating interest and penalties is often bankruptcy.  A Chapter 7 bankruptcy can completely eliminate tax, interest and penalties.   A Chapter 13 bankruptcy repayment plan can stop IRS interest accruals and force the IRS to accept a reduced amount of penalties by bankruptcy law, not tax law. An offer in compromise can result in the IRS forgiving tax, penalties and interest, but only if the collection is in doubt.

House Ways and Means Oversight Committe Chairperson Charles Lewis and Ranking Member Charles Boustany have introduced H.R. 2343, the Tax Compromise Improvement Act of 2009.

The bill would eliminate the requirement of IRC 7122(c) that lump sum offers must be accompanied by an upfront payment equal to 20% of the value of the compromise.  The bill would also eliminate the requirement that periodic payment offers must have the proposed payments made while the compromise is pending.  All of these payments are nonrefundable – meaning if the compromise is rejected, the money is lost.

The offer in compromise program has had offer submissions declining 21% since the upfront payment requrement took effect in 2006.  The IRS Taxpayer Advocate conducted a study finding that 56% of these payments were borrowed from friends and family members.

The proposed changes are a much needed first step to restore the offer in compromise program to viability and give deserving taxpayers who have had economic problems – usually through job loss, medical problems, divorce or business failure – a fresh start on their taxes.

The bill was introduced from hearings the Ways and Means Oversight Subcommittee conducted on February 26, 2009 as to assisting taxpayers with economic difficulties.   IRS Taxpayer Advocate Nina Olsen submitted testimony to the Oversight Committee recommending the change – read it here.  You can read my written testimony to the Oversight Committee on helping taxpayers in distress here.

A reader asks the following regarding IRS levies on social security benefits:

What is the difference between an automated federal levy on social security and a manual tax levy, and why does the IRS choose one over the other?

Here is my response:

1.     Automated Levy (15%).  Pursuant to section 6331(h) of the Internal Revenue Code, the IRS can continuously take, month after month, an automatic 15% of a taxpayer’s social security benefits.   All the IRS has to do is match its records of delinquent taxes to those of the government’s Financial Management Service, which indicate social security entitlement.  After a match is made, a notice is sent to the taxpayer from the IRS that the 15% levy will commence on his or her social security. Once the levy commences, the Financial Management Service sends a notice of confirmation to the taxpayer.

The automated social security levy is one of the most readily used IRS collection tools.  It is simple, and provides immediate, continuing and quantifiable results.  It also causes the most financial hardship.  In 2007, the IRS received 1.74 million payments from automated levies on social security benefits.  The IRS Taxpayer Advocate estimates that 86% of those levies were in situations were social security was the primary or only source of taxpayer income.

2.     Manual levy (100%).  The IRS is not limited by IRC 6331(h) to taking 15% of a taxpayer’s social security benefits.  The IRS can issue a manual levy that can continuously take all of the social security benefits under Internal Revenue Code section 6331(a), which permits levy on all wages, salary or other income (which would include social security).  The 15% automatic levy provision is a supplement to the manual levy power. The IRS can chose the manual approach if it deems fit and attempt to collect more than the automated 15%.

The manual levy requires the assignment of an IRS Revenue Officer, while the automatic levy is a paperless transmission.  The manual levy is usually made in extreme circumstances where there is a lack of cooperation.

3.     Exemptions on a manual levy.  One last, and very important, point:  It is important to understand that although the IRS can manually levy up to 100% of social security benefits, the taxpayer has the right to claim an exemption against the levy.  This exemption – contained in IRC 6334(a)(9) – permits the taxpayer to receive a minimum amount of the social security payment and defeat all or part of the manual levy.

The IRS publishes a table of the amounts that can be claimed as exempt.  A single taxpayer getting a monthly social security benefit can currently claim $779.17 as exempt from a manual levy.  That means the IRS, although it can make a manual levy, will only get amounts over $779.17 if the exemptions can be claimed in response to the levy.

The IRS has recently announced that they will attempt to be more reasonable in levy releases in hardship cases. If an automated or manual IRS social security levy does not leave sufficient funds to pay living expenses, the IRS should be contacted to demonstrate the hardship and to negotiate a release.

I am often asked by new clients how a tax lawyer can make a difference in an IRS dispute.  Here is my answer:
  • Once you retain a tax lawyer, the IRS must stop calling you.  The IRS is required to conduct all negotiations – telephone calls, meetings, etc. – through your attorney.  This valuable “buffer” allows time to determine the most accurate responses to IRS inquiries, not “on the spot” responses that cannot be taken back.
  • Your tax lawyer will have prior relationships with IRS collectors and auditors and understand how to keep your head out of the mouth of the bear.
  • Your tax lawyer will understand IRS laws that protects your wages, bank accounts, and property from IRS garnishment or seizure.
  • Your tax lawyer will know when to advise you if bankruptcy is the best way out, the differences between Chapters 7, 11 and 13, and be able to represent you in U.S. Bankruptcy Court.
  • Your tax lawyer will keep any statements made by you to him or her protected by the attorney/client privilege.  They generally cannot be revealed to the IRS or anyone else.
  • Your tax lawyer will represent you before IRS Appeals and U.S. Tax Court to seek judicial review of audit or collection cases.
  • Your tax lawyer may have previously worked for the Internal Revenue Service Office of Chief Counsel or the Tax Division of the U.S. Justice Department, and will bring that background and experience to the table.
Determining whether to hire an attorney to help you out of an IRS jam is an important decision.  If the nature of your case requires it, the right attorney can offer significant advantages.
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