Howard's IRS and the Law Blog

A common question from a reader about the IRS settling for tax and forgiving the interest and penalties:

I owe the IRS $35,000 – I would like to pay what I owe, but the interest and penalties just seem awfully high.  I want to offer to pay the IRS what I originally owed – will they accept that and forgive the interest and penalties?

In negotiating with the IRS, it is important to remember that the government is not a private enterprise, and common sense judgments often yield to tax laws and internal IRS guidelines about how a tax debt can be settled.   That means what might seem like a good deal to you is not a good deal to the IRS.  Negotiating with the IRS requires understanding their guidelines – it may seem unfair, but that is the reality.

And the IRS guidelines have no provision for a deal where they can simply accept the tax and forgive interest and penalties just because it seems like a good deal.

Let’s break that down.

First, the IRS authority to settle a debt is done through an offer in compromise.  In an offer in compromise, the IRS investigates how much can be collected from you over the time they have to do it (which is 10 years, known as the statute of limitations on collection).   In an offer, the IRS values your assets, your income, and your living expenses – arriving at how much you are worth, and how much you could pay back to them monthly.   If you owe $35,000 but you are worth $10,000, then $10,000 is the value of the compromise.  If you are worth $50,000, then there is no compromise as the IRS believes it can collect the full amount.

In an offer in compromise, you could settle for less than the amount of tax.  Or it could be more.  There is generally no factoring of tax vs. interest vs. penalty in the compromise settlement equation.  The settlement is based on collection potential.

Although it seems reasonable, the IRS does not approach settlement by saying “Let’s just take the tax and be done with it – that makes sense over waiting years to get paid.”  An offer in compromise is not designed for the IRS to consider the question of whether they should just accept the tax and be done with it because it makes sense.

Bottom line:  There must be a factual basis for interest and penalty to be forgiven by the IRS. It is not done as a collection decision.

If you are being audited, and have concerns that the IRS may discover that you committed fraud your tax return, don’t go at it alone.  The stakes have become high – here are guidelines to help you make a decision on the best way to proceed:

1.     Whatever you do, don’t represent yourself – hire a professional – whether a tax attorney, enrolled agent or C.P.A. – who has experiencing in defending potential IRS tax fraud cases.   A significant benefit to hiring a tax attorney is the attorney-client privilege – your communications with your attorney – telephone calls, emails, meetings – discussing your case, developing the facts, formulating a defense strategy – are confidential and cannot be disclosed to the IRS.

2.     You have the right to have your attorney handle all negotiations with the IRS for you.  All calls, conversations, negotiations, route directly through your attorney, not you.  You take a backseat in the negotiations.  You are no longer dealing directly with the auditor.  All conversations route through your attorney, who relays the information to you, with discussions to formulate responses.  No knee-jerk responses in potential fraud cases.

3.     If you have already met with the auditor, stop, and hire counsel.  It’s not too late.

4.     In potential fraud cases, it is best to distance yourself from the investigation.   The IRS would not mind if you, alone, gave testimony.  That is not recommended.  Going at alone allows you to make misstatements of facts – even if with good intentions – that can be difficult to go back on.  Nerves, anxiety, an over-eagerness to comply with the IRS – not too mention an unfamiliarity with the process – is a dangerous mix.   Adding untruths to a fraud investigation fuels the IRS’s fire.

5.     You have a Fifth Amendment right not to incriminate yourself.  That means you do not have to testify to the IRS, or provide them any firsthand information.  This is a tricky situation – you have the right to remain silent, but if you exercise it, the IRS often becomes more interested, more aggressive – something is clearly being hidden.  Sometimes, it is better to talk – but that is a determination that has to be carefully reviewed, with all the facts considered.

6.     Maybe we should fully disclose and admit to the problem, immediately.  The disclosures are made by your attorney, not you.  Chances are, the IRS is auditing your return because something on the return did not look right to them – remember, your tax return presents a financial portrait to the IRS.  The audit letter you received likely already identified the trouble areas.  The IRS already senses something is wrong – many times, the right amount of straight talk works with an auditor – and is appreciated.   I have found that there is a lot to be said for taking the edge off, coming forward and disclosing the obvious – auditors want to close cases, and often appreciate their work being done for them.  It is often the “a-ha” moment of auditor discovery that can doom a fraud case and turn it into more than negligence.  This strategy is fact specific – but usually will result in a reduction of charges to negligence – no fraud.

7.     If you already made misstatements on your tax return, don’t try to get around it with more creative accounting or explanations during the audit.  Making a mistake on a tax return can be explained away as negligence (which does not equate to fraud) – but lying to an auditor cannot.  Don’t pile it on.

8.     You are not necessarily going to jail.  There are different types of tax fraud – civil vs. criminal.  Civil tax fraud is money only, no jail, no criminal investigation.  The penalty is steep – 75% of the tax owed – but that beats a criminal investigation.

9.     Your case may be simply negligence – where the penalty is 25% of the tax owed.   The IRS has different standards of proof for tax negligence, civil tax fraud, and criminal tax fraud. Negligence is not fraud, and has no criminal repercussions.  Here’s the level of proof for the IRS, from highest to lowest:  (1) Criminal fraud, (2) civil tax fraud, (3) negligence.  You may have done something wrong, but it may not amount to criminal charges – it could be simply negligence, which is money damages only.

10.   IRS criminal indictment statistics are public record – and are instructive to the civil vs. criminal tax fraud concerns.  In fiscal year 2014, for example, the IRS initiated 2,015 criminal investigations, which resulted in 1,663 recommendations for prosecution.  1,590 of those recommendations resulted in prosecution.  The point:  IRS is very selective in how it uses its resources to prosecute tax crimes – 2,015 investigations is serious, but a very small number spread over the population base.  Few are prosecuted – the facts have to dictate the allocation of IRS resources.  Many IRS criminal investigations are specific programs – employment tax fraud, return preparer fraud, money laundering/related criminal activities, and abusive tax schemes.  But those who are prosecuted are usually convicted – IRS wants to win its criminal cases, and make them count.  Criminal tax fraud is extremely serious, but your facts have to be put into perspective with what the IRS is looking for.

And I say this often:  It is important to remember that an IRS audit is the beginning of a process, not an end.  If there is disagreement with the IRS audit results, you have rights to an administrative review of the audit with the IRS Office of Appeals.  If we cannot reach resolution in appeals, there are more rights – to file a petition to U.S. Tax Court, where a judge, independent of the IRS, will review our facts and law, compare to the IRS’s position, and give you an unbiased decision that is binding on the IRS.

When all else fails – or even if all else does not fail – Chapter 7 bankruptcy can be an excellent option to take old IRS problems out of your life.

Yes, bankruptcy can eliminate tax debt.

But bankruptcy is also incorrectly associated with losing assets, having everything you own wiped out by the bankruptcy court.

Chapter 7 is indeed what is known as a “liquidating bankruptcy,” meaning that in return for having your debt eliminated, a bankruptcy trustee can take your personal belongings, sell them, and pay the proceeds to your creditors.

But that would leave you with nothing – which is against public policy, not too mention prohibited by bankruptcy law.

Yes, you can file Chapter 7 bankruptcy on the IRS, eliminate your tax debt, and keep all of your property.

Here’s why:  Exemptions.

Exemptions are bankruptcy-speak for legal protections that prevent your creditors from taking your property.  Exemptions are law from Section 522 of the bankruptcy code – they make your property off-limits before bankruptcy, during bankruptcy, and after bankruptcy.

Here are some examples of exemptions in Ohio:

–     Up to $125,000 of equity for your interest in your house (increases to $250,000 if the house is jointly titled to and, say, your spouse).  Equity is the difference between what the house is worth and what you owe on your mortgage.

–     Up to $3,225 of equity in your car, increasing to $6,450 if the car is jointly titled.

–     Up to $10,775 of value in your household goods and belongings, increasing to $21,550 if jointly owned.

Retirement accounts are also protected from creditors in bankruptcy.

In most every case, these exemptions – and others too numerous to list – will allow taxes to be eliminated without the loss of any property to the bankruptcy trustee.

Yes – it is possible to eliminate taxes in a Chapter 7 bankruptcy, keep all of your property, and get a fresh start, debt-free.

What do you do when you disagree with an IRS auditor?

A common misperception of IRS audits is that whatever the auditor says, stands.

The reality is far different – an IRS auditor’s findings are not final.  It’s okay to disagree. You have options.  The audit is not the end of the road.

First, the IRS has an internal administrative appeal process for review of all audit findings. Once the auditor is done, he will send you a letter summarizing his findings, and give you 30 days to appeal.  If you appeal, the case will be sent to a separate IRS office where an independent IRS appeals officer will review the audit and your points of disagreement, trying to reach resolution.

But what if you feel battered by the audit, and want review from an outside, third party not affiliated with the IRS?

That’s were Tax Court steps in.

The Tax Court is a federal court – independent of the IRS.   It reviews IRS actions – including audit results and intended collection enforcement actions – and decides if the IRS right, or if you are right.  In essence, if you want to take an IRS audit to court, consider filing a petition to U.S. Tax Court.

Here are 5 reasons you can benefit by having the Tax Court decide your IRS dispute:

1.     You will be able to testify to things the IRS auditor may not believe.  Many audits get derailed by disagreements over what happened – How much did you pay your subcontractors? Were you conducting a hobby or a business?  Was the trip you deducted for business or pleasure?  In Tax Court, a judge will listen to your testimony, and will decide if you are right. Your fate is no longer in the hands of what the IRS believes to be true.

2.     Your records – receipts, logs – the documentation you submitted to prove your case in audit  – will be reviewed fresh by the Tax Court judge.  Your testimony can supplement the documentation – permitting you to tell your story to ears other than the IRS.  A common audit problem is the IRS bank deposit analysis – resulting in the IRS believing that you had more income than reported on your tax return.  The Tax Court can review your bank statements, your testimony and your documentation proving that not all bank deposits were earned.

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Negotiating with the IRS can be frustrating for the uninitiated.  Intimidating.  Overwhelming. Stressful.  Not the best way to feel when entering into a negotiation, much less when the party on the other side has the power of the IRS.

When I was an IRS trial attorney, I negotiated on behalf of the IRS.   Since moving into private practice over 20 years ago, I have spent most waking moments of my professional career negotiating with them, rather than for them.

And one thing is very clear:  Negotiating with the IRS has its own unique, unstated rules of engagement.

Here are a few tips I recommend that you keep in mind for the best results for when you face an IRS audit, or an IRS Revenue Officer, or a call on an IRS 1-800 line:

1.     Don’t rely on logic to carry the day.  IRS decisions are not always made from common sense, or logic.  Your way of thinking about a solution to a problem – options that would be successful in the private sector – do not apply to solving IRS problems.

The IRS process is primarily governed by their own internal rules and regulations.  This guidebook is called the Internal Revenue Manual (IRM).   The IRM contains chapter after chapter, page after page, of IRS procedures on handling most every conceivable situation – from audits to collections, and from levies and seizures to tax court litigation.

That’s the good news – there are guidelines for IRS negotiations.  But is very important to know the rules, and recognize how to apply the Internal Revenue Manual to a given situation.

Success with the IRS starts with knowing what they know – getting into their playbook – the Internal Revenue Manual – and applying it to negotiations.

2.      Loosening the grip is better than tightening the noose.   Respect the power of the IRS.  Do not understate it.  Their hammer is most likely bigger than yours.

IRS problems are best solved from building a position of credibility.  Credibility is gained from a show of respect to the IRS employee you are working with, whether you like it or not.  There are certainly times to take off the gloves, but that should be a last approach.

And this is where the Internal Revenue Manual comes into play.  Knowing the IRS rules, and when they are not being applied, or not being applied properly, is a powerful tool to loosen the grip.

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Proceeding blindly is something that you rarely want to do with the IRS.

If you owe back taxes, or have unfiled returns, or are in any way concerned about an IRS problem, it’s best to first find out what the IRS knows about you.

What is the IRS doing on your account?  What can they can do to you?  What is the current status?

This information about you can be obtained from an IRS account transcript.

An IRS account transcript can tell us:

1.    If the IRS can levy your bank accounts and wages, or seize your property.

The IRS cannot levy your income or seize your property unless you have first been given written notice.  This notice is called a Final Notice of Intent to Levy.  The IRS will send it to you by certified mail, or a local Revenue Officer could hand-deliver it to you at your home or place of business.

IRS account transcripts will tell us if the Final Notice of Intent to Levy has been issued – there will be a line item on the transcript confirming that is was issued, and stating when.

If the IRS has sent the Final Notice, you have important rights to dispute the intent to levy and put a stop to IRS collection.  By law, you have 30 days to file an appeal.  And by IRS administrative rule, that 30 days is extended to one year in most cases.

If the account transcripts do not have a Final Notice indicator, then you will have the peace of mind knowing that the IRS cannot take your wages or your property.

2.     How long the IRS has left to collect your debt.

The IRS has ten years, starting from you filed your tax return, to collect a tax liability.  After that, in most every situation, they are barred by law from taking any action to enforce the debt.  After the 10 years expires, the IRS must forgive what you owe.  This is known as the statute of limitations on collection.

The IRS account transcript has information to calculate when you will be done with the IRS.  This includes when the statute of limitations clock started, and if anything has happened that gave the IRS more than 10 years to collect.

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