Howard's IRS and the Law Blog

If an IRS tax lien is hurting your credit, or stopping you from purchasing a house or car, the IRS offers a path to freedom.

The IRS will withdraw the lien from public record in the following circumstances:

1.     The amount you owe is under $25,000.   But this is flexible – see #2, below.

2.     Don’t despair if you owe over $25,000 – the IRS calculates the $25,000 threshold not on your current balance, but what you originally owed when your tax return was filed.   Because of interest and penalty accruals since the filing of the return, the amount you owe could be more than what you owed when the return was filed.  In some cases, it can be twice as much (yes, interest and penalties double what is owed every five years).

But the IRS bases the qualifications for lien withdrawal on what you owed then, not what you owe now.  (In IRS technical terms, this is called the SUMRY balance.)  The $25,000 is what was originally assessed when your return was filed.  It does not include accruals since then.  This eases qualifications for the lien withdrawal.

3.     You are financially able to enter into an installment agreement with the IRS to repay what you owe within 60 months or within the remaining time the IRS has to collect, whichever comes first.

4.     Your installment agreement payments are made by automatic debit out of your bank account.  This is called a Direct Debit Installment Agreement.

5.     No financial disclosures should be required of you for lien withdrawal with a Direct Debit Installment Agreement – meaning you should not have to tell the IRS where you work, bank or what property you own for the lien to be withdrawn.

6.     After you have made three payments in a Direct Debit Installment Agreement, you can request that the IRS withdraw the Federal tax lien that they filed against you.

If necessary, lump sum payments can be made to reduce the original balance owed to under $25,000 to qualify for lien withdrawal.  Also, if you are already in an installment agreement, you can convert it to a Direct Debit to qualify for lien withdrawal.

Installment agreements can get tax liens withdrawn, improve your credit score and help you purchase a house or car. It is just a matter of knowing where to turn and how to negotiate the withdrawal with the IRS.

When working with an IRS Revenue Officer, there are two warning signs that levy action is imminent.

The first sign is the IRS Final Notice of Intent to Levy.  This notice is required by law (Internal Revenue Code 6331) and provides a 30 day right to stop levy action by filing an administrative appeal.  The appeal puts resolution in the hands of an IRS settlement officer (as opposed to an IRS enforcement officer).  This is known as a collection due process appeal because levy action cannot occur until you have exhausted your rights to review.  And if you cannot reach resolution with a settlement officer, there are additional rights of appeal to U. S. Tax Court.  While this process is pending, there is no levy action.

If you missed filing the appeal, there are virtually no restrictions on the IRS’s ability to levy your wages, bank accounts, etc.  Which leads to the second sign that levy action could occur: IRS Letter 3174, New Warning of Enforcement.

The IRS does not have to issue Letter 3174 before levying  – but by their own administrative rule (Internal Revenue Manual 5.11.1.2.2.7), the IRS does send a second warning in certain circumstances. The purpose of Letter 3174 is to provide a refresher to taxpayers if a long time has passed since the Final Notice of Intent to Levy was issued.  As an alternative to sending the letter, a Revenue Officer can also give the notice intended by Letter 3174 verbally.  This is an IRS administrative courtesy. The point here is to recognize the signs of when levy may be imminent.

It is important to recognize the circumstances that will lead to the IRS sending Letter 3174, New Warning of Enforcement.  Of course, there has to first be the Final Notice of Intent to Levy.  And you should not receive Letter 3174 from the IRS Automated Collection Service (ACS) – just IRS Revenue Officers.  Automated Collection Service letters are all computer generated – no human function involved.   Letter 3174, New Warning of Enforcement is generated by a Revenue Officer.  So, expect to receive Letter 3174 only if you are working with a local IRS Revenue Officer, who will manually generate the warning letter.  In most every other situation, it is unlikely you will get a refresher notice after a Final Notice of Intent to Levy has been issued.

There is also a time frame that Revenue Officers that follow in issuing the refresher levy warning notice. Revenue Officers are instructed to issue Letter 3174 if more than 180 days have passed since the Final Notice of Intent to Levy was issued, and no enforcement action or warning of enforcement has occurred in that time frame.

If you receive Letter 3174, it is important to call your Revenue Officer within 15 days of the date on the letter. That is the window the IRS provides before starting enforcement again. In most cases, all you need to do is make contact with the Revenue Officer, find out what it is she needs from you (i.e., a financial statement), and set a date to provide it. You should not need to resolve the case in 15 days, just make efforts to communicate with the Revenue Officer. Not responding to the notice will likely result in levy action against your wages and bank accounts.

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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