Whose Household is It?

The IRS just issued two FAQs providing information regarding offers in compromise (OIC).  One of the FAQs is unremarkable while I find the other FAQ inadequate for reasons that I will explain further below. 

Every year in the seminar that accompanies the clinic, I devote one class to offers in compromise because so many of the clients coming to the clinic need an offer in compromise or, at least, need us to analyze whether they qualify for an OIC.  I tweak the fact pattern a little bit every year but I still use the fact pattern developed by Les Book when he ran the tax clinic at Villanova before I took his place.  The first issue presented by the case involves the taxpayer’s household.  The students do not find the IRS’ instructions clear on this point.  This year, as is typical, about half of the students found that taxpayer’s household included persons he was living with and half found that the taxpayer had a household of one.  Why do they have trouble with this basic issue?

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The fact pattern has Steve Freshstart living with his girlfriend.  Steve moved in two months ago.  Steve and the girlfriend maintain separate bank accounts.  Steve pays has $900 a month to cover his share of the rent and utilities on the apartment.  Steve buys his own food.  Steve uses his money for Steve while his girlfriend, Cindy, uses her money for herself and her two children.  Whether Steve must include his girlfriend’s finances in his offer in compromise matters not only to the computation of his allowable living expenses and ultimately his reasonable collection potential but also to his relationship with his girlfriend.

Imagine you are Cindy and your boyfriend who moved in with you two months ago now needs you to bare your financial soul to the IRS because you are living together even though your financial living arrangement seems very much like one of roommates rather than soulmates.  If Steve must ask Cindy to provide all of her financial information to the IRS just because she shares an apartment with him seems unnecessarily intrusive yet the IRS instructions lead half of my students to that conclusion.  The latest FAQs do nothing to alleviate the confusion. 

Here are the new FAQs:

Q. Does Form 8821, Tax Information Authorization, allow taxpayers to designate a third party to represent them before the IRS on an OIC?

A. No. Form 8821 does not authorize a third party to speak on the taxpayer’s behalf or to otherwise advocate the taxpayer’s position before the IRS. Form 8821 only authorizes the designated third party (appointee) to inspect and/or receive a taxpayer’s confidential information for the type of tax and the years or periods the taxpayer lists on their Form 8821. Therefore, a taxpayer’s appointee cannot represent the taxpayer in a collection matter, such as an OIC before the IRS. Taxpayers should use Form 2848, Power of Attorney and Declaration of Representative, to authorize an individual to represent them before the IRS.

Q. Does a taxpayer need to include his or her spouse’s income on the taxpayer’s Form 433-A (OIC), If the taxpayer’s spouse doesn’t owe taxes?

A. Yes. A taxpayer needs to provide information about the taxpayer’s entire household’s average gross monthly income and actual expenses when making an OIC. The taxpayer’s entire household includes all individuals, in addition to the taxpayer, who contribute money to pay expenses relating to the household, such as rent, utilities, insurance, groceries, etc. The IRS needs this information to accurately evaluate the taxpayer’s OIC. The information may also be used to determine the taxpayer’s share of the total household income and expenses and what the taxpayer can afford to pay the IRS.

 The first FAQ provides a logical piece of information, viz., that a person who does not represent the taxpayer cannot represent them in an OIC.  The Form 8821 permits the holder to receive information but has nothing to do with representation of a taxpayer before the IRS.  While I do not know how necessary it was to issue this FAQ because I have no idea how many people try to represent a taxpayer based on a form allowing them to merely obtain information, I have no problem with this FAQ.

The second FAQ provides very little information that will assist my students in deciding what to do with Cindy and her children.  In the simulated problem they have, it’s really just a question of math whether Cindy’s finances get added to Steve’s since the students do not need to interface with Cindy.  In real life the questions become much stickier.  On several occasions the clinic has encountered significant others quite reluctant to bare their finances to the IRS and quite put out with the clinic for suggesting that they must do so or their boyfriend/girlfriend will not reach the promised land of an OIC.

My view is that the IRS does not need or really want Cindy’s financial information.  At this point in the relationship she is financially a roommate rather than someone whose finances have intertwined with the taxpayer needing collection relief.  It is no more appropriate to ask her for financial information than it is to ask college roommates to provide financial information should one of the other roommates seek an offer in compromise.  Yes, she and Steve live in the same household and share the same bed but they do not share finances and that is the critical factor in requiring her financial information.

These questions can be close.  Deciding who constitute a household requires more than simply sharing space.  The FAQ would help if it made that clear and if it was written so that Harvard and Villanova law students could figure out who belongs to a household for this purpose.  If these law students cannot make that determination, imagine how hard it is for pro se taxpayers to try to work their way through this problem. 

The Surprise Bill – Interest Due after Bankruptcy

The case of In re Widick, No. 10-40187 (Bankr. D. Neb 2019) provides a reminder that bankruptcy does not discharge all debts even when the debtor pays all of the tax for the year through the bankruptcy plan.  Mr. and Mrs. Widick completed a chapter 13 plan.  To obtain the plan and to complete the plan, they paid all of the income taxes for two years and all of the trust fund recovery penalties for two quarters.  I suspect that their bankruptcy attorney did not mention to them that paying all of the taxes does not keep the IRS from coming back after the bankruptcy case to collect the interest.  They brought this action to hold the IRS in contempt for violating the discharge injunction due to its efforts to collect from them after the bankruptcy court granted the discharge in this case.  With relative ease, the bankruptcy court delivered to them the sad news that the IRS could continue to collect from them after the discharge and the authority for the IRS actions went back for three decades in the controlling circuit case of Hanna v. United States (In re Hanna), 872 F.3d 829 (8th Cir. 1989).

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In bankruptcy creditors cannot generally collect post-petition interest from a debtor.  An exception to this rule exists if the creditor has a secured claim with enough equity to pay the interest or if the debtor is in chapter 11 where the creditor can receive interest after the plan confirmation (but not for the period from the petition to confirmation.)

Although bankruptcy generally serves as an interest free zone, interest still runs.  The difficult concept for debtors with tax debt comes where the IRS starts pursuing them after discharge to collect interest on a debt that they believe they have satisfied.  Whether the IRS can come after this debt post-discharge depends on whether the debt itself qualified as non-dischargeable debt.  In the case of the Widicks, it did.  Because the debt satisfied the exception to discharge in 523, the IRS could pursue collection of the interest after the granting of the discharge.

The Widicks owed income taxes that were recently incurred.  These income taxes received priority status under B.C. 507(a)(8)(A).  The unpaid TFRP liabilities also attained priority status under B.C. 507(a)(8)(C) and due to their nature have priority status no matter how old they were.  Because the income taxes and TFRP taxes had priority status, the debtors had to provide for payment in full of these taxes and all pre-petition interest in order to obtain confirmation of their plan.  The chapter 13 plan did not require, and could not require, the Widicks to pay the interest that ran on these taxes over the 5 year life of the plan.  Debtors might think that because the plan did not require payment of post-petition interest, they got a pass on this interest.  Because debtors might easily reach this conclusion, their lawyer must carefully advise them of the interest rules with respect to taxes.  Otherwise, they will become quite upset when the IRS offsets post-discharge refunds and takes other collection action.

A similar situation occurs in offers in compromise.  The standard language of the offer in compromise developed by the IRS requires that the debtor forego any refund for the year in which the IRS accepts the offer (and any pre-offer years.)  As with bankruptcy, the taxpayer’s representative must carefully explain to the individual obtaining the offer the consequence of this provision.  The taking of the refund might occur 12 months or more after the offer acceptance.  At that point the taxpayer can easily have forgotten the promise to forego the refund.  For this reason, putting a discussion of the refund taking in the letter closing out the offer provides a good way for the representative to prepare the taxpayer for the future and protect themselves from criticism and anger that occurs when the IRS takes the refund.

Here, the debtors’ chapter 13 attorney did not prepare his clients for the consequence of the post-discharge interest liability.  In its relatively short opinion the court points out that although the Hanna case cited above involved a chapter 7 debtor, case law existed with respect to chapter 11 and 13 cases in their district.  The law here is well settled even if it is surprising.  Clients may not like this aspect of the law, but if they know it’s coming, then they understand it’s part of the bargain of the discharge — just as the taking of the post-offer acceptance refund is part of the bargain of the offer in compromise.

IRS Can File a Proof of Claim in Bankruptcy Court for the Full Amount of Tax Liability Even After an Accepted Offer in Compromise

Guest blogger Ted Afield today discusses the intersection of offers in compromise with bankruptcy. Professor Afield (with co-author Nancy Ryan) will be creating a chapter on Offers in Compromise for the next edition of Effectively Representing Your Client Before the IRS. Christine

In our clinic at GSU, we do a lot of collections work and routinely submit offers in compromise, which the IRS often accepts, on behalf of our clients. While our hope is always that the accepted offer will be a critical step that allows the taxpayer to get back in compliance with his or her tax obligations and get out from under the weight of a detrimental financial liability, unfortunately the accepted offer is sometimes not enough to prevent a taxpayer from continuing to be overwhelmed by other financial obligations. In situations like these, the taxpayer may in fact file bankruptcy during the 5-year compliance window for the offer in compromise. If this happens, the IRS potentially has a claim in the bankruptcy proceeding because the offer in compromise may have already been defaulted or may be defaulted in the future if the taxpayer fails to file tax returns and timely pay taxes. Accordingly, the IRS will file a proof of claim in the bankruptcy proceeding, which raises the question of should this proof of claim be for the full amount of the tax liability or for the compromised amount of the tax liability.

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This was the question recently taken up in a memorandum opinion by the Bankruptcy Court for the Southern District of Texas, Houston Division, in In Re: Curtis Cole, No: 18-35182 (May 29, 2019). In this case, Mr. Cole and the IRS had entered into a compromise of tax liabilities for 2003-2014 totaling over $100,000 for the much more manageable sum of $1,000. During the five-year monitoring period, Mr. Cole started off well and timely filed and paid his 2016 income tax. For 2017, however, Mr. Cole recognized that he would not be able to timely file a return, and he accordingly requested and was granted an extension. Mr. Cole did then file his 2017 return and pay his 2017 tax bill on October 15, 2018.

PT readers who do a lot of OIC work will immediately recognize the potential problem that Mr. Cole created for his offer because an extension of time to file is not an extension of the time to pay taxes, raising the possibility that the IRS would default Mr. Cole’s offer for failing to pay his 2017 taxes in a timely manner. Compounding the problem was that Mr. Cole had filed for Chapter 13 bankruptcy one month earlier, on September 15, 2018. As a result, the IRS filed a proof of claim in the bankruptcy proceeding for the full amount of the original tax liability that was compromised under exactly that theory (i.e., that Mr. Cole’s late payment of 2017 taxes caused his offer to default and thus caused the amount of the IRS’s claim to be the full amount of the tax liability).

Mr. Cole was not happy with this development and attempted to raise a couple of equitable arguments that did not have much of a leg to stand on. Mr. Cole’s first hope was that he would be simply forgiven his confusion over whether a filing extension also constituted a payment extension. This did not have much resonance in light of the fact that it is well established that filing extensions are not in fact payment extensions. Mr. Cole also attempted to argue that he effectively had rights under the Internal Revenue Manual by asserting that the IRS violated its own procedures when it did not offer him any opportunity to cure his late payment before declaring the offer to be in default. See I.R.M. 5.19.7.2.20, which states that in the event of a breach of the offer’s terms, the IRS should send the taxpayer a notice letter and provide an opportunity to cure before defaulting the offer. Again, this argument could not carry much weight in light of the well-established principle that the IRM does not give taxpayers any rights, and thus the IRS was not obligated to provide an opportunity to cure the default. Ghandour v. United States, 37 Fed. Cl. 121, 126 n.14 (1997).

Mr. Cole’s strongest argument was based on his reliance on a bankruptcy court opinion from the Eastern District of North Carolina that had ruled on a similar issue and had concluded that the proof of claim should be for the compromised amount rather than the full amount of the tax liability. In re Mead, No. 12-01222-8-JRL, 2013 WL 64758 (Bankr. E.D.N.C. Jan. 4, 2013). The Mead court found that the contractual language in Form 656 stating that the IRS may file a “tax claim” for the full amount of the tax liability if a taxpayer files for bankruptcy before the offer’s terms expire is ambiguous in regards to whether the “tax claim” refers to the full liability or the compromise amount. Accordingly, the Mead court held that the IRS violated the nondiscrimination rule of 11 U.S.C. § 525(a), on the grounds that it appeared that the IRS was trying to collect the full amount of the tax liability, rather than the compromised amount, solely because the taxpayer was in bankruptcy.

The Cole court, however, was not persuaded by its sister court in North Carolina and held that Mead was both distinguishable and simply incorrect.  Mead was distinguishable because, unlike in Cole, there was not an issue of whether the offer had been defaulted. However, even without that distinguishing characteristic, the Cole court noted that the outcome would be the same. In other words, regardless of whether the offer was in default, if the terms of the offer had not yet expired, the IRS would still need to file a proof of claim for the full amount of the tax liability in order to preserve its rights in case the taxpayer did subsequently default the offer. This is why the terms of the offer explicitly state in Section 7: “If I file for bankruptcy before the terms and conditions of the offer are met, I agree that the IRS may file a claim for the full amount of the tax liability, accrued penalties and interest, and that any claim the IRS files in the bankruptcy proceeding will be a tax claim.” I do not agree with the Mead court’s assertion that this language is ambiguous.

It’s not that the issue of whether the offer has been defaulted is irrelevant. Rather, that issue is simply premature at the moment when the IRS files its proof of claim. Even if the offer has unequivocally not yet been defaulted, the IRS must file a proof of claim for the full amount of the liability to protect its right to recover the full amount, should a default occur. So when can Mr. Cole attempt to make his likely to be very uphill arguments that he has not defaulted the offer? As the court notes, he does this when he submits his Chapter 13 plan, in which he will propose how to treat the IRS’s claim. If he believes he has not defaulted his offer, he can propose that the IRS only receive what it is owed if the offer is still in force. The IRS can then object if it believes that the offer is in default, and the issue can then be decided.

In comparing Cole and Mead, I think the Cole court likely has the better argument. The contractual language in Form 656 pretty unambiguously gives the IRS the right to file a claim for the full amount of the tax liability in a bankruptcy proceeding during the five-year monitoring period. That does not mean that the IRS will recover the full amount if the offer is not in default, but taxpayers should certainly expect such a claim to be filed and that they will have to litigate whether the offer is defaulted when they propose their bankruptcy plan.

Offers in Compromise and Tax Refunds – Part Two

In this post I will review which refunds the IRS will seize to when a taxpayer seeks an OIC, and discuss when the taxpayer has options to keep their refund.  

The rules depend on the type of offer. At the end of Part One, I summarized the four types of offers that a taxpayer can make the IRS to settle their tax debt. This background is important because the danger to the client’s refund depends on the type of offer they are seeking. The possible offers to the IRS are: 

  1. Doubt as to liability (DATL) 
  2. Doubt as to collectibility (DATC) 
  3. Doubt as to collectibility with special circumstances (DATC-SC) 
  4. Effective Tax Administration (ETA) 

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A compromise is a binding contract between the government and a taxpayer. The terms of the contract for DATC, DATC-SC, and ETA offers can be found in the IRS’s Form 656 booklet. For doubt as to liability offers, the terms are in Form 656-L 

Refund Considerations: Pre-Offer 

When a taxpayer owes a debt to the IRS or to certain other agencies, the taxpayer’s refund may be applied to that debt pursuant to IRC 6402. Some taxpayers decide to stop filing as a result. This is generally counter-productive. If a taxpayer waits too long to file, they will lose the refund to the statute of limitations anyway, without receiving any reduction in their debt. Also, the IRS generally requires filing compliance before it will consider any proposal by the taxpayer for a collection process other than full payment or enforced collection.  

Many potential clients call LITCs seeking an Offer in Compromise even though they have unfiled returns. So, the first hurdle is getting the tax returns filed.  

A taxpayer should not have to be in filing compliance for a Doubt as to Liability offer to be processable. Alternatives to DATL – including audit reconsideration and Form 843 claims for refund or abatement – do not require filing compliance. A DATL offer is solely concerned with the correct liability for the tax period in question. Form 656-L lacks language on filing compliance which is present in the general 656 booklet, and a DATL offer does not include a 5-year compliance period post-acceptance. However, Rev. Proc. 2003-71 section 5.04 says that an offer can be returned if the taxpayer fails to file a return, and it does not appear to limit this statement by type of offer. I also found the IRM sections on offer processability unclear on this point. Perhaps I missed the relevant IRM provision, but it appears to me that IRM 5.8.2 could use clarification. Disagreements over processability of an offer are some of the most frustrating in tax representation, since the Service takes the position that its processability decision is not subject to appeal. Rev. Proc. 2003-71, sec. 5.05. I recall LITC reports a few years ago about centralized OIC processors refusing to forward an offer to the specialized DATL unit. If that is still a problem, it would be helpful to have a specific IRM provision on processability of DATL offers. I invite readers to comment on their recent experiences with this. 

Refunds generally don’t “count” towards the taxpayer’s offer 

If refunds are due for any unfiled years, our clients naturally would like the balances to count towards their offer. Taxpayers frequently ask whether they can just offer the IRS their next tax refund, or their refund from an unfiled year. Unfortunately for them, Congress in IRC 7122(d)(1) said that IRS gets to make the rules for the OIC program, and the IRS has decided that offset tax refunds don’t count as payments towards a DATC offer, nor do they reduce the taxpayer’s minimum offer amount for DATC, DATC-SC, or ETA offers. IRM 5.8.1.13.3, Amount Offered states 

The total amount of money offered must be indicated and must be more than zero. The amount offered may not include money already paid, expected future refunds, funds attached by levy, or anticipated benefits from capital/net operating losses. 

This is mirrored in the Form 656 booklet, p. 3.  

However, doubt as to liability offers are different – if IRS agrees that the correct liability should be lower, it will adjust the assessment and refund any excess payments that are within the refund statute of limitations. This is noted in the Form 656-L terms. So in that sense, refunds that have been offset will “count” as payment for DATL offers.  

The policy on not considering refunds as payments for DATC offers seems extremely unfair to most of my clients, but it is a logical policy. When the IRS is accepting less money than it is owed based on “doubt as to collectability,” it naturally wants to consider that refunds should be coming in to the Treasury anyway under section 6402. Taxpayers have filing obligations, and as mentioned above the IRS will not consider making a deal unless those obligations are being met. The taxpayer needs to offer more than that to make a compromise worthwhile for the IRS.  

This policy makes less logical sense when it comes to effective tax administration and DATC-SC. One could incorporate past or imminent refund offsets into the taxpayer’s economic hardship or public policy argument, and propose a lower offer due to the hardship or public policy implications of the offsets. However, this argument needs to be couched in the language of ETA hardship or public policy justifications. (See Part One.) It will not work to simply ask for past refunds to be credited towards the offer.  

There is one exception to the rule that seized refunds don’t count as payments towards an offer (DATC, DATC-SC, or ETA). If a taxpayer would receive their refund in the normal course of events (i.e. it is not due to be offset under the terms of the OIC or for any other reason), they can ask the IRS in writing to apply it to an outstanding offer amount. (IRM 5.19.7.2.21.3, Applying Refunds for Non Recoupment Tax Years.) As we’ll see below, this will mostly be applicable to DATC-SC and ETA offers 

Tax refunds while an OIC is under consideration 

The IRS will offset tax refunds while an offer is under consideration. This applies to all types of offers per the Procedure & Administration Regulations, sec. 301.7122-1(g)(5). This is business as usual for the Service under section 6402.  

Keith has written about circumstances where the IRS will not exercise its right of offset. If a taxpayer is facing serious economic hardship, it may be possible to receive an offset bypass refund (OBR). Taxpayers often ask if this is a possibility when an offer is pending.  

The question then arises whether requesting an OBR might violate the terms of the contract that the IRS requires for an OIC, in which case requesting an OBR could cause the IRS to reject the offer. Form 656-L does not contain any provisions regarding refund offsets. The DATC contract terms regarding offsets are: 

The IRS will keep any refund, including interest, that I might be due for tax periods extending through the calendar year in which the IRS accepts my offer. I cannot designate that the refund be applied to estimated tax payments for the following year or the accepted offer amount. If I receive a refund after I submit this offer for any tax period extending through the calendar year in which the IRS accepts my offer, I will return the refund within 30 days of notification.  

Thankfully the contract goes on to exclude DATC-SC and ETA offers from those terms: 

The refund offset does not apply to offers accepted under the provisions of Effective Tax Administration or Doubt as to Collectibility with special circumstances based on public policy/equity considerations. 

So taxpayers seeking offers based on doubt as to liability, doubt as to collectibility with special circumstances, or effective tax administration are free to request an OBR to save their refund while an offer is pending. For DATC the question is more complicated and is discussed below under planning concerns and uncertainties 

Tax refunds after an OIC is accepted 

Refund offsets should stop for taxpayers with DATC-SC and ETA offers when the offer is accepted.  Offsets will stop for taxpayers with accepted DATL offers after the agreed-upon correct liability is paid.  

For regular DATC offers, unfortunately, the OIC offset terms extend to the calendar year in which the offer is accepted. The 656 booklet explains on page 1 that  

The IRS will keep any refund, including interest, for tax periods extending through the calendar year that the IRS accepts the offer. For example, if your offer is accepted in 2018 and you file your 2018 Form 1040 on April 15, 2019 showing a refund, IRS will apply your refund to your tax debt. The refund is not considered as a payment toward your offer. 

This can come as a surprise to taxpayers, and it can cause serious hardships. (As we saw above, the DATC offset terms do not apply to ETA or DATC-SC offers.)  

The National Taxpayer Advocate has recognized that multiple refund offsets can cause hardships for low-income taxpayers who rely on refunds to pay basic living expenses. In her 2018 Annual Report to Congress, she designated problems with the OIC program as a Most Serious Problem facing taxpayers. This is particularly concerning where additional refunds are lost because of the time it takes the IRS to process the offer. If an offer is rejected and appealed, Office of Appeals consideration adds an average of 6.5 months in processing time. This can easily push the taxpayer into the next calendar year. To solve this problem as a matter of fairness and to prevent hardship, the NTA recommends that the IRS change its policy to only seize one tax refund while an offer is pending.  

DATC Offer Planning Considerations and Uncertainties  

One way to avoid the standard offset provisions of Form 656 would be to request a “special circumstances” offer. If the offer can be so categorized, you avoid the need to reform or change the OIC contract. As we saw in Part One, an offer for DATC-SC technically requires the taxpayer to offer less than their reasonable collection potential, and to justify this on hardship or public policy grounds. Since calculating RCP involves judgment calls on the value of assets, and can involve judgment calls as to appropriate household income and living expense figures, there may be cases in a gray area between “regular” DATC and DATC-SC. The offset provisions could weigh towards making a DATC-SC offer, depending on the taxpayer’s circumstances.  

Keith gave this very good advice to a commenter on his OBR post: 

One of the “preprinted” provisions of the standard offer in compromise is that the IRS will keep the refund, if any, for the year in which the offer was approved. Because the refund comes months, or sometimes even a year, later the retention of this refund comes as an unpleasant surprise to many who have received relief through an offer. The existence of this provision requires discussion and planning with the client at the time of acceptance to ensure that withholding in the year of offer acceptance carefully matches the anticipated liability. If the client can claim the EITC or other refundable credits, it is usually not possible to adjust withholding in order to prevent a refund yet the money provided by the EITC refund could be critical to the financial success of the individual. Although I have never done it, I am told that it is possible to negotiate concerning this provision when entering into the offer. So, if you anticipate a big refund in the year of offer acceptance and if the refund will be critical to the financial success of the individuals obtaining the offer try at that point to negotiate out of the offer contract the provision allowing the IRS to offset the refund for the year of the offer. If you cannot do that or if it was not done, you can request offset bypass at the time you file the return for the year of offer acceptance but you are asking for something different than offset bypass under the IRS’ ability to waive offset under 6502 you are asking to reform the contract. I have never done this and do not know the chances of success. I expect the IRS would treat it similar to a regular bypass request but am unsure. Consult the IRM.  

I followed that advice and consulted the IRM. Unfortunately, it is not clear to me that it will be possible to reform the DATC contract to allow a refund to reach the taxpayer. Perhaps I missed a relevant provision; if so please let me know in the comments. It should not hurt to call the offer examiner, or call TAS, and inquire.

A taxpayer cannot alter the preprinted DATC conditions up front. IRM 5.8.1.13.5 (05-05-2017) Standard Conditions provides that

If the taxpayer submitted the Form 656 altering any of the provisions of Form 656, Section 7, the offer should be immediately deemed not processable based on an altered Form 656.

In some cases it is possible to make a collateral agreement to an offer. However, the IRM section on collateral agreements appears to foreclose the possibility of using a collateral agreement to get around the refund provisions:

Form 656 contains a term which waives refunds and overpayments for all tax years through the year the offer in compromise is accepted. This waiver is a standard term, which cannot be altered. 

IRM 5.8.6.4 (10-04-2017) Waiver of Refunds 

I also checked the IRM sections on offset bypass refunds, IRM 21.4.6.5.11 (05-07-2018) Hardship Manual Refunds and 21.4.6.5.11.1 (11-08-2017) Offset Bypass Refund (OBR). These do not mention OICs. If you have experience with obtaining a refund through the OBR or another process while a DATC offer was pending or accepted, please share your experience with us in the comments. It is an important issue for affected taxpayers who may be faced with choosing between an OBR to avoid eviction and maintaining their DATC compromise.

 

Offers in Compromise and Tax Refunds – Part One

Taxpayers often fail to grasp the relationship between offers in compromise and tax refunds. Based on recent email list queries, tax season is a good time for a refresher.

Before we get to tax refunds, a brief overview of OICs will set the stage. Guest blogger Marilyn Ames explained in a previous post that “section 7122 and its predecessors give the IRS the authority to compromise any civil or criminal case arising under the internal revenue laws.” (Read her post for a discussion of the permanent nature of a compromise.) There are three grounds for a compromise with the IRS: Doubt as to Liability (DATL), Doubt as to Collectibility (DATC), and Effective Tax Administration (ETA). 26 C.F.R. 301.7122-1. Revenue Procedure 2003-71 describes the three types of offers as well as the process for submitting and resolving offers.

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Doubt as to Liability means what it says. An OIC-DATL is an alternative to an audit reconsideration for taxpayers who can demonstrate that the assessment is likely erroneous either wholly or partially. Under Rev. Proc. 2003-71, the taxpayer’s offer must “reasonably reflect[] the amount the Service would expect to collect through litigation,” if the underlying liability were litigated.

Effective Tax Administration is less obvious. It originates from a Congressional directive in the legislative history of the IRS Restructuring and Reform Act of 1998. The implementing regulation at § 301.7122-1(b)(3) provides in part:

(i) A compromise may be entered into to promote effective tax administration when the Secretary determines that, although collection in full could be achieved, collection of the full liability would cause the taxpayer economic hardship within the meaning of § 301.6343-1.

(ii) If there are no [other] grounds for compromise …, the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability. …

The regulation goes on to give helpful examples of appropriate ETA offers. There are three hardship examples:

Example 1.

The taxpayer has assets sufficient to satisfy the tax liability. The taxpayer provides full time care and assistance to her dependent child, who has a serious long-term illness. It is expected that the taxpayer will need to use the equity in his assets to provide for adequate basic living expenses and medical care for his child. The taxpayer’s overall compliance history does not weigh against compromise.

Example 2.

The taxpayer is retired and his only income is from a pension. The taxpayer’s only asset is a retirement account, and the funds in the account are sufficient to satisfy the liability. Liquidation of the retirement account would leave the taxpayer without an adequate means to provide for basic living expenses. The taxpayer’s overall compliance history does not weigh against compromise.

Example 3.

The taxpayer is disabled and lives on a fixed income that will not, after allowance of basic living expenses, permit full payment of his liability under an installment agreement. The taxpayer also owns a modest house that has been specially equipped to accommodate his disability. The taxpayer’s equity in the house is sufficient to permit payment of the liability he owes. However, because of his disability and limited earning potential, the taxpayer is unable to obtain a mortgage or otherwise borrow against this equity. In addition, because the taxpayer’s home has been specially equipped to accommodate his disability, forced sale of the taxpayer’s residence would create severe adverse consequences for the taxpayer. The taxpayer’s overall compliance history does not weigh against compromise.

However, most offers are submitted and accepted on Doubt as To Collectability grounds. That is also fairly obvious, although the devil is in the details of the minimum acceptable offer. Rev. Proc. 2003-71 explains,

An offer to compromise based on doubt as to collectibility generally will be considered acceptable if it is unlikely that the tax can be collected in full and the offer reasonably reflects the amount the Service could collect through other means, including administrative and judicial collection remedies. …This amount is the reasonable collection potential of a case. In determining the reasonable collection potential of a case, the Service will take into account the taxpayer’s reasonable basic living expenses. In some cases, the Service may accept an offer of less than the total reasonable collection potential of a case if there are special circumstances.

That last sentence is important – doubt as to liability with special circumstances (DATC-SC) can be considered the fourth type of offer, although it does not appear in the regulation. The distinction matters when it comes to tax refund issues, as we will see below. I.R.M. 8.23.3.1 explains that “an offer based upon doubt as to collectibility with ‘special circumstances’ will be evaluated using the same criteria as an ETA offer.” Those considering a “special circumstances” offer should review the examples in the regulation at § 301.7122-1(c)(3).

To summarize, the four OIC flavors are:

  1. Doubt as to liability – I should not owe this; I am offering or what I’d likely owe if the liability were litigated (or at least $1).
  2. Doubt as to collectibility – I can’t pay this; I am offering to pay my “reasonable collection potential” (or at least $1).
  3. Doubt as to collectibility with special circumstances – I can’t pay this, and I am offering less than my “reasonable collection potential” for hardship or public policy reasons.
  4. Effective Tax Administration – my “reasonable collection potential” is more than I owe, but I am offering less for hardship or public policy reasons.

With that background, we will move on to refund issues in the next post.

Gambling Addiction Does Not Justify Effective Tax Administration Offer

Gillette v Commissioner is a collection due process case arising from the tax consequences of prematurely withdrawing funds from an IRA and underpaying taxes while a taxpayer was suffering from compulsive gambling that she claimed was attributable to an addiction to prescription medication. The taxpayer sought an effective tax administration offer in compromise. While unsuccessful, the case warrants attention as there is very little law around this type of offer.

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The opinion situates the sad tale that led to the sizable underpayment of taxes on her 2012 tax return. Ms. Gillette is a veteran and former firefighter who managed and owned a stable of rental properties. After retiring from firefighting, she developed a serious gambling addiction that she attributed to the side effects of pramipexole, a prescription medication.

Occasionally she would go days without sleep and at times slept in her car if she wasn’t given a complimentary night’s stay at a casino. Other times she would fall asleep at blackjack tables and slot machines only to be awakened by dealers and casino attendants. Nearly all of the money she collected from her rental properties went to casinos. When she ran out of money, she borrowed from friends and didn’t pay them back, took money and credit cards from her husband’s wallet, and eventually withdrew money from her retirement account in 2012.

In 2013, following the intervention of her son who recognized that the side effects of the medication she was taking were likely contributing to her gambling, she sought medical care to wean off the drug. Within a couple of years she was no longer taking the drug and was able to stop gambling. One lingering effect though was the 2012 alternative minimum tax (AMT) of about $17,000 and early IRA withdrawal penalty of about $10,500, both of which contributed to a tax balance due of almost $76,000 on her and her husband’s 2012 tax return.

Following a notice of intent to levy, the taxpayers requested a CDP hearing, challenging the underlying AMT liability and eventually offering $38,968 to compromise the liability based on effective tax administration (ETA). The ETA offer was sought because they were not a candidate for an offer based on doubt as to collectability, as the equity in assets (including the rental properties) exceeded the tax due (in fact Appeals determined that the reasonable collection potential in light of the assets was over $800,000).

The main part of the opinion dealt with Appeals’ rejection of the ETA offer and the Tax Court’s refusal to find any abuse of discretion in Appeals’ rejection.

The case originally went up to Tax Court a couple of years ago, but the Tax Court on the IRS’s motion remanded the case back to Appeals for a supplemental hearing because the original determination had an insufficient discussion of the reasons why Appeals agreed with the offer specialist’s decision to reject the ETA offer. By requesting a remand, the IRS avoided reversal for failure to consider the taxpayer’s equitable arguments. Guest blogger Professor Scott Schumacher previously discussed this requirement on PT.

After going back to Appeals, the settlement officer considered the taxpayer’s argument and again rejected the offer, in part on a finding that the side effect of the medications, including compulsive gambling, were known since 2006 and that the taxpayer made a choice to continue taking the medication anyway. In rejecting the offer on remand, Appeals did not refer the offer to the IRS’s ETA Non-economic Hardship Group, the group the IRM states should review ETA offers in “appropriate” cases.

Before exploring this further, it is worth emphasizing the law that applies to offers based on effective tax administration. The regulations provide the standard:

If there are no grounds for compromise under paragraphs (b)(1) [doubt as to liability], (2) [doubt as to collectability], or (3)(i) [economic hardship] of this section, the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability. Compromise will be justified only where, due to exceptional circumstances, collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner. A taxpayer proposing compromise under this paragraph (b)(3)(ii) will be expected to demonstrate circumstances that justify compromise even though a similarly situated taxpayer may have paid his liability in full.

Reg. Sec. 301.7122-1(b)(3).

Thus, the regulations provide that the IRS may accept a compromise where there are “compelling public policy or equity considerations.”  Unlike offers based on doubt as to collectability, which essentially default to a more mechanical comparison of the offer amount relative to the taxpayer’s collection potential, this standard is relatively vague. The regs do provide some examples of cases that should be considered under a public policy or equity ETA offer:

(1) a taxpayer with a serious illness requiring hospitalization for a number of years who, at the time, was unable to manage his or her financial affairs, including filing tax returns and (2) a taxpayer who learns after an audit that incorrect advice was given by the Commissioner and is now facing additional taxes and penalties because of that advice.

The IRM also provides guidance for IRS, providing additional factors and examples:

  • where the taxpayer’s liability was the result of the Commissioner’s processing error,
  • following the Commissioner’s erroneous advice or instructions,
  • the Commissioner’s unreasonable delay, or
  • the criminal or fraudulent act of a third party

In addition the IRM states that accepting a public policy or equity offer-in-compromise may be appropriate where rejecting it would cause a significant negative impact on the taxpayer’s community or “the taxpayer was incapacitated and thus unable to comply with the tax laws.”

The main argument that the taxpayers made was that because of the drug use Ms. Gillette was mentally impaired and incompetent, essentially claiming that this was akin to an incapacitation that would justify acceptance of an offer below the collection potential.

The Tax Court disagreed, primarily by distinguishing her situation from the examples and factors cited in the regs and the IRM:

Ms. Gillette and Mr. Szczepanski argue that their public policy or equity offer-in-compromise should be accepted because Ms. Gillette’s mental illness was caused by her prescription medication. While Ms. Gillette’s circumstances are unfortunate, Ms. Gillette and Mr. Szczepanski did not provide grounds for treating them differently from a similarly situated taxpayer who paid his or her liability in full. Their situation also differs from the examples given in the regulations: Ms. Gillette did not require hospitalization for a number of years, she was able to file her tax returns, she collected rents from her rental properties, and she did not receive incorrect advice from the Commissioner.

In addition, the opinion, while acknowledging the impact of the gambling addiction, distinguished the incapacity from others that would render an inability to comply with the tax laws:

Finally Ms. Gillette and Mr. Szczepanski do not meet any of the compelling factors outlined in the IRM. Ms. Gillette was not so incapacitated that she was unable to comply with the tax laws, rejection of their public policy or equity offer- in-compromise would not have had a significant negative impact on their community, and their 2012 tax liability was not caused by an error or delay of the Commissioner or the fraudulent or criminal conduct of a third party.

Conclusion

This is a close case. No doubt the taxpayers come away feeling that the system did not adequately address their legitimate concerns. From a process standpoint, I feel their pain; the initial Appeals determination did little in explaining why the offer was originally rejected; on remand Appeals did not refer the case to the unit specifically that hears ETA offers (a point the opinion notes was not an abuse of discretion as the decision to do so is essentially one completely in Appeals’ wheelhouse); and at trial the Tax Court did not allow the testimony of the taxpayer’s doctor or VA social worker, among other witnesses.

I am not equipped to evaluate the level of the taxpayer’s incapacity or the degree to which the medication contributed to or caused the gambling that led to the liability and underpayment of taxes. It would seem to me, however, that the Tax Court might have benefited from the testimony of the doctor. While some circuits follow the record rule and limit review of CDP cases to the evidence in the administrative record, the Seventh Circuit, where the case is appealable, has declined to decide that issue. In addition, given the lack of guidance in this area, the IRM factors and examples have heightened importance, a curious result again from a process standpoint given the absence of any public input in their promulgation.

To be sure, as the opinion notes, and as the IRS emphasized, there is no explicit unfairness hook that would require the IRS to accept an ETA offer. In addition, the taxpayer has significant assets. Given the lack of case law in this area, it is likely that this case will be one that the IRS will lean on when taxpayers seek to resolve a liability even after a taxpayer makes a credible case that substance abuse has contributed to the taxpayer’s liability.

For readers interested in more on ETA offers, including suggestions on how the IRS can improve standards for evaluating the offers, check out Rutgers Law School Professor Sandy Freund’s 2014 Virginia Tax Review article Effective Tax Administration Offers-Why So Ineffective.

 

 

 

Making an Offer in Compromise Does not Stop Seizure and Sale of Home

In United States v. Brabant-Scribner, No. 17-2825 (8th Cir. Aug. 17, 2018) the Eighth Circuit affirmed the decision of the district court allowing the sale of taxpayer’s home and affirmatively determining that an offer in compromise request filed by the taxpayer has no impact on the ability of the court to grant the request by the IRS to sell the home or on the IRS’ ability to sell the home once the court granted its approval. In reaching this conclusion the Eighth Circuit analyzes the exemptions to levy in IRC 6334 and the relief those provisions do and do not provide.

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Taxpayer owes the IRS over $500,000. The opinion does not discuss the actions by the taxpayer to pay or resolve her liability prior to the action by the IRS to sell her house. I imagine that the IRS considered her a “won’t pay” taxpayer. Before seeking to sell her home, the IRS had seized and sold her boat and levied on her bank accounts.

The 1998 Restructuring and Reform Act added IRC 6334(e)(1)(A) to require that prior to seizing a taxpayer’s principal residence the IRS must obtain the approval of a federal district court judge or magistrate in writing. Before the passage of this provision, the IRS could seize a taxpayer’s home with the same amount of prior approval needed to seize any other asset owned by the taxpayer. No approval was necessary to seize any asset of the taxpayer. Prior to 1998 collection due process did not exist. Prior to 1998 the 10 deadly sins did not exist one of which calls for the dismissal of an IRS employee who makes an inappropriate seizure. So, the landscape regarding seizures, and especially personal residence seizures, changed dramatically after 1998; however, the amount of litigation regarding seizure of personal residences is low and the Brabant-Scribner case offers a window on one aspect of this process.

As the IRS initiated the process of seizing her personal residence by obtaining the appropriate court approval, the taxpayer filed an offer in compromise. She filed an effective tax administration offer of $1.00, but the amount and sincerity of her offer do not really matter to the legal outcome of this case. The timing and the amount of the offer may have influenced the thinking of the judges and made them more inclined to dismiss her argument but her possibly bad faith effort to stop the approval and execution of the sale should not have affected the outcome here.

To convince the court to allow the sale of a personal residence, the IRS must show compliance with all legal and procedural requirements, show the debt remains unpaid and show that “no reasonable alternative” for collection of the debt exists. Taxpayer argued that her offer was a reasonable alternative; however, the court spends three paragraphs explaining that an offer does not matter in this situation. The relevant language in the applicable regulation is “reasonable alternative for collection of the taxpayer’s debt.” The court explains that the word “for” holds the key to the outcome.

“For” refers to an alternative to the sale of the personal residence such as an installment agreement or the offer of funds from another source to satisfy the debt. An offer in compromise is not an alternative for collection but an alternative “to” collection.

Having determined that the words of the regulation point toward a resolution other than an offer as providing the necessary alternative, the court looks at the remainder of the regulation for further support of its conclusion. It points to the provision in Treasury Regulation 301.6334-1(d)(2) which provides that the taxpayer has a right to object after the IRS makes its initial showing and “will be granted a hearing to rebut the Government’s prima facie case if the taxpayer … rais[es] a genuine issue of material fact demonstrating … other assets from which the liability can be satisfied.” This regulation, like the one providing an alternative “for” collection, looks not to relief from payment of the liability but a source for making payment. It does not provide the offer in compromise as a basis for relief. Based on this the court concludes that “nothing requires the district court to ensure that the IRS has fully considered a taxpayer’s compromise offer before approving a levy on a taxpayer’s home.”

Since the IRS properly made its case for seizing and selling the home and the taxpayer did not rebut that case, the Eighth Circuit affirms the decision of the district court to approve the sale. The decision provides clear guidance for district courts faced with the request by the IRS to seize and sell a personal residence. Personal residence seizures by the IRS remain rare at this point. Taxpayers faced with such a seizure, almost always taxpayers the IRS characterizes as “won’t pay” taxpayers, will find it difficult to stop the seizure and sale based on this decision. I do not think this decision will motivate the IRS to increase the number of personal residence seizures but it will make it a little easier to accomplish when it decides to go this route.

 

When Does an Offer in Compromise Extend the Statute of Limitations on Collection?

United States v. Kenny, No. 1:16-cv-02149 (N.D. Ohio June 6, 2018) involves a spectacularly non-compliant taxpayer against whom the IRS seeks both the reduction of assessments to judgment and an injunction. The court grants both. Mr. Kenny’s defense relied upon the statute of limitation on collection and the failure of his three OICs to extend it. The issue arises regularly because of the handling of OICs by the offer groups in Brookhaven and Memphis.

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Mr. Kenny failed to pay taxes voluntarily for about 25 years. He receives income as an independent contractor or a business owner and not as a wage earner. The court described in some detail his failure to voluntarily comply with his tax obligations and his expenditures which included almost $5,000 in monthly rent, almost $2,000 each month in meals and gas, extensive travel, payment of his son’s student loans and his daughter’s tuition. As with almost any case of this type, the described behavior would appear to have the facts needed in order to pursue prosecution under IRC 7201 for evasion of payment; however, for reasons not explained in the opinion, the government seeks other remedies against Mr. Kenny.

In addition to obtaining a judgment against him for the outstanding balance of the taxes, the IRS also sought an injunction to “to comply with his on-going tax obligations.” In addition to the almost $1.5 million in income taxes he also owes about $10,000 in trust fund recovery penalty. I have seen injunction cases to keep taxpayers from pyramiding trust fund taxes, but his case appears to be an injunction directed at complying with the income tax laws.

The court starts out stating that it generally disfavors injunctions “that do no more than require on-going compliance with the law.” The court goes on, however, to state that the unique facts here support the use of injunction as a tool to promote compliance. It cites to five factors developed by the 6th Circuit for determining whether to issue an injunction:

  • The gravity of the offence
  • Extent of participation
  • Scienter
  • Recurrent nature of offense
  • Likelihood that his business activities will involve him in some offense again

The court spends a long paragraph explaining how Mr. Kenny fits into all of the categories set out by its circuit. The paragraph ends with the notation that the IRS withdrew the request for the appointment of a receiver to handle the business affairs of Mr. Kenny. The appointment of a receiver is a remedy even more extraordinary than an injunction.

Statute of Limitations

Mr. Kenny’s defense to the effort to obtain a judgment against him focuses on the statute of limitations and the impact on the statute on the three offer in compromise (OIC) requests that he filed with the IRS. Essentially, he argues that the IRS rejected the OICs as non-processable returning them without consideration. Further, he argues that because each of the offers were returned as non-processable his submission of the OICs would not extend the statute of limitations on collection and that the IRS needs the extra time it argues results from his submission of the OICs in order for the suit against him reducing the liability to judgment to be considered timely. The applicable IRM provision (IRM 5.8.7.2) provides “An offer can be returned as either a “not processable return” or a “processable return”. It is important to note the distinction because when there is a not processable return the collection statute is not suspended…”  The court does not provide the detail needed to reveal exactly what happened when Mr. Kenny submitted his OIC requests; however, it appears that the IRS rejected the OICs at some time after the processability point thereby triggering the statute of limitations extension needed by the IRS.

The issue of when the IRS rejects an OIC has significance not always noted when the OIC gets returned to the taxpayer. Just as a taxpayer should not submit an OIC without thinking about the statute of limitations implications, a taxpayer should carefully note the basis for the IRS returning an OIC without acceptance. Many things can cause the IRS to return an OIC as non-processable and a detailed description of the circumstances that cause the IRS to determine an offer is non-processable as well as the process for making the determination can be found in IRM 5.8.2. The Centralized OIC units make the determination as stated in IRM 5.8.7.2.1 which provides:

Not Processable Returns

  1. An offer is determined to be not processable if any of the “Not Processable” criteria listed in IRM 5.8.2.3.1, Determining Processability, is present. This decision is the sole responsibility of the Centralized OIC (COIC) sites located in the Brookhaven and Memphis Campus.

About a dozen years ago several taxpayers litigated the processability issue with respect to the bankruptcy criteria. These taxpayers argued that making bankruptcy a processability criteria disadvantaged them in an inappropriate manner. After a couple of victories at the bankruptcy level (See In re Holmes, 298 B.R. 477 (Bankr. M.D. Ga. 2003); In re Chapman, 1999 Bankr. LEXIS 1091 (Bankr. S.D. W. Va. 1999)), the tide turned on this issue and the IRS prevailed (See In re Shope, 347 B.R. 270 (Bankr. S.D. Ohio 2006); In re Uzialko, 339 B.R. 579 (Bankr. E.D. Pa. 2006). I mention the cases for those who might have interest in attacking the processability criteria to show that such an attack would prove difficult because of the discretion IRC 7122 gives to the IRS in making the OIC determination.

A sure sign that the IRS is returning an OIC as non-processable is that the IRS does not give a taxpayer appeal rights when it rejects an OIC. Those who regularly submit offers know that getting a call from the OIC unit relatively quickly after submitting an OIC where the person at the offer unit says “if I do not receive X within 10 days I am going to return your offer as non-processable” happens fairly regularly.

It appears from IRS activity on Mr. Kenny’s OIC submissions several months after the initial submission that the IRS did consider the OICs on their merits before rejecting them; however, the type of rejection may not always be clear. In a recent post complaining about the telephone number provided by the offer unit, I spoke about a processability rejection (an incorrect one) because the assessment occurred as a result of a restitution order and when it does the IRS has no ability to administratively compromise the liability. Unfortunately, the Kenny case offers little guidance on when the return of an OIC results from a non-processable submission verses an unacceptable one on the merits of the offer because Mr. Kenny did not provide much evidence. Despite the absence of clear guidance, the Kenny case serves as a reminder that submitting an offer suspends the statute of limitations on collection and submitting multiple offers can suspend it for quite some time if the submitted offers make it past the processability stage. For taxpayers seeking to defend collection suits on the basis of the statute of limitations keeping careful track of these submissions and the basis for denial of the OIC requests becomes important in deciding if a procedural defense to the suit is available.