As soon as the IRS files a Federal Tax Lien against a delinquent taxpayer, it becomes public record that the person or business has a balance due to the IRS. The lien is filed very soon after a liability is assessed. The fact that the lien is public record means that anybody who cares to search can identify taxpayers who owe the IRS. That, in turn, means that tax resolution companies come out of the woodwork soon after the lien filing, offering their services, and attempting to convince the taxpayer to hire them.
Other tax resolution companies advertise on TV, the internet or radio. Oftentimes, their ads are designed to lead the listener to believe that they can call an 800 number and settle their tax debts for a fraction of what they owe.
Many tax resolution companies tell their prospective clients that they can make the whole problem disappear by filing an Offer in Compromise (OIC). But, if you are the delinquent taxpayer, how do you know whether all of the sunshine and rainbows promised by the resolution companies are even possible? How do you decide whether to sink thousands of dollars into a representative who says she can resolve your IRS debt for “pennies on the dollar?” The answer is to learn the basics of what makes a good OIC candidate, which will be explored below.
At its most basic, the IRS’ formula for an Offer in Compromise is fairly simple: net realizable equity in assets plus future income.
Net Realizable Equity IRS Offer formula
Net realizable equity (NRE) in assets is the quick sale value of the assets (80% of fair market value, according to the IRS) minus any outstanding loan balance. For example, if you have a home, worth $100,000, with a $50,000 remaining mortgage balance, the net realizable equity in that asset is 80% of $100,000, or $80,000, minus the $50,000 loan balance, for total NRE of $30,000. If that is your only asset, you have calculated the first component of the Offer formula. If, on the other hand, you have other assets, you have to add all of the NRE together, using the same quick sale reduction percentage for each asset.
Keep in mind that you only use the quick sale value for non-liquid assets. For example, if you have $10,000 in your checking account, you do not use the 80% formula. The NRE of your $10,000 is simply $10,000.
Some assets are exempt from the Offer formula, such as income-producing assets for a viable business as well as normal household items that are needed to live. The IRS offers guidance on exempt assets, as can a qualified representative.
Once you have determined your NRE, the IRS Offer formula calls for you to turn to calculating your net monthly income. This is your gross monthly income, minus all allowable, verifiable living expenses. If we use the same hypothetical taxpayer from the equity example above, we already have the $30,000 in NRE. Say that taxpayer has a four person household, and makes $5000 per month. Let’s assume that total allowable living expenses for our hypothetical taxpayer total $4500 per month. That leaves $500 per month in net income. Depending on how the Offer will be funded, that $500 per month net income is multiplied by either 12 for a lump sum cash Offer, or 24 for a periodic payment offer. That means that the total Offer amount for lump sum would be $36,000, or the total Offer amount for a periodic payment Offer would be $42,000.
Pre-qualifying yourself for an Offer with the IRS gets the trickiest when looking at the net income calculation, for a few reasons. First, the net income must account for the IRS National Standards for Allowable Living expenses, Local Standards for Housing and Utilities, and a hybrid of local and national allowable transportation expenses, which are available on the IRS website. Even if your actual living expenses are higher than the allowable standards, the IRS will hold you to the allowable standards, absent a compelling case for allowing a variance. Second, the IRS requires a high degree of proof that not only are the claimed expenses actually due to creditors, vendors, and suppliers, but also that you can prove that you actually pay those expenses, in the form of bills, invoices, cancelled checks, bank statements, etc.
Finally, if the claimed net income will be sufficient to pay off the IRS liability within the remaining life of the Collection Statute of Limitations, the IRS generally will not accept an Offer. If our hypothetical taxpayer owes $50,000, and there are more than one hundred months left for the IRS to collect, the net income of $500 per month will pay everything off in a little more than eight years. The IRS prefers to play the long game in that situation, and will generally not accept an Offer.
At its very essence, an Offer in Compromise (OIC) is a good tool for a taxpayer who owes a substantial sum to the IRS, has limited equity in assets, and can show a low monthly net income. Of course, a good tax negotiator may be able to take a taxpayer who does not fit all of those criteria, and still negotiate a reasonable settlement.
Also, it is extremely important to understand the value of a seasoned tax resolution pro when it comes to negotiating an Offer in Compromise. Offer Specialists, the IRS employees who review OICs, are notorious for overvaluing assets, disallowing expenses that should be allowed, and even inflating income. In other words, they skew the variables of the math formula so that they favor the IRS. Thus, the fee that you pay to a good tax resolution professional for an OIC will very often pay for itself many times over in terms of a much lower settlement. On borderline OICs, having a good professional could be the difference between a settlement and no settlement at all. If you are interested in learning how the professional fees for an OIC are oftentimes “free,” I recommend that you review this article written by our company’s president.
If a tax resolution firm tells you that you are a great candidate for an OIC, here are a few red flags:
- The representative did not ask you about your income, expenses, and equity in assets. This is a BIG red flag. Most taxpayers are not good OIC candidates. If someone tells you they can settle your taxes without asking anything about your financial situation, hang up the phone.
- You have high income. If you live in a very expensive county, have many dependents, and/or you have other significant allowable expenses (e.g. ongoing medical bills), it may be possible that you actually are a good OIC candidate despite your high income. However, if your high income is spent on a luxury home, fancy cars, lavish vacations, private school tuition for your kids, and such, an OIC probably won’t work for you. Also, if this describes you, get help. The IRS doesn’t like if it perceives that you live high on the hog and simultaneously claim an inability to quickly repay your tax debt.
- You have significant equity in assets. If you were to sell everything you own, would there be enough money left to full-pay the IRS after paying off senior creditiors (e.g. your mortgage, your car loan, etc.)? If the answer is yes, you are probably not a good OIC candidate.
One final recommendation if you are told that you qualify for an OIC and it sounds too good to be true is to get a 2nd and 3rd opinion from reputable tax resolution companies—those that have an A or A+ rating with the Better Business Bureau and who have been in business for at least 7 or 8 years. Think about the dynamics. The representative wants you to hire his or her firm. What could be more enticing to you, the taxpayer, than to have your tax debt settled for a small fraction of the total? If your 2nd or 3rd opinion tells you that you are not a good candidate for an OIC, there is a good chance you are talking to someone with a strong sense of ethics who isn’t out to pick your pocket in exchange for a false bill of goods.