Our U.S. tax system is built on the premise that all taxpayers are expected to report their tax liabilities accurately and pay them on time. However, the Internal Revenue Code (§7122) gives the IRS the authority to “compromise” (i.e., settle based on a taxpayer’s adverse economic circumstances) a tax liability for less than its stated amount at certain times when 1) Doubt exists as to the liability; 2) Doubt exists as to the liability’s collectibility; or 3) It would advance effective tax administration to settle the liability.
Defining the 3 OIC Fundamental Concepts
- “Doubt as to liability”—Doubt as to liability exists when there is a real dispute about the existence or amount of the correct tax liability of a taxpayer.
Such doubt doesn’t exist, though, if the liability has been settled by a final court decision or judgment concerning the genuineness or amount of the liability. But an offer under the “doubt as to liability” category can’t be rejected just because the IRS can’t locate the taxpayer’s return or information to verify the liability (IRC 7122(c)(3)(B)). The IRS indicates it will consider an offer based on doubt as to liability if it reasonably reflects the amount the IRS could expect to get by going to court. Since trying to predict the outcome of a court case is far from an exact science, the IRS relies on “discretion” in determining what it will consider as a reasonable offer (Rev. Proc. 2003-71, 2003-2 C.B. 517).
- “Doubt as to Collectibility”—Doubt as to Collectibility may be present in any case when a taxpayer’s assets and income are less than the full amount of the assessed liability. To determine doubt as to Collectibility, the IRS considers the taxpayer’s ability to pay. In settling such a case, the taxpayer must be allowed to preserve sufficient funds to pay for his/her basic living expenses. To determine settlement, IRS considers expenses only to the extent they are necessary for health and welfare of the taxpayer and family or are needed to produce income (Rev. Proc. 2003-71).
In general, the IRS won’t consider an offer based on doubt as to Collectibility if the ability of the government to collect the tax is not in doubt. This kind of offer is considered appropriate when liquidation of assets or maximum levy of income isn’t enough to pay the tax. The assets of a non-liable spouse generally aren’t considered to determine a taxpayer’s ability to pay unless those assets have been conveyed to the spouse in order to defraud creditors (or unless state law makes the spouse’s assets available to creditors, such as in community property states). However, action against the spouse’s assets must be weighed against how such action will affect the standard of living of the taxpayer and family.
The IRS publishes schedules of national and local living expense standards to help evaluate family needs (Publication 1854, How to Prepare a Collection Information Statement (Form 433-A)). They use these standards based on the individual facts and circumstances of each individual case. The standards aren’t used if the amounts they prescribe would deprive a taxpayer of adequate support for basic living needs.
- “To promote effective tax administration”—If the IRS finds no grounds to compromise based on the two previously described categories, they may enter into a compromise to promote effective tax administration. This could happen when collection of a full tax liability creates economic hardship. Alternatively, it could result where detrimental public policy or unfairness to the taxpayer provide basis for a compromise. Although acceptance of a compromise under this standard may occur where full collection would undermine public confidence in the tax law, a compromise would not be accepted if it would undermine compliance with the tax laws by taxpayers.
Congressional intent with this provision was that the IRS would take into account factors like equity, hardship, and public policy in the tax administration process. Factors that may be considered in determining hardship might include serious illness that depletes a family’s financial resources (Reg. Section 301.7122-1(c)(3)(i)(A)). On the other hand, a compromise of a tax shelter liability would be one that could undermine rather than promote compliance within the tax system.
Excerpt from 2013 Taxes: Affordable Care Act and Other Special Circumstances by Lee T. Reams, Sr.