When You Owe IRS

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, October 26, 1997

Copyright 1995-7 Robert L. Sommers, all rights reserved.

When You Owe IRS

When IRS says you owe money, don’t panic. Take one step at a time. Remember, you have rights. Review the interest charge: It is estimated IRS miscalculates interest charges 25 percent of the time. Determine whether interest is based on the correct year; then, check the amount. Calculate a rough estimate of interest at 1 percent per month. If you owe interest on $1,000 for two years, the notice should state approximately $240 in interest.


Check The Penalties

Often, an IRS computer generates penalties that can be fully abated. A negligence penalty, for instance, does not automatically apply if the taxpayer is wrong -- the taxpayer must be negligent. Penalties are negotiable, so always try to get penalty charges excused. You may now abate interest when IRS, through ministerial or managerial acts ( loss of records, agent training or personnel transfers), causes unreasonable errors or delays.

Don't pay until you are certain IRS is correct: Once you pay an erroneous statement, it is difficult to get a refund. As long as IRS expects money from you, your bargaining position is stronger. But once you concede taxes are owed, and that the interest is calculated correctly -- and if you cannot reduce or eliminate the penalties -- then send a check (marked with the tax year and your Social Security number). Keep copies.


If you owe the IRS but cannot pay, generally there are three alternatives:

Installment Arrangement

Enter into an installment arrangement to pay IRS over time. You’ll be promising to pay the full taxes owing, plus interest, usually in equal monthly installments, but IRS will not take collection action while the agreement is in force. You must provide financial information so that IRS may determine whether you can afford to pay the tax immediately. Installment arrangements work best when the taxpayer has a steady income; those on commissions or working for themselves often have difficulty maintaining monthly payments.

Unfortunately, IRS is notorious for canceling installment arrangements without warning and then levying bank accounts or paychecks. In response, Congress enacted new rules to make IRS comply with installment arrangements once in effect.


Offer in Compromise

In Offer in Compromise is an agreement to pay less than the taxes owed. IRS will compromise taxes based on its doubt as to liability (you might not owe the tax - no financials are necessary) or collectibility (IRS cannot collect in full from you). If your Offer is based on doubt as to collectibility, you submit financial statements showing your assets and monthly income. Your offer must exceed the larger of (1) the quick sale value of your assets (generally 80% of fair market value); or (2) 60 months’ worth of your so-called "excess income" (income that exceeds your necessary living expenses). You submit your offer on Form 656, but read the fine print on the back.

For example: If you owe $100,000 in taxes, have $10,000 in assets and have $100 a month in excess income, your offer must exceed $10,000 (your assets are worth more than your income stream). If you have $5,000 in assets, then your offer must exceed $6,000 ($100/mt. X 60 months) since your income stream is higher than your assets. Note: Your Offer is based on IRS’s ability to collect, not on the amount of taxes you owe. Generally, you should offer at least $5,000, even when you have no excess monthly income. An unrealistically low offer is a waste of time.

There are two drawbacks to the Offer process: First, you cannot Offer IRS assets already available for collection. For instance, if you have $10,000 in savings, you cannot offer IRS that asset since it can take it anyway. You usually need a financial "angle" (someone to gift or lend you the money). Second, you must file and pay all taxes owing for the next five years in a timely matter. Watch out: IRS erroneously believes that using extensions to file cause those returns to become "untimely" and could void your Offer.

In addition, IRS will keep your tax refund in the year the offer was accepted – a nasty surprise. If your Offer is accepted in 1997 and you file for that refund during 1998, IRS will keep that refund. Further, it will not be applied toward your Offer balance. Plan ahead: Make sure your refund is as small as possible.


Bankruptcy

If all else fails, consider filing bankruptcy on your income taxes. Bankruptcy can eliminate your liability for income taxes that are more than three years old, provided you have filed non-fraudulent tax returns (fraud is usually court-determined) at least two years before declaring bankruptcy. If IRS has assessed you additional taxes, you must wait 240 days from the date of assessment before filing bankruptcy.

For example: If you incurred a $100,000 capital gain in 1996, the due date for that return will be April 15, 1997. If you file a non-fraudulent tax return by that due date, you must wait until April 16, 2000, to eliminate your tax liability in bankruptcy.

Trust fund taxes (i.e. payroll taxes or other payments held in trust for the government) are not dischargable in bankruptcy. Also, there is a trap lurking for taxpayers who sold a principal residence for a taxable gain but did not replace it within the two-year period under old Section 1034 (the principal residence rollover rules). IRS has argued, and one court has agreed, that you cannot discharge these taxes in bankruptcy until three years after you file an amended tax return reporting the gain from the sale.




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