By R. Kevin Cross, MST, EA, CPA*
“I owe the Internal Revenue Service. Where am I going to get the money to pay?” You may have heard a client tell you this. As their adviser, you should know what to do next.
According to statistics1, economic hardships fall right after the death of a family member and before poor physical health. However, we can offer our clients hope that is far less stressful while preserving the integrity of the tax system2. Albeit it may be true that taxes are the cost of a civilized society3, as practitioners we must work within the financial limitations of our clients. Thus knowing what options are available is not only important, but also critical to effective tax administration.
There are essentially five options that the practitioner must analyze to determine which is the best choice for the client and often more importantly permissible by the Internal Revenue Service ("Service"). More important than spotting the five options is the necessity of competently resolving a client’s tax issue with the best option. The practitioner who does not work with the Service on a daily basis should consult someone with specific competence in the tax controversy field4. Clients who find themselves in the position of owing the Service will find at least one option available, even if the result is not completely desirable. The outcome more often than not will be less stressful and less financially devastating than ignoring it altogether.
Your client’s options:
1. Full Pay
2. Installment Agreement
3. Currently Not Collectible
4. Offer In Compromise
1. Full Pay:
The least sexy but most obvious option is to "full pay" the tax liability — even if it means borrowing from other sources. Actually it isn't the interest5 that is obscene on an amount owed to the Service, it’s the combination of interest and penalties. The failure to pay penalty6 enables the Service to assert a penalty up to 25 percent for nonpayment. One should consider owing virtually anyone else but the Service if this penalty is being assessed.
One of the options to explore on behalf of clients who have a collection issue is the abatement of penalties7. Often clients have surrendered to the fact that they owe the taxes along with the penalties and interest, but the client may not have to “say uncle” to the penalties. Many times the penalties can be abated. In each case, even if the chances seem remote, the practitioner should put together a thorough and comprehensive compilation of facts and circumstances that supports a client’s reasonable cause campaign. The Code8 provides a defense9 against the assertion of a penalty if the client can show reasonable cause10 and has acted in good faith. The key to submitting a well-prepared and effective abatement of penalty request is to quote the Internal Revenue Manual11 (IRM). An effective tax practitioner must be intimately familiar with the IRS’s playbook — the consolidated penalty handbook12 of the IRM.
Generally each abatement letter should include the following factors. State the taxpayer’s reason13, his or her compliance history, which clearly demonstrates strict compliance with filing and paying, length of time between the event cited above as the cause for noncompliance and the subsequent compliance (virtually seamless, and without any hesitation), coupled with the fact that the circumstances were beyond the taxpayer’s control. An abatement of the penalty based on the establishment of ordinary business care and prudence should be granted14.
2. Installment Agreement (IA):
After discovering a tax liability owed to the Service, the Service allows taxpayers the option of entering into an installment agreement15 if the full amount cannot be paid immediately. You should consider this only after you have made use of the “extension of time to pay”16 provisions, which permits the client to extend payment up to 120 days without a lien filed against them.
If your client owes less than $10,000 in tax17, and agrees to "full pay" within 36 months, Congress mandates the Service to enter into an installment agreement18. This type of installment agreement is called a “guaranteed” or “statutory” installment agreement. The most impressive aspect of securing a guaranteed IA is the ease — no collection information statement, no lien, no manager approval.
As many clients owe more than $10,000 in tax, the Service's announcement of a more liberal policy in March 1999 was welcome relief. This new policy is commonly referred to as a “Streamlined Installment Agreement”19. The Streamlined Installment Agreement program is available to taxpayers that owe the Service less than $25,000.
If your clients cannot avail themselves of the IA provisions above, you may want to combine the IA with CNC status discussed below. Unfortunately, a lien will be filed if it has not been previously filed.
3. Currently Not Collectible (CNC):
This is one of the most overlooked strategies for certain clients who cannot pay their tax liability. The Internal Revenue Manual20 provides for currently not collectible status, "CNC status," when a taxpayer has no ability to "full pay" or even make payments. CNC status, sometimes referred to as “53 status,”21 has strong "pros" with some "cons." The strongest "pro" is that the Service will suspend collection activity — indefinitely if the client’s financial situation does not improve. However, a Notice of Federal Tax Lien (NFTL) will be mailed to the client and a subsequent tax lien filed — merely to protect the Government’s interest.
Why is this such a wonderful option? The collection period after a proper return22 has been filed and an assessment of the related tax liability gives rise to a 10-year statute of limitation23. If your client is fortunate enough to be “currently not collectable,” the statute continues to run, and in many situations the statute will run out.
The last day the Service can collect on your client’s tax liability is called the “collection statute expiration date” or "CSED." As a tax practitioner you must be intimately familiar with the CSED, due to the fact that many events suspend the running of the statute of limitations — including some of the options that are presented in this article. Fortunately, currently not collectable does not extend the statute.
Generally a client’s ability to make payments on his or her tax liability is largely determined by calculating the excess of income over necessary living expenses. Accounts may be reported CNC if collection of the liability would create an undue hardship for taxpayers that create a situation where they are unable to meet necessary living expenses .
Clients on a fixed income such as Social Security and/or a small amount of other income are typically the best candidates for this strategy. While they may not be able to take advantage of an offer-in-compromise (see below) due to equity in their home, and bankruptcy may be effective but costly (see also below), CNC is a way to achieve very satisfactory results without the costly professional fees25. The “waiting-out” of the collection statute is often difficult for a few who desire immediate gratification, but with patience this option may be by far the least expensive remedy.
Some other specific reasons cited by the Internal Revenue Manual for being designated CNC status are: inability to locate the taxpayer, inability to contact a taxpayer with no means of enforcing collection, suspension of corporation business activities and no assets remaining, corporation liquidated in bankruptcy, death of an individual with no collection potential from an estate, collection of the liability would create an undue hardship for taxpayers, a corporation has paid current taxes but unable to pay back taxes and has no assets and special cases, such as military personnel in combat zones26.
Today the “offer-in-compromise” (OIC) program is probably the most abused27 and misunderstood taxpayer option available. By the same token, an OIC is probably the most popular request by clients due in large part to the hope of quick and inexpensive relief. The Service accepts very few OICs. Not every client with an outstanding tax liability is a good candidate for the OIC program.
If you think your client is a candidate for the OIC program you must explore one of three possible scenarios, which must be submitted as part of the OIC application. These scenarios are: “Doubt as to Liability,” which essentially means you don’t think you owe and you want your proverbial “day in court” or another “bite at the apple.” Your case will be assigned in all probability to a Revenue Agent and, at that point, you either prove you owe or not. The second and most submitted OIC is the “Doubt as to Collectibility,” which says to the IRS, “I can’t afford to pay” and “I don’t have the assets nor the future income to pay; however, I can borrow $2,500 from my Aunt Sally.” The amount that is offered and should be accepted is called the “Reasonable Collection Potential” (RCP). This is a combination of how much income your client has left over each month after the Service's acceptable expenses, plus equity in your assets. The third and least accepted OIC is the “Effective Tax Administration.” This says to the Service, “I can pay but due to very special circumstances [like future medical bills for a chronic illness] it would be unfair and inequitable to collect from me.” Since this is so subjective and the Secretary has full discretion on accepting offers, the success stories are few and far between for this option.
As stated previously, the Service accepts very few OICs. Coupled with the fact that the Secretary has been granted full discretion to reject even "fair" or "textbook" offers, taxpayers and tax practitioners alike find the OIC program a challenge. In Nina Olson’s National Taxpayer Advocate’s report to Congress28 she noted, “The Service’s current processes continue to prevent taxpayers from utilizing the program by imposing barriers to entry, unnecessary returning offers, and unreasonably rejecting many of the offers that make it into the program“29 .
As learned from practitioner’s focus groups as a result of these IRS practices, eligible taxpayers may be discouraged from utilizing the OIC program at all30. Such limits are clearly inconsistent with Congress’s goal of making it “easier for taxpayers to enter into OIC agreements”31.
Since most OIC’s do not get accepted on their merits, many require appeals for the opportunity to have a reasonable evaluation into the taxpayer’s RCP.
An easy, “slam dunk32” OIC may take six months; however, based on prior history there is no indication from the Service as to what constitutes a “slam dunk” OIC. It should be noted that more complicated OIC's could take two years or longer to settle.
OIC’s now require a user fee of $15033, and Form 65634 to be filed. Note the new Frivolous OIC Penalty provisions included in Circular 230. Further note that an OIC does in fact extend the statute of limitations during the time the OIC is being processed, for this reason the “collection statute expiration date” must be known and considered prior to submitting an OIC.
In certain situations, relief from certain tax liabilities35 may come from your client filing bankruptcy36. Regardless of your personal position on bankruptcy, the learned tax practitioner should be able to spot the issues, refer the client to individuals specializing in bankruptcy and allow the client to make the decision as to whether to pursue such an option that will yield results that they believe is in their best interest.
1 As per Stressful Life Events a report to the surgeon general as researched and reported in (Holmes & Rahe, 1967; Lazarus & Folkman, 1984; Kreiger et al., 1993) see full report at http://www.surgeongeneral.gov/library/mentalhealth/chapter4/sec1_1.html.
2 As intentionally reiterated time and time again by the Honorable Mark Everson, Commissioner of the Internal Revenue Service.
3 “Taxes are what we pay for a civilized society,” as quoted by the Honorable Supreme Court Justice Oliver Wendell Holmes in 1904.
4 “Many advisors make victory sure. ” (Ancient Proverb) In all cases, solving the client’s needs is “best practice.”
5 Beginning on Oct. 1, 2004 (IR-2004-112; Rev. Rul. 2004-92) The IRS has announced that interest rates for the calendar quarter beginning on Oct. 1, 2004, will rise to 5 percent for overpayments (4 percent in the case of a corporation), 5 percent for underpayments, and 7 percent for large corporate underpayments. The interest rate for the portion of a corporate overpayment exceeding $10,000 will be 2.5 percent. The interest rates are computed from the federal short-term rate based on daily compounding determined during July 2004.
6 As per I.R.C. § 6651(a)(2) (1986), All references to section numbers, hereinafter cited, are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.
7 I.R.C. § 6664(c).
8 I.R.C. § 6664(c)(1).
9 Stubblefield v. Commissioner, T.C. Memo. 1996-537; Treas. Reg. § 1.6664-4(b)(1).
10 I.R.C. § 6724; Treas. Reg. § 301-6724-1(2) defines reasonable cause.
11 The Internal Revenue Manual consists of guidelines that IRS employees must follow, much like an employee handbook.
12 I.R.M. § 184.108.40.206.2 (08-20-1998) Purpose of IRM 20.1 “The purpose of the consolidated penalty handbook is to provide guidance to all areas of the Service for all penalties imposed by the Internal Revenue Code. It sets forth procedures both for assessing and abating penalties and contains discussions on topics such as various types of relief from the penalties.”
13 Internal Revenue Manual § 220.127.116.11.1 — In determining if the taxpayer exercised ordinary business care and prudence, review available information including the following: taxpayer’s reason, compliance history, length of time, and circumstances beyond the taxpayer’s control.
14 Abatement of a penalty because the taxpayer established ordinary business care and prudence is identified by the use of Penalty Reason Code (PRC) 22.
15 I.R.C. § 6159 authorizes the Secretary to enter into a written agreement with any taxpayer that allows them to satisfy the tax liability in payments if such agreement will facilitate collection of such liability.
16 I.R.M. § 18.104.22.168
17 Determined without regard to interest, penalties — see I.R.C. § 6159(c)(1).
18 See I.R.C. §§ 6159(c)(1)&(2).
19 See I.R.M. § 22.214.171.124
20 Ibid at 7.
21 This status 53 is due to the internal transaction code 530, which is tagged on delinquent account declared uncollectible by the service — see IRM 126.96.36.199 (01-01-2004).
22 See Durovic v. Commissioner, 417 US 919 (1974); Jarvis v. Commissioner, 78 TC 646 (1982); Ledbetter v. IRS, 837 F2d 708 (5th Cir. 1988).
23 I.R.C. § 6502(a)(1).
24 See I.R.M. 188.8.131.52(2)(bullet point 11)[01-01-2004].
25 Albeit the CPA and attorney may forfeit fees, the trade off is doing the right thing for the client, which is our first and foremost goal.
26 See I.R.M. 184.108.40.206(2) [01-1-2004]
27 See Check Carefully Before Applying for Offers in Compromise — IR-2004-17, Feb. 3, 2004 — WASHINGTON — The Internal Revenue Service today issued a consumer alert advising taxpayers to beware of promoters’ claims that tax debts can be settled for “pennies on the dollar” through the Offer in Compromise Program. http://www.irs.gov/newsroom/article/0,,id=120169,00.html.
28 The Honorable Nina Olson presented The National Taxpayer Advocate’s Fiscal Year 2005 Objectives Report to Congress (June 30, 2004).
29 Note 34, Page 8, Paragraph 4.
30 The author of this article was honored to participate in one of these 2003 IRS focus groups held during the 2003 Nationwide Tax Forums, entitled Customer Satisfaction Issues of Practitioners, Project 01.08.005.03.
31 See H.R. Conf. Rep. No. 105-599, at 289 (1998).
32 Which may not be the textbook OIC due to the fact that the OIC reject rate is 60 percent without appeal rights, and another 20 percent rejected with appeal rights [Data source: IRS Business Measures DataMart].
33 See IR-2003-99 (8/15/03).
34 Form 656 (Rev. 7-2004) http://www.irs.gov/pub/irs-pdf/f656.pdf
35 See companion article entitled Discharging your client’s taxes in bankruptcy, on the www.FICPA.org website.
36 The CPA or EA must be cautious to avoid treading the fine line of practicing law without a license, therefore presenting the options to a client and allowing him or her to make the decision to pursue bankruptcy protection with a licensed attorney is best practice. In the absence of disclosing this option to a client the tax practitioner may be considered negligent in not communicating all the available options.
* Regulated by the State of Florida