When a tax problem arises it is not uncommon to become overwhelmed and sometimes even paralyzed by the situation. No doubt, much of the anxiety is due to the uncertainty of whether the problem can be solved and how to go about doing so. Over the past few years there has been a proliferation of advertisements from self-professed “tax experts” promising great results for individuals that find themselves in this very situation. As most people know, when the flashy ads sound too good to be true, that usually is the case. What is not revealed in these sound bite splashes is that most of these so-called experts take a very narrow “one-size-fits-all” approach to dealing with a tax problem. While it is true that sometimes it is possible to settle a tax debt for a fraction of what is owed, very often this option is not available because of the taxpayer’s circumstances. Usually there are many options that should be evaluated before a decision is made as to how best to deal with a tax problem and an experienced tax professional will approach the situation very differently than the 1-800 marketing mills.
As a general rule a tax problem needs to be evaluated in two distinct phases. Phase I deals with how much is owed. Phase II deals with howto pay the amount owed. Most of the time you know whether you are in Phase I or Phase II of the process. For example, if you receive an IRS audit notice, you are clearly in the early stages of a Phase I situation. If you receive a collection notice after filing a tax return without full payment of what you agree is due, you are in Phase II. But what if you never filed a tax return reporting a balance due and now the IRS has levied a bank account? Where are you in the process? What are your options?
While there are often recurring themes and “typical” situations when tax problems arise, solutions are best when tailor-made for the specific taxpayer in question. Evaluating where the taxpayer is in the process helps determine what options are available. The “one size fits all” approach may result in a resolution, but it may not be the best solution under the circumstances.
Phase I Considerations: What Do I Owe?
Most income tax obligations arise through the filing of a tax return that reports a balance owed. This situation is typically referred to as a “self-assessment” since the taxpayer is volunteering, under penalties of perjury, what he or she acknowledges to be his obligation. Even after a self-assessment is made the amount owed can still be changed by the taxpayer or the IRS. The taxpayer can seek a change by filing an amended return. The IRS does so through an audit. As a general rule, any such change must occur within three years of when the return was filed.
In the case of an audit, if the taxpayer does not agree with the proposed audit adjustments there are both administrative and judicial appeal rights. The vast majority of administrative appeals are resolved without the need to go to court. The audit and appeal process can take months, sometimes years. But as long as this process is ongoing, the taxpayer is still dealing with Phase I issues. It is only after the taxpayer has foregone or exhausted all of these options to determine whether and how much is owed, does the tax problem move to Phase II of the process.
As long as a taxpayer is in Phase I of the process, most of the time no collection activity (Phase II) can be taken by the IRS. But that is not always the case. For example, if no tax return is ever filed the IRS has the ability to determine a person’s tax liability based upon information that has been reported by third parties (for example, W-2s and Forms 1099). When a tax liability arises as a result of this process, it is said to arise out of a “substitute for return.” If the IRS goes through the substitute for return process, an amount due has now been determined (Phase I) so collection activity (Phase II) will commence. And yet, when the IRS prepares a return for a taxpayer, usually the amount determined to be owed is significantly higher than what would have been owed had the taxpayer filed the return himself. Under these circumstances it is usually very beneficial to prepare the actual return for the year in question so the correct tax debt can be determined (Phase I).
Another instance when Phase II collection activity may occur before Phase I ends is when the IRS imposes penalties for the late filing of a return or the late payment of the tax owed. There may be no question that the underlying tax obligation is due but the circumstances that caused the late filing or late payment may serve as a basis to have penalties abated. Penalty abatement requests need to be submitted in writing and the written request must demonstrate reasonable cause and not willful collect. There is considerable guidance on what will constitute reasonable cause and things like serious medical issues or catastrophic events usually qualify.
Each of these Phase I examples — the substitute for return and penalty abatement request – muddy the Phase I and Phase II distinction. In these situations, there are Phase I issues to be addressed but IRS collection activity may also be well underway. Therefore, Phase II issues are also going to be in play.
In sum, any time the IRS asserts a liability that does not arise from the tax return filed by the taxpayer, the possibility of there being a “Phase I issue” should be considered. After it has been determined that Phase I is over, it is time to consider Phase II.
Phase II Considerations: What (and How) to Pay?
When taxpayers are in Phase II of a tax problem they are dealing with the collection efforts of what is generally regarded as the most powerful creditor in the country. In most cases the IRS has 10 years to collect unpaid taxes and the laws are written to enable the IRS to have considerable advantages when doing so. Having said that, the IRS can be expected to follow the rules quite carefully, thus making the IRS one of the most predictable creditors to be dealt with.
In the Phase II arena there are generally three different outcomes that can be pursued: no payment, partial payment, or full payment. Aside from the obvious distinction between these options, other considerations come into play as well. While of course the “no payment” outcome may seem very appealing, a determination that the taxpayer is presently unable to make payments– in IRS parlance the account is marked “currently not collectible” – this is not necessarily a lasting solution. A “currently not collectible” determination is based upon detailed financial disclosure which demonstrates the taxpayer presently has neither liquid assets with equity nor income in excess of necessary living expenses available. Because the tax debt is not canceled under these circumstances, should the taxpayer’s financial situation change before the 10 year collection period expires, the IRS may resume collection activity. For this reason, the no payment option does not necessarily bring closure.
The full payment option typically involves negotiating the timing for payment, and significantly, ensuring that more aggressive collection activity such as the filing of tax liens and issuance of tax levies does not occur while payment is made. As a general rule, the sooner the payment is made the easier it is to keep the IRS collection activity on hold. A promise of full payment within 60 or 90 days is usually enough to prevent any such activity. The promise to pay over four or five years will almost certainly result in the filing of a tax lien. Factors such as the total amount owed, a history of noncompliance, and the type of assets all come into play when structuring payment plans.
The partial payment option — the offer in compromise program — is the option that is getting the most publicity these days. There is nothing new about this option as the IRS has been entertaining offers in compromise for some time. The IRS did significantly overhaul the offer program about 20 years ago and the IRS continues to make changes in some of the program rules which have made the offer option very appealing. If a taxpayer’s circumstances are right, the offer in compromise is a great option. Most offers are submitted on the basis that full payment can never be made during the 10-year collection window due to current and anticipated future financial circumstances. Detailed financial disclosure is required in connection with this process. There are many rules pertaining to the valuation of assets, the calculation of income, and the allowance of expenses that go into the determination of a taxpayer’s ability to pay. There is no formula for an offer in compromise. That is to say, there is no minimum percentage of the balance owed that must be offered. If the amount owed is $50,000 and the ability to pay is determined to be $1000, then the IRS will accept $1000 in full satisfaction. On the other hand, if the ability to pay is determined to be $50,100, then no amount less than full payment will be considered.
Oftentimes when evaluating these Phase II options the possibility of filing bankruptcy should be considered. Most income tax obligations that are more than three years old may be discharged in a bankruptcy action. The age of an income tax obligation is determined by the assessment date for the debt. Usually this is the date on which the tax return is filed for the year in question but there are many exceptions and modifications to these rules. Certain types of tax obligations such as payroll tax related penalties and state sales tax obligations are generally not dischargeable in bankruptcy. If an individual has debts other than tax liabilities, the bankruptcy option may be the solution for a number of problems. A professional focused only on taxes may overlook the value of this option.
Consideration needs to be given to both distinct phases of the tax process to ensure that the best outcome possible can be achieved. Calling upon the experience and guidance of a seasoned tax professional is often the best place to begin.