This week, Gail offers tips on how to settle your I.O.U. with Uncle Sam.
Let's say that back in 2004 you exercised stock options that by the end of the year were worth less than what you paid for them. Or, maybe you simply "forgot" to report that time you hit the jackpot in Vegas. Or maybe your tax preparer had you invest in one of those can't-fail schemes that promised to give you a big tax write-off.
In early 2005 you spend your savings account to turn your basement into a home theater. Then in mid-summer your world starts to crumble. You get laid off. Your child needs and emergency operation and you no longer have health insurance.
A few months later you receive a letter stating that the way the IRS calculates your taxes, you actually owe the government $34,000 for the previous year. Since you have no cash, you send back a check for a few hundred bucks hoping the IRS will interpret this as a "good faith effort."
In 2006 you find a job at half the salary and are able to again (barely) cover your mortgage payments. However, to make ends meet during the period you were unemployed, you maxed out your credit cards. Collection agencies are hounding you. The IRS repeatedly reminds you of the obvious: you owe Uncle Sam a bunch of money from the year before and interest charges are being assessed.
Since you needed as much money as possible in order to throw an occasional check at your creditors, you didn't have enough tax withheld from your paychecks last year. As a result, your (new) tax preparer informs you that you owe an additional $9,000 in federal income tax. By this time, you're so far in the hole you can't afford to include a check when you file your return.
The IRS notices keep coming. Since you don't know what to do, you take the "ostrich" approach: you stuff them in a drawer. But you're a nervous wreck. You're sure you'll show up for work one day and an IRS agent will be waiting for you.
Then, one sleepless night you stumble downstairs, turn on your 60-inch plasma screen TV and (in surround sound) hear the answer to your prayers:
"Settle your back taxes for pennies on the dollar!"
The actor in the ad describes something called an "Offer in Compromise," explaining that this allows you to wipe out your tax bill by making an offer to the IRS of an amount that you feel are able and willing and able to pay. How civilized! The ad even includes a testimonial from "Joe in Fargo" who was able to discharge (the legal term for "erase") $200,000 in taxes by paying just $2,000, or some other amazingly puny amount.
Although you feel slightly stupid for not knowing about this sooner, a huge weight is lifted from your shoulders. The company sponsoring the infomercial will even help you fill out the paperwork — for a fee, of course. But who cares if you can wipe out your back taxes. You rush upstairs and wake your spouse to share this wonderful news.
Now here's a little reality check.
"Offers in Compromise" have been around for years. But attorney Mike Goller at the Milwaukee firm of Reinhart Boerner says in order to literally settle your tax bill for pennies-on-the-dollar, you really have to be poor.
If you have no equity in your home, don't own any assets or investments, and are not likely to earn enough to ever pay back your debt, the IRS will settle for a small amount of money just to save the cost of seizing whatever paltry assets you do own.
However, Goller says, "If you're upper middle class, the IRS will want a big chunk of your assets." Moreover, "generally it's not how much you owe, it's how much you can pay."
And that is determined, not by you, but by the IRS.
In other words, don't think for a second that you get to pick a number out of the sky and submit this as your "offer." (Forget about proposing that your settlement be a percentage of your outstanding tax debt. That won't fly at all.) There's a formula that determines how much you can theoretically afford to pay. You arrive at this amount by filling out two IRS worksheets — Form 656 and Form 433-A (businesses would use Form 433-B). These require you to list the value of your assets, including your home, as well as all of sources of income. Everything must be documented.
After the paperwork is submitted to the IRS the fun begins. Government examiners will review your numbers. According to Goller, they could agree that your offer is acceptable, or they could come up with a different amount and kick it back.
You might have to negotiate what your future wages will be and/or the current value of your assets. This is where the "compromise" comes in.
"Say you estimate your house is worth $200,000 and the IRS says it's worth $300,000," says Goller. "That's a $100,000 difference in equity."
Oh, and that company you hired to fill out the forms for you? Don't assume they're going to help if you reach the negotiation stage. Read the fine print: it might say that their only obligation is to complete the original paperwork.
Here's the good news: you don't have to pay someone else $5,000-$10,000 to file an Offer in Compromise. "You absolutely can do this yourself," according to Goller. Besides, wouldn't you be better off if that money went toward reducing your tax bill, instead? The forms and instructions can be downloaded from the IRS website, www.irs.gov.
The number of Offer in Compromise submissions has increased significantly in recent years (those infomercials are apparently quite effective). Goller says one reason more folks are filing them is that once it receives your offer, "generally, the IRS will stop its collection activity."
Translation: if the IRS is about to garnish your paycheck, filing an Offer in Compromise can put that on "hold."
In order to reduce the volume of bogus Offer in Compromise requests (presumably by people who could afford to pay up, but want to postpone doing so), in recent years the IRS has instituted a number of changes in how these are processed. One of the first was to slap a fee of $150 on every application.
Goller, an expert on this topic, says the IRS is also taking a very technical approach. If your paperwork is incomplete or if you don't meet specific deadlines, your offer will be rejected. "I've seen offers denied because they were a day late," he says.
His advice: read the instructions carefully, be sure the worksheets are complete and accurate, attach copies of all back-up documents required — bank statements, pay stubs, brokerage statements, etc.— and, by all means, observe all deadlines.
However, Goller say it's the latest policy change that has sent a shiver through the legal and accounting profession: effective last July, anyone submitting an Offer in Compromise has to include a non-refundable partial payment for 20 percent of the amount they are offering as a settlement.
Say you owe $50,000 in back taxes and penalties. According to the way you value your assets, you figure you should be able to settle for $10,000. In addition to the $150 filling fee, you now have to include a check for 20 percent of this.
"You scrape together your last $2,000 and hope you can get another $8,000," says Goller. "The risk is that the IRS rejects the offer and keeps the money. So you still owe $48,000." Now you've got to negotiate a new amount.
According to Goller, most offers are lump sum settlements where the taxpayer agrees to settle up with the government in one or no more than five payments, usually within 90 days after agreement is reached with the IRS.
However, he stresses that "those 90 days could be a year from now" because of how long it takes to process your offer. In other words, you've got time to come up with the rest of the money.
If you choose the "periodic payment" method it's more costly. Although you get to spread your payments over several years, you have to make payments each month — including the months you're waiting for the IRS to review your offer. And, either way, "you have to pay a good percentage of your offer up front," says Goller.
At this point you may be wondering why you shouldn't just file for bankruptcy and get your back taxes wiped out that way. The simple answer is that it's probably not possible.
Philadelphia attorney Stephen Ross, who does a lot of bankruptcy work, says that under Chapter 13 certain debts are "non-dischargeable," i.e. you still have to pay them back. This includes child support, attorney fees, up to a year of mortgage payments, and taxes owed.
Filing under Chapter 7 erases more debt, but this does not include child support, student loans, or taxes — with one exception. "If your back taxes are at least five years old and you filed income tax returns for those years this could be discharged under Chapter 7," says Ross.
The bottom line: if you find you owe taxes you can't afford to pay, the sooner you contact the IRS and try to work out a deal, the better.
If back taxes are keeping you awake at night, try a glass of hot milk and an old movie instead of watching those infomercials.
Hope this helps,
If you have a question for Gail Buckner and the Your $ Matters column, send them to: firstname.lastname@example.org, along with your name and phone number.