Offers in Compromise for Retirees on a Fixed Income

The offer in compromise is the most advertised and most misunderstood option in tax resolution. Radio ads make it sound like a coupon. It is not. It is a formula, and the IRS applies the formula to everyone.

The good news for retirees is that the formula often works in your favor once you understand it. Fixed income, limited earning years, and real medical costs all count. So does the money in your IRA, which is where most retiree offers are won or lost.

The legal basis

Internal Revenue Code section 7122 authorizes the IRS to compromise tax debts. Treas. Reg. 301.7122-1(b) recognizes three grounds:

• Doubt as to liability: you dispute that you owe it.
• Doubt as to collectibility: your assets and income are less than the full liability.
• Effective tax administration: the IRS could collect in full, but doing so would cause economic hardship, or there are compelling public policy or equity reasons.

Most retiree offers are doubt as to collectibility. Some of the strongest are effective tax administration offers, and the regulation itself uses a retiree as its example.

Reasonable collection potential

In a collectibility offer, the IRS computes your reasonable collection potential (RCP): the net equity in your assets plus a multiple of your monthly disposable income. You must generally offer at least that much. The future income piece is 12 months of disposable income if you pay the offer in five or fewer payments within five months of acceptance, or 24 months if you pay it over a longer period, as explained in the Form 656 booklet.

Disposable income is your monthly income minus allowable expenses under the IRS Collection Financial Standards. On a fixed income with real health care costs, disposable income is often small or zero. That is the first place retirees have an advantage.

How the IRS values your IRA and 401(k)

IRM 5.8.5.10 governs retirement accounts in offer investigations. The rule: funds in a retirement plan are an asset and must be valued. For an IRA, 401(k), or Keogh, equity is the cash value less the tax consequences of liquidating the account and any early withdrawal penalty.

Two retiree-specific rules in that IRM section matter:

1. If you are retired or within one year of retirement, the plan may be treated as income instead of an asset, if the income from the plan is required to provide for necessary living expenses.
2. Plans that cannot be accessed until separation from employment are counted as equity once you are retired or eligible to retire.

That first rule is a big deal. If you are drawing $1,200 a month from an IRA to pay your bills, the IRS can count that $1,200 as income in your monthly budget instead of treating the whole balance as an asset you must hand over. Which treatment applies is a judgment call, and it is worth arguing for the right one.

Watch for the dissipation rule. IRM 5.8.5.10 notes that significant voluntary retirement contributions made after the tax was assessed, or within three years before the offer, may be added back as a dissipated asset.

Pensions and Social Security

A pension in pay status and Social Security are income streams, not lump-sum assets. They go on the income side of Form 433-A (OIC). Because they are fixed, they also argue against any assumption that your income will rise. That matters in the future income calculation.

Effective tax administration: the retiree example

Treas. Reg. 301.7122-1(c)(3)(iii) gives examples of hardship-based effective tax administration offers. Example 2 reads like a retiree case file: the taxpayer is retired, his only income is a pension, his only asset is a retirement account large enough to pay the liability, and liquidating it would leave him without an adequate means to provide for basic living expenses. The regulation says that type of case may be compromised.

The factors in 301.7122-1(c)(3)(i) include being unable to earn a living because of long-term illness, medical condition, or disability where resources will be exhausted by care, and having assets you cannot borrow against or liquidate without being unable to meet basic living expenses. IRM 5.8.11 covers how the IRS evaluates these offers. The compliance history factor in (c)(3)(ii) matters: a long history of non-filing weighs against you.

When you dispute the tax itself

If the real problem is that the balance is wrong, for example because the IRS assessed tax on a Social Security lump sum or an IRA rollover that should not have been taxable, a collectibility offer is the wrong form. Treas. Reg. 301.7122-1(b)(1) recognizes doubt as to liability as its own ground, and 301.7122-1(d)(1) says an offer based solely on doubt as to liability does not require financial statements. The IRS uses a separate form for it, Form 656-L. In many retiree cases, an amended return, audit reconsideration, or a response to the original notice fixes a wrong assessment faster than any offer.

Whatever the ground, Treas. Reg. 301.7122-1(i)(1) suspends the collection statute while levy is prohibited because the offer is pending. Count that time before you file.

The paperwork

• Form 656, Offer in Compromise, from the current Form 656 booklet.
• Form 433-A (OIC) for individuals, with three to six months of bank statements, retirement account statements, your SSA benefit letter, pension statements, and proof of expenses.
• The $205 application fee and the initial payment, unless you meet the low-income certification. Low-income qualifiers do not pay the fee, the initial payment, or periodic payments while the offer is under review.
• All required returns filed and estimated payments current. An offer from someone who is not in filing compliance is returned.

What happens while it is pending

Once the IRS accepts the offer for processing, IRC 6331(k)(1) bars levy while it is pending, for 30 days after a rejection, and during an appeal. A pending offer is also an exclusion from the Federal Payment Levy Program, so it stops a 15 percent Social Security levy. The collection statute is suspended during the same period. A federal tax lien may still be filed.

If the offer is accepted, you must stay compliant with filing and payment for five years, and the IRS keeps any refund for the year the offer is accepted and earlier years. Default the terms and the IRS can reinstate the full balance.

Why retiree offers get rejected

When I review an offer that the IRS rejected, the reasons usually fall into a few groups.

• The IRA was ignored. The taxpayer left a retirement account off Form 433-A (OIC) or argued it did not count. It counts. The question is how it is valued, not whether.
• Expenses were not documented. Claiming health care costs above the standard without proof gets them cut back to the standard.
• The offer amount ignored future income. A pension plus Social Security that exceeds allowable expenses by $300 a month creates $3,600 of future income on a lump-sum offer and $7,200 on a periodic offer. The offer has to cover it.
• Filing compliance slipped. A missing return or unpaid current-year tax during the review gets the offer returned.

Each of those is preventable before you file.

When an offer is the wrong tool

If your collection statute expires soon, an offer can extend it by the time it is pending. If your RCP exceeds the balance, the offer will be rejected. If you have no income beyond basic expenses and no assets, hardship status may get you to the same place with less paperwork. And if you are tempted to cash out an IRA to fund an offer, read should you cash out your IRA to pay the IRS? first.

The general Pinellas overview is offers in compromise in Pinellas County.

Next step

Run the numbers before you pay the fee. The IRS has a pre-qualifier tool, and the firm's page on the offer in compromise explains the process. If you want a lawyer to compute your RCP and decide whether the offer or another option fits, call (813) 229-7100.