Offer in compromise

What Is an Offer in Compromise?

An Offer in Compromise (OIC) is an agreement between a taxpayer and the Internal Revenue Service (IRS) that settles a taxpayer's tax debt for less than the full amount owed. It falls under the broader category of tax law and debt resolution, providing a potential pathway for individuals and businesses facing severe financial hardship to resolve their outstanding federal tax liabilities. The IRS generally approves an Offer in Compromise when it determines that the amount offered represents the most it can expect to collect within a reasonable period, considering the taxpayer's ability to pay, income, expenses, and asset equity. This program aims to achieve a resolution that is in the best interest of both the taxpayer and the government, promoting future voluntary compliance with tax obligations.

History and Origin

The concept of an Offer in Compromise has roots in earlier IRS practices, but its formalization and increased visibility gained traction over time. While often anecdotal, the program's origins are sometimes linked to high-profile cases, such as that of boxer Joe Louis in the 1930s, who faced substantial tax arrears. His unique situation reportedly led the IRS to devise a settlement plan for his outstanding tax liability. The Offer in Compromise program was officially codified into law in the early 1970s under 26 U.S.C. § 7122, with further structural refinements introduced by the Tax Reform Act of 1986. ¹⁶In more recent decades, particularly in the late 1990s, television advertising by tax relief companies brought the Offer in Compromise program into broader public awareness, sometimes leading to misconceptions about its ease of access and guaranteed outcomes.
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Key Takeaways

• An Offer in Compromise allows taxpayers to settle their federal tax debt for less than the full amount owed.
• Eligibility is determined by the IRS based on the taxpayer's ability to pay, current income, living expenses, and the value of their assets.
• There are generally three grounds for an OIC: doubt as to liability, doubt as to collectibility, or effective tax administration.
• The process involves submitting detailed financial information and often an application fee and initial payment.
• Acceptance of an Offer in Compromise means the remaining tax debt is forgiven, provided the terms of the agreement are met.

Formula and Calculation

While there isn't a single universal "formula" for an Offer in Compromise, the IRS calculates a "Reasonable Collection Potential" (RCP) to determine the minimum amount it will accept. The RCP is an estimate of a taxpayer's ability to pay the tax debt, considering their financial circumstances. It generally includes:

• Net Realizable Equity in Assets: This is calculated by taking the fair market value of a taxpayer's assets (e.g., real estate, vehicles, bank accounts) and subtracting any secured debts on those assets and an allowance for quick sale costs.
• Future Income: This is derived from a taxpayer's monthly disposable income (gross income less necessary living expenses) multiplied by a specific number of months (typically 12 or 24 months, depending on the payment option chosen). The IRS provides national and local standards for certain expenses to ensure consistency.

The proposed Offer in Compromise amount must generally be equal to or greater than the calculated RCP. The IRS uses forms like Form 433-A (OIC) for individuals or Form 433-B (OIC) for businesses to gather the necessary financial data for this calculation.
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Interpreting the Offer in Compromise

An Offer in Compromise is interpreted as a final settlement of a federal tax liability. If an Offer in Compromise is accepted, it means the IRS agrees that the taxpayer cannot pay the full amount due or that doing so would cause extreme financial hardship. The amount accepted reflects the IRS's assessment of what could realistically be collected, given the taxpayer's current and future financial capacity. It's not a negotiation in the traditional sense, but rather a proposal based on the taxpayer's demonstrated inability to pay. Taxpayers often use the IRS's online OIC Pre-Qualifier Tool to get a preliminary idea of whether they might be eligible and what amount the IRS might consider.
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Hypothetical Example

Consider Sarah, who owes the IRS $50,000 in federal income tax debt from several years ago. She lost her job two years ago, used up her savings, and now works part-time, earning barely enough to cover essential living expenses. She owns an older car with no equity and rents her home.

1. Assessment: Sarah gathers her financial documents, including income statements, bank statements, and a list of her monthly living expenses.
2. Calculation of RCP: The IRS would review her income, subtracting allowable living expenses based on national and local standards. If her disposable income is minimal, say $100 per month, and she opts for a 24-month payment plan, her future income component would be ( $100 \times 24 = $2,400 ). If her car has no equity, her asset component is $0. Her total Reasonable Collection Potential (RCP) would therefore be $2,400.
3. Offer Submission: Sarah proposes an Offer in Compromise of $3,000, slightly above her calculated RCP, along with the required forms and application fee.
4. IRS Review: The IRS reviews her application, verifies her financial information, and assesses her ability to pay.
5. Acceptance: Given her limited income, lack of assets, and the fact that $3,000 represents a realistic collection potential, the IRS accepts her $3,000 Offer in Compromise. Upon Sarah paying the $3,000 according to the agreed-upon terms, the remaining $47,000 of her tax debt is forgiven. This allows her to move forward without the burden of the full tax liability.

Practical Applications

An Offer in Compromise is primarily applied in situations where taxpayers are struggling with significant federal tax debt and can demonstrate that paying the full amount would create an undue financial hardship or is simply beyond their means. Key practical applications include:

• Resolving Back Taxes: It's a critical tool for individuals or businesses with accumulated back taxes from previous years, helping them avoid ongoing collection activities such as wage garnishments or bank levies.
• Bankruptcy Alternative: For some, an OIC can be a less drastic alternative to filing for bankruptcy to resolve tax obligations, as it specifically targets the tax debt without affecting other creditors in the same way.
• Fresh Start: An accepted Offer in Compromise allows taxpayers to get a "fresh start" by settling their debt, enabling them to focus on future tax compliance.
• State Tax Debt: While the federal IRS offers the OIC, many state tax authorities also have similar programs to help resolve state income or sales tax liability when taxpayers face financial difficulties. For instance, the California Department of Tax and Fee Administration (CDTFA) offers an Offer in Compromise program for state sales and use taxes.
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Limitations and Criticisms

Despite its utility, the Offer in Compromise program has several limitations and faces criticisms:

• Low Acceptance Rate: The IRS does not accept every Offer in Compromise submitted. Historically, the acceptance rate has been relatively low, with the Government Accountability Office (GAO) noting mixed performance and suggesting improvements to the program. ¹¹For example, one report noted that in fiscal year 2005, the IRS accepted just over 14,000 offers. ¹⁰This low rate can be due to incomplete applications, taxpayers not meeting strict eligibility criteria, or the IRS determining a higher "reasonable collection potential" than the taxpayer offered.
  ⁹* Complexity: The application process is intricate, requiring extensive documentation of income, expenses, and assets. Taxpayers often need to complete Forms 656 and 433-A (for individuals) or 433-B (for businesses), along with supporting financial statements. ⁸Errors or omissions can lead to rejection or significant delays.
• Application Fees and Payments: A non-refundable application fee is typically required, along with an initial payment, which can be a hurdle for those already in dire financial straits. These payments are applied to the tax liability even if the offer is rejected.
  ⁷* Impact on Future Compliance: If an Offer in Compromise is accepted, taxpayers must comply with all future filing and payment requirements for a specified period (typically five years) or the offer may default, and the original debt could be reinstated. This highlights the importance of sustained tax compliance post-acceptance.
  ⁶* No Guarantee: The Offer in Compromise is not guaranteed to be accepted. The IRS evaluates each case on its specific facts and circumstances, and the decision rests solely with the agency. Taxpayers should explore all other payment options before submitting an Offer in Compromise.
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Offer in Compromise vs. Installment Agreement

An Offer in Compromise (OIC) and an Installment Agreement are both programs offered by the IRS to help taxpayers resolve their tax debt, but they serve different purposes and have distinct characteristics:

While an Offer in Compromise is suitable for taxpayers who genuinely cannot pay their full tax liability and face severe financial hardship, an Installment Agreement is for those who can pay their full debt but need more time to do so in monthly payments.

FAQs

1. How does the IRS decide if it will accept an Offer in Compromise?

The IRS evaluates an Offer in Compromise based on your ability to pay, your income, your expenses, and the equity in your assets. They generally approve an offer when the amount you propose represents the most they can expect to collect within a reasonable period. The agency considers your unique financial situation.
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2. What are the different types of Offer in Compromise?

There are three main grounds for an Offer in Compromise:

• Doubt as to Collectibility: You agree you owe the tax, but you can't pay the full amount. This is the most common reason.
• Doubt as to Liability: There's a genuine dispute about whether you actually owe the tax debt or the amount.
• Effective Tax Administration: You can pay the full amount, but doing so would cause significant economic hardship or be unfair and inequitable due to exceptional circumstances.

3. Will an Offer in Compromise affect my future tax refunds?

If your Offer in Compromise is accepted, the IRS typically retains any tax refunds due to you through the date the offer is accepted, and potentially for the tax year in which the offer is accepted. This condition generally does not apply if the offer is based solely on doubt as to liability.
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4. How long does it take for the IRS to process an Offer in Compromise?

The processing time for an Offer in Compromise can vary significantly depending on the complexity of the case and IRS workload. While the IRS aims for efficiency, it can take several months to over a year for a decision. If the IRS does not make a determination within two years of receiving your offer (excluding any appeal period), the offer is automatically accepted.
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5. Can I still be subject to IRS collection actions while my Offer in Compromise is pending?

While your Offer in Compromise is being evaluated, the IRS generally suspends most of its normal collection activities, such as levies or wage garnishments. However, the IRS may still file a tax lien during this period. ¹It's crucial to continue making any required payments specified in your offer application during the review period.