Owing back taxes to the IRS can be a stressful and overwhelming experience for many individuals. The financial burden of paying back a large tax debt can seem insurmountable, leaving taxpayers feeling hopeless and unsure of where to turn for help. One option that may provide relief for those struggling to pay their tax debt is the Offer in Compromise (OIC).
An OIC is a program offered by the IRS that allows taxpayers to settle their tax debt for less than the full amount owed. This can provide taxpayers with a fresh start, allowing them to move on from their tax debt and start rebuilding their financial future. However, it is important for taxpayers to have realistic expectations when submitting an OIC.
One important aspect to consider is the taxpayer’s lifestyle expenses. The IRS will evaluate the taxpayer’s ability to pay and compliance history, not just their personal lifestyle choices. This means that taxpayers should be prepared to provide detailed financial information, including their income and expenses, to support their OIC offer. Furthermore, the IRS has set national and local standards for living expenses, so it’s important for taxpayers to be aware that their personal lifestyle choices may not be taken into account when evaluating their OIC. It’s important for taxpayers to understand this process and be realistic about their financial situation in order to increase the chances of their OIC being accepted.
This was reinforced in the recent court case of Flynn v. Commissioner, T.C. Memo. 2022-5, where the taxpayer argued for higher expenses due to unpaid credit card debts. This is a very common issue that taxpayers must carefully navigate when submitting an OIC.
Facts & Procedural History
Mr. Flynn failed to file his 2012 federal income tax return and was assessed a tax of $7,680, along with additions to tax and statutory interest. He also filed his 2013 and 2014 tax returns late and was assessed additional taxes and statutory interest for those years, bringing his total tax liabilities to $15,557.
The IRS attempted to collect this amount by sending a levy notice, and Mr. Flynn requested a Collection Due Process (CDP) hearing to discuss an Offer in Compromise (OIC) or an installment agreement.
The case was assigned to a settlement officer, who advised Mr. Flynn to submit an OIC for evaluation by the Centralized Offer in Compromise (COIC) unit. Mr. Flynn submitted an OIC of $3,600 to settle his 2007, 2009, and 2011-17 tax liabilities and provided financial information to support his claim of doubt as to collectibility. However, the COIC unit determined that his reasonable collection potential (RCP) was $330,206 over the next 10 years and rejected his OIC.
Mr. Flynn petitioned the U.S. Tax Court, arguing that his proposed OIC should be accepted due to his inability to pay the full amount of taxes owed.
About the Offer in Compromise
An OIC is an alternative to immediate full payment of taxes and can be based on three different grounds: Doubt as to Liability (DATL), Doubt as to Collectibility (DATC), or Effective Tax Administration (ETA).
That is the textbook answer. At this point in my career, having submitted hundreds of OICs, I am confident that there is really no such thing as a DATL. The IRS has a form for it, it has a group that considers them, but, to my knowledge, the IRS has never granted one. So I don’t consider that an option. There are only two options when it comes to OICs, namely, the DATC and ETA.
I’ll focus on the DATC as that is the subject of this court case. In the early 1990s, the IRS shifted its approach and began to focus on a taxpayer’s “reasonable collection potential” (RCP) instead of their maximum capacity to pay. The RCP standard allows for reasonable living expenses and prioritizes creditors linked to certain living expenses.
Today’s focus is on Doubt as to Collectibility (DATC) OICs and the analysis of a taxpayer’s RCP. The RCP consists of what the IRS believes a taxpayer can raise by selling assets and using their disposable future income over a certain period of time. Asset values may be discounted to account for the costs of quickly selling them, and disposable future income takes into account reasonable living expenses.
The Taxpayer’s Lifestyle Argument
In this case, the IRS determined that Mr. Flyn’s monthly net income was $1,783. Mr. Flynn did not object to this calculation. He took issue with the IRS’s disallowance of a portion of his reported housing expenses and credit card payments.
The IRS took into account $1,315 for housing expenses, which was consistent with the applicable local standard in effect at the time. The IRS also did not allow Mr. Flyn’s credit card debt payments as an allowable expense.
Mr. Flynn asserts that the allowances were insufficient because they did not support his particular lifestyle.
The Court’s Thoughts on Lifestyle Arguments
The court concluded that the IRS had no obligation to consider the full amount of expenses and was following IRS standards in determining his net monthly income. The court also stated that deviations from the national and local allowances set by the IRS are only permitted upon a showing that the standard amounts are “inadequate to provide for basic living expenses.”
In this case, the fact that Mr. Flynn’s housing cost was higher than the allowable standard did not show that he couldn’t pay for his basic living expenses. It just showed that he needed to downsize his living arrangements.
As for credit card debt, credit card debt is not an allowable expense. It is a method of payment. And in this case, the taxpayer even acknowledged that the credit card debt was not incurred for his basic living expenses.
The Takeaway
One important factor that the IRS will consider when evaluating an OIC is the taxpayer’s ability to pay. This includes a review of the taxpayer’s assets, income, and expenses. The IRS will also take into account any potential future income or assets that the taxpayer may acquire. The IRS will compare the taxpayer’s ability to pay to their proposed offer, and if the offer is not reasonable in light of their ability to pay, it may be denied.
An OIC is not a guaranteed process and the IRS has the final say on whether to approve or deny an offer. Additionally, the IRS may also counter an offer if they believe it is too low. Taxpayers seeking an OIC should also be aware that the process can be time-consuming and require a significant amount of documentation and financial information to be submitted.
As shown by this case, the IRS will apply its standards. This does not mean that taxpayers shouldn’t push for deviations from those standards, as taxpayers should very well do just that. This can result in significant tax savings. In doing so, they should also provide evidence and have a plausible theory as to why a deviation is warranted. Simply saying that they live a higher lifestyle is insufficient.