Under IRC Sec. 7122(a), taxpayers may request an offer in compromise (OIC) with the IRS to settle outstanding tax liabilities for less than the full amount owed. To qualify, taxpayers must prove that their outstanding tax liabilities exceed the amount of income and assets available to satisfy those liabilities during the time remaining in the collection period, generally, the statute of limitation. This is known as establishing the taxpayer’s reasonable collection potential (RCP).
The higher the taxpayer’s RCP, the lower the taxpayer’s chances of qualifying for an OIC. In calculating the RCP, the IRS takes into account current and potential earnings, as well as the value of assets exceeding those needed for necessary living expenses. The sum of the taxpayer’s income and assets is treated as available to satisfy the taxpayer’s federal tax liability.
Taxpayers that dispose of their assets solely to qualify for an OIC are likely to fail, since a number of court cases support the IRS’ practice of including dissipated assets in the RCP calculation. A dissipated asset is defined as any asset (liquid or non liquid) that has been sold, transferred or spent on non priority items or debts and that is no longer available to pay the tax liability.
The Tax Court recently decided two cases upholding the IRS’ rejection of OICs where the court found that the taxpayers had disposed of assets that would otherwise have been available to satisfy their outstanding tax liabilities. In Tucker, T.C. Memo. 2011-67, the individual taxpayer’s request for an OIC was denied when the examiner included dissipated assets in the RCP calculation, resulting in an RCP sufficient to satisfy the outstanding tax liability within the statutory collection period. The taxpayer was aware of his unpaid tax liabilities when he transferred funds into an on line brokerage account to engage in day trading and subsequently lost a portion of the money. The IRS determined, and the Tax Court held, that the taxpayer lost the money in disregard of his outstanding tax liability. But for the failed investments, the taxpayer’s reasonable collection potential exceeded his outstanding tax liabilities, and the court held that the settlement officer did not err in determining that the taxpayer could fully pay his federal income tax liabilities.
Dissipated assets are not limited to those lost through negligence or disregard of one’s tax liabilities, however. In Layton, T.C. Memo. 2011-194, the taxpayer’s request for an OIC was rejected after the IRS examiner included the excess balance of an IRA distribution in the RCP calculation. The taxpayer had been unemployed for several years and had liquidated an IRA account to help pay her necessary living expenses. The remaining balance of the taxpayer’s IRA distributions, however, went to pay other nonessential debts. The taxpayer was not able to demonstrate that the debts she paid were necessary living expenses, so the Tax Court ruled in favor of the IRS.
The IRS has issued guidelines for all examiners evaluating OICs. Internal Revenue Manual section 22.214.171.124 provides the following factual considerations or queries that examiners must analyze to determine whether an asset has been dissipated and should be included in the RCP:
When an asset was dissipated in relation to the OIC submission (generally, the value of assets dissipated more than five years before the OIC submission will not be included in the RCP);
1. If an asset was used by the taxpayer to pay existing, ongoing business operating expenses, the funds should not be considered a dissipated asset;
2. When the asset was dissipated in relation to the liability;
3. How the asset was transferred;
4. Whether the taxpayer realized any funds from the asset transfer;
5. How any funds realized from the disposition of assets were used; and
6. The value of the assets and the taxpayer’s interest in them.
Many taxpayers looking to qualify for an OIC will naturally be tempted to spend down their assets to qualify. Practitioners should make these taxpayers aware that the IRS is on the lookout for this type of behavior and that this strategy will usually fail.