Lesson From The Tax Court: The Proper Baseline For Offers In Compromise

Paying taxes can be painful.  When money is tight and other needs are pressing, sending money to the federal government understandably sinks on the taxpayer’s priority list.  But not the government’s!  Congress wants to make sure that paying taxes remains at the top of every taxpayer’s priority list.  That is why it gives the IRS really awesome collection powers.  If that duty to pay taxes is not uniformly enforced, the thinking goes, then voluntary compliance goes out the window and soon that window will be smashed by rocks thrown by rioting mobs.  Don’t want that.

At the same time, Congress recognizes that, sometimes, circumstances  should permit payment of less than the full amount.  The Offer In Compromise (OIC) process is designed to address those situations. The ability to secure an OIC, however, must always be evaluated against a default of full payment, not against a default of no payment.  That is what we learn from Edmund Gerald Flynn v. Commissioner, T.C. Memo. 2022-5 (Feb. 3, 2022) (Judge Urda).  There, the Court held that the taxpayer was not entitled to an OIC just because the full-pay obligation would be financially painful.  Details below the fold.

Law:  OICs
An OIC is an alternative to immediate full payment of tax.  Taxpayer can compromise their liabilities on the basis of either: (1) Doubt as to Liability (DATL); (2) Doubt as to Collectibility (DATC); or (3) Effective Tax Administration (ETA).  All three bases create the same policy tension: when and under what circumstances should the federal government let taxpayers off the full payment hook?  For a terrific description of these and other payment alternatives, and a thoughtful discussion of the underlying policy tension, see Professor Shu-Yi Oei’s excellent article: Who Wins When Uncle Sam Loses? Social Insurance and the Forgiveness of Tax Debts, 46 U.C. Davis L. Rev. 421 (2012).

The authority to enter into OICs comes in §7122.  Traditionally, the IRS took a very constricted view of its authority.  It limited OICs to just the first two of the current three bases: situations where there was either a sufficient doubt as to the correctness of the assessed liability or there was sufficient doubt as to the ability of the taxpayer to meet their full-pay obligation.  And what was “sufficient” was a really high bar.  It generally meant the IRS was determined to collect the taxpayers’ “maximum capacity to pay.” Preamble to the Temporary OIC Regulations, 64 FR 39020 (Wednesday, July 21, 1999).  See generally Daniel T. Maggs, Section 7122 of the Internal Revenue Code: The Offer in Compromise, 11 Gonz. L. Rev. 481 (1976) (reviewing history of IRS strict interpretation of compromise authority).

In the early 1990’s, the IRS loosened up.  See generally,  Richard C. E. Beck, Is Compromise of a Tax Liability Itself Taxable? A Problem of Circularity in the Logic of Taxation, 14 Va. Tax Rev. 153 (1993) (discussing reasons for expansion of OIC in the early 1990’s).  Notably it stopped seeking to collect the “maximum capacity to pay” and instead sought only to determine a taxpayer’s “reasonable collection potential” (RCP).  The RCP standard was intended to incorporate allowances for reasonable living expenses.  In effect, the government would allow taxpayer to prioritize creditors linked to certain living expenses (e.g. utility companies, mortgage lenders, etc.).  See Preamble, supra. 

In 1999, in response to the IRS Restructuring and Reform Act of 1998, Treasury added the ETA basis for OIC.  More about those next week.

Today's lesson is about Doubt as to Collectibility (DATC) OICs and revolves around an analysis of the taxpayer’s “Reasonable Collection Potential” (RCP).  

RCP consists of what the IRS believes the taxpayer can raise by (1) selling assets and (2) using the taxpayer’s disposable future income over some period of time.  Asset values are often discounted by some percentage to reflect the costs of quickly selling them.  Disposable future income accounts for reasonable living expenses as determined by various national and local tables.

How much future income counts towards RCP?  I dunno.  I cannot figure the time period over which future disposable income counts.

On the one hand, appears that the IRS will only count up to 12 months of future disposable income as part of the RCP for when the taxpayer offers to pay off in 5 months or less, and up to 24 months of future income for when the taxpayer wants to spread the payoff over 24 months.  See IRM 5.8.5.25 (09-24-2021)(“Calculation of Future Income”).

On the other hand, in today's case, the OIC unit used a 10-year period to calculate the Mr. Flynn's RCP, and Judge Urda took pains to note that the IRS could use up to the time remaining in the collection limitation period to calculate RCP. Op. at 4, note 4.  I welcome comments (with citations) that can clarify the rule or the scope of discretion.

However it’s done, IRS employees calculate the RCP using an internal program called the Decision Point tool.  See IRM 5.8.4.7. Taxpayers can use this online calculator to help them determine their RCP and, thus, what type of OIC is most likely to be accepted.  For what it’s worth, the online calculator appears to use the 12/24 month periods, at least when I used it to calculate the proper OIC for an imaginary tax liability.

However calculated, the RCP may either smaller or larger than the full amount of taxes owed.

If the RCP is smaller, the IRS will generally require any OIC to match the RCP.   Sometimes, however, a taxpayer may be able to show Special Circumstances that justify acceptance of an offer amount even lower than the RCP.  Those are called DATC-SC offers.  See IRM 5.8.4.2 (05-10-2013).

If the RCP is larger—that is, if the IRS decides the taxpayer’s RCP is enough to fully pay the tax—then the IRS will generally reject the offer.  Again, however, sometimes a taxpayer may be able to show special circumstances that justify acceptance of offer for less than the full amount owed even when the taxpayer can fully pay.  That is when the taxpayer might qualify for an ETA OIC.

Today’s case teaches us the importance of the RCP, and the proper way to explain it to your clients.

Facts
Mr. Flynn owed some $16,000 in taxes for the years 2012-2014.  When you add penalties and interest, and some other years, however, his total outstanding liability to the IRS reached almost $64,000.  But it was in response to collection efforts for the 2012-2014 years that Mr. Flynn successfully secured a CDP hearing.  He asked for an OIC based on doubt as to collectibility (DATC).  He offered to pay $150 per month for 24 months (2 years).  To support his OIC, he submitted the requisite Form 656 showing about $5,000 in assets, monthly income of about $5,000, and monthly expenses of $3,331.  The Settlement Officer (SO) sent the OIC to the Centralized OIC unit for processing.  Remember, Appeals will not work the case.  See generally  IRM 8.22.7.10.4 (08-26-2020) (“Processing OICs”).

In April 2019, the OIC unit rejected the OIC, finding an RCP of $330,000, using a 10-year window for future payments.  It based that on finding his monthly income to be $5,300 and reducing his allowable expenses to about $2,600, thereby concluding that he had some $2,700 in monthly disposable income to pay his tax obligations.  By this calculation, Mr. Flynn could fully pay his total liabilities in 25 months.

To calculate allowable expenses, the OIC unit used a set of national standards for some items (like food, clothing, etc.) and a set of local standards for other items, such as housing.  I don’t know what that would have been in 2018, but here are the 2021 table for food/clothing/etc. and here are the 2021 housing and utilities tables for NY localities.  It appears that the OIC unit allowed Mr. Flynn 53% of the national standard allowances for two people.  Why 53%?  Well, because that mirrored his share of the couple’s total monthly income.  Op. at 3.  His wife also had income.   So it appears that, between them, they were clearing some $10,000 per month.  Not too shabby.

Instead of asking Mr. Flynn to pay $2,700 per month, however, the SO offered Mr. Flynn an installment agreement of $750 per month.  That would pay off the liability in about 7 years.  Mr. Flynn refused.  He upped his offer to $250 and was adamant that was his best and final offer.  He must have thought he was negotiating for a car or something.

As you might expect, the SO sustained collection on the 2012-2014 liabilities.  After Mr. Flynn petitioned Tax Court, he and the IRS agreed to remand the case to Appeals to allow Mr. Flynn to present evidence of additional relevant expenses.  After accounting for those, such as snow removal costs and yard care costs, the SO still found his disposable income was just under $1,800 per month, much more than Mr. Flynn’s $250/month offer.  Again, the SO suggested a $750/month installment agreement.  Again, Mr. Flynn refused and chose to try his luck in Tax Court.

He did not get lucky.

Lesson: Forced Frugality Does Not Entitle Taxpayer To OIC
Mr. Flynn wanted to dispute the amount the IRS allowed him for expenses.  He argued that “the allowances were insufficient because they did not support his particular lifestyle.”  Op. at 8.  Specifically, he said that his housing expenses were some $700 more than the SO permitted and, hey, he had credit card debt to pay off.

Judge Urda was not impressed.  While taxpayers can sometimes argue that the standards are inadequate, they must basically show that using the standards would result in financial hardship, the inability to meet basic living expenses.  See IRM 5.8.11.3.1.  Mr. Flynn did not do that.  More fundamentally, Judge Urda points out that even giving Mr. Flynn credit for his claimed housing expenses, the resulting monthly disposable income was still way over even the $750 installment agreement offered by the SO.

As for credit card debt, Judge Urda explains that it is not a category of expense.  It is just a method of paying for expenses and “Mr. Flynn dooms his own argument by his admission that the credit card debt had not been incurred to pay basic living expenses.”  Op. at 8.

Having to pay $750 per month is certainly not trivial.  It means you must live a more frugal life.  If you compare it to not having to pay anything at all, it seems burdensome.  But that is not the proper comparison for evaluating OICs.  The proper comparison is fully paying the liability.  Here, fully paying the liability appears to mean that Mr. Flynn and his wife must live more frugally for the next 7 years.  That’s fair.  I’ve seen honest but unfortunate taxpayers, taxpayers who have far less monthly income than Mr. Flynn, be required to scrimp far more to pay off their tax debt, debt that arose from perfectly understandable errors.  OIC is not a "get out of tax free" card.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each week for a new Lesson From The Tax Court.