When it comes to tax rules and government administrative guidance, one may expect that the provisions are clear and can be easily applied. However, this is often not the case.
Even detailed regulations with explanations may fail to provide readily discernible answers. Applying such rules to common situations can still lead to questionable or incorrect outcomes. This is why many government statutes and policies have built-in flexibility for interpretation by the government.
When taxes are involved, these flexible standards are often thought of as the gray areas of the tax law. They are frequently at the heart of disputes between taxpayers and the IRS.
Defining what constitutes “income” for IRS collection purposes offers one example. The IRS policy manual provides instructions for estimating a taxpayer’s expected short-term earnings, dubbed “future income.” These future income calculations are often critical for taxpayers. They dictate whether the IRS will settle a tax balance for less than what is owed and determine required installment payment amounts for unpaid taxes.
The recent Cloar v. Commissioner, T.C. Memo. 2024-17, case provides an opportunity to examine these IRS future income rules and how taxpayers can navigate the inherent ambiguities in these rules.
Facts and Procedural History
The taxpayer owed over $107,000 in unpaid taxes, penalties, and interest for the 2008-2010 and 2012 tax years. After receiving an IRS notice of intent to levy in 2017, the taxpayer requested a Collection Due Process hearing and submitted an installment agreement request to pay $25 per month for his back taxes.
As part of the Collection Due Process hearing, the taxpayer submitted an offer-in-compromise for $756 to resolve his unpaid tax liabilities for the years at issue.
The IRS computed that the taxpayer could pay $18,824. This amount was based on total monthly income of $5,249, total monthly expenses of $4,358, and total assets of $8,132 (for the quick sale value of his retirement account).
IRS Appeals offered to close the case to currently not collectible status if the taxpayer withdrew his offer.
When the IRS issued its notice of determination rejecting the offer, the taxpayer filed a petition for review with the U.S. Tax Court.
Before the court date, the taxpayer lost his job. A year later, the IRS attorney and taxpayer filed a joint Motion to Remand the case to Appeals given the changed circumstances.
The taxpayer liquidated his retirement account and paid the balance to the IRS, and submitted an offer-in-compromise proposing to settle the balances for $25.
The IRS computed that the taxpayer could pay $23,155. This included $4,762 in total monthly income and $3,510 in total monthly expenses, resulting in $1,252 per month that could be used towards his unpaid tax liabilities.
Even though the taxpayer had been unemployed for two years at that point, the IRS computed the monthly income of $4,762 by averaging the taxpayer’s income from the 2018 and 2019 tax years.
The IRS noted that the taxpayer’s unemployment was “only temporary” and that his “profession, license, and education” would allow him to find employment at his previous level of income. This “future income” is what the court had to consider in this case.
About IRS Collections & the Formula
Both installment agreements and OICs involve determining the taxpayer’s “reasonable collection potential” (RCP) — the total amount the IRS computes the taxpayer can afford to pay based on their assets, income, expenses and future earnings potential.
The general formula is computed monthly. It is net monthly income (which is income less allowable living expenses) plus the quick sale value of the taxpayer’s assets that the IRS could levy (such as homes, retirement accounts, cash, cars, investments, etc.). This produces a monthly amount that the IRS thinks the taxpayer can afford to pay.
As you can see with this formula, it is on the taxpayer to show that they have lower income and higher allowable expenses and their assets are worth less. This is often where negotiations fall apart with the IRS. More specifically, the IRS may assert that the taxpayer has more income than what the taxpayer receives. This happens when the IRS uses the taxpayer’s future income rather than their actual income.
Current Income vs. Future Income
The IRS’s policy manual suggests that current income is to be used in the above formula. Current income can often be determined by looking at the taxpayer’s recent bank statements or by considering the prior income tax returns filed by the taxpayer.
However, there are instances when current income is not a clear reflection of the taxpayer’s income. This is where “future income” comes into play.
The IRS’s policy manual suggests that future income can be considered in situations like these:
- Temporary Unemployment: If the taxpayer is temporarily unemployed but future employment is likely, the IRS may estimate the taxpayer’s income based on their pre-unemployment earnings or anticipated future pay. Factors like the taxpayer’s profession, licenses, and education play a role in this decision.
- Underemployment: Similar to temporary unemployment, if the taxpayer is underemployed with the prospect of returning to higher-paying work, the taxpayer’s future income might be adjusted accordingly.
- Long-Term Unemployment: When unemployment stretches over a year and future employment prospects are uncertain, the IRS usually sticks to the taxpayer’s current income for RCP calculation. However, if verifiable proof of future employment exists, adjustments can be made.
So what is future income? The short version is that it is the IRS employee’s guess as to what the taxpayer could earn. The IRS policy manual just advises IRS employees to consider “the taxpayer’s overall general situation including such facts as age, health, marital status, number and age of dependents, level of education or occupational training, and work experience.”
Curiously, this does not necessarily include future payments.
The Variability of Future Income
This brings us to the dispute in this case. The court noted that the IRS did not follow the guidelines in the IRS policy manual concerning the taxpayer’s future income. The IRS used his past income from tax records rather than his over two years of unemployment.
On appeal, the Tax Court found no abuse of discretion, ruling the IRS policy manual does not rigidly bind IRS employees. As long as the determination of greater collection potential was reasonable, the rejection should be upheld. In this case, the court noted that the taxpayer should be able to find new work given his professional credentials and even a modest projected income exceeded his $25 offer.
IRS employees have discretion in determining the amount of future income in situations where current income is not a reasonable reflection of the taxpayer’s likely income. The IRS policy manual guides IRS employees in calculating the amount of the taxpayer’s future income. However, these provisions are not all that clear. This ambiguity provides even more leeway to IRS employees. This is why these rules are often at the heart of disputes between taxpayers and the IRS. As this court case shows, it is up to the taxpayer to advocate for their position and convince the IRS that a lower amount should be used. Taxpayers seeking to resolve their tax balances with the IRS should be prepared to do just that.