The IRS “Effective Tax Administration” Settlement

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IRS Collections Economic Hardship, Houston Tax Attorney

Life has a way of getting in the way. Whether it is a health issue, a financial setback, or some other circumstance.

The IRS often finds itself having to contend with these situations experienced by taxpayers. This often comes up when there are back taxes. Or when the life issue results in back taxes.

Taxpayers are able to submit proposals to settle their taxes due to these situations. We have rules and IRS procedures that apply to these proposals. One set of rules involves the offer in compromise submitted based on effective tax administration.

The recent Serna v. Commissioner, T.C. Memo. 2022-66 provides an opportunity to consider these settlement offers.

Facts & Procedural History

The taxpayer is a warehouse worker who earns less than $40,000 a year. He lost his job and moved in with his parents.

The taxpayer trying to find a way to provide for his family, but not be ordered to pay child support. He probably worried about being able to pay on a regular basis given that he was unemployed.

The taxpayer took a retirement distribution in excess of $300,000. He used part of the proceeds to pay for a house for his wife and four children in lieu of paying child support.

The withholdings from the distribution were insufficient to cover the tax on the distribution. This was likely due to the 10 percent additional tax on distributions for those who are under 59 1/2 years old. He filed a tax return that reported more than a $60,000 tax shortfall.

The IRS attempted to collect the tax one year later. The taxpayer submitted an offer in compromise based on doubt as to collectibility. The IRS rejected the offer, as did IRS Appeals. The taxpayer filed a petition in the U.S. Tax Court as part of his collection due process hearing.

The taxpayer asked the court to find that IRS Appeals abused its discretion in denying his settlement offer.

As a side note, this involved 2016 taxes and the taxpayer may have been able to use the alimony tax rules that applied at that time to avoid this tax. There are other posssible solutions that might have helped, such as a qualfiied domestic relations order, having the IRS directly levy on the IRA to avoid the 10 percent penalty, etc. These options are beyond the scope of this article.

About the IRS Offer in Compromise

The offer in compromise program has been around for a long time. We have covered various aspects of this program on this website.

You can read about the offer in compromise here.

You can read several of our other articles about OICs here:

This should give you a good overview of the offer in compromise program and the nuances of how the IRS evaluates offers.

The current court case addresses the the offer based on effective tax administration.

The Effective Tax Administration Offer

The IRS can accept an offer based on “effective tax administration.”

The effective tax administration rules say that a settlement to promote effective tax administration is justified (i) when it is determined that full collection could be achieved but would “cause the taxpayer economic hardship within the meaning of [Treas. Reg.] § 301.6343-1” [that applies to IRS levies] or (ii) when exceptional circumstances exist such that collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner.

Thus, there are two possibilities for this type of offer. The first option applies if the IRS could collect the full amount due because the taxpayer has sufficient assets or income. The second option applies regardless of whether the IRS could collect the full amount due.

If the IRS Could Collect the Tax Debt

If the IRS could collect the full amount due, we have to consider the economic hardship rules that apply to levies.

The “economic hardship” rules say that there is an economic hardship if satisfaction of the levy in whole or in part will cause an individual taxpayer to be unable to pay his or her reasonable basic living expenses. The rules go on to say that “[t]he determination of a reasonable amount for basic living expenses will be made by the director and will vary according to the unique circumstances of the individual taxpayer” and “[u]nique circumstances, however, do not include the maintenance of an affluent or luxurious standard of living.”

The following factors are to be considered:

(A) The taxpayer’s age, employment status and history, ability to earn, number of dependents, and status as a dependent of someone else;

(B) The amount reasonably necessary for food, clothing, housing (including utilities, home-owner insurance, home-owner dues, and the like), medical expenses (including health insurance), transportation, current tax payments (including federal, state, and local), alimony, child support, or other court-ordered payments, and expenses necessary to the taxpayer’s production of income (such as dues for a trade union or professional organization, or child care payments which allow the taxpayer to be gainfully employed);

(C) The cost of living in the geographic area in which the taxpayer resides;

(D) The amount of property exempt from levy which is available to pay the taxpayer’s expenses;

(E) Any extraordinary circumstances such as special education expenses, a medical catastrophe, or natural disaster; and

(F) Any other factor that the taxpayer claims bears on economic hardship and brings to the attention of the director.

Regardless of Whether the IRS Could Collect the Tax Debt

The taxpayer can also request that the offer be accepted based on “exceptional circumsances.”

The rules for “exceptional circumstances: are similar to the economic hardship rules. They say that an offer should be accepted if:

(A) The taxpayer is incapable of earning a living because of a long term illness, medical condition, or disability, and it is reasonably foreseeable that taxpayer’s financial resources will be exhausted providing for care and support during the course of the condition;

(B) Although taxpayer has certain monthly income, that income is exhausted each month in providing for the care of dependents with no other means of support; and

(C) Although taxpayer has certain assets, the taxpayer is unable to borrow against the equity in those assets and liquidation of those assets to pay outstanding tax liabilities would render the taxpayer unable to meet basic living expenses.

The exceptional circumsances rules set out similar factors that are to be considered:

(A) Taxpayer has a history of noncompliance with the filing and payment requirements of the Internal Revenue Code;

(B) Taxpayer has taken deliberate actions to avoid the payment of taxes; and

(C) Taxpayer has encouraged others to refuse to comply with the tax laws.

That brings us back to this case.

The Court Review of the CDP Hearing

In the present case, the taxpayer argued that he qualified based on the economic hardship and on the special circumstances rules.

For economic hardship, the taxpayer cited the examples in the regulations that involve the sale of an asset to satisfy back taxes. There are five examples in the regulations. Here is the first example:

The taxpayer has assets sufficient to satisfy the tax liability. The taxpayer provides full time care and assistance to her dependent child, who has a serious long-term illness. It is expected that the taxpayer will need to use the equity in his assets to provide for adequate basic living expenses and medical care for his child. The taxpayer’s overall compliance history does not weigh against compromise.

The examples involve dependents, medical expenses, and old age in the context of retirement accounts and houses.

The court suggested that it would have accepted the offer based on these rules; however, the court was not in the position to do so. The case was before the court on a collection due process hearing appeal. The question was whether the IRS abused its discretion. The court concluded that it did not as this was a decision within the IRS’s discretion to make.

The court reached the same conclusion based on the exceptional circumstances rules.

The Takeaway

The IRS has wide discretion to accept or reject offers to settle back taxes. This is particularly true for offers based on effective tax administration. These decisions often come down to the mindset and views of individual IRS employees. What is accepted by the IRS in one case may not in another case even though the facts are the same or even identical. As this case shows, litigation involving a collection due process hearing appeal may not provide an effective remedy.

The offer in this context merely delays the collection of the tax. The delay can be substantial. This alone may be worth pursuing in many hardship cases as, given the passing of time, hardships may get worse. This may allow a second offer to be submitted once the first offer is finally decided by the IRS.

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