Receiving notice that you owe back taxes can be overwhelming. Fortunately, the Internal Revenue Service (IRS) recognizes that not every taxpayer is in a position to pay their tax liability in full at any given time. Depending on a taxpayer’s financial circumstances, there may be options available to resolve their tax debt over time or, in limited situations, for less than the full amount owed.
Two of the most common collection alternatives are an Installment Agreement and an Offer in Compromise. While both are designed to help taxpayers revolve outstanding tax liabilities, they serve very different purposes and have different eligibility requirements. The general details of each are explained below:
An Installment Agreement allows a taxpayer to pay an outstanding tax liability over time through monthly payments rather than in one lump sum. For many taxpayers, this is the most straightforward option when they have the ability to pay the full amount but need additional time to do so. Generally, an Installment Agreement may be appropriate for taxpayers who fit the following:
- Cannot pay their balance in full immediately;
- Have enough disposable monthly income to make regular payments; and
- Are current with their tax filing obligations
The IRS offers several different types of Installment Agreements depending on the amount owed and the taxpayer’s financial circumstances. Some require little financial documentation, while others require a detailed review of the taxpayer’s income, expenses, assets, and liabilities. Once approved, taxpayers must continue filing future tax returns and paying future taxes on time. Missing payments or failing to remain complaint may result in the IRS terminating the agreement. Although the process varies depending on the type of agreement requested, it generally involves:
- Filing all required tax returns;
- Determining the total amount owed
- Submitting the appropriate application and financial information, as applicable.
- Negotiating a monthly payment amount with the IRS.
- Making all required monthly payments while remaining current on future tax obligations.
An Offer in Compromise (Offer), on the other hand, allows certain taxpayers to resolve their tax liability for less than the full amount owed when the IRS determines it is unlikely to collect the entire balance. Offers are often misunderstood as simply “settling tax debt for pennies on the dollar.” In reality, the IRS accepts Offers only in limited circumstances and after carefully reviewing a taxpayer’s financial situation. Before considering an Offer, the IRS generally requires taxpayers to have done the following:
- File all required returns;
- Be current on estimated tax payments or federal tax deposits, if applicable;
- Not be involved in an open bankruptcy proceeding; and
- Submit extensive financial information regarding their assets, income, expenses, and liabilities.
When considering an Offer, the IRS evaluates whether the taxpayer has the ability to pay the tax debt in full through available assets or future income. If the IRS believes it can reasonably collect the full amount, it will generally reject the Offer. In some cases, the IRS may also consider an Offer based on exceptional circumstances where requiring full payment would create an economic hardship or otherwise be unfair or inequitable. In either case, an Offer typically involves several steps:
- Ensuring all filing and payment requirements have been met.
- Preparing a detailed financial statement using IRS financial statement forms and additional information or documentation.
- Calculating the taxpayer’s reasonable collection potential.
- Submitting the Offer application, supporting documentation, and any required application fee or initial payment.
- Responding to additional requests for information while the IRS reviews the application.
The review process can take several months, and in some cases potentially more than a year, depending on the complexity of the case and the IRS’s workload.
But how does a taxpayer know which option is right for them?
To put it simply, the appropriate collection alternative depends entirely on the taxpayer’s financial circumstances. Generally speaking, an Installment Agreement may be appropriate if the taxpayer has the ability to pay the full balance overtime, they have sufficient monthly income to make payments, and they simply need additional time to satisfy the liability. Whereas an Offer may be appropriate if the taxpayer does not have the financial ability to full-pay the liability, their assets and future monthly income are insufficient for the IRS to collect the full amount, or exceptional circumstances exist that may justify a compromise. Because every taxpayer’s financial situation is different, the same solution will not work for everyone, and there is no “catch all” resolution.
Determining the most appropriate resolution often requires a detailed analysis of a taxpayer’s financial condition, collection potential, and long-term goals. In some situations, pursuing an Offer when an Installment Agreement is more appropriate can result in unnecessary delays and additional costs. In others, taxpayers may enter into an Installment Agreement only to discover later that they may have been qualified for more favorable relief. An experienced tax professional can evaluate one’s financial situation, explain the collection alternatives available to them, and help determine which option is most likely to produce a successful outcome.
Owing the IRS does not necessarily mean that immediate full payment is a taxpayer’s only option. Whether an Installment Agreement or an Offer in Compromise is appropriate depends on the taxpayer’s individual financial circumstances and their ability to satisfy the outstanding tax liability. If a taxpayer has received notices from the IRS or is struggling with unpaid tax debt, seeking professional guidance early can help with understanding options moving forward and developing a strategy tailored to their situation.