When deciding whether to file bankruptcy or try to do an offer in compromise to deal with your tax debt, there are many variables to consider. You’ll have to consider what you can afford and the probability of a case being accepted and being completed.
Written by Attorney John Coble.
Updated June 21, 2021
Whether an offer in compromise (OIC) or a bankruptcy case will better suit your needs will depend upon several factors unique to your situation. The following information will help you to evaluate which option may work best for you. This article explains how OICs, Chapter 7 bankruptcies, and Chapter 13 bankruptcies work. This article discusses how each option may affect your federal tax situation along with the pros and cons of each debt management opportunity. This article concludes with some examples of when it's best to use each strategy.
What Is An Offer In Compromise (OIC)?
An OIC is a settlement agreement with the Internal Revenue Service wherein you'll have your tax liabilities eliminated in return for paying an amount that's less than the full amount due. With an OIC, you'll file Forms 656 and 433-A (OIC). The 433-A (OIC) is an eight-page form that delves into every aspect of your financial situation. The IRS requires backup documents like bank statements, pay stubs, and much more to prove each line of Form 433-A (OIC). By evaluating this form, the IRS determines what amount of your tax debt they think you can afford to pay.
The IRS will use the following formula to determine the minimum offer amount that the agency would be willing to accept from you. This is a simplified version for a taxpayer who is “only” a wage earner. In the real world, most people who benefit from filing an offer in compromise are self-employed as a sole proprietor, an owner of some other business entity, or an independent contractor. The example below shows the basics of how the formula works.
|Add the Following Amounts:||Value|
|100% of the value of cash assets such as cash on hand, bank accounts, and cash surrender value of a life insurance policy||$x,xxx.xx|
|80% of the value of assets that must be sold to be converted to cash. These assets include houses, cars, stocks, jewelry, and more. Subtract any loan balance that you owe for a particular asset before adding to the total. If any asset has a net value of less than zero, use zero before adding to the total of this type of asset.||$x,xxx.xx|
|Box A||Total Asset Value (This is Box A on the Form 433-A (OIC))||$x,xxx.xx|
|Box D||Add your income together from all sources (Box D on Form 433-A (OIC))||$x,xxx.xx|
|Box E||Add your allowable living expenses together from all sources (Box E on Form 433-A (OIC))||$x,xxx.xx|
|Box F||Subtract Box E from Box D to get Remaining Monthly Income||$x,xxx.xx|
|Multiply Box F by 12||$x,xxx.xx|
|Add Box A||$x,xxx.xx|
|Add the Last 2 Lines Above||$x,xxx.xx|
|This is your minimum offer amount if you pay in 5 months or less|
|Multiply Box F by 24||$x,xxx.xx|
|Add Box A||$x,xxx.xx|
|Add the Last 2 Lines Above||$x,xxx.xx|
|This is your minimum offer amount if you make monthly payments between 6 months to 24 months|
After you’ve completed the calculations in the formula above, you’ll know the minimum amount to offer the IRS. If it’s an offer you can afford, you should make the offer to the IRS by submitting Form 433-A (OIC) and the Form 656 along with the required documentation. If the Internal Revenue Service doesn't accept your offer or if there's an IRS offer that won't work for you, you may be able to get a partial payment installment agreement (PPIA), an installment agreement, or CNC status currently not collectible (CNC) status.
How Can A Chapter 7 Bankruptcy Help Me With My Taxes?
A Chapter 7 bankruptcy case provides debt relief for most types of debt, including most overdue taxes. A Chapter 7 bankruptcy usually takes 4 to 6 months to complete. When the case is over, your dischargeable debts are eliminated, which means that you won’t have to pay them back and your creditors can never ask again that you repay them.
Not all tax debts are dischargeable via the Chapter 7 bankruptcy process. There are a few questions you’ll have to ask about your taxes to determine whether they're dischargeable. First, you need to know if your taxes are general unsecured debts, priority debts, or secured debts. Taxes are secured for the purposes of a Chapter 7 bankruptcy if there's a lien recorded for the relevant tax year.
The next thing you’ll need to know is whether the taxes are priority debts. If the taxes are priority debts, they can't be discharged in a Chapter 7 bankruptcy unless some of your property is sold to pay those taxes down. The good news is that, usually, in a Chapter 7 bankruptcy, filers don’t have enough nonexempt equity for the bankruptcy trustee to sell any of their property. Taxes are general unsecured debts if they're not priority debts and there's no lien recorded. General unsecured debts are the types of debts that can be eliminated in a Chapter 7 bankruptcy without you losing anything first.
Taxes are generally unsecured if the following conditions are met:
There's no tax lien, and
They're individual income taxes, and
The deadline for filing your return was more than 3 years ago. For example, a 2015 return would have had its deadline in April of 2016. Therefore, in 2021, it would be more than 3 years after the deadline, and
You filed the return over 2 years before you filed for bankruptcy. For example, if you were to file your Chapter 7 bankruptcy on May 1, 2021, you must have prepared and filed the relevant return before May 1, 2019, and
Any assessment of the tax by the IRS must have occurred at least 240 days before you filed for bankruptcy.
If all these conditions are met, you can discharge your tax debt with a Chapter 7 bankruptcy filing.
How Can A Chapter 13 Bankruptcy Help Me With My Taxes?
A Chapter 13 bankruptcy is different from a Chapter 7 bankruptcy proceeding in a few ways. In a Chapter 7 bankruptcy (though it rarely happens) it's possible that a bankruptcy trustee could sell some assets to pay some money to a filer’s unsecured creditors. Assets aren’t sold to pay down debt in a Chapter 13 case. Note though, that secured creditors are always paid, in either type of bankruptcy, if you want to keep the collateral tied to the loan. For example, if you have a car loan and you want to keep your car, you’ll have to pay the car loan.
Also, a Chapter 13 bankruptcy is different from a Chapter 7 in that a Chapter 13 bankruptcy includes a 36 to 60 month payment plan. That payment plan is used to pay your secured creditors with interest, pay priority creditors in full, and pay something to your general unsecured creditors. How much you’ll pay to the general unsecured creditors will depend on your nonexempt equity and your disposable income. Often, the amount is pennies on the dollar.
When are taxes dischargeable in a Chapter 13 bankruptcy? Just like in a Chapter 7 bankruptcy, taxes could be classified as general unsecured debts, priority debts, or secured debts. To determine if your overdue taxes are priority debts in a Chapter 13 bankruptcy, you’ll use the same 3/2/240 test from §507(a)(8) of the Bankruptcy Code as in the Chapter 7 bankruptcy. If the taxes were due over 3 years ago, the tax return was filed over 2 years ago, and any assessment was at least 240 days ago, it will not be considered a priority debt.
If there's a lien, it will be considered a secured debt, regardless of whether the underlying tax is a priority debt or general unsecured debt. But, with a Chapter 13 bankruptcy, you may be able to "strip" the tax lien from the underlying tax.
Stripping a lien is a technique used to change a debt secured by a lien into unsecured debt. Debt that’s unsecured can be discharged in bankruptcy. Stripping a lien is done when there's less equity for the lien to attach to than the amount of the tax. Normally, you would be considering nonexempt equity for the property to attach to. Yet, there's an exception for the Internal Revenue Service in which the normal bankruptcy exemptions don't count.
Consider this example: if you have a tax lien against your property for $20,000 of back taxes but you only have $2,000 worth of property that you own free and clear (and you have a $5,000 wildcard exemption available to apply to that $2,000 of equity), you'll be able to strip that $20,000 tax lien down to a $2,000 tax lien. Another type of lien would be stripped down to zero due to the wildcard exemption, but the exception for the IRS leaves you with a $2,000 tax lien which is a secured debt you must pay. Still, you just eliminated $18,000 of secured debt.
Now that the lien is stripped from that $18,000, your next question is whether this new unsecured debt is a priority debt or a general unsecured debt. If it's a priority debt, it still must be paid in full. But, if it passes the 3/2/240 test, it's a general unsecured debt that may be discharged after paying only pennies on the dollar in a Chapter 13 plan. If it's a priority debt or a secured debt, you would have to pay the debt in full to eliminate it in a Chapter 13 plan, but you would be able to pay it over 36 to 60 months - using monthly installments that are designed to be manageable - while eliminating your other debts too.
Mixed OIC-Bankruptcy Strategy
There are situations wherein it makes sense to file a Chapter 7 bankruptcy followed by an offer in compromise (OIC). One example would be if you have substantial medical bills and/or credit card debts as well as priority tax debts that can't be discharged without full payment. If you don't have sufficient income to make the full payment on the IRS debt required for a Chapter 13 plan, you may want to shed your dischargeable debts in a Chapter 7 bankruptcy. Then, you'll free up more of your income to be put toward an offer in compromise.
An offer in compromise doesn't distinguish between priority debts, secured debts, and such. The Internal Revenue Service considers how much money they can get from you when determining if they will accept an offer in compromise. If you couldn't afford a Chapter 13 bankruptcy, the IRS will probably realize that it can't get the money that would have been fully paid in a Chapter 13 bankruptcy. This is when the IRS will be willing to settle for less than the full amount of taxes due. If the IRS accepts your offer and you fulfill your obligations under the offer in compromise, you'll have eliminated your IRS debt without having paid the full amount due.
Pros And Cons Of Offers In Compromises And Bankruptcy
|Different Methods to Eliminate Tax Debts|
|Offer in Compromise||There's a method to calculate the offer acceptance amount, but this is an administrative procedure and the IRS has more leeway to accept a wider range of amounts than a bankruptcy trustee can in a Chapter 13.||It usually takes the IRS 1 to 2 years to decide if it will accept your offer amount.|
|2||You can have a payment plan up to 24 months.||The acceptable offer amount is much less predictable than what you will end up with in a Chapter 13 bankruptcy.|
|3||You can make a lump sum payment.||An OIC eliminates only your tax debt.|
|4||You have to have completed any bankruptcy before you can file an offer in compromise with the IRS.|
|5||The IRS only accepts about 40% of the offers it receives.|
|6||The IRS requires extensive documentation to back up the calculations of your offer amount.|
|7||An OIC with the IRS doesn't help your state taxes, though some state revenue departments have their own OIC programs.|
|Chapter 7 Bankruptcy||It can discharge many types of debt, including many taxes.||A Chapter 7 bankruptcy may not be allowed due to being time-barred by having filed another bankruptcy too soon before or not meeting income requirements.|
|2||A Chapter 7 can't be used to strip a tax lien.|
|Chapter 13 Bankruptcy||The court decides if it will accept your Chapter 13 plan at a confirmation hearing.||If you have too much nonexempt equity or you have too much in non-dischargeable debts and not enough income, you may not be able to afford the required Chapter 13 plan payments.|
|2||The confirmation hearing is usually held 3 to 4 months after filing.||You may be time-barred from a discharge due to having filed another bankruptcy too recently.|
|3||There is a rigid method of calculating a Chapter 13 that leads to a relatively predictable outcome in court.||There's a much lower discharge rate than there is with Chapter 7 bankruptcies due to filers suffering from unforeseen circumstances that make it impossible to continue to make their Chapter 13 payments. An example of such an event would be long-term unemployment.|
|4||You have up to 60 months for your payment plan.|
|5||You have set procedures for dealing with temporary losses of income during your Chapter 13 plan.|
|6||You can eliminate many types of debt. For debts that must be paid in full, you have 36 to 60 months to pay those debts.|
|7||You may be able to strip a tax lien.|
|8||Whereas an offer in compromise has an approximately 40% acceptance rate, a Chapter 13 bankruptcy has a high acceptance rate.|
Examples Of Using Offers In Compromise And/Or Bankruptcies
Examples of situations and which strategy would be best in each situation:
Here, the taxpayer has $20,000 of income tax debt from 2015. This taxpayer filed their 2015 return in 2018. The IRS hasn't assessed anything new within the last 240 days. The IRS hasn't recorded a tax lien. The taxpayer has no non-exempt equity. This taxpayer also has $10,000 of credit card debt. This taxpayer is eligible to file a Chapter 7 due to having income lower than the median income in their state. It's now 2021.
This is a perfect tax discharge scenario for a Chapter 7 bankruptcy. The tax return was due in 2016, which is over 3 years ago. The return was filed in 2018, which is over 2 years ago. The taxes haven't been assessed within 240 days. There's no lien. If this taxpayer files a Chapter 7 bankruptcy, they will eliminate $20,000 in tax debt and $10,000 in credit card debt.
Everything is the same as in Example 1, except there's a tax lien recorded. The taxpayer has a disposable income of $100 per month. The taxpayer only has $1,000 of equity for the tax lien to attach to. In this case, the taxpayer will have a $1,000 secured debt and $29,000 in general unsecured debts. This taxpayer may be able to pay approximately $3,600 over 36-months through a Chapter 13 bankruptcy plan and eliminate the $1,000 secured debt and the $29,000 ($10,000 credit card debt and $19,000 of the tax debt) of unsecured debt for $2,600. That means this taxpayer would be paying around 9 cents on the dollar to eliminate $29,000 in unsecured debts and $1,000 for the tax lien that is actually attached to equity.
This one has the same situation as in Example 1 except the tax year was 2017. These taxes were due on April 16, 2018. The return wasn't filed until May 1, 2020, and hasn't been paid. The taxpayer has just received a Letter 1058 from the IRS stating that it will place a levy on the taxpayer and the taxpayer has 30 days to ask for a collection due process hearing. Here, the taxpayer has to do something quickly or the IRS may start taking money from their paycheck or their bank accounts.
These are priority tax debts, since the tax return was filed only 1 year before instead of more than 2 years ago. This means the taxpayer will have to pay the entire $30,000 in a Chapter 13 bankruptcy to discharge these taxes. The Chapter 13 payments would be at least $500 per month due to having to fully pay the $30,000 tax debt over 60 months.
The bankruptcy court will not confirm (approve) this Chapter 13 plan because this taxpayer has a disposable income of only $100 per month. They must have at least $500 per month for their Chapter 13 plan to work. The judge would dismiss a Chapter 13 bankruptcy.
An offer in compromise doesn't have such rigid requirements. The IRS might accept as little as $2,200 ($1,000 in assets + 12 times $100 per month) from the taxpayer to settle the $30,000 in tax debts. It's likely the IRS would want more since it still has 9 years before the collections statute expiration date (CSED). Even at $100 per month for 9 years calculation, the high end would be $10,800 (9 times 12 times $100 per month). Either way, the possible outcome is better than what it would be with a Chapter 13 bankruptcy. It's a "possible" outcome because the IRS has the final say on what offer it'll accept.
It's more likely the IRS will accept the offer if it sees no opportunity for financial improvement for the taxpayer over the next 9 years until the CSED. In this case, if the taxpayer has to pay $10,800 over 24 months, they may have to get a second job. The payments would be $450 per month, but it would be over within 2-3 years.
If the IRS doesn’t accept an offer the taxpayer can afford, then the taxpayer may do better with a partial payment installment agreement allowing them to pay less than $450 per month since they’ll have at least 72 months.
Here, everything is the same as in Example 3 except the taxpayer has $30,000 in a combination of credit card debts, unsecured installment loans, and medical bills. While the taxpayer may need to file bankruptcy with just $10,000 of unsecured debts when they only have $100 per month of disposable income, it's a more favorable situation if they file bankruptcy because they have $30,000 of dischargeable debts.
Here, the taxpayer has $30,000 in dischargeable debts and $30,000 in non-dischargeable debts in the form of priority taxes. In this case, filing a Chapter 7 followed by an offer in compromise after the Chapter 7 discharge is probably the best choice. Within 6 months, the taxpayer can eliminate $30,000 of debt through the Chapter 7 bankruptcy process. Then, the taxpayer can work to eliminate the tax debt through an OIC.
When deciding whether to use one of the chapters of bankruptcy or an offer in compromise, there are many variables to consider. You’ll have to consider what you can afford and the probability of a case being accepted and being completed.
There's a lot to consider. This is why it's a good idea to speak with someone who does this every day. Many times, if you go to a bankruptcy attorney, they'll be biased toward using bankruptcy. But, if you go to a tax attorney, CPA, or enrolled agent authorized to practice before the IRS, they'll be partial to an offer in compromise. The best choice is to find a bankruptcy attorney who is also a tax attorney. There are a few of these around. Upsolve can help you find an experienced attorney in your area.