Arizona Tax Lawyer Blog

The IRS has dramatically changed the guidelines and rules that govern how an offer is calculated. In theory...this should increase the number of taxpayers who will qualify on paper and who will ultimately be successful.

The changes were published by the IRS on May 21, 2012. (See, IRS News Release)
Additional detail can be found in the Attachment 1 to Internal Revenue Manual 5.8.5 Financial Analysis

If you investigate past articles in this blog and our website about the Offer in Compromise program, you will see that we have never been terribly thrilled about it. Most people just didn't make great candidates. These changes are a big deal though. Such a big deal that we are in the process of reviewing all of our past client files to determine whether the new rules help those that it may not have helped before.

The biggest change and the one that will probably make the most difference in the numbers of Offers filed and the success of those Offers, is the way the rules are now being used to calculate the offer amount.

The amount that is supposed to be offered to settle a tax debt has always been determined by adding the taxpayer's asset value to his or her future available income.

Future available income was basically, gross income minus reasonable and necessary living expenses (An amount partially or some would argue primarily determined by the IRS guidelines or standards - an unfriendly set of numbers) for a predetermined number of months. Those months were 48 and 60, prior to this change.

If the future available income was agreed to at $500.00 and the taxpayer could pay the offer in a very short period of time. than $500.00 was multiplied by 48 and added to the asset value. Things added up in a hurry this way. If the asset value was $10,000.00 and the available income was $500.00, than the "cash" offer would have to be $34,000.00

Now...the multipliers are 12 and 24.

Given the same scenario, the cash offer would only be $16,000.00 instead of $34,000.00. A difference of $18000.00.

Some other very important changes to the Offer in Compromise calculation include:

1. Certain student loan payments will be allowed as part of the calculation of reasonable and necessary budget.

2. A car that is six years or older or that has 75k in miles will be allowed an additional expense for gas/upkeep of $200.00 per month.

3. The first $400.00 per vehicle of retired debt will not be added back to the monthly available income.

4. Assets which have been spent or "dissipated" three or more years prior to the submission of the offer won't be included in the calculation of the reasonable collection potential.

5. Payments on late state taxes may be allowed to some degree as part of the budget calcuation.

Despite these grand changes and the possibility that many with serious tax debt may be able to find long term relief now outside of bankruptcy, we remain guarded for several reasons:

1. The IRS is likely going to be overwhelmed with offers that could potentially drag the process out over a few years.

2. Even more offer "mills" will magically appear and oversell the offer process to those for whom it may not make sense.

3. The IRS is not famous for following it's own rules. Just because the manual says something, doesn't mean it will be easy to get the IRS to do it.

4. The IRS can reject an Offer for other reasons. Just because the numbers make sense doesn't mean the Offer will be successful.

If you have a serious tax debt though, or expect to have one, and you want to learn more about your options contact us and speak to tax resolution lawyer, Michael Anderson about your situation.

Time flies when your having fun. As you get older, it flies by whether you are having fun or not. For people with multiple years of late,unfiled tax returns, time flies whether they are old or not.

One tax return is missed because a debt is lurking at the other end, and all of a sudden four years have gone by and 5 tax returns are late. Oh, and by the way, your 10 year old is now driving.

If you have several years of missing tax returns there are a number of reasons why you should straighten your tie, take a deep breath, and get the returns done.

Jail

Most non-filers don't go to jail. However, one missing return can be considered a crime. The IRS goes after the high rollers and "Moms and Pops" alike.

It just isn't worth the risk to wait. Especially when there is a likely solution, even if long term, to deal with the debt.

Penalty

The penalty the IRS tacks onto the debt for failing to file can be as high as 25%. After a few years, 25% with interest can amount to alot of dough. Just filing the return on time prevents this from happening. The return needs to be filed anyway, so why wait until it's late and incur the penalty.

Lose the Refund

There is a little known and very strange rule the IRS has. If you file a tax return more than three years after it was originally due...you lose your refund. They get to keep it and no, there really isn't any amount of begging that will get it back.

The IRS "collects" millions each year because people who are entitled to a refund don't file on time.

Not filing because you will owe? I can see that line of reasoning, it has a certain logic to it, but not filing when you will get a refund? Not logical at all.

Audit

Don't you think it makes sense that a late filed return may get a bit more attention paid to it. I think they do. Especially if an IRS Revenue Officer is looking at the return with her own eyes as she determines whether to stop your levy or not.

In this day and age - it's good to fly "under the radar".

Substitute Returns

The IRS has the authority to use what has been reported to them, stick a standard deduction to it and call it a return. It doesn't even need your signature.

TO REPEAT for those guys staring at their I-Phones when I said that...

The IRS gets to do the returns for you and they don't use any basis amounts for stock sales, gambling winnings or home sales. They don't deduct your business expenses from schedule C. They don't include the emergency room cost of your 8 year old's broken arm.

They don't need your signature.

This is a very common problem. A problem that usually results in large, overstated debts that are used to beat you over the head...OR more commonly to levy accounts and garnish wages and keep you up at night.

There are other large problems associated with these types of returns i.e substitute returns.

If the IRS files this substitute return, you do not have a "right" to challenge it if 90 days pass after it's assessment.

Oh sure, you can ask them to replace it with the correct return, and they probably will...but they don't have to. Not nice.

The other...if you ever need to discharge this particular debt in bankruptcy, probably isn't going to happen, at least not in Arizona.

IRS Collection

Most people can't formally stop IRS collection without filing a bankruptcy case... unless their returns are filed. No, I didn't say most people can't file for bankruptcy unless their returns are filed, although that is arguably correct.

I said...it is a mistake to wait until your bank account is frozen to do six tax returns. You need to be "compliant" to stop the IRS collection machine, in most cases.

Conclusion and a few more items.

Having said all of the above...there are reasons you may want to:

1. Speak to an attorney before preparing the returns and

2. Get them prepared but not necessarily file them until you have spoken to an Attorney.

For some people it may be very important to create some attorney client privilege related to the return work. So even if you are using a CPA or tax preparer, you may want to involve the Attorney first.

For some other people, it will be important to know which years may not need to be filed and whether certain returns need to be filed at specific times.

Catch me later about this.

In any event, if you are missing returns, or know someone who is missing returns, tell them to go to the telephone and get it started. We do lots of tax returns. There are hundreds of tax return preparers and CPA types as well.

Finding someone qualified is the easy part. Getting them done before life passes you by...that may be easier than you think.

Call Michael at 480-507-5985 if you have multiple years of unfiled tax returns and you are an individual or a small business person whose 10 year old son suddenly turned 16.

Collection Letters, Bills, Late Notices, IRS Statements.

If you are like me, you probably don't want to open a bill when you get it. You put it in your bill pile to be dealt with later that month.

But what if you are in trouble financially and you know the bill isn't going to be paid later that month. It probably goes in a different pile. IT sits there and sits there and in the meantime the creditors start to call, the IRS begins the wage garnishment process, and you may even get sued.

When the debt gets to the point where you have created a "special" pile for it, and the calls are coming in, you need to understand your options.

Bankruptcy is a powerful option that many with debt problems wait to consider until they are already in real trouble.

Bankruptcy is found in the U.S. Constitution and it allows for the modification of the ways your debts can be collected.

The initial modification of the creditors ability to collect is found at 11 USC Sect. 362.
This code section empowers the bankruptcy court to stop collection activity by almost all creditors, including the IRS.

Once the collection activity is stopped. The rest of the Bankruptcy Code kicks in.

The Bankruptcy Code forces your creditors into categories and than can eliminate many of those categories entirely. Other categories of debt like new tax debt, don't always get eliminated, but they can often by adjusted in a way that allows you to more easily find a way to pay them.

The first question you must answer when deciding whether bankruptcy should be considered is whether or not you can deal with your creditors without it's protections. Do you have funds sufficient to make reasonable offers to settle? If so, are you willing to accept the negative aspects of settling debt?

If you don't have funds to try to convince the creditors to settle, are you susceptible to levy, garnishment or seizure, ie. do you have wages or assets?

If so, and the pile of bills you haven't looked at for a while is large, there is probably good reason to at least speak to an Attorney who is knowledgeable about bankruptcy.

Yes.

The "FPLP" or the Federal Payment Levy Program allows for Social Security Benefits paid under Title II of the Social Security Act to b "levied" by the IRS to pay a tax debt.

The levy amount is limited to 15% of the total payment. Lump sum death benefits and benefits paid to children, can't be touched.

Before the IRS can grab 15% of your social security check via FPLP, it has to send you a final notice of it's intent to levy. You have the ability to appeal the levy once you receive that final notice. In Social Security cases, the IRS will also send another notice called a "Final notice Before Levy on Social Security Benefits". This notice also comes with appeal rights.

The IRS has produced a good question and answer pamphlet regarding this situation.
You can find it here.

If you are concerned about the levy of your social security check as a result of IRS debt, and feel like you need some help, talk to a qualified and experienced attorney about your options. You can call me and discuss your options for free.

Small business is the lifeblood of our economy.  Starting a small business is difficult though.  Marketing and management problems, government regulation and taxes all lie in wait to derail the best laid plans.  I typically see the small business owner at the end of what is usually a monumental effort gone bad.

The owner now has a number of debts.  Business related and personal.  He or she often has a debt that can be very difficult to deal with.

Employment tax, or as some call it "payroll tax".

This is the tax the business owner may have withheld from the employees' paycheck, matched with some business income and sent in to the IRS (or failed to send in)

When this type of debt exists, the owner will usually talk to a tax professional in hopes that the  IRS offer in compromise program (OIC) will be an available remedy.

The OIC can result in a vast reduction of the tax debt, and for some it does, for most...it doesn't.  The OIC usually fails for a number of reasons.  I have written about a few here.  There are other lawyers and tax professionals who are familiar with the offer in compromise process and who are generally dissatisfied with it as well.

Some examples here , here and here.  Yes, even the IRS is concerned about it.

I agree that the OIC must be explored and in some cases it will be successful.  But where it isn't, does the business owner have other options short of paying the debt or moving to a remote island?

1.  Long term payment plan

- A payment plan that will fluctuate as the business owner's income fluctuates but will end when the statute of limitations on collection ends ten years from the date of assessment.  (give or take a few years - read more here)  It can end sooner of course, if the business owner pays the debt off.  There are different types of payment plans as well.

2.  Bankruptcy 

But wait a minute.   Bankruptcy can wipe away income tax debt but employment taxes?  No way right?  Not so fast.  Employment tax as mentioned above is divided into two parts:

The employee portion

The employer portion

The employer portion is the part of the tax that includes the obligation to "match" the employee's 6.2% social security tax and the 1.45% medicare tax.  This portion of the employment tax can be discharged in bankruptcy if:

1.  There have been more than 3 years between the date the 941 tax return was last due including any extension and the date the bankruptcy filing takes place.

2.  There have been more than 2 years between the date the 941 tax return was filed and the date the bankruptcy filing takes place and;

3.  The business owner didn't willfully attempt to evade the tax (a topic for another day)

The employee portion or what is often called the "Trust Fund" is NEVER dischargeable.  This portion is withheld by the employer in "trust" and sent in.  This part of the debt survives a chapter 7 bankruptcy and must be paid over a period of time in a chapter 13 bankruptcy or directly. It can be settled as mentioned in an OIC, and a payment plan coupled with the statute of limitations on collection will eventually kill it off. (see above as well)

Despite the non - dischargeable nature of the trust fund portion of the employment tax, a bankruptcy may make sense for the business owner with a personal liability for the non trust fund portion.  Especially where other debt exists.

Scenario

• The bankruptcy attorney has explained that the money  in your 401k plan is safe from creditors, and therefore safe from those creditors and the bankruptcy trustee if you file a chapter 7 bankruptcy.


• You also owe the IRS some serious back income tax.  The income tax debt meets the criteria to be discharged in the bankruptcy filing.  In other words, when the chapter 7 bankruptcy is over, you won't have a personal obligation to pay the IRS debt.


• Several months prior to the bankruptcy filing,  the IRS recorded a number of "Notices of Federal Tax Lien" documents in the local County Recorder's office.


• You file the bankruptcy case.


• The case goes well, discharge is entered and the case is closed.


• Six months after the bankruptcy case is closed, you receive a letter from the IRS.  The letter states that the tax obligation was discharged, but that the IRS is enforcing it's tax lien on your retirement account and is taking action to seize the account.


• You are confused as you believed that the retirement account was safe and that the tax debt was wiped out.   Sleepless nights ensue.

If you have serious tax debt and a retirement plan, the above scenario may be important to you.  There are a few things about the law that you need to understand as a result:

• Most retirement accounts i.e. 401k, IRA, 403B funds are safe or exempt in bankruptcy.  Actually, certain "ERISA" accounts aren't even part of the bankruptcy estate.   The bankruptcy trustee has no interest in them from the outset.
• Unlike other creditors, the IRS isn't subject to exemption rules i.e. a percentage of social security checks and retirement accounts are theoretically fair game.
• IRS liens properly recorded, survive a chapter 7 bankruptcy filing even if the underlying tax debt, the tax debt that was the basis for the lien was wiped out.  That tax lien survives and it is worth whatever you were worth on the date of the bankruptcy filing.  If you owned one asset worth $5000.00, like a car, and the discharged tax debt was $100,000.00, the lien is worth $5,000.00.
• In a way, the IRS is like the lender on a car.  If you file a chapter 7 bankruptcy and you want to quit paying on the car, the chapter 7 bankruptcy will discharge your obligation to do so.  You will not be legally required to make the payment to the car lender.  The car lender however, still has a relationship with the car i.e. a security interest in it, and that security interest is worth whatever the car is worth.  When the case is closed, the secured lender can take the car as a result or request payment of the car's value in exchange for release of the lien.  It cannot sue you for the balance or deficiency if one exists.
• The retirement account is like the car.  In the scenario above, it is worth however far more than $5000.00.  If it were worth only $5000.00, it is highly likely that the IRS would agree to simply release the tax lien.  The amount of the tax debt was quite high though and more than the value of the retirement account, so the IRS could, at least in theory, seize the account based on the lien.

Solutions
Some solutions to this problem include:

• If possible,  file the bankruptcy before the tax lien is recorded.  This can be tricky of course.  The tax debt won't become dischargeable in the bankruptcy case for a period of time.  (See bankruptcy discharge date requirements). The IRS will try to record that tax lien notice as soon as it can where the debt is relatively large.  There are defenses to the recording of the lien, but their application is fairly narrow for large debts.
• Remind the IRS that internal policy requires it to consider collection alternatives before levying or seizing assets.  (Although this may be changing)  Alternatives include IRS installment agreements and IRS offers in compromise.  The fact that you may have been saving money in the 401k plan while ignoring the tax may not bode well for you in this regard.
• Prove to the IRS that you need the retirement account funds to survive or will need them in the near future.  It may be sensitive to the fact that the proceeds are paying your basic living expenses perhaps for the remainder of your life.
• Make an offer.  Try to get the IRS to accept a smaller amount than the tax lien is worth in exchange for leaving the account in place.

If the above scenario is familiar or you think it will be in the near future, the wisest thing to do initially is to speak with an attorney experienced in bankruptcy and tax debt matters as soon as possible.

Earlier this month the First Circuit Court of Appeals upheld the conviction of a couple who based their actions on some bad advice from their dentist.  (See United States V. Allen) Apparantly, the dentist convinced the couple that tax return filing and tax payment weren't legally required. 

So in 1998, they began to claim exemptions from withholding for federal income taxes and their employer stopped withholding income tax from their paychecks.  They then classified themselves as independent contractors and as a result the employer stopped withholding FICA i.e. social security and medicare.  In 2000, they stopped filing tax returns.   They also closed all bank accounts, had checks written to them made payable to cash or directly to their creditors and transferred title on the home into a trust.

In 2009, the Government charged them with one count of  conspiracy to commit fraud on the United States, one count of attempted tax evasion, and four counts of willful failure to file income taxes.

At trial, the primary defense was a good faith reliance on the prior advice they received from this dentist.  There is a basis to argue that a taxpayer lacks the "willfulness" necessary for a tax evasion conviction, if he or she honestly (not necessarily reasonably) believed, based on a misreading of the tax law, that no tax is owed, [See Cheek v. United states, 498 U.S. 192 (1991)]  The Jury didn't buy it though. The pair were convicted and each ended up recieving three years in prison.

To some, the moral of this story is that you should file your tax returns, disclose your income, and pay the tax.

For others, the outtake from this case, is to be extra careful when picking one of the many tax advice dispensing dentists in your area.

image credit: popular-pics.com

When a creditor cancels or "forgives" a debt, it is deciding not to collect that debt.  It does this for various reasons, none of which are for the purpose of helping you.

When the debt is forgiven following a settlement negotiation, a short sale, or a foreclosure, the creditor must report the amount of the cancelled debt to the IRS on a form 1099-c.

Under Section 108 of the Internal Revenue Code, the IRS than treats that cancelled amount as income.

If, for example, you earn $75,000.00 per year and a home sold at short sale for $100,000.00 less than the lender was owed, the IRS will treat you as having earned $175,000.00 in income.

UNLESS:

1.  The debt was discharged in bankruptcy

If the obligation on the debt was included in and than discharged in a bankruptcy proceeding, it isn't attributable to you as income.  If you received a bankruptcy discharge on the obligation, and a 1099c document from the lender, you will need to file a form 982 with the tax return.  This form tells the IRS how the forgiven debt is being treated and why it is not being included in the income disclosure on the return.

2.  If the cancelled debt occurred while you were insolvent

If you were "insolvent" you can reduce the amount of the cancelled debt from your income.  See U.S.C. Section 108(a)(1)(B).  Unlike bankruptcy, a determination of your asset value for insolvency purposes includes all of your assets, including retirement funds like IRA and 401k funds.  In Bankruptcy, these assets are generally out of reach.

3.  If you qualify under the Mortgage Forgiveness Debt Relief Act of 2007

President Bush signed this act into law and it is in place through the end of this year 2012.  In essence it protects those who have cancelled debt related to a principal residence.  It doesn't apply to second mortgages used to buy a boat or pay off debt, nor does it apply to second homes.

Losing a home, whether as a result of forced sale, short sale or foreclosure is traumatic.  I speak with many people who have made the experience more traumatic than necessary by ignoring the consequences of the 1099c.  If a debt is going to be forgiven and it is relatively large, you will need to determine whether an insolvency or the 2007 act will apply to reduce or eliminate taxation on the amount.  If not, bankruptcy as an option should be reviewed before the debt is forgiven if possible.

About a week ago on January 4, the 5th Circuit Court of appeals in the case "McCoy v. Mississippi State Tax Commission"  ruled that a debtor wasn't entitled to a discharge of state taxes where the tax return was filed late even though it was filed by the taxpayer.  In essence, they ruled that a late filed state tax return filed by the taxpayer/debtor is not a "return" for purposes of satisfying the "two year rule" in bankruptcy.

Specifically, the State argued that the debt wasn't discharged because the return was filed late.  The Appeals Court agreed and added that unless a late filed return is filed under a "safe-harbor" provision of the bankruptcy code, a late filed state income tax return is not a return for discharge purposes under Section 523(a) of the bankruptcy code.

This case has raised the interest of many who deal with tax debts and bankruptcy, because to some...it stands for the proposition that a tax return filed one day late i.e. one day after it was legally required to be filed, can never be discharged in a bankruptcy unless it was filed with the aid of the State taxing Agency i.e. IRS.

This line of reasoning has been attempted to some degree before, and in response, the IRS issued at least one notice ( irs-cc-2010-016-late-filed-tax-return) indicating that "form 1040 is not disqualified as a "return" under section 523(a) solely because it was filed late."  The IRS doesn't agree that a late filed return should be considered a non return.

So...for now, and at least in the 9th Circuit, the late filed return still qualifies as a return for purposes of discharge in bankruptcy if filed by the taxpayer more than two years before the filing of the bankruptcy case and before the IRS assesses a debt.  I don't think this will change in the future, but just in case...file your tax return on time.

I met with a person recently who has a six figure IRS income tax debt.  Many of my clients do.  As is common, he had been talking to several "Tax Resolution" Companies about his options.  There are hundreds if not thousands to choose from, so finding several isn't hard to do.

This person is single, no children and earns a six figure income.  All of his tax returns have been filed.  These facts about him are important because without knowing anything more, they probably mean that he is NOT a good candidate for an IRS Offer In Compromise, i.e. he is not likely a good candidate to reach a settlement with the IRS for less than is owed.

A quick review of the realities that exist in regards to the offer in compromise program is in order here,  before I get to my point.

1. Standard Allowances are usually applied

The IRS will disagree with this person's amount of living expenses.  It will review his expenses closely in order to calculate how much money he SHOULD have at the end of each month to pay toward his tax debt.  I emphasized the word should on purpose.

The IRS doesn't have to pay much attention to what he actually spends each month.  It can rely primarily on some "standard allowances" which have been created to tell it what the "average joe"  lives on each month.  Applying these standards will leave this person with fake or phantom income.  That income will be the basis of the amount the IRS thinks he can afford to pay.  Typically they won't allow for his payments of credit card debt, retirement investment, vacation, Christmas, birthday, eating out, etc. etc. etc.  If a single person in Maricopa county earns $6500.00 per month after tax withholding, the IRS will probably see an ability to pay a few thousand per month toward the debt.  These standards can be challenged to some degree, but it is not easy to do.

2.  The Offer in Compromise process isn't informal

The taxpayer has to disclose his entire financial life to the IRS.  Bank accounts, work history, paystubs, proof of payment of bills, asset values etc.  This isn't done based on a chat over the phone.  It is a formal process much like filing a lawsuit, that comes with some rights but mostly responsibilities.  Often, while the taxpayer is in the process of submitting items to the IRS, things change.  Income increases, someone dies and leaves money or property.  The chances that the offer as submitted are accepted are reduced as a result.

3.  The IRS isn't interested in settling with most

On average, the IRS agrees to settle about 20-25% of offers in compromise that are submitted.  When I explain this to people though they still get the impression that this is random.  It isn't.  The offers that are accepted are those that meet the formal criteria.  What constitutes a good offer varies as well.  One person may have a $100,000.00 tax debt and be able to obtain an agreement to settle for $50,000.00, but have no way to pay it.  Another with the same set of facts may have a rich uncle.  Trying to reach some sort of conclusion about the IRS' willingness to settle these cases based on their average acceptance rate is almost meaningless as a result.

4.  Not a quick process

Most Offers in Compromise take 6-12 months from filing.  Sometimes many more months are spent on the front end getting things right and on the back end appealing a negative result.  If the offer is accepted, the taxpayer either needs to pay the amount now, or spread it out typically over two years adding to the already long time frame.

5.  Statute of Limitations on collection is extended

The offer in compromise filing stops the clock.  It extends the timeframe the IRS has to collect the debt from you.  This timeframe is called the "statute of limitations" and it lasts ten years.  If you spend 15 months trying to get the offer in compromise accepted and it doesn't work,  you will add 15 months to the timeframe.  If there was only a relatively short period of time left on the statute of collection when the offer is filed, filing the offer may have been a big mistake.

So, the point...(finally).  

This person had decided to hire a tax resolution company he had heard on the radio before speaking to me.  The company promised to "solve" his problem and requested $10,000.00 + as a flat fee to do so.  What he didn't understand is what I have laid out above.  He is not going to "solve" the problem with an offer in compromise.  In reality, he will solve the problem with some sort of IRS installment plan in combination with the statute of limitations period or bankruptcy.

Of course, the tax resolution company isn't a law firm and has no ethical duty to really explain this...and didn't. In fact, it probably uses a commissioned salesperson whose main objective is to close the "deal".

The company is hoping that it can arrange a payment plan with the IRS, and pocket the $11,000.00 for "solving" the problem.  It is really a play on words.  "Solving" doesn't mean reducing via an offer in compromise necessarily. The potential client doesn't fully get this until it is too late.  He ends up paying  3 times or more than what he should, for the end result...a partial solution.

Tax resolution companies are not law firms.  They can't practice in Bankruptcy Court, they have no duty to tell the truth, and for most taxpayers the offer in compromise just doesn't work.  What these companies are left with are subtle sales pitches that leave the wrong impression.  A very expensive wrong impression.

If you have serious tax debt, your situation has to be fully reviewed/analyzed, bankruptcy and the statute of limitations must be considered AND a period of planning and adjusting should probably take place as well, before an offer in compromise is filed.  Don't pay a large fee to someone on the promise of a "solution" until this work is done.

Everyone who has either missed the filing of tax returns or owes the IRS significant tax debt wonders, at least once or twice, what it is the IRS can actually do to them...?

Unfortunately, it can do a number of things...mostly bad.  Well...all bad really.

I am providing this list of the most common actions I see that the IRS takes against individual Americans.

Substitute Tax Return

Internal Revenue Code Section 6020(b) (1) states:

"If any person fails to make any return required by an internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary, shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise"

This means that the IRS can prepare a return based on information it has at it's disposal or that it can find otherwise.  It doesn't have to report deductions, expenses etc.  So the return is done as a single person, with a standard deduction and it's creation usually results in a debt that is overstated, sometimes by tens of thousands of dollars.

It than uses this return to do some of the other bad things mentioned below.

The good news...if the return is wrong it can usually be "challenged" and fixed.  We have saved clients literally millions of dollars in tax debt by simply doing the correct returns and "challenging" the IRS return during an audit reconsideration process.

Levy

The IRS has the authority to take wages, federal payments, state tax refunds, bank account funds, and monies owed to independent contractors.

They don't need a court order, all they need is the "assessment of the tax debt" and some time to provide written warnings or final notices of intent to levy, that go unheeded.

If wages or federal payments are levied, the levy won't stop until of course it is released, you pay the debt or the statute of limitations on collection ends.

If the IRS levies your bank account, your bank must hold funds up to the amount that is owed for 21 days.  This is done to give the bank a chance to make sure you own the account.  After the 21 day period is up, the bank must send money with any accrued interest to the IRS.

Lien

A recorded Notice of Federal Tax Lien provides the IRS a legal claim to your property as security for payment of the debt.  Before this notice can be filed though it must "assess" the debt, (see above), send a notice and demand for payment and you must refuse to pay or neglect to pay within 10 days of that notice.  This process creates the lien and the notice of lien makes other creditors legally aware that the IRS is first in line.

The lien attaches to property even if is acquired after the lien is noticed out.

Releasing a lien can be very difficult.

Sell Property

Yes the IRS can sell your property.  Recently, it has become more aggressive about seizing retirement accounts and homes as well.

The process as it is related to seized property under IRC sections 6335 and 6336, is as follows:

The IRS will post a public notice of sale in a local newspaper and deliver a copy to you or send it certified.

After placing it, the IRS has to wait ten days before holding the sale, unless the items are perishable.

Before the sale, a minimum bid price is created.  This is usually 80% of the forced sale value of the property, after liens are taken into account.  This value can be appealed and sometimes needs to be as the more money that can be brought from the sale the less debt the taxpayer will have in the end.

Trust Fund Recovery Penalty

Where a business has held employment taxes from employee checks and hasn't sent the funds in to the IRS, the IRS can assess a penalty against the "responsible parties" called a "trust fund recovery penalty".  That penalty consists primarily of the employees portion of the tax withheld and not the matching portion.  This means that individuals become liable for the businesses debt.  It is a difficult penalty to deal with as it isn't dischargeable in bankruptcy and the IRS will often assess it against everyone involved and let the chips fall "where the may".

If you have serious tax debt and the internet, you are likely familiar with the term "national standards".  The IRS calls them more generally "Collection Financial Standards" and has this to say about them:

"Collection Financial Standards are used to help determine a taxpayer's ability to pay a delinquent tax liability.  Allowable living expenses include those expenses that meet the necessary expense test.   The necessary expense test is defined as expenses that are necessary to provide for a taxpayer's (and his or her family's) health and welfare and/or production of income."  See "Collection Financial Standards"

On the page just mentioned, you can find what the IRS uses as "guidelines" to determine how much you should be living on each month as far as it is concerned.  This determines how much you should have leftover to pay toward the debt.  These numbers are used both in an installment agreement setting and in an offer in compromise calculation.

In Maricopa County, the standards for a Family of 3 are as follows:

• 1812  Housing and Utilities
• 1171  Food, Clothing and Expenses
• 992  Vehicle Ownership for 2 cars
• 582  Operating cost for 2 cars (includes insurance)
• 180   Out of pocket medical care under age 65

If the car payments and housing/utilities numbers are lower than the standards the IRS will use the lower number.

Examples of other items that are typically allowed in calculated the living expense amount:

• tax withholdings
• health insurance
• term life insurance
• regular out of pocket medical expenses greater than the standard

If the expenses for the Family of 3 are larger than these numbers, the IRS will try to treat those amounts as if they didn't exist.  For example, if the Family actually spends 2400.00 per month for mortgage and utilities on the home, the IRS will treat the difference of 588.00 as "available" to pay the tax debt on a monthly basis.

The IRS will consider however the higher number i.e. allow for the actual expense in certain circumstances.  As it states on the same page linked to above:

"If the IRS determines that the facts and circumstances of a taxpayer's situation indicate that using the standards is inadequate to provide for basic living expenses, we may allow for actual expenses.  However, taxpayers must provide documentation that supports a determination that using national and local expense standards leaves them an inadequate means of providing for basic living expenses".  (Read more here)

The IRS employee making the determination about whether the standard or whether the actual number should be used, doesn't have a tremendous amount of discretion.  As a result, most taxpayers who have expenses that exceed the standards find themselves in a no win situation.  i.e. a requirement to pay the same amount of money to two different creditors.

The result is often that the payment plan agreed to fails in the end and the taxpayer is back where he or she started.

There are other solutions to this problem.  Some of which include:

• paying the debt below 25000.00 in order to avoid basing the payment plan on the standards and the taxpayer's income
• using the Taxpayer's actual budget where the remaining excess income will pay the debt over 5 years
• filing for chapter 7 bankruptcy where the debt or some large portion of it is dischargeable
• filing for chapter 13 bankruptcy where the debt is dischargeable and/or the budget allowed in the bankruptcy court is higher than the IRS standards

If your budget exceeds the standards, and you can't afford to pay the debt over 5 years or pay the debt to 25,000.00, you will probably need to look at other options.

Choosing to leave a tax return unfiled because you can't afford to pay the debt associated with it, is a mistake.  For some, just a small one.  For others...a big one.

There are a few important reasons why this is true.  The most common that I see are as follows:

1.  Failure to file penalty

Not only can the IRS assess a civil penalty for the failure to pay the tax debt but it can also assess one for a failure to file.  This penalty is calculated based on the time from the deadline to file your tax return (including extensions) to the date you actually filed it.  It is 5% for each month the return is late, up to a total of 25%.  This percentage is based on the amount of the tax due as it is shown on the tax return.  So..if the amount you owe is quite high, the penalty will be as well.  Filing it on time avoids the penalty entirely.

2.  Criminal Failure to File

Failing to file a tax return on time is a crime.  However, it is the IRS' internal policy not to recommend prosecution for failure to file if the return is voluntarily filed or arrangements are made to file before the taxpayer is notified of a criminal investigation.  The vast majority of people with late tax returns are not prosecuted but this is probably true because the eventually file and do so before the IRS begins the criminal investigation.

3.  Substitute Returns

The IRS will commonly do a tax return for a non filer.  When it does this, it doesn't do the return correctly.  No credit for deductions and exemptions etc.  These returns almost always overstate the debt.  They are always used as a basis for the filing of the notice of tax lien and to start the collection process.  They can be fixed but it is often much more difficult to fix them years after the fact.  There are circumstances where an old substitute shouldn't be replaced by a correct return.  It is wise to get advice before every corrected return is filed.

4.  Lose ability to bankrupt debt

If a substitute tax return is assessed - the debt associated with that tax year whether based on that return or the taxpayer's later filed correct return is likely never going to be considered dischargeable in a bankruptcy.  This is often a very bad result, as bankruptcy can be the best way for many to remove the debt and get a fresh start.

5.  Lost Refunds

If you are owed a tax refund and you wait more than three years from the date the return is due to file the return, you will lose the refund.  This applies to the earned income tax credit as well.  I have seen taxpayers lose tens of thousands of dollars as a result.

Several rules exist that govern whether an  income tax debt is dischargeable in a bankruptcy case.  They are all important, but the first one typically mentioned is often given the least amount of thought.  That is the "three year rule".

The bankruptcy code, specifically section 523, disallows the discharge of income tax based on a tax return that was due to be filed less than 3 years before the  filing of the bk case.

If, for example,  the case was filed on Oct 14, 2011, and the tax debt was from the year 2007,  the 2007 tax return should have been filed or was due to be filed April 15, 2008.  This would satisfy the 3 year rule.

But...what is often missed is when the return was actually due to be filed.

As stated above, the 2007 tax return would have been due to be filed on April 15th 2008.  This would be more than three years prior to the filing date of the bankruptcy and the debt would meet the first requirement in obtaining a discharge of the debt.

BUT...what if the taxpayer filed an extension to file the tax return on April 14th, 2008.  The due date for that return would have been moved to October 15, of that same year.  Given the above filing date of the bankruptcy of October 14, 2011, the bankruptcy would have been filed a  day too soon to meet the 3 year rule and the debt wouldn't be discharged in the bankruptcy.

This extended time period adds an equal amount of time to the calculation of the three year rule for purposes of discharging the income tax debt.  Taxpayers with serious tax debt and their counselors need to be aware of this glitch in the law.  I have been contacted often by many filers after the fact,  who didn't understand why their tax debt wasn't wiped away.  Often, it is because they filed three years after the April 15th due date and not three years after the extension date.

The IRS substitute tax return is based on the reported gross income...only.  It doesn't take into account:

• mortgage interest
• children (dependency exemptions)
• business expenses
• basis amounts - sale of property and stock
• charitable contributions
• marriage situation
• depreciation

In essence, it doesn't take anything into account that would reduce the tax on the gross reported income.  Therefore, the amount is almost always substantially overstated.  The IRS knows it is substantially overstated and it is hoping that the threat of such a return will cause the taxpayer to supply the correct return.  Unfortunately, many taxpayers don't file on time to beat the ssessment and feel they are stuck with the incorrect assessment amount.

Fortunately, these returns can be "challenged"  via the audit reconsideration process.  The taxpayer can create a correct return and submit it as a challenge to the substitute return.  As a general rule the IRS will replace the incorrect substitute tax return with the more correct taxpayer created return.

I have prepared many actual returns after the substitute return has been assessed, and have often been able to get rid of many thousands of dollars for clients.   I recently finalized a return for a client and reduced his debt related to one tax year from $100,000.00 to less than $5000.00.  In many cases the reduction results in a refund to the client if the return is filed within 3 years of it's due date.

In most cases, it is best to get the return filed before they do.  Doing so preserves the ability to use bankruptcy to discharge the debt later.  Where they have  beaten you to the punch, there may be a way to correct it in any event.  If there isn't... there may be a way to reduce or eliminate the debt.

You should also read:

Reasons why you should file your return now