The amount of the trust fund recovery penalty charged to the individuals is equal to the taxes deducted from employee paychecks but not paid to the IRS.

Usually, the trust fund recovery penalty involves defending on the basis of liability – developing facts to indicate you had no control over company finances.

But even if you had control, an inability to personally repay the taxes can be a procedural defense to the trust fund recovery penalty.  The investigating IRS Revenue Officer has discretion not to hold you responsible if it can be proven that you are – and will continue to be – uncollectible.

Uncollectible is defined by the IRS as being financially unable to pay – doing so would create a hardship for you and your family, leaving you unable to pay for basic necessities.  Uncollectible status also requires that your assets be of minimal value to the IRS.

The basis for using collectibility, not liability, as a method of defense in trust fund investigations can be found in the Internal Revenue Manual Sections 5.7.5.1(2) and 5.7.5.3.1.

The IRS will consider many factors in determining whether they should withhold assessment of the trust fund recovery penalty based on financial hardship.  Factors include whether you have had IRS troubles in the past, your age, occupation, family size, amount of income tax refunds, future earning potential and the probability of an increase in the value of your assets.

The future ability to pay should not be overlooked as a defense to the trust fund recovery penalty. It is important to recognize the right situation where personal financial disclosure during the IRS investigation could make a difference to the defense. If there will be problems paying the trust fund taxes later, considering asking the IRS to eliminate the problem early.

The IRS wants to know how much you can repay them – and the government relies on their standard expense allowances to help them calculate it.

But there are three expenses that the IRS should allow you under their guidelines with no verification required.

And because verification is rarely necesary for these expenses, the IRS will allow the expenses according to their guidelines - even if you spend less.  This can provide a welcome cushion to your budget in negotiations with IRS over what you can pay.

Here are the three expenses the IRS should allow you without verification:

1.     Food, clothing and household supplies will be allowed by the IRS – without verification – based on how many are in your household.  The IRS is currently allowing $1,371.00 monthly for food and clothing for a family of four. Take a look at the IRS tables to see how you compare here.

2.     Out of pocket medical expenses are allowed in the amount of $60.00 per month, per person in your household.  A family of four should automatically be allowed $240.00 in monthly medical expenses, even if less is spent.  If you are 65 and over, the IRS will allow $144.00 per month -no verification required.  If you spend more, and you can verify it, the IRS should allow it.

3.     Car operating expenses are allowed by the IRS based on the city or region you live in.  For example, if you live in Detroit, the IRS will allow  $588.00 monthly for gas, insurance and maintenance for two cars in a household.  See what the IRS will automatically allow you for driving your car here.

These allowances are used by the IRS in determining how much is paid in installment agreements, the settlement value of an offer in compromise, and whether collecting from you would pose a hardship.  Most every IRS collection case involves navigating the government’s standard expense allowances. As IRS collection cases turn on these guidelines, understanding and maximizing them is essential to sucess.

To help in understanding taxes and bankruptcy, I thought it would be helpful to provide real life examples, starting here with a “bankruptcy timing” question I recieved from an enrolled agent on behelf of his client:

Howard, I have a client considering Chapter 7 bankruptcy on her IRS income tax debt.

2001 – owes $59,000.  Her return was due on 4-15-02, but she did not file it until 9-15-08.

2003 – owes $9,800.  Her return was due on 4-15-04, but she did not file it until 9-1-08.

2006 – owes $1,400.  Her return was due on 4-15-07, but she did not file it until 8-25-08.

She is in currently non-collectible status with the IRS.

When would she first be eligible for a Chapter 7 bankruptcy?

This illustrates Rule No. 1 in eliminating taxes in bankruptcy:  To be successful, tax returns must have (1) a due date that is three years before the bankruptcy is filed and (2) been actually filed two years before the bankruptcy starts.

In this example, it has been more than three years since the returns were due. But it has not been two years since they were filed.

The result: She could have all of the taxes discharged in a Chapter 7 bankruptcy on 9-15-10.  This is two years after the returns were filed.

If the returns were filed on time, then she would not have wait any longer – both the three year and two year rules would have been met – and bankruptcy could be filed immediately.

The non-collectible status will keep the IRS on hold while awaiting the bankruptcy filing date.

Stay tuned – I will be periodically posting more real examples of how bankruptcy, taxes and the IRS works.  You can also read my other blog entries on it and my articles.

1.   Offer in compromise.  This is the first option on every one’s mind.  But it can be difficult to obtain an compromise under current IRS procedures – it is not for everyone.  Many compromises are initially rejected by the IRS and have to be appealed.  And with IRS expense allowances lower than what most people need to live, the best chance of success is to be pretty much broke.  The IRS compromise program is not dead, but caution needs to be exercised and other options reviewed first to avoid disappointment.

2.     Tax bankruptcy.   I emphasize this all the time – with the results of the IRS compromise program difficult to predict, bankruptcy is often the next best option.  A Chapter 7 bankruptcy can eliminate an income tax liability without any recovery to the IRS and without losing any of your property. A Chapter 13 bankruptcy can allow you to continue or set up an installment agreement to repay your taxes without interest and penalties.  In many Chapter 13’s, the amount of tax repaid is less than what you actually owe.

3.     Uncollectible.  The IRS does make “bad debt” decisions on its collection inventory.  This is known as being uncollectible.  To be a bad debt, the IRS will require a financial statement listing income, living expenses, assets and liabilities to prove that any attempt to collect the debt would result in a hardship. Sometimes, the IRS will put an older tax debt in its nonactive queue on its own. It is important to carefully analyze and understand when to call the IRS, and when to let sleeping dogs lie.

Next: IRS installment agreements, statute of limitations and interest/penalty abatements (Part II).

The IRS, by policy in its Internal Revenue Manual, ceases collection activity against taxpayers whose debt is deemed “currently not collectible.”  See Section 5.16 of the IRM regarding uncollectible accounts here.

The IRS will categorize a taxpayer as having an inability to pay and stop efforts to collect if it determines that collecting the debt would impose a financial hardship (see my blog post on IRS financial hardship here).  IRS debts can also be put in uncollectible status if it cannot locate the taxpayer or if it determines the amount owed is below IRS tolerance levels (i.e., amount owed, age of account).

The IRS Taxpayer Advocate has repeatedly recommended in her Annual Reports to Congress and in testimony that the IRS review its collection model to correct the imbalance between the amount of bad debt it carries and collects.  View her most recent testimony here. 

The Revenue Officer function is localized, with their offices located near your home or business.  Revenue Officers are “field agents,” meaning they are expected to get out of the office and get into the “field.” 

If you case has been assigned to an IRS Revenue Officer, expect an initial unannounced visit to your place of business or residence.  These visits are known to occur on Fridays and often before holiday weekends. If you are not in your office or at home, the Revenue Officer will leave a “calling card” in the door, requesting that you contact them by a set date.  If you do not voluntarily comply, the Revenue Officer has the power to summons your attendance at an IRS office.

If there is a lack of cooperation on your end, expect the Revenue Officer to start procedures to take your bank accounts, wages, retirement accounts, receivables.  Revenue Officers can also seize any equity you have in cars, autos and business equipment, but these are usually last resorts in severe cases.

And remember:

(1)     The Revenue Officer wants case resolution and a closed file as much as you do.

(2)     Case resolution can mean an offer in compromise, installment agreement or even having your case closed as uncollectible – it all depends on your finances; and

(3)     When your mouth is in the head of the bear, say nice bear.

The IRS is trying to collect on employment taxes from a company that has been out of business for several years. As an officer, I have already been held liable.  Can the IRS continue to go after a company that has no assets even though it has already filed for the same tax liability against an officer?

First, it is unlikely the IRS has much interest in the business.  It is closed, and in the world of the IRS, the account is probably deemed not collectible.  If the business closed in an orderly fashion and did not transfer any of its assets to nominees to continue its operations as a sham, there is probably little interest from the IRS.  If the IRS is sending notices, they are probably computer generated.  

The IRS has assessed a trust fund recovery penalty against you the employment taxes that were withheld from employee paychecks.  The IRS can come after those that were in charge of the decisions not to pay the IRS employment taxes – the IRS had some belief that included you.  

The IRS can collect these “trust fund” taxes from both you and the business, but probably has no ability to collect from a business that is closed and uncollectible.  For practical purposes, it is just you, and any other owners, officer or managers of the business that were tagged with personal liability. 

It is a joint and several liability, so if the IRS collects 100% of the liability from someone else, you are relieved of the obligation.  It can be collected from the individuals in any manner the IRS deems fit, not to exceed 100% of what is owed.   

For what its worth, the IRS Taxpayer Advocate reported that from 2002-2007, the IRS collected only 13.5% of the trust fund assessments it made against owners, officer and managers.  That percentage is to your advantage.

Internal Revenue Service Policy Statement 5-71 permits hardship status on IRS accounts, as follows:

If there are limited assets or income but it is determined that levy action would create a hardship, the liability may be reported as currently not collectible. A hardship exists if the levy action prevents the taxpayer from meeting necessary living expenses. In each case a determination must be made as to whether the levy would result in actual hardship, as distinguished from mere inconvenience to the taxpayer.  If, after taking all steps in the collection process, it is determined that an account receivable is currently not collectible, it should be so reported in order to remove it from active inventory.

Internally within the IRS, hardship aka currently not collectible, is known as a “53″ case, for the transaction code the IRS inputs into your account to indicate a suspension of collection activities.  

To obtain hardship status, the IRS requires a complete financial disclosure of your monthly income and living expenses, as well as a valuation of your assets and liabilities.  The IRS will compare your monthly expenses to their charts of food and clothing, housing and utilities and car expenses.  For example, if you have a $600 monthly car payment, the IRS will object to hardship status.  Your car payment, according to their charts, would be too high for you to claim a hardship.  

The IRS requires you to have no cash flow to be a hardship.  You may think you have a zero budget; the IRS may feel differently.  There are procedures to give you time and opportunity to adjust your budget.  For those who cannot adjust expenses to the satisfaction of the IRS, sometimes a Chapter 7 or Chapter 13 bankruptcy is a better option to eliminate the taxes.  You can learn a little more on bankruptcy and the IRS here.  

Economic hardship does not forgive interest and penalties.  Expect the amount you owe to double every five years from the running of interest and penalties.  

In many situations, being on a continued hardship status is an effective method for resolution of an IRS liability.  The IRS has 10 years to collect the amount you owe.  After the 10 years lapses, the IRS will clear the account balances to zero, as required by law (read more on that here).  

The IRS can also settle a hardship case by submission of an offer in compromise rather than have it linger in the system.  

A comparison between the pros and cons of resolution by sitting on a hardship status, filing bankruptcy or submitting an offer in compromise is essential to resolving a tax delinquency.  No option should stand alone.  

• When there is insufficient equity in the property.  There must be sufficient net proceeds from the sale to provide funds to apply to the taxpayer’s unpaid tax liabilities.  This protects, for example, your car that is worth $5,000 but has a $5,000 loan against it – there is no equity for the IRS (the loan would be paid first if the IRS took it).  Same goes for houses, personal belongings, etc. 

• When an installment agreement is in effect.  If you are making payments, the IRS will leave you alone.

• If your installment agreement is terminated or your request for an IA is denied, you have the right to appeal those decisions.  The IRS cannot take action during the 30 day time period after notice of termination or denial, and while an appeal filed within that 30 day period is pending.

• When an offer in compromise is pending, and while an appeal of a rejected offer is being decided. 

• When a innocent spouse claim is pending.  I have had clients with IRS garnishments come into my office frustrated because they did not have involvement or knowledge of the liability and have a strong innocent spouse claim.  Upon submission of the innocent spouse claim, the IRS garnishment is immediately released.  There is no further collection action while the claim is being reviewed by the IRS.   

I will post Part II next.

1.     779,000 taxpayer accounts were assigned to the IRS collection queue.

2.     The number of offers in compromises accepted by the IRS declined by 70% from 2001 (38,643) to 2007 (11,618).

3.     40% of withdrawn and rejected offers in compromise are ultimately written off as uncollectible.   

4.     The number of IRS levies against wages and bank accounts increased from just over 500,000 in 2000 to 3.7 million in 2007.

5.     The number of IRS seizures against property like real estate, automobiles and business equipment increased from 74 in 2000 to 676 in 2007.  

Source:  Annual Report of the IRS Taxpayer Advocate Service