Offer in compromise vs. bankruptcy – Which settlement amount will be the lowest?
With new clients, I spend time discussing the options for obtaining a fresh start from IRS problems. The consultation most always involves making the client aware of the pros and cons of resolution by compromise, and by bankruptcy.
In that spirit, here then is the first of a continuing series on the use of an offer in compromise vs. bankruptcy to solve an IRS problem. Future topics will include the impact of each on Federal tax liens, limitations on their scope and use, expectations of success, life after each, situational examples, and their ability to stop IRS collections.
For now, which one can be the lowest settlement amount?
Chapter 7 Bankruptcy
In most cases, the lowest settlement amount to the IRS will be in a no-asset Chapter 7 bankruptcy. You can’t go lower than zero, which is the IRS recovery in these cases.
The term “no-asset” means that your property does not have enough value to entice a Chapter 7 bankruptcy trustee to take it. Most Chapter 7 cases are no-asset cases. Because of this, you keep all of your assets in “no-asset” Chapter 7 cases. And the amount you owe the IRS is discharged by bankruptcy law if you meet three rules: (1) the taxes you owe are income taxes, (2) you filed the returns more than two years before you filed the bankruptcy, and (3) the tax returns you owe money from were due to filed more than three years before you filed the bankruptcy.
In other words, income taxes that have been filed and are a little bit older can be wiped out in a no-asset Chapter 7. There is no repayment if there are no assets.
Chapter 13 Bankruptcy
A Chapter 13 bankruptcy entails monthly payments to the IRS over a course of three to five years. You make monthly payments in a Chapter 13 because you can afford to; in most cases Chapter 7 is for those who cannot afford a repayment.
Chapter 13 is an excellent alternative to an IRS installment agreement because it can stop interest and penalties accruals on many IRS claims. It is often the interest and penalties accruals that make installment agreements so difficult. Chapter 13 shrinks the IRS claim.
Chapter 13 also provides for older income tax liabilities (and the interest and penalties on the taxes) to be repaid a small percent of what is owed (called a “cramdown.”). On these older claims, you repay what you can afford monthly. The amount you cannot repay is eliminated by bankruptcy law.
Because of the ability of a Chapter 13 to stop interest and cramdown older tax recoveries, there can be substantial savings in making monthly payments by modifying IRS claims through a Chapter 13 tax bankruptcy. Chapter 13 can also modify and lower other debt repayments, such as credit cards and medical bills.
Chapter 13 bankruptcy laws has less power to modify the repayment on more recent tax liabilities (last three years), trust fund taxes and property subject to an IRS tax lien.
Offer in Compromise
The cost of an offer in compromise will be (1) equity in your assets and (2) the value of your cash flow to the IRS in the future. If the IRS predicts there will be enough cash flow over the timeframe that they have to collect the liability, there will be no compromise. The timeframe is 10 years from when the tax liability was put on their books. Most assets will be reduced in value by 20% to get arrive at IRS valuations.
The IRS has financial standards that they use in calculating what cash flow should be. You may have no cash flow; but the IRS may think that your expenses are too high, and come up with a settlement number that is not representative of reality. Bankruptcy bears the advantage of quantifiable results by application of objective criteria (bankruptcy law). An offer in compromise is more subjective within the discretion of the IRS, but can have a greater impact on more recent taxes which bankruptcy does not reach.
If a compromise results in a dispute over cash flow, that can often be solved with the filing of a Chapter 7 or Chapter 13, which can force the IRS to accept a bankruptcy court interpretation of what cash flow should be.
For more on bankrupting taxes, see my article from the Enrolled Agent Journal here. For more on offers vs. bankruptcy, see my article from the Journal of Tax Practice and Procedure here.
