Offer in Compromise: What you should know about calculating your income
If you are self-employed and own a business, you know there are good months and not-so-good months.
It can be seasonality (lawn care), or the ebbs and flows of the stock market (financial advisor), or simply waiting for an account receivable to be paid.
One thing is constant: Your income goes up, and goes down, and tomorrow can be different from today.
At one point, you got behind on taxes, and are considering filing an offer in compromise with the IRS to put the past behind you. But before you jump in, it is important to understand how the variances in your income impacts the IRS settlement calculations, possibly to your detriment.
The IRS has a formula to calculate if they will accept a settlement, and if so, the amount they will approve. The calculation starts with the IRS determining what your net profit is from your business.
Quantifying your net profit is an essential component of success in an offer in compromise.
Net profit is defined as what your bring in (gross receipts), less your business operating expenses.
The IRS will take your net profit and use it to calculate what you can pay back every month. If the IRS finds you can pay them back in full, they will not even consider a compromise, instead rejecting it and putting you in an installment agreement.
But your net profit is a moving target: This year is great, last year was good, the year before that just okay, and next year probably will not be as good as this year.
Which year do you use?
If you give the IRS this year’s net profit – your highest – you can bet they will take it, and use it to overstate what you usually make, and what you can pay. You have just shot yourself in the foot, with a result not based on the reality of your business and year-to-year income. You just went to the IRS with the highest offer.
There is a solution: Income Averaging.
Income averaging permits you take three years’ net profit and arrive at an average of what you make. This allows you to take out the high year, and bring down your net profit by factoring in the good and not so good years. Income averaging is permitted by the IRS under Internal Revenue Manual (IRM) 18.104.22.168, and can have a substantial impact on the amount of your compromise.
Here’s an example of how to income average your net profit:
Let’s say your net profit over the last three years has been as follows:
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You do not want to file your offer with net profit of $145,000 as that is your high point. You will be overstating what you usually earn to the IRS. To account for the variances, income averaging is acceptable under IRS offer in compromise guidelines.
With income averaging, your economic reality comes into focus. We will take your total net profit of $365,000 over the last three years, and divide it by three. The result is an average net profit of $121,666 per year and $10,138 per month.
We will show our work to the IRS, and cite to Internal Revenue Manual 22.214.171.124 as support for it, as follows:
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Income averaging saved $1,945 per month ($12,083 last year less $10,138 income average).
That $1,945 monthly difference in net profit is significant to the success of your offer in compromise. Using only last year’s higher income (instead of income averaging down) could result in your offer being rejected, or the settlement amount increased to an amount you cannot afford.
In our example, let’s say that you owe the IRS $100,000, and filed an offer in compromise using only last year’s income ($12,083/month). By not using income averaging, you have given the IRS an extra $1,945/month, and they will use that to calculate you can pay them back in a little over four years. Your offer will be rejected in favor of an installment agreement.
If you owe the IRS $500,000, they will find that the $1,945 extra will not pay them back, and your offer is still alive. But the IRS will use that extra money to hit you with an increase in the amount of your settlement. To calculate your settlement, the IRS formula will put up to a two year future value on that extra money. This can result in a possible increase in your settlement of $46,680 ($1,945 x 24 months). That’s $46,680 more to settle simply by not making use of IRS guidelines to spread your net profit out over time with income averaging.
Every dollar counts in an offer in compromise.
The more you make, the more your offer in compromise could be in jeopardy.
With your income varying from year to year, it is important to use IRS income averaging to your benefit. IRS offer in compromise guidelines permit your income to be averaged over a three year period, taking out the highs and allowing the lows to be factored in. This permits you to present a more accurate picture of what you make and increases your chance of offer in compromise acceptance.