Taxpayers who owe money to the IRS may be confused by options for repaying their debt or may be afraid to reach out to the IRS altogether. But when taxpayers can’t navigate the process alone, they turn to tax pros like you to help them find the best solution. So, regardless of whether your client is facing a single year of tax debt, or facing multiple years of penalties and fees, here’s what every tax preparer should know to help clients settle their debt with the IRS.
First Steps
Before you and your client can begin reaching out to the IRS, you’ll need to take care of these tasks:
File All Returns
It’s not uncommon for taxpayers with significant tax debt to avoid filing altogether. Sometimes, they may have years of unfiled returns by the time they seek out help.
The first step in resolving their debt is filing all back tax returns. If they’ve lost the prior year W-2s, 1099s, or other forms they need to file, they can contact their employer to get new copies or request transcripts of the forms from the IRS online.
Make Estimated Tax Payments for the Current Year
If your client isn’t caught up on estimated tax payments for the current year, it’s a good idea to catch up with those payments before contacting the IRS. Getting current on your estimated payments will prevent your client from incurring additional fees and penalties and enable them to submit an Offer in Compromise application.
Verify Your Representation Rights & Secure a Power of Attorney
Once you’ve filed all past returns and have an exact total for your client’s debt, you can discuss their options or reach out to the IRS. If you and your client choose the latter, be sure your client has representation rights.
All CPAs, Enrolled Agents, and attorneys have unlimited representation rights before the IRS. Annual Filing Season Program participants have representation rights for clients whose returns they have prepared. If you don’t have any of these credentials, you won’t be able to represent your client before the IRS, meaning you won’t be able to communicate with the IRS on their behalf.
If your client wants you to handle the application and communication process, you’ll also need to secure a Power of Attorney by filing Form 2848, Power of Attorney and Declaration of Representative.
Discuss Payment Options
If your client can’t pay the debt in one lump sum, it’s time to discuss other payment options.
Taking Loans from Retirement Accounts
Some tax experts recommend taking out a loan from a retirement account to pay the tax debt off in full. This way, your client avoids negotiating with the IRS, and they may save money in the long run.
Even though they will have to pay back the loan with interest, both the money they withdrew, and the interest paid will simply go back into their retirement account and not to a lender. Effectively, they are borrowing from and repaying their future selves. While they may lose out on some gains when the money is not in their retirement account, this loss is almost always less than what they’d owe in penalties and interest from the IRS.
Of course, for this to be an option, your client must have enough money in their retirement accounts to pay all or most of their tax debt. If your clients are interested in exploring this option, make sure they know that taking a loan from their retirement accounts is different than simply withdrawing the money as a taxable distribution, which would cause them to incur unnecessary taxes and fees.
Short-term Payment Plans
If your client can’t borrow from a retirement account but can manage to pay off their tax debt within six months, a short-term payment plan with the IRS is their best option. Short-term plans last 180 days or less, and they do not require a setup fee but incur late penalties and interest.
If your client owes less than $100,000, they can apply for a short-term payment plan online. You can help them with this process and advise them to set up Direct Pay or an EFTPS account to avoid additional fees.
Installment Agreements
Long-term payment plans, or installment agreements, last more than 180 days. Unlike short-term payment plans, installment agreements require a setup fee, but paying through Direct Debit reduces the fee from $130 to $31.
If you’re filing your client’s return, you can help them request an installment plan by attaching Form 9465 to their tax return. You can also help them apply for a payment plan online if they owe less than $50,000 for individuals or $25,000 for businesses. We recommend applying online whenever possible, as applying by phone has a higher setup fee of $225.
However your client applies, if their total debt is less than $25,000 and will be paid in full within five years, the IRS will almost always approve the installment agreement request. If your client has more detailed questions, you can find answers in the IRS’s Additional Information on Payment Plans.
Offer in Compromise
If your client has researched their repayment options, they’ll likely ask you about an IRS Offer in Compromise. This option of settling tax debt is particularly attractive because it reduces the total amount owed to the IRS.
But for this reason, Offers in Compromise aren’t easy to come by. The IRS typically only approves them when they don’t think there’s any possibility of collecting the total amount owed. To improve your client’s chance of getting an offer in compromise approved, we offer tips for the application process below.
Applying for an Offer in Compromise
Before applying, use the Offer in Compromise pre-qualifier test to ensure your client meets all eligibility requirements, such as having no unfiled returns and being caught up on estimated tax payments for the current year. Otherwise, the IRS won’t even consider their application.
After you’ve ensured your client’s eligibility to apply, it’s helpful to know how the IRS reviews Offer in Compromise applications. First, they’ll conduct a thorough review of your client’s finances, including bank accounts, income, and other assets.
Using this information, the IRS will calculate a “reasonable collection potential” (RCP). This is the amount they think they should be able to collect from your client before the collection statute expires (usually ten years from the initial tax bill). The IRS will only approve an offer in compromise if the proposed amount is greater than or equal to their calculated RCP.
Attempting to determine your client’s RCP will help you make a reasonable Offer in Compromise that is more likely to be accepted. The first factor the IRS will consider is your client’s net realizable equity in assets – in other words, how much money your client could get if they were to sell their assets immediately.
To get this figure, the IRS will subtract any debt owed on the asset from the asset’s quick sale value, which is usually 80% of the fair market value. For example, let’s say your client’s home is worth $300,000, and they owe $200,000 on their mortgage. The quick sale value of the home would be $240,000.
When you subtract the $200,000 they still owe, the net realizable equity of this asset would be $40,000. The IRS will typically include homes, real estate, automobiles, and other properties of significant value when calculating RCP.
Next, the IRS will consider your client’s disposable income over 12 or 24 months, depending on whether you propose a lump sum payment or periodic payments made over 24 months. To come up with their monthly disposable income (MDI), subtract their necessary monthly expenses from their monthly income.
Note: If your client is experiencing a temporary setback, such as being unemployed or underemployed, the IRS will project how much they will make when they become fully employed again. Thus, they won’t approve an offer in compromise based purely on a temporary financial situation.
Add your client’s net realizable equity in assets to 12 or 24 months of MDI (12 months for lump sum payments or 24 for periodic payments) to estimate their RCP. Your offer should be the same as your client’s estimated RCP. When you’re ready to apply, submit Form 656 and Form 443-A.
Stopping IRS Collections
If your client’s debt has existed for some time, the IRS may have already begun freezing and seizing assets or levying your client’s wages. To help your clients know what to expect, refer to our article, How to Help Your Clients Understand the IRS Collections Process. Reassure them that these involuntary collections will stop when the IRS approves a payment plan or offer in compromise.
