Late-night television commercials promise that the IRS will settle your tax debt for "pennies on the dollar." While offers in compromise do exist and can be a legitimate resolution tool, the reality is far more nuanced than the advertisements suggest. An offer in compromise allows a taxpayer to settle their tax liability for less than the full amount owed, but the IRS accepts offers only when it determines that the amount offered represents the most it can expect to collect within a reasonable period.
The Three Grounds for an Offer in Compromise
The IRS considers offers in compromise on three grounds. First, doubt as to collectibility—this is the most common basis, and applies when the taxpayer's assets and income are insufficient to pay the full tax liability. Second, doubt as to liability—this applies when there is a genuine dispute about whether the tax is owed. Third, effective tax administration—this applies when collecting the full amount would cause economic hardship or other exceptional circumstances that would be inequitable.[1]
The vast majority of accepted offers are based on doubt as to collectibility. The IRS examines the taxpayer's ability to pay by calculating the "reasonable collection potential" (RCP), which is the sum of the taxpayer's net equity in assets plus the taxpayer's expected future income over a specified collection period.
Calculating Reasonable Collection Potential
The RCP calculation is the heart of the offer in compromise process. The IRS starts with the quick sale value of the taxpayer's assets—generally 80% of fair market value for most assets, less any encumbrances. The IRS then adds the taxpayer's future income, calculated as the monthly disposable income (gross income minus allowable expenses) multiplied by either 12 months (for lump sum offers) or 24 months (for periodic payment offers).[2]
The IRS uses national and local expense standards to determine allowable living expenses. These standards cover housing, transportation, food, clothing, and other basic necessities. Taxpayers whose actual expenses exceed the standards must justify the excess, and the IRS often disallows expenses it considers excessive or unnecessary. This is one of the areas where the IRS and taxpayers most frequently disagree, and where experienced representation can make the most significant difference.
The Application Process
An offer in compromise is submitted on IRS Form 656, accompanied by a detailed financial disclosure on Form 433-A (OIC) for individuals or Form 433-B (OIC) for businesses. The taxpayer must also submit a $205 application fee and an initial payment—either 20% of the lump sum offer amount or the first month's payment for a periodic payment offer. Low-income taxpayers may qualify for a fee waiver.[3]
Once submitted, the IRS assigns the offer to an examiner who verifies the financial information, may request additional documentation, and may negotiate the offer amount. The process typically takes six to twelve months, and during this period, the IRS is generally required to suspend collection activity.
Common Reasons for Rejection
The IRS rejects approximately 60% of offers in compromise. Common reasons include the taxpayer's RCP exceeds the offer amount, the financial disclosure is incomplete or inaccurate, the taxpayer is not current on all filing obligations, the taxpayer has not made estimated tax payments for the current year, or the taxpayer has an open bankruptcy proceeding. Many rejections can be avoided by ensuring that all returns are filed, all current tax obligations are met, and the financial disclosure is complete and accurate before submitting the offer.[4]
Alternatives to an Offer in Compromise
For taxpayers who do not qualify for an offer in compromise, several alternatives exist. An installment agreement allows the taxpayer to pay the full liability over time in monthly installments. Currently not collectible (CNC) status pauses collection activity when the taxpayer demonstrates an inability to pay anything beyond basic living expenses. Partial payment installment agreements combine features of both. The appropriate resolution depends on the taxpayer's specific financial circumstances, and the right approach requires careful analysis of all available options with a qualified tax controversy practitioner.[5]