Offers-in-compromise in Bankruptcy

Journal Issue

Sep 2004

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Offers-in-compromise (OIC)
have become a useful tool for taxpayers in paying heavy tax burdens where
the taxpayer has limited distributable assets or income. As such, a
taxpayer can propose to pay taxes on the basis of an ability to pay or on
the basis of the Internal Revenue Service's (IRS's) ability to
collect the taxes, thereby relieving the taxpayer of a tax burden that
otherwise could not be paid. More importantly, the IRS has encouraged the
use of OICs as an alternative to bankruptcy for the payment of taxes where
the Bankruptcy Code imposes a payment scheme for which the taxpayer does
not have the resources to pay the taxes in accordance with the Code. The
IRS has not, however, embraced the use of OICs as a means to pay taxes
through bankruptcy. Consequently, in the IRS's opinion, bankruptcy
and OICs remain mutually exclusive methods of tax payment.

<h4>Offers-in-compromise</h4>

The IRS's authority to compromise tax
liabilities is provided for in I.R.C. §7122(a).<a href="#2" name="2a">2</a> 26 U.S.C.
§7122(a) provides in relevant part that "The Secretary may
compromise any civil or criminal case arising under the internal revenue
laws prior to reference to the Department of Justice for prosecution or
defense, and the Attorney General or his delegate may compromise any such
case after reference to the Department of Justice for prosecution or
defense." The decision to compromise, including whether to consider a
compromise and how much to accept, is within the IRS's discretion. See Treas. Reg.
§301.7122-1(a). Further, the IRS's position on all OICs is to
compromise cases only when settlement furthers the best interests of the
taxpayer and the United States.

The IRS also has certain threshold requirements that
govern the processing and acceptance of OICs. For example, the IRS will not
process or consider OICs where the OIC does not contain sufficient
information, where the OIC was submitted in an attempt to delay tax
collection or where the OIC is "otherwise non-processable." The
IRS has determined that certain omissions or situations render an OIC
non-processable: (1) The OIC is not submitted on a proper form; (2) the
taxpayer has not complied with all filing and payment requirements—i.e., is not current on
making estimated individual income or business taxes for a requisite period
of time or that the taxpayer has unfiled returns; (3) the required
processing fee is not paid; (4) the taxpayer is in bankruptcy; and (5) the
taxpayer has failed to meet any other minimum requirement that the IRS has
established.

<blockquote><blockquote>
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<big><center>
As a practical matter, the IRS should be reluctant to accept a payment proposal that is less than what the Bankruptcy Code would require.
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</blockquote></blockquote>

In addition, the IRS's Internal Revenue Manual (IRM) prescribes certain
thresholds and conditions<a href="#3" name="3a">3</a> that the IRS may consider in determining whether
or not to accept an OIC. Although the IRM does not have the force and effect of law, it nonetheless
regulates how the IRS is to function regarding a host of activities,
including consideration of OICs See In re Holmes, 298 B.R. 477, 484 (Bankr. M.D. Ga. 2003) (provisions of the
IRM are directory,
rather than mandatory, and do not have the force and effect of law)
(citation omitted); Nader v. United States of
America (In re Nader), 1999 WL 627394, *4
(Bankr. E.D. Pa. 1999) (the IRS may prescribe guidelines [the IRM] for IRS personnel to use
in evaluating whether IRS personnel are to accept an OIC, and establish
procedures that allow a taxpayer to appeal any rejection of an OIC).

<h4>Must the IRS Consider and Process an OIC in Bankruptcy?</h4>

It is the criteria that the taxpayer may not be in
bankruptcy in order for the IRS to accept an OIC that has sparked some
consideration by bankruptcy courts. Courts that have considered the
question of whether the IRS must consider and process an OIC in bankruptcy
have for the most part concluded that the IRS's failure to do so
would run afoul of the anti-discrimination provisions of §525.<a href="#4" name="4a">4</a> See, e.g., Holmes, 298 B.R. at
481; Mills v. United States of America, (In re
Mills), 240 B.R. 689 (Bankr. D. W.Va. 1999)
(IRS's failure to consider OIC in bankruptcy is in conflict with the
anti-discrimination provision of §525); Chapman
v. United States (In re Chapman), 1999 WL
550793 (Bankr. W.D. Va., June 23, 1999). These courts conclude that to deny
the taxpayer/debtor the right to submit an OIC in bankruptcy denies the
debtor a remedy under the I.R.C. and is discriminatory as to debtors.

Conversely, many of those same courts also hold that
the IRS has the sole discretion<a href="#5" name="5a">5</a> of accepting or rejecting OICs and that
the IRS cannot be compelled to accept an OIC. See,
e.g., In re Holmes, 301 B.R. 911, 913 (Bankr.
M.D. Ga. 2003) ("the decision to accept or reject a compromise offer
is discretionary and cannot be compelled by any action"); Mills, 240 B.R. at 695-96 (IRS
cannot be compelled to accept an OIC); Chapman, 1999 WL 550793, *7 (Bankr. W.D. Va. 1999) (IRS is
correct that it cannot be compelled to accept an OIC). As such, while a
court could direct the IRS to consider an OIC, it could not direct the IRS
to accept an OIC.

<h4>The IRS's Rationale in Not Accepting OICs in Bankruptcy</h4>

As a practical matter, the IRS should be reluctant to
accept a payment proposal that is less than what the Bankruptcy Code would
require. In situations where the debtor owes taxes entitled to priority
under the Code, the IRS can insist on full payment (§§1129
(a)(9)(C), 1222(a)(2) and 1322(a)(2)). In situations where the debtor
wishes to retain property, the IRS can insist that its lien value
(inclusive of exempt assets) be paid plus interest. Because business taxes
are non-dischargeable, it does a debtor little good to file bankruptcy and
not to pay the tax in full because the IRS generally will not compromise
the tax liability owed. If less than the full amount of the business taxes
are paid, the IRS can pursue collection of the unpaid tax and statutory
penalties and interest.

Additionally, there is the practical matter of how the IRS should evaluate an
OIC in bankruptcy. Feasibility considerations in bankruptcy are first
evaluated under schedules "I" and "J," which give
an initial snapshot of excess income to pay plan debts. How much is allowed
per a particular expenditure on schedule "J" is subject to
local practice. Further, in business cases the secured parties can dictate
an appropriate budget for the debtor on the basis of the use of cash
collateral. Under an OIC scenario, the IRS will utilize IRS schedules to
evaluate an OIC. Allowances for expenses in bankruptcy (i.e., a private school, a
mortgage for a luxury home, entertainment) may be disallowed for purposes
of calculating an acceptable OIC with the IRS. Further, the length of an
acceptable OIC with the IRS (three to five years) may be significantly less
in duration than a chapter 11 or 13 plan.

Additionally, what if the IRS does not accept an OIC
in bankruptcy? The bankruptcy court could review the IRS's discretion
in disallowing the OIC. As noted, courts have been fairly uniform in
stating that the IRS cannot be compelled to accept an OIC. Nonetheless,
§505(a) allows the court to adjudicate any tax dispute whether or not
previously adjudicated. As such, bankruptcy courts could become the refuge
for contesting the denial of OICs in bankruptcy on good-faith grounds.

Possibly a better approach to this conundrum would
be for the debtor to enter into an OIC with the IRS before bankruptcy and
then to pursue bankruptcy relief for reasons other than tax debts such as
the protection of a homestead from foreclosure. The debtor could attempt to
continue the OIC in bankruptcy or possibly assume it through bankruptcy. Of
course, this remedy is available to a limited number of debtors simply
because under the current Code many debtors are eligible for either
liquidation or reorganization. In sum, debtors can expect the IRS not to
accept OICs where the debtor has the ability to pay tax debts in accordance
with the Code.

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<h3>Footnotes</h3>

<a name="1">1</a> The views
expressed in this article are Mr. Gargotta's and do not necessarily
reflect the views of the Department of Justice or Internal Revenue Service. <a href="#1a">Return to article</a>

<a name="2">2</a> "I.R.C."
denotes Internal Revenue Code. <a href="#2a">Return to article</a>

<a name="3">3</a> I.R.C.
§§7122(c)(1) and (2) state that the Secretary shall develop
schedules of national and local allowances for basic living expenses and
guidelines as to how IRS employees should evaluate OICs. <a href="#3a">Return to article</a>

<a name="4">4</a> Section
525(a) states in relevant part that "a governmental unit may
not...refuse to renew a license, permit, charter, franchise or similar
grant to...or discriminate [against]...a person that has been a
debtor...solely because such debtor is or has been a debtor...."
Courts that have found that a taxpayer's ability to have the IRS
consider an OIC in bankruptcy a "license"—the ability to
do an act such as to negotiate a lower amount of taxes paid. Holmes, 298 B.R. at 482-83.
Moreover, a number of courts have concluded that §525 is not
exhaustive in scope as written and that Congress intended to make
§5252 as expansive as possible to protect debtors from discrimination.
See Mills, 240
B.R. at 698. <a href="#4a">Return to article</a>

<a name="5">5</a> Section
7122(a) states that "The Secretary may compromise any civil or criminal case...."
(emphasis added). <a href="#5a">Return to article</a>

Journal Authors

Craig A. Gargotta

Journal Date

Wednesday, September 1, 2004 - 12:00

Bankruptcy Rule

2004