Taxation & Estate Planning

Bankruptcy as leverage in an offer in compromise

By howardlevy

On more than one occasion I have used the possibility of bankruptcy as leverage in reducing the value of a offer in compromise.  The possibility of bankruptcy can have a big impact on an IRS compromise. 

Here’s why:

1.     A Chapter 7 bankruptcy can “discharge” a tax liability.  

2.     Any taxes that could be discharged by a potential bankruptcy cannot be collected against the future income of the taxpayer.

3.      A critical component of an offer in compromise is an IRS calculation of how much can be collected from future income. 

4.     If bankruptcy is “Plan B” to an offer in compromise, the IRS may reduce the value of future income to account for the limited collection potential.  

The Internal Revenue Manual 5.8.5.6(5)) on reducing the value of a compromise from bankruptcy states as follows:

“Some situations may warrant placing a different value on future income than current or past income indicates…if a taxpayer will file a petition for a liquidating bankruptcy (Chapter 7)…consider reducing the value of future income.”

It is important to know when bankruptcy can discharge taxes to do this - it often will need to be explained in detail to the IRS offer investigator, who may not be familiar with taxes and bankruptcy.  The taxes being compromised would need to have been (1) due to be filed three years prior (2) filed two years prior and (3) the tax assessed 240 days prior to the potential bankruptcy filing.  

When properly inserted into the compromise negotiations, Internal Revenue Manual 5.8.5.6(5) can have a significant impact on the value of a compromise. It can also avoid a bankruptcy filing by pushing a compromise over the goal line.    

For more on taxes and bankruptcy, see my article in the Journal of the National Association of Enrolled Agents, presentation outlines and my other tax bankruptcy related posts.

Full post as published by IRS and the Law on May 27, 2009 (boomark / email).