Tax Refund Impacts of an Offer in Compromise
What do you do when you owe the Internal Revenue Service more than you can possibly pay? The tax code provides for an option called an Offer in Compromise. You can enter into an agreement with the IRS to pay less than your full tax debt and make the whole problem go away...sort of.
Of course, the IRS won't simply take your word for it that you don't have the resources to pay your entire tax debt. You'll have to prove it by submitting various forms of documentation. And yes, the IRS will keep your tax refunds for a period of time.
Offer in Compromise Criteria
The IRS might approve an Offer in Compromise for one of three reasons:
- The total of your assets and income are less than what you owe the IRS.
- You've reached a stalemate with the IRS regarding the legitimacy of your tax debt—you can't prove you don't owe it but the IRS can't prove that you do, either.
- Paying the tax debt would create an economic hardship for you based on "exceptional circumstances."
The IRS and Your Refunds
The IRS will keep any tax refunds you're entitled to during the period of time while your offer in compromise is being considered and processed, and it will also keep any tax refunds due to you in the year during which your offer is approved.
As an example, let's say that you made your offer in 2017 and it was also accepted in 2017. As part of the offer agreement, the IRS will keep any refund you might be entitled to in April 2018 for income you earned and taxes withheld and paid during tax year 2017. Future refunds for income earned during tax years 2018 and beyond would not be affected. You'll get those refunds, but you would not receive any still due to you from tax year 2016 or earlier.
The OIC contractual agreement reads in part:
- You agree to let the IRS keep any tax refunds, payments, and credits applied to your tax debts prior to submitting your Offer in Compromise.
- You agree to let the IRS keep any tax refunds that would have been payable to you during the calendar year that your Offer in Compromise is approved.
These refunds may not be counted as part of your total offer in compromise payment amount. That's right—they won't reduce the OIC balance you've agreed to pay. Neither can you apply them toward next year's estimated taxes. This obviously makes tax planning a little trickier.
Take Steps to Adjust
Try to figure out how much tax you'll likely owe in the current year and attempt to break even or owe just a small amount that you can pay in full when you file your return. There are several ways in which you can do this. If you're not entitled to a refund in the first place, there's no issue. There's nothing for the IRS to keep.
Maybe you can sell some profitable investments and generate some capital gains which you'd have to pay taxes on, or perhaps you can convert some of your traditional IRA into a Roth IRA. Maybe you could pay more self-employment taxes by claiming fewer business expense deductions. You could also adjust your paycheck withholding or estimated tax payments to keep your withholding and/or estimated payments as close to your tax liability as possible. Yes, it sounds weird, but the idea is to try to reduce your refund by increasing your tax liability.
You want any potential refund to be as close to zero as you can get it because you aren't going to see that money anyway and some of these tactics can be beneficial in other ways.
A Bright Side
Increasing your self-employment taxes if you're self-employed won't just reduce your tax refund. It will actually help you out a little in retirement by boosting your Social Security benefits. The self-employment tax is a combination of Medicare and paying into Social Security.
And if you're not self-employed? If you convert part of your traditional IRA to a Roth IRA, you'll pay tax on the conversion. This can help eliminate your tax refund, and Roth IRAs provide tax-free withdrawals in retirement. In other words, you'd pay now for tax-free income later.
You might want to consider seeking the advice of an experienced tax professional for other tips on how to handle your tax situation. And remember—those lost refunds are a temporary situation lasting a year or two at most. You won't be losing your refunds for the rest of your life.
In the meantime, examine what happened to cause you to owe such a significant tax debt in the first place. An experienced tax professional can help you with this, too, as well as with measures you can take to avoid having it happen again.
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