One of the twin pillars of an offer in compromise is determining the taxpayer’s future income. The IRS looks to future income to determine the taxpayer’s reasonable collection potential, which is the taxpayer’s ability, or inability, to pay the tax due and owing. If the taxpayer is unable to pay the tax, the IRS may be willing to compromise the tax debt.
For the self-employed taxpayer with irregular income, determining future income can be a challenge due to the natural ups and downs in business. The basic rule used by the IRS for determining future income is that self-employed taxpayers, including single member LLCs taxed as disregarded entities (in other words, taxed as a sole proprietor), must provide gross income and a profit and loss statement from the most recent 6-12 months.[1]
IRS Form 433-A (OIC), which is completed to apply for the offer in compromise, permits the taxpayer to either submit a stand alone profit and loss statement or complete Form 433 with the appropriate information to provide profit and loss.
However, with irregular income, the taxpayer may engage in income averaging over three years rather than be limited to the past 6-12 months since it is possible that the previous 6-12 months may not be an accurate representation of income. The Internal Revenue Manual states[2]:
IF: A taxpayer has an irregular employment history or fluctuating income
THEN: Average earnings over the three prior years. The use of a time period other than three years should be the exception and only when specific circumstances are present.
An example would be if the taxpayer is a stock-broker whose income in 2015 was $150,000 and income in 2016 was $25,000. In this case, you should consider income averaging the prior three years or secure a future income collateral agreement if the offer is accepted.
Note: This practice does not apply to wage earners. Wage earners should be based on current income unless the taxpayer has unique circumstances.
In addition, the IRS must take future reduced anticipated income into account if future income is anticipated to be less than historical income:[3]
IF: Income will increase or decrease or current necessary expenses will increase or decrease
THEN: Adjust the amount or number of payments to what is expected during the appropriate number of months.
Practice points: The self-employed taxpayer must provide 6-12 months of profit and loss information. However, the taxpayer should be prepared to argue that reduced income is likely or that income averaging over three years is appropriate in order to provide a calculation of more accurate income. With these two approaches, which provide an exception from providing the IRS only the income of the past 6-12 months, the taxpayer can attempt to list income that reflects a corrected estimated future income. I urge the taxpayer to contact a tax professional to assist with this determination.
Jared M. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal and state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
[1] I.R.M. 5.8.5.3.1.3(2).
[2] I.R.M. 5.8.5.20 (4)
[3] Id.