You’re facing back taxes you don’t think you’ll be able to pay in full. You’ve done some research on your options. You may have even contacted a tax resolution professional for a free consultation. Now, you’re looking at an offer in compromise vs bankruptcy. Which is right for your situation?
Offer in Compromise
Before deciding if an offer in compromise is right for you, you must determine (with the help of a professional) whether or not you qualify. Submitting an offer is much more involved than just picking a number you’re willing to pay and hoping the IRS will accept it. To be eligible for an offer in compromise, you must have filed all necessary tax returns and be unable to pay the full amount of back taxes you owe before the collection period expires. The offer you make to the IRS must be reasonable, based on the equity in your assets, your income, and allowable living expenses–all of which you’ll need to document. The IRS bases its decision to accept or reject your offer on your ability to pay (reasonable collection potential), not on the amount you owe.
An offer in compromise may be your best option to resolve any IRS back taxes you can’t afford to pay when your taxes are not dischargeable in bankruptcy. In addition, submitting an offer in compromise won’t impact your borrowing ability and credit as bankruptcy will. Regardless of whether the IRS accepts your offer, collection actions (with the exception of a lien) will be suspended while your offer is considered.
When choosing an offer in compromise vs bankruptcy, one of the biggest factors in your decision will be whether or not you have debt beyond back taxes. An offer in compromise only addresses your IRS tax debt. Bankruptcy can help you resolve a much wider range of debt such as credit card debt, medical bills, and personal loans. However, certain debts (including student loans, child support, alimony, and trust fund taxes, as well income taxes that do not meet certain criteria) are nondischargeable.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy, which can be thought of as a “liquidation” bankruptcy, is designed to give you a fresh start from your debts, including certain tax debts. If you own property with equity, it could be sold and the proceeds used to pay creditors. However, bankruptcy law provides exemptions that determine what property you can keep, such as your home, car, personal property, an IRA, or other property.
In order to use Chapter 7, you must deal with the means test which calculates whether your income exceeds the median income for a family of your size in your state. The purpose of means testing is to determine whether your income is high enough to make repayment on your debts and what the minimum payments might potentially be. If you make more than the average family in your state, you’re considered to have failed the means test and may be required to use Chapter 13 bankruptcy and establish a payment plan.
However, the unwanted effects of means testing can be avoided if your debts are not considered “primarily consumer debts” (more than 50% of total debt). Consumer debt is debt that is primarily incurred by an individual for personal, family, or household purposes. Tax debt is not consumer debt.
Once it’s determined that you qualify to use Chapter 7, your tax debt must meet very specific criteria to be dischargeable:
- Your debt is from income taxes, not payroll taxes.
- You have not committed any tax fraud.
- Your tax return was due at least three years before your bankruptcy filing date.
- Your tax return was filed at least two years ago.
- The IRS assessed your tax debt at least 240 days before you filed for bankruptcy.
Tax debt that does not meet the above criteria is nondischargeable in bankruptcy and will need to be paid to the IRS after bankruptcy. Depending on your circumstances, you may be able to settle this remaining balance by submitting an offer in compromise.
Interest is considered part of the tax, having the same status as the tax it relates to. Therefore, if a tax debt is dischargeable, the related interest will be dischargeable as well. Tax penalties are dischargeable if they relate to the tax being discharged or are imposed with respect to an event or transaction that occurred more than three years before filing bankruptcy.
No matter whether your tax debt is considered dischargeable or not, Chapter 7 bankruptcy will not necessarily remove any IRS lien placed on your property prior to your filing bankruptcy if there is equity in the property. This means you’ll need to pay off the lien if you sell the property. However, keep in mind that most tax liens expire when the 10-year period on collections ends.
Similar to an offer in compromise, declaring bankruptcy gives you time to breathe. The Automatic Stay prohibits creditors from trying to collect your debt directly during bankruptcy proceedings.
You may find bankruptcy to be a better option than an offer in compromise when you have debts other than taxes you’d like eliminated. After your offer is accepted, you must meet a five-year tax filing and payment compliance rule; otherwise, your offer will be revoked. This rule does not apply in bankruptcy.
Lasting Tax Debt Resolution
Both tax resolution strategies discussed here are very nuanced. Depending on your situation, one may be better than the other. You may also find, with the help of a tax resolution professional, that neither is right for you. It is important to consult with a bankruptcy attorney in your state. No matter which method you use to remedy your tax debt, it’s essential you file on time and pay your taxes going forward so you don’t find yourself with back tax problems in the future.