How to Settle Your Tax Debt With the IRS Via an OIC

Depending on your circumstances, tax season could bring with it an exciting financial windfall or the horror of  discovering that you owe a tax debt to the IRS. If you fall into the latter category, the good news is that you don't have to pay your tax debt in one lump sum. You can apply for a tax debt settlement arrangement with the IRS known as an offer in compromise or, more often, an "OIC."

How the Offer in Compromise Works

When you owe a tax debt, the IRS will send you written notice of your debt. When you receive your IRS bill, you have three options:

1. Pay the debt in one lump sum. 
2. Pay the debt in installments
3. Settle the debt with an OIC

Like other forms of debt settlement, an offer in compromise allows you to pay less than the amount you actually owe. You can pay an OIC either through a lump sum settlement or by making periodic payments on your delinquent taxes until you satisfy the debt. 

Offer in Compromise Restrictions and Guidelines. 

The IRS has overwhelming collection power

When you request a settlement from a creditor or collection agency, whether or not your settlement offer gets approved often rests on who you happen to be talking to. Debt collectors have quite a bit of leeway when deciding to grant or deny your settlement request. This is not the case for the IRS. The IRS has specific criteria you must meet in order to be eligible for an OIC. One of the following three requirements must be met in order for the IRS to approve your OIC request: 

1. Possible Billing Errors – If any doubt exists as to whether or not you actually owe the debt, the IRS will accept your offer in compromise. The same is true if doubt exists about whehter or not the tax debt the IRS demands is accurate. Unfortunately, doubt on your part alone isn't enough to convince tax officials that you deserve a settlement. Personally, I find it chilling that if there is a chance that the debt isn't even yours, the IRS will grant you a settlement, but you still have to pay the debt – even when the IRS knows it may not be yours. Scary, eh?

2. Debt Not Collectible – Some consumers get a tax bill only to discover that the amount they owe exceeds their assets. The IRS has extensive collection rights and can generally seize almost all of your assets when attempting to collect a debt. If the sum of your tax debt exceeds the total value of your assets, its much easier on the IRS to grant you a tax settlement than expend time and resources to collect a debt that isn't fully collectible anyway.

3. Economic Hardship – The IRS wants the delinquent taxes you owe, but it doesn't want to leave you so broke that you can't continue paying taxes in the future. Thus, if you can demonstrate that paying your tax debt would leave you and your family completely destitute, the IRS will generally approve your application for a tax settlement.

How to Apply for an OIC

You'll need to use different forms to apply for an OIC depending on which criteria you meet. If, for example, you are applying for a tax settlement based on possible billing errors, you must fill out and send in Form 656–L. If, however, your OIC request is based on a possible economic hardship or a lack of assets, you must fill out and send in Form 656 and Form 433-A.

Unlike debt collection settlements, there is no negotiating your settlement for a federal tax debt. You are responsible for including your offer in your OIC paperwork. The IRS then either accepts or rejects your offer. Before acceptance or rejection takes place, expect the IRS to request extensive paperwork from you to validate your income and assets. The IRS will continue to apply penalties and fees to your tax debt during the evaluation process.

OIC Application Costs

The IRS charges a fee of $150 to evaluate your OIC request. The $150 fee is nonrefundable, regardless of whether the IRS approves or denies your tax settlement. This fee does not apply if you are requesting an OIC based on possible billing errors or if your income falls below 250% of federal poverty guidelines.

When you submit your settlement offer, you have the option to pay your delinquent taxes via a lump sum settlement or installments. If you select the lump sum option, you must include a good faith payment of 20% of the proposed settlement offer with your OIC application. If you select the option to pay your tax debt in installments, you must include the first payment with your OIC request. Like the application fee, the initial good-faith payment is nonrefundable. If the IRS denies your OIC application, it will apply the payment you made to the tax debt you owe.

A settlement via an offer in compromise is a good option for those with overwhelming amounts of tax debt. If you don't qualify for an OIC, however, keep in mind that the IRS will provide you with a payment plan that allows you to pay off your delinquent taxes over time. 

What Does a Tax Lien Do To Your Credit Score?

The IRS is watching...

If you're like myself and not one of those lucky people who gets money back at tax time and instead find yourself facing a bill every year, putting aside the funds to pay it is mandatory. If you don't pay your federal tax debt in full or arrange a payment plan with the IRS, you'll soon find yourself looking down the barrel of a smokin' tax lien. A tax lien is a financial Godzilla, smashing through your assets and leaving you in a state of panic. It also has a considerably negative effect on your credit scores.

What Is a Tax Lien?

A tax lien is a blanket lien. When a regular creditor gets a judgment against you, it can file its judgment with the appropriate government office in your state and then place a lien against property you own, such as your home or car. Then you're stuck. You can't sell the asset without first paying off the lien.

IRS liens work a little differently. For starters, they don't have to sue you. If you don't pay your tax debt immediately, you'll get a letter from the IRS giving you ten days (yep, ten days!) to make some sort of payment arrangement before the IRS files a tax lien. Once the tax lien is filed, it attaches to all of your assets automatically. It also shows up on your credit report.

For more information about tax liens in general, visit the IRS and read Understanding a Federal Tax Lien.

How Much Does a Tax Lien Hurt Your Credit Score?

A tax lien is a public record, like a bankruptcy or civil judgment. Public records almost always have a negative effect on your credit scores. Like every other negative credit entry, the degree to which a tax lien hurts your credit depends on how high your credit score is when it hits your report.

Do it right!

What makes tax liens so damaging to most consumers' credit scores is the fact that a tax lien comes out of nowhere. Other negative entries generally have "warning" entries that prevent them from having the full negative effect on your credit scores. Collection accounts, for example, generally do not appear on your credit report until the original creditor has reported 180 days' of missed payments to the credit bureaus. This brings your credit score down to the point that a collection account doesn't have the full negative effect that it could have. Remember, the lower your credit score, the less negative entries affect your credit rating.

In general, you stand to lose about 100 points – maybe more if you have a particularly high credit score – when a federal tax lien hits your credit report.

Tax Liens and Foreclosure 

Most judgment creditors that hold a lien against your assets aren't actually going to seize your property. It's a long story as to why these creditors would rather hold your lien that call it due, but you generally have little to fear from collection liens and mechanics' liens. Tax liens are another ballgame.

The more equity you have in your home, the more attractive a tax foreclosure is to the IRS. They can and do seize the homes and cars of individuals who owe unpaid taxes. The moral of the story here? Do whatever you have to do to pay your federal tax debt and keep a tax lien off your credit report. Not only will it severely damage your credit score, it could leave you homeless.

Can Collection Agency Collect After Original Creditor Issues 1099 Tax Form?

Here's an unsettling little fact you may not be aware of: When a creditor writes off your debt and sells it to a collection agency, that creditor may send you a Form 1099-MISC at the end of the year. The Form 1099-MISC notes the amount of your debt that the creditor "forgave." Of course, we both know that collection agency debt is about the furthest thing from "forgiven" debt that there is, but the original creditor can get a tax break by taking uncollected debt as a tax loss. As with most things that debt collectors and creditors do, their minuscule tax break can come back to bite you in a big way.

Forgiven Debt, Form 1099-MISC and Your Taxes

When you receive a Form 1099-MISC from a creditor, that means the creditor has reported your debt, and you, to the IRS. Thus, in order to stay on the IRS' good side (and believe me, we all want to do that) you must include the debt as income on your tax return and–you guessed it– pay taxes on it.

I know what you're thinking, "Oh good. I'd rather pay a portion of the debt as tax than pay the full amount plus fees to a collection agency." But not so fast, here comes the kicker: A collection agency still has the right to collect the debt after you've received a Form 1099-MISC from the original creditor and paid taxes on the debt.

And now you're thinking I've either developed early-onset Alzheimer's or have been hittin' the bottle again. I know there are a plethora of forums posts and blogs and articles everywhere making these claims. There are an equal number saying it isn't true. After all, it just doesn't make any sense. It is true and I am going to explain to you exactly why this is.

The IRS, Taxes and Forgiven Debt

The people who shout from the rooftops that a collection agency can't legally collect after you've paid taxes on a debt are generally referring to this lovely bit of jargon from the Code of Federal Regulations:

"When collection action on a debt is suspended or terminated, the debt remains delinquent and further collection action may be pursued at a later date in accordance with the standards set forth in this chapter. When an agency discharges a debt in full or in part, further collection action is prohibited. "

Yes, that's federal code. And yes, it contains the claim that once a debtor pays taxes on a forgiven debt, that debt is no longer collectible  But what most people who find this bit of text fail to realize is that it governs the actions of government entities, not consumers and commercial creditors. There is no comparable code offering consumers the same benefit, and if it isn't in the law, it isn't enforceable.

Told you it was real.

Let me give you an example. Once upon a time in Japan a vending machine appeared in a subway tunnel. The vending machine sold, of all things, young women's used undergarments (This is too crazy for me to make up). The city immediately took action to remove the vending machine, but discovered that there were no laws on the books making such a vending machine or what it claimed to sell, illegal. The city eventually found some obscure law regarding second-hand clothing and licenses to eliminate the machine, but until then there was nothing they could do.

The same principle applies here. There is no law protecting consumers from being double-charged. As a matter of fact, there is case law supporting the practice.

Debt Buyers' Association vs. Snow

It's easy to misread the code and assume that, once a 1099-MISC is issued, all collection efforts on the debt must stop. Back in 2006, this very assumption led the Debt Buyers' Association–an agency that represents the  interests of a number of collection agencies–to file a lawsuit.

The lawsuit was simple in scope: The DBA claimed that, because the law required creditors and collectors alike that met certain requirements (I won't go over those requirements here) to send the debtor a Form 1099–MISC, this impinged on the entire collection industry. Basically, collectors faced the inevitability of not being legally permitted to collect on any debts for which a 1099 had been issued.

The court ruled that there was no reason a debt collector could not continue its collection efforts after a 1099 had been issued. And legally there isn't since, as ridiculous and unfair as the whole thing sounds, there is no law prohibiting the practice. The court noted, however, that the debt collector could send the debtor a statement informing him/her that a Form 1099-MISC had been issued because the debt met certain technical requirements, but that collection activity would continue.

How thoughtful of them.

What to Do When You Get a 1099 From a Creditor or Collection Agency

While you can just refuse to pay a collection agency and take your chances with the statute of limitations, you don't have that same freedom with the IRS. If you get a Form 1099 from a collection agency or the account's original creditor, you have to factor it into your income. Period. Whether or not to pay the collection agency what they ask (or pay the debt and subtract the amount the 1099 claim increased your tax liability) is your decision.

Why Laws Regarding Debt Collection and 1099 Tax Forms Aren't Likely to Change

I once naively believed that someday some savvy consumer was going to file a lawsuit over this claiming that, according to legal language, the 1099 could only be issued for "forgiven" debt. Thus, the debt must be forgiven as soon as the debtor pays taxes on it. It didn't take me long to realize that the collection industry has a powerful lobby effectively preventing any case law supporting the consumer's rights. In addition, politicians tend to treat debtors like pariahs, so don't expect any new laws on the books anytime soon that protect consumers from this "double-billing" on the part of creditors and collectors.

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Can a Collection Agency Take My Tax Refund?