Category Archives: Loans and Indebtedness

Settling Large Tax Debts with the IRS Just Became Easier

It seems you can not watch TV, listen to the radio, or read the newspaper without seeing at least one of those ads for someone claiming to be a “Tax Specialist” who can fix your IRS problems.  Helping people with tax issues seems to be big business these days.  Most of these advertisements are pushing what is a rather longstanding program with the IRS known as the “Offer in Compromise.”  In my experience, the Offer Program is an excellent program with one significant caveat; you must meet the stringent requirements to qualify.  None of the ads bother to mention this important detail.

                Last month the IRS announced that in 2010 they accepted 27% of all Offers submitted.  In 2011 that number rose to 34%.  In my estimation, those numbers are too low.  Given how the Offer Program works, acceptance rates should be well over 80%.  What this means to me is that too many offers are being submitted by people that don’t qualify.  This would seem to reinforce my impression that too many people claiming to be “Tax Specialists” are really just salespeople.  Like anything that is important in life, if you need professional assistance make sure you find someone who knows what they are doing.

                There are a lot of details behind the Offer in Compromise process.  At the heart of it, the IRS is measuring a taxpayer’s ability to pay by quantifying both the taxpayer’s equity in assets and available cash flow.  Understanding the rules that underlie how this calculation is arrived at is critical.  Just this month, the IRS announced some very favorable changes to some of these rules which should show a significant improvement in the acceptance rates of submitted Offers.  In my practice, this will mean that a lot more people should now have the opportunity to settle substantial tax obligations for much less than what is owed.  This very recent change in a longstanding program is clearly an indication that the IRS would like to resolve more cases than recent statistics indicate. 

                The Offer in Compromise program is not for everyone.  If a taxpayer cannot settle with an Offer, there are always other options ranging from convincing the IRS that you cannot afford to pay anything to setting up payment arrangements over as much as four or five years.  Experienced tax practitioners should be able to assess key information relatively quickly and steer individuals and businesses to the best solution available.

Some Thoughts Before You Pay the IRS

Anytime you make a voluntary payment to the IRS, you have the absolute right to tell the IRS how to apply the money.  For most taxpayers, this may never be an issue because they only owe one type of tax for one tax year.  But for some, there may be a number of unpaid tax obligations.  If that is the case, how the money is applied may be important.  For example, if some tax debts are joint obligations with a spouse and others are not, you may want to pay off the joint obligations so your spouse’s assets are no longer exposed to collection efforts.  If you owe money for a number of years and some of the years can be discharged in bankruptcy and some can not (a topic for another day), you will want to pay the taxes that can’t be discharged first. 

You may think this payment strategy could be used when you file a tax return with an overpayment.  If so, you would be wrong.  If you file a tax return that reports an overpayment of tax, you generally lose the right to tell the IRS how to apply that overpayment.   Most people know that if they file a tax return with an overpayment, rather than ask for the money back in a refund they can check a box on the return and apply the overpayment towards their tax liability for the next year.  For individuals that need to make estimated tax payments, this is often a mechanical choice since otherwise they are asking the IRS to send them a check the same time they are mailing in their estimated tax payment.  This is a good system as long as there aren’t other unpaid tax obligations, and sometimes nontax obligations, outstanding. 

If you owe other taxes, whether income tax, employment tax or excise taxes, the IRS is going to override your election to apply an overpayment to the next tax year and, instead, use the money to pay your other outstanding tax obligations. The overpayment will be applied first to the tax, then to penalties and then to interest for the oldest obligation. Certain kinds of other obligations such as child support and student loan payments may also be satisfied with a tax overpayment.  If you have these sorts of obligations, you need to be very careful when doing your estimated tax payment planning for a subsequent year.  If you think your overpayment is going towards your estimated tax payment and it doesn’t, you may now be underpaid in your estimates which will result in penalties. 

A good tax preparer can help you think through this situation, but they need to know that you have these outstanding obligations.  Once a return that reports the overpayment is filed, it is too late.  If you don’t want your overpayment to be used to pay off another tax obligation, then the best advice is to plan in advance not to have the overpayment.

Can I deduct the interest I pay on student loans that are in my parents’ names?

For most college graduates, paying back student loans is part of growing-up.  A portion of those payments is, of course, payment of interest.  While most personal interest is not deductible for income tax purposes, the Internal Revenue Code (the “Tax Code” or “Code”) provides a special exception for student loan interest.  The Code, in Section 221(a), provides:

Allowance of deduction.  In the case of an individual, there shall be allowed as a deduction for the taxable year an amount equal to the interest paid by the taxpayer during the taxable year on any qualified education loan.

The Code limits this potential deduction in several ways, and this post discusses one such limitation.  Many parents help pay for their children’s college by obtaining Parent PLUS Loans, which are government loans that recognize parents (and some others) are generally in a better credit-position to borrow than their children.

In addition to Parent PLUS Loans, students often take out loans in their own name to cover the remaining expenses.  After graduating, students quite often pay back their loans and the Parent PLUS Loans as all of the debt went to pay for their education.  As long as the student meets the Tax Code’s conditions, he or she can deduct the student loan interest paid on loans in their own name up to a certain amount.  But can they deduct the interest they paid on the Parent PLUS Loans?

The answer is no – even when the student is the one actually making the loan payments from they own funds.  The reason comes down to the Code’s definition of a “qualified education loan,” which reads as follows:

. . . any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses . . . . 42 U.S.C. § 221(d)(1) (emphasis added).

With a Parent PLUS Loan, only parents are legally obligated to pay the loan and the loan’s interest.  The student takes on no legal obligation, and therefore, no indebtedness where his or her parent utilizes a Parent PLUS Loan.  IRS publications agree this is the case.  Click the following link for the student loan interest portion of IRS Publication 970 with Joshua Werbeck’s notes.

Furthermore, students cannot simply execute an agreement with their parents obligating them to pay the interest.  The Tax Code’s definition of qualified education loan exempts indebtedness to related persons and some business entities.  See 42 U.S.C. § 221(d)(1) (“flush language” at the bottom of the subsection).

If you’d like, you can read the law yourself.  Here is a link to Section 221(a) of the US Tax Code covering the student loan interest deduction with Joshua Werbeck’s notes.

But what happens to the potential deduction if the person actually paying the loan is not entitled to utilize the deduction.  The person legally obligated to pay the qualified education loan, the parents in my example above, are entitled to the deduction even if they never actually made a loan payment.

Some payment options with the IRS just got a little kinder and gentler!

When you owe the IRS money and you can’t pay everything right away,  typically there are three  options:  (1) convince the IRS you can not currently pay anything and have your account marked as “currently not collectible;” (2) set up a payment arrangement; or (3) seek to settle through the offer in compromise program.  Each option has its pros and cons.  The IRS recently announced some helpful changes if you want to pursue the second option of setting up a payment plan.

 Rules for IRS payment plans have always been classified based on how much is owed.  These rules generally address the length of time that can be given for payment, the amount of financial disclosure required before a monthly payment amount will be accepted, and whether a tax lien will be filed.  The significant thresholds of balances owed are $10,000, $25,000, $50,000 and over $100,000.   As you would expect, the more you owe the more involved the rules become.  Therefore, as a threshold consideration,  before approaching the IRS about a payment plan, consider whether a partial payment can be made to move you down a tier or more in the escalating set of rules.   

 The recent changes relate to the “streamline installment agreements” for taxpayers owing less than $25,000 and those owing between $25,000 and $50,000.  In each instance, taxpayers may now be given up to six years to pay an obligation (increased from five years).  Taxpayers owing between $25,000 and $50,000 now need to make monthly payments by direct debit from a bank account.  Also, at this higher level some financial disclosure will be requested but the sole purpose for gathering this information is to ensure that the payments can be maintained for the life of the plan, not to glean the highest monthly payment that can be made.  Generally a tax lien will not be filed at either of these levels under the streamline rules.

 If a payment plan is the best option to resolve a tax debt, all of these changes should make setting up a payment plan easier.

If you find yourself in a hole, stop digging…

Ever hear the expression, “If you find yourself in a hole, stop digging.” That is as good a place to start when someone has fallen behind in their obligation to pay their taxes. So often when someone has a tax problem I see that they are always playing catch up.

A typical scenario may be: Bob files his 2009 return late with a big balance due. Determined to fix the problem, he stops his withholding for 2010 and he starts paying all of his 2010 tax money over to the IRS to pay off the 2009 bill. Or if Bob is self-employed, he commits to pay over a lump sum payment (when his next deal closes) and neglects to make his estimated tax payments for the 2010 income. So now, when the 2009 debt is satisfied, the 2010 return comes now due and Bob realizes he is going to owe about as much again for 2010. My advice: stop digging Bob. What Bob is doing is running up more penalties and interest than is necessary.

A better approach would be to contact the IRS and come up with a payment plan to pay off 2009 which allows Bob to stay current on his obligation for 2010, and beyond. Yes, penalties and interest will continue to accrue on the 2009 balance until it is paid off, but failure to file and failure to pay penalties max out at 25% of the tax for each year. Consider that the cost of needing more time to pay the 2009 debt. Using the “catch-up” approach, Bob is now likely to face that 25% penalty for each year he owes. In the long run, he will pay a lot more than he should have to.

If you fall behind for one year, work out a plan for that year that allows you to stay current for subsequent years. Now you have minimized the cost of having fallen behind.