Under IRC Sec. 7122(a), taxpayers may request an offer in compromise (OIC) with the IRS to settle outstanding tax liabilities for less than the full amount owed. To qualify, taxpayers must prove that their outstanding tax liabilities exceed the amount of income and assets available to satisfy those liabilities during the time remaining in the collection period, generally, the statute of limitation. This is known as establishing the taxpayer’s reasonable collection potential (RCP).
The higher the taxpayer’s RCP, the lower the taxpayer’s chances of qualifying for an OIC. In calculating the RCP, the IRS takes into account current and potential earnings, as well as the value of assets exceeding those needed for necessary living expenses. The sum of the taxpayer’s income and assets is treated as available to satisfy the taxpayer’s federal tax liability.
Taxpayers that dispose of their assets solely to qualify for an OIC are likely to fail, since a number of court cases support the IRS’ practice of including dissipated assets in the RCP calculation. A dissipated asset is defined as any asset (liquid or nonliquid) that has been sold, transferred or spent on nonpriority items or debts and that is no longer available to pay the tax liability.
The Tax Court recently decided two cases upholding the IRS’ rejection of OICs where the court found that the taxpayers had disposed of assets that would otherwise have been available to satisfy their outstanding tax liabilities. In Tucker, T.C. Memo. 2011-67, the individual taxpayer’s request for an OIC was denied when the examiner included dissipated assets in the RCP calculation, resulting in an RCP sufficient to satisfy the outstanding tax liability within the statutory collection period. The taxpayer was aware of his unpaid tax liabilities when he transferred funds into an online brokerage account to engage in day trading and subsequently lost a portion of the money. The IRS determined, and the Tax Court held, that the taxpayer lost the money in disregard of his outstanding tax liability. But for the failed investments, the taxpayer’s reasonable collection potential exceeded his outstanding tax liabilities, and the court held that the settlement officer did not err in determining that the taxpayer could fully pay his federal income tax liabilities.
Dissipated assets are not limited to those lost through negligence or disregard of one’s tax liabilities, however. In Layton, T.C. Memo. 2011-194, the taxpayer’s request for an OIC was rejected after the IRS examiner included the excess balance of an IRA distribution in the RCP calculation. The taxpayer had been unemployed for several years and had liquidated an IRA account to help pay her necessary living expenses. The remaining balance of the taxpayer’s IRA distributions, however, went to pay other nonessential debts. The taxpayer was not able to demonstrate that the debts she paid were necessary living expenses, so the Tax Court ruled in favor of the IRS.
Although gift tax audits are historically rare, the IRS has examined hundreds of taxpayers in the last two years whom the IRS suspects made large gifts, yet failed to file the appropriate returns.
Borrowing from techniques long employed to identify noncompliant taxpayers in the income tax context, the IRS is using records obtained from third parties—namely, land records maintained in state and county offices—to root out intra-family land transfers for little or no consideration.
According to Bonaffini, in the past two years, 323 taxpayers have been audited for failure to file gift tax returns relating to gifts of real property, 217 cases were still under examination, and another 250 cases were being researched to determine whether to conduct gift tax audits. At the time, the IRS had determined that ninety-seven taxpayers had violated gift tax reporting requirements by failing to file, and just twelve cases resulted in assessment of tax and penalties.
The recent flurry of gift tax compliance activity took many in the tax community by surprise. The compliance initiative received no appreciable public attention until the recent dispute in California federal court where the District Court for the Eastern District of California, refused to enforce the IRS' John Do Summons against the California Board of Equalization (“BOE”) where it refused to voluntarily turn over this requested information. The court’s denial of the government’s petition may embolden additional states to refuse the IRS’s request for records.