Capital Gains and Losses

The IRS put out a tax tip recently with information about capital gains and losses.  It’s not bad, but I can sum it up better, and tell you why you might care.

To begin with, capital gains and losses are the gains and losses from the sales or exchanges of capital assets.  So, what is a capital asset?  Pretty much everything unless it is specifically excluded from the definition found in Internal Revenue Code Section 1221, most notably business assets such as inventory, accounts receivable and depreciable property.  There are others, but most assets you can think of (your house, your car, your couch, your dog), those are capital assets.

When you sell a capital asset, you are probably going to have a gain or a loss.  That gain is taxable, unless there is some kind of exclusion for it, such as on the sale of a personal residence.  However, this capital gain may be subject to more preferential tax rates than an ordinary gain.  On the other hand, a capital loss may be used to offset ordinary income that would have been taxable at the larger ordinary tax rate, but there are, of course, limits.

First, you have to classify your gains and losses into long-term or short-term.  If you acquired the asset over a year before you sold it, then you will have a long-term gain or loss, and if not, then it is short-term.  You then net the long-term gains and losses out and do the same with the short-term sales.  If you have a net long-term gain, you would then subtract any net short-term loss to arrive at your net capital gain.  That income will be taxed at the lower capital gains tax rate, thus allowing you to pay a lower tax rate than your secretary.  Or so I have heard some describe it that way.

If you have capital losses after netting against those capital gains, you can deduct those losses against ordinary income, but only up to $1,500, or $3,000 if you file jointly.  However, if you find you run into that limit, you do get to carry forward the amount of the loss that you couldn’t claim this year.  The capital loss that you carry forward keeps its original short-term or long-term character for purposes of running them through the same matrix described above, as if the loss occurred in that year.

Perfectly clear now, isn’t it?  No?  Well, I tried.

Updates to the Offer in Compromise Program

Actually, these new features came out about a year ago, but at least by this point I’ve been able to see how they work in practice.  The basics of how an Offer in Compromise works (equity and assets, future income, pretty much everything I discussed before) remains the same.  However, the IRS has made some key changes in what they allow for expenses, how they calculate future income, and how they value some assets.

Future Income Calculation

Previously, for cash offers paid within 5 months, the future income component was the disposable income multiplied by 48, while the multiplier was 60 for short-term offers paid within 24 months.  That has now dropped to 12 for cash offers and 24 for short-term offers.  Thus, for a cash offer, a taxpayer now only needs to come up with 12 months of future income (in addition to the equity component) to come up with an acceptable offer amount, and 24 months of income to be paid over the 24 months of a short-term offer.  This doesn’t change the initial determination to see if an offer is acceptable by calculating if the balance could be fully paid over the remaining time the IRS has left to collect, but once it is determined that the taxpayer does qualify for the Offer, this significantly reduces the minimum acceptable amount.

Some changes in the expenses that are allowed could reduce the disposable income for a taxpayer, and thus the lowest acceptable offer amount, even more.  Briefly, these changes are:

• $200 extra in vehicle operating expenses are allowed on vehicles six years or older or having 75,000 miles.
• Up to $400 is still allowed as an expense in future months after a car has been paid off, up to two vehicles for a married couple (Previously, the amount of the payment that no longer occurred was considered “retired debt” and was added back into the calculation of disposable income in future months).
• Minimum student loan payments are now allowed.
• An amount is allowed if back state taxes are owed by the taxpayer (The computation for what is allowed is somewhat involved, but at least some amount is going to be allowed, even if no arrangements have yet been made with the state yet).

Equity Calculation

Several changes to how the IRS calculates the value of equity in assets also significantly reduces the minimum amount that could be acceptable as an Offer:

• $3,450 in the net equity, after reducing by the loan amount, of a vehicle is excluded for one vehicle, two if married.
• The computation of the amount of cash on hand or in the bank now specifically does not include any amount that is needed to cover monthly expenses, and another $1,000 on top of that is excluded.  By the example that the IRS provided, if the taxpayer lists $3,000 in the bank, but has $2,700 in allowable monthly expenses, none of that amount is included in the equity calculation, as the $300 left over after paying the monthly expenses is less than the $1,000 exemption.
• Income producing assets (This one is complicated, but what it boils down to is that if the IRS is going to factor in the income, then the assets used to produce that income, if they have equity, should not be factored into the equity calculation; and conversely, if it is concluded that a business could operate without those assets, the IRS could factor in the equity, but then would have to reduce the income generated by those assets in the income calculation).

Those are all of the changes in a nutshell.  You can see what the impact of all of this could be if a taxpayer has even a few of these newly allowed expenses, but beyond that, to exclude several thousand in equity from the vehicles and even cash and to reduce the monthly multiplier results in acceptable offers that are going to be thousands of dollars less, possibly tens of thousands for some.

Why Did My Take Home Pay Just Drop? What Do You Mean, “Tax Holiday”?

For those who may not have noticed yet, your taxes just went up.  And we’re not talking about owing more when you file your tax return, we’re talking an immediate tax hike affecting what you bring home each pay check.  What the heck just happened?

All of the talk about the “fiscal cliff” with regards to the impending tax hike had to do with the tax cuts originally put into place in 2001, what many refer to as the “Bush” tax cuts.  Congress had managed to lower tax rates across the board as well as make other significant changes, such as the complete repeal of the Estate Tax, but because the tax cuts weren’t “paid for” in the sense that they would result in lower revenues and there was not a cut in spending to offset that, the tax cuts required a super majority in the Senate in order to remain permanent.  Since there were not enough votes for that, the tax cuts were set to expire after 10 years.

Congress and President Obama managed to punt on the issue when the time came in 2011, deciding to keep the tax rates the same for another couple of years, but then that led to the battle that transpired at the end of 2012.  That battle resulted in the American Taxpayer Relief Act of 2012, which managed to keep the rates in place for most taxpayers but raise them on those making large incomes, as well reduce deductions for those same folks.  These new rates are not set to expire, which is nice, and other provisions, such as those that made fixes to the Alternative Minimum Tax were also made permanent, while a handful of provisions which we won’t get into here were extended for another year.

So, if the rates for all but the highest income earners were kept the same, how is it that most people are immediately taking home less?  The answer is because the American Taxpayer Relief Act of 2012 had absolutely nothing to do with the tax reduction that has now expired in the first place.

In 2011, in an effort to put more money in the hands of taxpayers in the hope that they would go out and spend that money, giving a welcome boost to the economy, Congress passed and the President signed into law not only an extension of those “Bush” tax cuts that were about to expire, but also included a 2% cut to your FICA withholding taxes.  These are your Social Security taxes.  Myself, I wondered at the wisdom of cutting taxes meant to fund the Social Security program, something that is already hurting for money, but I couldn’t complain at having 2% more of money stay with me.

It’s because Social Security has funding issues that this tax cut was never intended to be permanent.  It was a “Tax Holiday”, which means that it was just going to last for a while, one year in this case, and then the tax would be back.  Probably thinking it would look bad for that tax to spring back in an election year, the tax holiday was extended for another year, through 2012.  Now it’s 2013 and the FICA taxes are right back to where they were before the tax holiday began, and you are taking home 2% less than you were in December.

So, love it or hate it, the American Taxpayer Relief Act of 2012 made provisions to preserve income tax cuts for most of us, but did nothing to affect the employment tax hike for anybody out there making a living.

Hiatus is Over

I’ve been telling myself that I need to get back to trying this whole blog thing again.  So, here I am.

We’ll see how it goes.

Please look forward to it.

IRS Leniency: What Exactly Does That Mean?

I’ve been asked this by a number of clients as they hear reports in the media about how the IRS will be more “lenient” owing to the current state of the economy.  The only answer that I’ve been able to come up with is, not much.

If you can’t pay your 2008 taxes on time, or older tax years for that matter, is the IRS going to hold off on charging penalties and interest?  No.  Will they reduce the penalties and interest.  No.  The IRS is still encouraging you to pay as much as you can in order to keep the penalties and interest to a minimum, but they aren’t reducing them.  As always, you can request an abatement of penalties if you can establish “reasonable cause,” but a sour economy does not constitute reasonable cause, since taxpayers are supposed to be paying the taxes as they earn the income.  Even if there is reasonable cause, taxpayers are still stuck with the interest.

So, if you can’t pay, what do you do, and how is the IRS going to be “lenient”?  Well, you can probably set up a payment agreement.  Which has pretty much always been an option for taxpayers.  If you can’t meet the IRS minimum payment guidelines based on the amount that you owe, you can provide your financial information to establish what you can afford to pay per month.  Again, much as always has been the case.  Where the IRS is being somewhat lenient, supposedly, is in the expectation that you try to borrow against equity in your home before setting up a payment plan, a home that may very well have declined in value over the past few years.  So, do you not need to try to borrow?  No, you still do, and typically you have to provide a copy of the loan application showing how much you tried to borrow and a copy of the loan denial letter if you were unable to do so.  So, how is this lenient?  So far, in my experience, it hasn’t been.  Occasionally, I will get an IRS agent that doesn’t press the issue as much, but that is about it.  The “leniency” factor seems to be applied at the individual level, with no real hard guidelines, so you don’t know what you are going to get until you call and and speak with someone.

What if you already have a payment plan, but you can’t afford it?  Well, the IRS may allow you to miss a payment.  Then again, they have historically allowed taxpayers to miss one payment anyway, so I don’t really see a change there.  The IRS is saying that they may accept a reduced payment if the taxpayer provides financial information showing that only a lesser amount can be paid.   But then, the IRS has been willing to lower payment plans based on financial information in the past, so again, not really a change in policy.  The key is, if you need to establish a payment plan, or if you already have one but need to change the terms, you need to contact the IRS and work with them.  Don’t just ignore the problem.  But don’t expect to get a great deal due to any “leniency” program.

For those trying to refinance to get a lower monthly mortgage payment in order to avoid foreclosure, a tax lien field by the IRS poses a major obstacle.  To complete the transaction, the taxpayer will need to request a lien subordination from the IRS.  That shouldn’t be a problem, especially where no money is being pulled out, but the taxpayer is just securing better terms, or in the case where the taxpayer is conducting a short sale, just to get out from under the mortgage.  The IRS is suggesting that in these situations, because they know times are tough, they will expedite the processing of the lien subordination request.  So, in other words, they will do what they did before, but they will do it faster.  Needless to say, I am underwhelmed.  The units of the IRS handling these cases never seem to move particularly fast, so if the IRS can speed the process up, that would be great.  I just have my doubts that things will improve much.  And the relief offered isn’t any different than what was offered before, it is just supposed to be faster.  Big deal.

Some suggest that an Offer in Compromise will more likely be accepted owing to the more lenient approach taken by the IRS.  Nope, I don’t think so.  From what I have been able to gather, the only real issue here is in the calculation of equity in a home.  Since home values have been declining in many areas lately, the reviewer of the offer is supposed to be willing to take a second look in order to determine what the actual value of the home is, and take into account any decline in the value of the home.  As I alluded to in my last post, the IRS should be doing this anyway.  If the taxpayer can establish what the value of the home actually is, old IRS records to the contrary should be dismissed.  So again, not really seeing any leniency here.

While I have noticed that some agents in the collection area seem to be more willing to give a taxpayer a break to some extent, I don’t know that I have seen any proof of a widespread directive of leniency.  My response to my clients to their original question has to be that any talk of leniency is more of a feel good marketing gimmick, both by the IRS itself and to some extent my competitors, than any kind of real policy change that will effect the lives of most taxpayers.  Just my opinion.

Offer in Compromise – Part 5 – Equity

In most cases, figuring out the equity of a taxpayer for purposes of calculating an acceptable Offer in Compromise amount isn’t very complicated. 

Some may find it difficult coming up with a fair value of their home, or their automobiles.  For the home, one may start with property tax records, but that often isn’t a reliable source depending how the local government calculates the assessed value.  There are websites that may be helpful in finding a realistic value of your real estate, such as Zillow.com.  For most automobiles, Kelly Blue Book is a good source.  IRS agents also look to these and other sources, so they can be relied on pretty well.   However, the taxpayer is going to know the condition of his or her property better than these websites, so while they may be a good place to start, the taxpayer should adjust the value appropriately if it is believed that the value is more or less than what the sites seem to suggest.  As long as the value can be backed up, which if absolutely necessary, could be done by giving a detailed description of the assets and maybe even pictures, the taxpayer should use what he or she believes to be correct.

As described before, most assets are valued at their “Quick Sale Value.”  The theory is, if the taxpayer we’re selling everything in order to pay off the taxes, and if getting the sale done quickly is more important than getting full value, the proceeds would undoubtedly be less.  So, the IRS discounts the value of most assets by 20%.  So, by way of example, if the taxpayer had a home with a value of $200,000, the Quick Sale Value would be $160,000.  Once that value is determined, the value is then further reduced, not below zero, by any outstanding loan secured by the property.  So, if that same home had an outstanding mortgage of $180,000, the Net Realizable Equity would be $0, since the mortgage is greater than the Quick Sale Value.

The above situation tends to suggest some of the best candidates for the offer in compromise: those who have a little equity that might possibly be borrowed against to fund the offer amount, but not so much that the equity is included in the Offer calculation.  Even if you change the numbers a little, and assume the mortgage is $150,000, it still looks favorable.  The actual equity is $50,000, but the Net Realizable Equity, taking into account the Quick Sale Value, is only $10,000.  Hopefully, in this situation, the taxpayer would be able to borrow enough to fund the offer amount (which would be at least $10,000, but the future income would need to be factored in to determine the full offer amount).

Not all assets will be reduced by 20%.  Obviously cash on hand or the money in bank accounts wouldn’t be reduced.  But pretty much anything that would have to be sold in order to get the cash out would be reduced.

There are also some assets that are, quite frankly, insignificant.  The IRS isn’t going to have the taxpayer add up the value of all of the clothing, furniture, and kitchen gadgets in the house.  Typically, the taxpayer can get by with a guess as to the total value of all of that, which in my experience, never seems to add up to more than a few thousand for most folks, and the IRS exempts the full amount anyway.  So, there is no need to give a detailed, itemized list with the value of such assets, nor is a discount for Quick Sale Value needed.  If the taxpayer owns a $10,000 painting or the like, the IRS is going to want to know about it, but failing that, the IRS doesn’t really care about the assets in the house.

For retirement assets, you can typically get a reduction for the amount of taxes that would have to be paid if the retirement account were cashed out.  So, if there were $10,000 sitting in a 401k, the taxpayer should be able, for purposes of calculating the offer amount, to reduce the value by the taxes that would have to be paid on the distribution the following year, including the 10% penalty that would be incurred.

The Internal Revenue Manual goes into more detail regarding how to account for these and other items of equity.  The more interesting and complicated items include how to calculate the value of income producing property, and how to determine the value of the taxpayer’s ongoing business.  For the income producing property, a rental home for instance, the value could be reduced, or the income could be reduced, depending on what exactly the taxpayer is proposing to do with the property in relation to the funding of the offer.  The valuation of an ongoing business isn’t a problem for most of my clients.  The concern here is that a business that might not be producing enough money for the taxpayer to full pay the taxes owed may nevertheless have a value greater than its assets because of a long history and a good name.  In both cases, the result is going to be very fact specific, so it is hard to give you generalized advice.  But if you take a look at the Manual, you can see what the IRS is looking for regarding these and other equity issues.

Offer in Compromise – Part 4 – Retired Debt

I mentioned retired debt in a previous post, so I figured it must be time to explain it in more detail.  For those that may already have submitted an Offer in Compromise, and you have received a preliminary analysis from the IRS, you will likely notice that the Offer Examiner has calculated an acceptable offer amount that is made up of three components: equity in assets, future income, and retired debt.  For you folks who have seen that and wondered, “what the heck is retired debt?”, this post is for you.

As I said in my previous post on the basics of doing an offer, the offer amount is based on equity in assets and a calculation of future income.  “Retired debt” is basically just another component of the future income calculation.  When the IRS does the analysis of income and expenses, they are looking at the current income and current expenses, and determine a monthly amount that can be paid towards the taxes.  Again, that is the current amount that can be paid, based on the documentation provided to the IRS proving how much income there is and what exactly the allowable expenses are.

However, income and expenses will change over time.  Sometimes we can’t say for sure what the change is going to be.  We would hope the income would go up, but you can’t usually tell how much.  The cost of living generally goes up, too, causing many of the expenses to rise, but again, it is hard to say with any certainty what the increase will be.  So, the IRS doesn’t worry about these kinds of changes.

In other instances though, we can tell the exact amount of an expense that is going to change.  These tend to be the retired debt items.  The most common examples that I come across are car payments that end once the car is paid off, and child support payments that are set to end when a child reaches 18, or some other specified age.  For instance, the Offer Examiner will notice that a car payment of $350 per month is set to end in 36 months.  There are 90 months left before the last tax balance owed expires.  That means for 54 months, there would be another $350 available to pay towards the taxes.  Assuming the current monthly income available is $0 or more, that would mean there is retired debt of $18,900 (If the current monthly income available is less than $0, the retired debt might be less to account for the shortfall).

The way the IRS calculates the acceptable offer amount, they determine how much money could be collected over the time period remaining before the balances expire.  Once they determine that the full amount cannot be collected, they then use a monthly multiplier based on the type of offer that was submitted to determine the future income and the amount of retired debt to be included in the offer amount.  If the taxpayer made a cash offer to be paid within 5 months, the multiplier is 48 months; and if it is a short-term offer to be paid within 24 months, the multiplier is 60 months.  So, using the above example, if the taxpayer made a cash offer, and if $18,900, plus the equity, plus the future income (based on current income and expenses) is not enough to full pay the balance, the acceptable offer amount would equal the equity, plus 48 months of future income, plus $4,200 of retired debt (That’s 48 months, minus the 36 months until the car is paid off, times the payment of $350).  If the taxpayer made a short-term offer, the acceptable amount would be the equity, plus 60 months of future income, plus retired debt of $8,400 (Because there is another year of retired debt added in, that’s 60 months, minus the 36 until the car is paid off, times the $350 payment).

What is frustrating is when you have a situation where the equity is next to nothing, the future income based on the current situation is next to nothing, but the taxes don’t expire for another 8 or 9 years, and a car is going to be paid off in a few years, leaving a retired debt amount that is so high that the taxpayer doesn’t technically qualify for the offer.  Again using the above example, imagine that the equity is only $500, there is $0 monthly income after expenses, and the taxpayer owes $19,000.  It would appear that the taxpayer would qualify for a cash offer of $4,700 ($500 in equity plus $4,200 for the retired debt as calculated above).  That isn’t a bad deal, if the taxpayer could find a way to come up with that amount.  However, the taxpayer doesn’t appear to qualify for the offer because the “reasonable collection potential” (as the IRS calls it) is equal to the $500 in equity plus the retired debt of $18,900 for the remainder of the collection period.  That equals $19,400, and since that is more than the total amount currently owed, the taxpayer doesn’t qualify for an offer in compromise, and the offer would likely be rejected.

That sucks.  So, what can you do about it.  Often, not a whole lot.  If you are close to getting the reasonable collection potential (again, that is the total amount the IRS thinks they can recover over the remaining time period they have left before the balances expire) down to an amount that is less than the total amount owed, even if it is just barely less, you can try to find an additional allowed expense, or prove that one of the allowed expenses is actually a little higher.  In my example above, the taxpayer only needs to reduce the reasonable collection potential by $401 to force the IRS to use the lower multiplier.  If the taxpayer could prove another $10 per month in allowable expenses, he or she may be able to use that to reduce the retired debt calculation just enough to make it a non-issue.

Another option is to point the Offer Examiner towards our friend, the Internal Revenue Manual.  Specifically, section 5.8.5.6 paragraph 4, which says, basically, that the retired debt should not automatically be included and that the Offer Examiner should use his or her judgment in deciding whether to include it.  Unfortunately, their judgment usually seems to be to automatically include the amount.  However, if the numbers are as close as my example above, I would think that this would be a good instance to pull out the Internal Revenue Manual and ask for a break.  The passage mentions that special circumstances should be considered, and if the taxpayer has any (medical issues that could likely cause additional expenses in the future for example), absolutely present those to the IRS.  But even without special circumstances, if it is a close thing, I think this IRM passage may be useful in making an argument to remove the retired debt, at least to the extent that it causes the taxpayer not to qualify for the offer (The taxpayer is probably still stuck coming up with the $4,200 unless those special circumstances are present).  If nothing else, at least the taxpayer has something interesting to talk about on Appeal, if it comes to that.

Financial Analysis: Using IRS Standards

Whether you are trying to do an Offer in Compromise, mailing financial information to the IRS to support an installment agreement proposal, or perhaps providing your expenses over the phone to an IRS agent, you are going to run into the IRS use of standards for some expenses.  So, it may useful to know how those standards are used by the IRS.

For expenses such as food, housekeeping supplies, apparel and related services, personal care products and related services, and miscellaneous, there is a national standard.  Up until a couple of years ago, the amount of the standard varied based on the household income, but now it is the same for all income levels.  As this is a “national” standard, there is also no fluctuation based on where you live.  The amount allowed is based solely on the number of people who live in the household.

This is probably the most convenient standard the IRS uses, since most taxpayers really don’t keep track of what they are spending on all of these items.  The IRS pretty much allows this standard as a matter of course.  That said, they don’t generally allow claims for expenses that are greater than the standard.  However, if the taxpayer can prove that he or she has expenses greater than the standard, can prove that the amount is paid, and that the amount is necessary, the IRS will allow the additional expenses.  For instance, if the taxpayer establishes that he or she has a special diet that costs more than the amount allowed, that would probably work.  Generally though, a taxpayer is just going to use the national standard and that’s that.  It really isn’t worth arguing for additional expenses unless there are exceptional circumstances.

The standards for housing are local standards, and the amount allowed varies by the county the taxpayer lives in.  Taxpayers are allowed more based on the number of people living in the household, although the amount doesn’t get any higher after 5 people.

The standards for transportation are also local.  Mostly.  For those that use public transportation, the standard for that expense is $173, no matter where you live.  The standards for ownership costs, the loan or lease payments, are $489 for one car, another $489 for the second car.  The operating costs vary by region, with some localities getting a larger standard than others.  One taxpayer is only going to get credit for one car, and two can get credit for the second car, but for those with three or more cars, providing transportation for their children or some such, there is going to be a problem with those expenses.  Typically, a taxpayer isn’t going to get credit for both the public transportation standard and operating costs for a vehicle, but if the expenses are actually paid and are considered necessary, it is possible to get credit for both.

No matter where you live, the standard is low.  I’ve never spoken with anyone, including people at the IRS, who think the current standards are realistic.  Gas prices have leveled off somewhat, but when they go up, the standards don’t follow.  In fact, we’re lucky if they update the standards once a year.

Fortunately, while the local standards for housing and transportation are generally used as a cap, expenses in excess of the standards can often be allowed if the taxpayer can prove that the larger expenses are actually being paid.  This is usually easy to do with the housing expenses, as people can usually come up with the rent or mortgage and utility bills.  Not many taxpayers keep all of their gas, maintenance, and insurance expenses for several months handy though.

In both cases though, the amount of the expenses claimed in excess of the standards are typically classified as “conditional” expenses.  These expenses are allowed in calculating the amount the taxpayer can pay on a monthly basis, but only if the amount of the balance owed to the IRS is going to be fully paid within 5 years.  So, for those looking at doing an Offer in Compromise who have a huge mortgage or car payment, you are going to have a problem.

Both standards are used as a cap, which means that if the actual expenses are less, the taxpayer will only get credit for the lesser amount.  As I said before, the transportation expenses are ridiculously low, so this issue never comes up there.  In fact, to avoid the issue altogether, I typically try to claim the standard for the transportation operating expenses and just avoid the argument altogether.  However, I do see the issue come up with taxpayers who don’t spend the full housing allowance.  This doesn’t suggest that those with tax problems who have low housing expenses should go out and spend more, since they typically can’t afford more housing expenses, but it is something that taxpayers should be aware of as they are working through a financial analysis.

The last standard to discuss, and the newest standard that the IRS has come up with, is the out-of-pocket health care standard.  They only came up with this a couple of years ago.  This is also a national standard that doesn’t vary from place to place.  Every taxpayer is allowed $60 for every person in the household under 65 and $144 for every person 65 or older.  The standard is just for the out-of-pocket costs, such as co-pays and prescription drugs.  So, this amount is allowed in addition to any health insurance that the taxpayer can prove he or she pays.

Like the other national standard, this amount is pretty much a gimme.  Basically, the taxpayer isn’t required to prove the amount, so he or she should just claim the full standard that is allowed.  However, unlike the other standards, there is no problem claiming an amount in excess of the standard if the taxpayer can prove that a larger amount is actually paid.  The IRS generally isn’t going to argue about whether or not a taxpayer’s health care costs are necessary or not, as long as we’re not talking about elective cosmetic surgery or the like.  So, as long as the taxpayer has proof of the actual expenses in excess of the standard, it isn’t going to be a problem to get the larger expenses allowed.

Lien vs. Levy

I often get clients who are confused with the IRS terminology, so I thought a brief discussion of these items would be helpful.

A notice of “lien” filing means that the IRS has filed a claim down at your local courthouse in order to give notice to the world that they have a right to your assets (your house, your car, whatever) that is superior to anyone else’s claim, except for those who have already perfected their own claims (such as the bank holding your mortgage or car note).  Having a lien doesn’t mean that the IRS is getting ready to seize your assets, but it does mean that if you try to sell or encumber your assets, their interest in your assets will be protected.

A notice of “levy” means that the IRS is actually trying to seize assets from you.  Typically sent to banks and income sources, these notices of levy require that funds that would otherwise be sent to you instead be sent to the IRS.  In the case of levies sent to your employer, the levy is continuous, and you are allowed a small exempt amount of income, but the rest goes to the IRS, and the levy stays in place until the levy amount is paid or you get the IRS to release the levy.  Bank levies are one-time affairs, and whatever amount that is in the bank when it processes the levy, up to the amount of the levy, will be sent to the IRS 21 days later, unless you can convince the IRS to send a release to the bank.  These levies are not continuous, so in order to get any more money out of the bank, the IRS would need to issue another levy.

So, both levies and lien are bad things, but the levies tend to be the more urgent of the two, as they effect the amount of money you keep out of your paycheck, or they concern an amount of money seized out of your checking account.  But liens can also be nasty.  Certainly if you are looking to sell or refinance your home, they can prove difficult to deal with, but even if you aren’t looking to do something like that, liens are still going to show up on your credit report, and that isn’t something you are going to want either.

Adding to the confusion, some states use different terminology.  You might receive a garnishment on your wages, or a warrant for the taxes owed.  The warrants are particularly scary, as people tend to think that the state is looking to arrest them.  Actually, in some case, they are, but not usually.  If you don’t have someone to help you with your state issues (and you can get help here), then I would suggest that you read the notices very carefully to see if you can figure out what they are, and failing that, call whatever number you see on the notice and someone with the state should be able to tell you exactly what they are proposing to do.

Cancellation of Debt Income

This is really annoying actually.

The theory that a cancellation or discharge of debt could result in income makes some sense.  If a taxpayer uses a credit card and buys $5,000 worth of stuff, doesn’t pay the bill, and eventually the credit card writes-off the debt, the taxpayer has benefited to the tune of $5,000.  He or she might still have the $5,000 worth of stuff that was purchased.  So, we can see how that could be considered income.

Where it is less obvious is when the stuff is taken away.  For instance, the taxpayer buys a car for $15,000, pays the balance down to $10,000 before defaulting on the loan.  The car is repossessed and sold to a third party at auction for $2,000.  The taxpayer is hassled for a while about paying the remaining $8,000, but eventually the lender gives up and the balance is written off.  The lender issues a 1099-C to the IRS, takes a deduction for the bad debt, and hopefully leaves the taxpayer alone at this point.   But now the IRS is saying that the taxpayer has $8,000 of additional income for the year, and they expect to receive the additional taxes.  At a %25 marginal tax rate, that amounts to another $2,000, plus interest and penalties if it wasn’t reported and paid on time.

That doesn’t seem right.  However, most of the time, it doesn’t work out that way.  Many of these cancellation of debt issues arise in conjunction with a bankruptcy, which makes sense.  If the cancellation occurred during a bankruptcy, the resulting income is not taxable.  That seems easy enough, but what if there was no bankruptcy?

If the discharge happened at a time when the taxpayer was insolvent, the income is not taxable.  To determine insolvencey, you look to the assets and liabilities immediately before the time of the discharge.  So, it’s really a matter of coming up with a balance sheet as of the time of the discharge to see if the taxpayer was underwater at the time.

For more on the rules, including how to report this kind of income when you get a 1099-C, check out Publication 4681.

The problem my clients often have is that they didn’t report, and possibly didn’t know about, the cancellation of debt until several years later.  Usually not until the IRS sends them a notice proposing to assess additional taxes.  It isn’t impossible to deal with this, but if your argument is that you were insolvent at the time of the discharge, and the discharge took place three or four years ago, how well are going to be able to reconstruct a balance sheet from back then?

Fortunately, I’ve had pretty good luck working through that issue.  I think the IRS employees who work on these things don’t look at it too hard when the taxpayer claims to be insolvent.  After all, if they weren’t insolvent, why the heck would the lender cancel the debt?

It seems to me that the default position should be to assume that the taxpayer was insolvent, and that the cancellation of income should not be taxable, unless there are some fact to lead the IRS to believe otherwise.  But that is not the case, and there isn’t anything I can do about that.  I suggest everybody write their Congressman and tell them about this rather stupid aspect of income tax law.

In the meantime, I will continue to help out taxpayers who continue to receive these notices purporting to assess thousands of dollars of additional income taxes on them, usually at a time when they are hurting financially, and do what I can to alleviate the unnecessary stress that the IRS is causing by going about it this way.