What Is an Offer in Compromise?
An Offer in Compromise (OIC) is an agreement between a taxpayer and the IRS that settles a tax debt for less than the full amount owed. It's one of the most powerful tax relief options available, but also one of the most misunderstood and difficult to obtain.
The IRS will accept an OIC when they determine that the amount offered represents the most they can expect to collect within a reasonable period of time. In other words, if you can prove that paying your full tax debt would create financial hardship or is simply not possible given your current financial situation, the IRS may agree to accept less.
However, it's important to understand that an OIC is not automatic debt forgiveness. The IRS carefully scrutinizes every application and only approves offers when they believe it's in the government's best interest. In recent years, the IRS has accepted approximately 33% of OIC applications, meaning that proper preparation and presentation are critical to success.
An Offer in Compromise can provide a fresh start for taxpayers who are genuinely unable to pay their full tax liability, but it requires a comprehensive understanding of IRS guidelines and calculation methods.
Who Qualifies for an Offer in Compromise?
Not everyone qualifies for an Offer in Compromise. The IRS has specific eligibility requirements that must be met before they'll even consider your offer:
Basic Qualification Requirements:
First, you must be current with all filing requirements. This means you've filed all tax returns that are legally required. If you have unfiled returns, the IRS will reject your OIC application immediately.
Second, you must be current with estimated tax payments (if you're self-employed) and federal tax deposits (if you have employees). The IRS wants to see that you're compliant with current tax obligations before they'll negotiate past debts.
Third, you cannot be in an open bankruptcy proceeding. The IRS will not consider an OIC while you're in bankruptcy.
Financial Qualification:
Beyond these basic requirements, you must demonstrate that you cannot pay your full tax debt through any other means. The IRS will evaluate your reasonable collection potential (RCP), which includes:
- The equity in your assets (real estate, vehicles, investments, retirement accounts)
- Your future income potential over a specific period
- Your monthly disposable income after allowable expenses
If the IRS determines you have the ability to pay your full debt through an installment agreement or by liquidating assets, they will reject your OIC. This is why many taxpayers who think they qualify for an OIC actually don't—they have sufficient assets or income to pay their debt over time.
It's also worth noting that if you're facing <Link href="/irs-wage-garnishment">IRS wage garnishment</Link> or other collection actions, an OIC can potentially stop these actions, but you must be eligible and submit a properly prepared offer.
How the IRS Calculates Reasonable Collection Potential
Understanding how the IRS calculates your Reasonable Collection Potential (RCP) is crucial to submitting a successful Offer in Compromise. The RCP is the IRS's estimate of what they can realistically collect from you, and your offer must equal or exceed this amount to be accepted.
The RCP Formula:
RCP = Net Realizable Equity in Assets + Future Income
Net Realizable Equity in Assets:
This includes the value of your assets minus any loans or encumbrances, multiplied by an 80% quick sale value. Assets evaluated include:
- Real estate (primary residence and any other property)
- Vehicles
- Bank accounts
- Investments and retirement accounts (with some exceptions)
- Business assets
- Cash value of life insurance
For example, if you own a home worth $300,000 with a $250,000 mortgage, your equity is $50,000. The IRS applies a quick sale value of 80%, resulting in $40,000 of net realizable equity.
Future Income:
The IRS calculates your future income by taking your monthly disposable income (gross income minus allowable living expenses) and multiplying it by either 12 or 24 months, depending on your payment terms:
- If you're offering a lump sum payment within 5 months, they multiply by 12
- If you're proposing a periodic payment over 6-24 months, they multiply by 24
Allowable Living Expenses:
The IRS doesn't let you deduct any expense you want. They use national and local standards for expenses like housing, transportation, food, clothing, and healthcare. Some actual expenses are allowed (like court-ordered payments or secured debt payments), but discretionary expenses are generally not.
This calculation method is why many taxpayers who think they qualify for pennies on the dollar actually don't. The IRS's formula is designed to maximize collection while still being realistic about what you can actually pay.
Three Types of Offers in Compromise
The IRS accepts three different types of Offers in Compromise, each based on different circumstances:
1. Doubt as to Collectibility (DATC)
This is the most common type of OIC and the one most people think of when they hear about settling tax debt. With a DATC offer, you're not disputing that you owe the tax—you're simply demonstrating that you cannot pay the full amount within a reasonable time frame.
The IRS accepts a DATC offer when the amount offered represents the maximum they can expect to collect based on your RCP calculation. This type requires complete financial disclosure, including Form 433-A (for individuals) or Form 433-B (for businesses), along with supporting documentation.
2. Doubt as to Liability (DATL)
A DATL offer is appropriate when you have legitimate doubts about whether you actually owe the tax. This might occur if:
- The IRS made an error in assessing the tax
- You have evidence that disputes the tax liability
- There are questions about whether you're responsible for the debt
DATL offers are much less common than DATC offers and require substantial documentation proving why the liability is incorrect. Similar to <Link href="/irs-penalty-abatement">IRS penalty abatement</Link>, you need concrete evidence to support your position.
3. Effective Tax Administration (ETA)
An ETA offer is the rarest type and applies when you don't dispute the debt and could theoretically pay it, but doing so would create an economic hardship or would be unfair or inequitable due to exceptional circumstances.
Examples might include:
- A serious medical condition that requires expensive ongoing treatment
- Paying the debt would prevent you from meeting basic living expenses
- Other compelling public policy or equity considerations
The IRS sets an extremely high bar for ETA offers, and they're typically only accepted in truly exceptional circumstances. You must demonstrate that collection of the full liability would undermine the purpose of the tax laws or be fundamentally unjust.
The Offer in Compromise Application Process
Applying for an Offer in Compromise is a complex process that requires careful preparation and attention to detail. Here's what you need to know:
Step 1: Verify Eligibility
Before investing time and money in an OIC application, use the IRS's Offer in Compromise Pre-Qualifier Tool on IRS.gov. This will give you a preliminary idea of whether you might qualify.
Step 2: Complete the Required Forms
The OIC application package includes several forms:
- Form 656, Offer in Compromise
- Form 433-A (OIC) for individuals or Form 433-B (OIC) for businesses
- Form 656-L if you're making a DATL offer
- Supporting documentation (bank statements, pay stubs, asset valuations, etc.)
Step 3: Calculate Your Offer Amount
Based on the RCP calculation, determine your offer amount. You need to offer at least your RCP for the IRS to accept. Some taxpayers offer slightly more than the calculated RCP to increase the likelihood of acceptance.
Step 4: Decide on Payment Terms
You have two payment options:
- Lump Sum Cash: Pay 20% of the offer amount with your application, and pay the remainder within 5 months of acceptance
- Periodic Payment: Pay the first installment with your application, and continue monthly payments while the IRS considers your offer
Step 5: Submit Your Application Fee
The application fee is $205, though low-income taxpayers may qualify for a fee waiver.
Step 6: Submit Your Application
Mail your complete application package to the appropriate IRS address based on your state of residence. The address is listed in the Form 656 instructions.
Step 7: Wait for IRS Review
The IRS typically takes 6-12 months to review an OIC application. During this time:
- Collection actions are generally suspended
- The statute of limitations on collection is extended
- You must remain current with all filing and payment requirements
Step 8: Respond to IRS Requests
The IRS will likely request additional documentation or clarification. Respond promptly and completely to avoid rejection.
Step 9: Receive a Decision
The IRS will either accept your offer, reject it, or return it without consideration (if you don't meet basic eligibility requirements). If rejected, you have 30 days to appeal.
Throughout this process, accuracy and honesty are paramount. The IRS will verify all information you provide, and any misrepresentation can result in immediate rejection and potential fraud penalties.
Common Mistakes That Lead to OIC Rejection
Many OIC applications are rejected not because the taxpayer doesn't qualify, but because of avoidable mistakes in the application process. Here are the most common errors:
1. Incomplete or Inaccurate Financial Information
The IRS requires complete transparency about your financial situation. Failing to disclose assets, understating income, or overstating expenses will result in rejection. The IRS has access to your financial records and will verify everything you report.
2. Not Being Current with Filing Requirements
This is the number one reason for OIC rejection. If you have any unfiled returns, the IRS will reject your offer immediately. File all required returns before submitting your OIC.
3. Offering Too Little
Your offer must at least equal your RCP. Many taxpayers submit offers based on what they want to pay rather than what the IRS calculates they can pay. Use the IRS's calculation method to determine your minimum offer amount.
4. Including Non-Allowable Expenses
The IRS uses standardized expense allowances. You can't claim expenses for private school tuition, cable TV, gym memberships, or other discretionary items. Trying to inflate your expenses will hurt your credibility and likely result in rejection.
5. Not Staying Current During Processing
If you fall behind on current tax obligations while your OIC is being processed, the IRS will automatically reject your offer. This includes making estimated tax payments if you're self-employed.
6. Having Significant Available Assets
If you have substantial equity in assets that could be liquidated to pay your debt, the IRS will reject your OIC. This includes significant retirement account balances, valuable collections, or real estate with high equity.
7. Poor Timing
Submitting an OIC while you're experiencing temporary financial hardship may not be strategic. If the IRS believes your financial situation will improve soon, they may reject your offer and wait to collect when your circumstances change.
8. Not Responding to IRS Requests
When the IRS requests additional documentation or clarification, you must respond within the stated timeframe. Failure to respond is treated as a withdrawal of your offer.
Understanding these common pitfalls can significantly improve your chances of acceptance. Consider consulting with a tax professional who specializes in OICs to ensure your application is properly prepared and presents the strongest possible case.
Success Rates and What to Expect
Understanding the reality of OIC success rates can help you set appropriate expectations and decide whether pursuing an OIC is the right strategy for your situation.
Current Success Rates:
According to recent IRS data, approximately 33% of Offer in Compromise applications are accepted. However, this statistic doesn't tell the whole story:
- About 27% of applications are rejected after full review
- Around 24% are returned without consideration due to eligibility issues
- Approximately 16% are withdrawn by the taxpayer
Factors That Increase Your Chances of Success:
- Professional Preparation: OICs prepared by experienced tax professionals have significantly higher acceptance rates than self-prepared offers. A professional understands the IRS's evaluation process and can present your financial situation in the most favorable light while remaining honest.
- Accurate RCP Calculation: Offers that accurately reflect the RCP calculation are more likely to be accepted. Lowball offers are almost always rejected.
- Complete Documentation: Providing all required documentation upfront and responding promptly to IRS requests demonstrates cooperation and increases credibility.
- Legitimate Financial Hardship: Taxpayers with genuine inability to pay (not just unwillingness to pay) are more likely to be accepted.
- Clean Compliance History: Being current with all filing and payment obligations shows good faith and increases acceptance likelihood.
Alternative Options if Your OIC Is Rejected:
If your OIC is rejected, you're not out of options:
- Appeal the Decision: You have 30 days to appeal an OIC rejection to the IRS Office of Appeals
- Installment Agreement: You may qualify for a monthly payment plan that fits your budget
- Currently Not Collectible Status: If you truly cannot pay anything, the IRS may temporarily suspend collection efforts
- Partial Payment Installment Agreement: Make reduced monthly payments that won't fully pay off the debt before the collection statute expires
Timeline Expectations:
The OIC process typically takes 6-12 months from submission to final decision, though complex cases can take longer. During this time, you must:
- Continue making the proposed periodic payments (if applicable)
- Stay current with all filing and payment requirements
- Respond promptly to any IRS requests for information
While an Offer in Compromise can provide significant tax relief, it's not a quick or easy process. Success requires thorough preparation, accurate financial disclosure, and often professional guidance. However, for taxpayers who genuinely cannot pay their full tax liability, an accepted OIC can provide a fresh financial start and resolution of overwhelming tax debt.