Pennies on the dollar? What is true and false about settling back taxes with the IRS

Sometimes, but rarely the way the ads describe

The IRS can settle a tax debt for less than the full amount through an offer in compromise, but it is not a discount program anyone can sign up for. The IRS describes the offer as something that may allow you to settle for less, and says it considers your income, expenses and asset equity, and generally will not accept an offer if you could pay in full through a payment plan or your assets. For most people who owe, a payment plan, penalty relief or a temporary hardship status is the realistic path.

I am an Enrolled Agent and Certified Tax Resolution Specialist, and much of my work on back tax cases starts with undoing expectations set by advertising. People arrive convinced they will pay a fraction of their balance, sometimes after paying a large fee to a company that told them so. The real options are often good ones. They are just not the ones in the ads. I see this with clients across the Dallas area every tax season.

Here are the beliefs I hear most often and what is actually true, based on IRS guidance and my experience. This is general information; talk with a licensed tax professional about your specific case.

Myth: anyone who owes can settle for a fraction

An offer in compromise is based on what the IRS calculates it could collect from you, not on what you would like to pay. Our firm's guide to IRS debt relief options explains that the IRS computes a reasonable collection potential from your income, expenses, assets and equity, and that offers below that figure are rejected. If you have steady income above allowable expenses, or equity in a home, retirement account or business, the IRS may conclude you can pay more than you hoped. That is why two people who owe the same amount can get very different answers: one has little income and few assets, the other has a paid-off house.

The IRS also sets eligibility conditions before it will even consider an offer. It lists filing all required returns, making required estimated tax payments and not being in an open bankruptcy, and it requires employers to be current on federal tax deposits for the current and last two quarters. Every offer requires a $205 application fee and a first payment, unless you meet the low-income qualifications for individuals.

• All required tax returns filed
• Required estimated payments made for the current year
• Not in an open bankruptcy
• Employers current on federal tax deposits
• Application fee and initial payment, unless low-income rules apply

Myth: a company can guarantee you qualify

No one outside the IRS decides whether you qualify. The FTC tells consumers to ignore claims that they qualify for a program, because only the IRS or a state comptroller makes that call, and adds that every taxpayer's situation is unique and no company can promise a particular result. It also warns against anyone who asks for the whole fee upfront.

The warning signs I watch for are consistent: a settlement promised before anyone has reviewed your transcripts and finances, manufactured urgency like a program that is supposedly closing soon, and no named licensed practitioner. If you are interviewing representatives, the questions in my guide on hiring an outsourced bookkeeper apply here too: who does the work, what credential they hold and what exactly the fee covers.

Myth: penalty relief wipes out the whole balance

Penalty relief is real and underused, but it removes penalties, not tax. The IRS first-time abatement policy covers failure-to-file, failure-to-pay and failure-to-deposit penalties for taxpayers with a timely compliance history, generally meaning the same type of return was filed on time for the prior three years without penalties. The IRS says you can request it by calling the number on your notice or in writing, and that interest related to a removed penalty is reduced automatically.

Reasonable cause relief covers situations like serious illness or a disaster that kept you from filing or paying, argued with evidence. In my experience, being too busy or not knowing the deadline rarely succeeds on its own, and requests that lay out a clear timeline with supporting documents do far better than a general explanation. Either way, the underlying tax and the interest on it remain. Penalty relief makes a balance smaller and a payment plan more affordable; it rarely makes the debt disappear.

Myth: if you ignore it long enough, it goes away

There is a limit on how long the IRS has to collect, which our firm's debt relief guide describes as a 10-year collection clock. But waiting it out is not a plan. Our guide also notes that a pending offer pauses that clock, and in the meantime the balance grows with interest and penalties while collection continues. Notices escalate toward liens and levies, and a lien is public and can make credit harder to get.

Ignoring the letters also closes doors. Some protections, such as the right to request a Collection Due Process hearing after a final notice of intent to levy, have short deadlines. Responding early keeps every option open. If a notice is sitting unopened on your desk, opening it and noting the deadline is the most valuable thing you can do today.

Myth: hardship status means the debt is forgiven

If paying anything would leave you unable to cover basic living expenses, the IRS can place an account in currently not collectible status. Our debt relief guide explains that levies and active collection stop while the hardship lasts, but the debt is not forgiven: penalties and interest keep accruing, refunds may be applied to the balance, and the IRS reviews the status when finances improve.

That status can be the right answer for someone whose income has collapsed, and it buys real breathing room. It is not a settlement, and it should be paired with a plan for what happens when circumstances change. When I recommend it, I also put a reminder on the calendar to revisit the client's finances, because the IRS will.

What an offer in compromise actually involves

If an offer does fit, it is a serious financial disclosure, not a phone call. You submit a detailed statement of income, expenses and assets along with the offer. The IRS offers a pre-qualifier tool on its website so you can check eligibility and prepare a preliminary offer before you apply. The financial statement has to be complete and documented, because an offer built on figures the IRS can disprove is likely to fail and can damage your credibility for whatever option comes next.

While the offer is under review, the IRS says it suspends most collection activity, extends the collection period and may file a notice of federal tax lien, and you must keep making any required offer payments. If the offer is rejected, the IRS applies payments to your balance and does not return the application fee. The IRS also states that an offer it does not accept or reject within two years is automatically accepted, not counting time spent on appeal.

• Check eligibility with the IRS pre-qualifier tool
• File every missing return and get current on this year's taxes
• Prepare a complete financial statement with documentation
• Submit the offer, the fee and the first payment, unless low-income rules apply
• Keep filing, paying and making offer payments while it is reviewed

Where most back tax cases actually end up

In my experience, most cases resolve through some combination of filing missing returns, requesting penalty relief where the facts support it, and setting up a payment plan the client can actually keep. Many individuals can set up that plan themselves; I explain who can and who should get help in setting up an IRS payment plan yourself. None of these is glamorous, and none fits in a radio ad. But they are predictable, they stop the balance from growing faster than you can pay it, and they end with the account closed rather than with another round of notices next year.

The first step is almost always the same: find out exactly what is owed and for which years by pulling IRS transcripts, then deal with any unfiled returns, because the IRS generally will not approve a payment plan or consider an offer while returns are missing. For a business owner, that often means rebuilding the books first. My guide on catching up books that are months behind explains how that work is organized.

• Pull transcripts to confirm the real balance by year
• File missing returns from accurate records
• Request penalty relief where it applies
• Choose the option that fits: full pay, payment plan, offer or hardship status
• Stay current on future filings and payments

Getting an honest read on your options

A free consultation is a good place to start if you are unsure whether an offer is realistic. Bring your notices and a list of which years were filed. I will tell you plainly which options look possible and which do not, and if you can handle the next step yourself, I will say so.

If you would like us to represent you, the fee is set in writing before work begins, and the case stays in-house with an Enrolled Agent rather than going to a call center. We serve clients from offices in Plano, Garland and Flower Mound, across Dallas–Fort Worth and remotely, and we have handled back tax cases for individuals and small businesses since 2005.

Questions people ask me