Household Expense Rules for IRS Offers in Compromise

The IRS has broad discretion to settle unpaid taxes. It can compromise taxes for any amount and for any reason–even for no reason.

Absent the IRS dropping the ball, the IRS set up a very specific process and rules that it applies in deciding to compromise tax debts. This is the IRS’s offer in compromise (“OIC”) program. The rules look to the taxpayer’s income and expenses, plus his or her assets. The IRS’s rules are nuanced, but they leave a lot of unanswered questions.

For example, what counts as an expense? There are standards. But what if the taxpayer is cohabitating with someone who does not owe back taxes, like a girlfriend? Can the IRS count the girlfriend’s income or expenses in deciding whether or not to settle the taxpayer’s unpaid taxes?

The court recently addressed this very question in Winters v. Commissioner, T.C. Memo. 2012-183.

Facts & Procedural History

The taxpayer owed back taxes. When the IRS filed a notice of federal tax lien, the taxpayer submitted a collection due process hearing request. As part of the collection due process hearing, the taxpayer proposed to settle his taxes by way of an offer in compromise.

The IRS requested proof of household income, including proof of his live-in girlfriend’s income. The IRS noted that her income must be counted in computing the taxpayer’s allowable expenses.

The taxpayer contended submitting his girlfriend’s financial data violated her privacy rights. After he refused and failed to provide the information, the IRS rejected the taxpayer’s OIC. The rejection was based on insufficient documentation. The taxpayer filed a petition in the U.S. Tax Court to contest the IRS’s determination.

IRS Collection Standards & Rules

The IRS uses Collection Financial Standards to assess a taxpayer’s ability to pay overdue tax liabilities based on allowable living expenses. This is often referred to as the taxpayer’s reasonable collection potential. These expenses are considered necessary if they contribute to the health and welfare of the taxpayer and their family or income generation.

1. National Standards for Food, Clothing, and Other Items: These standards are uniform across the United States and cover expenses for food, housekeeping supplies, apparel, personal care products, and miscellaneous items. Taxpayers are allowed the total National Standards amount monthly for their family size, regardless of their actual spending.
2. National Standards for Out-of-Pocket Health Care Expenses: These standards account for out-of-pocket health care costs, including medical services, prescription drugs, and medical supplies. The amount is determined on a per-person basis for taxpayers and dependents under 65 and those 65 and older.
3. Local Standards for Housing and Utilities: The Local Standards vary by location and are based on data from the U.S. Census Bureau and other sources. They include expenses related to housing and utilities such as rent or mortgage, property taxes, insurance, and more. Taxpayers are generally allowed the amount actually spent or the local standard, whichever is lower.
4. Local Standards for Transportation: Transportation standards are composed of ownership costs (such as car loans or leases) and operating costs (including maintenance, fuel, insurance, etc.). Ownership costs are based on nationwide figures, while operating costs vary by Census Region and Metropolitan Statistical Area (MSA). Public transportation expenses are also allowed, and taxpayers can claim either actual expenses or the standard amount, whichever is less.

In some cases, taxpayers may qualify for the six-year rule, which allows for the payment of living expenses that exceed the Collection Financial Standards and other expenses like minimum payments on loans or credit cards. This rule applies if the tax liability, including penalties and interest, can be fully paid within six years.

A Closer Look at Household Expenses

As noted above, the IRS applies local standards for household expenses. This includes housing and utilities.

Housing and utilities standards include mortgage or rent, property taxes, interest, insurance, maintenance, repairs, gas, electric, water, heating oil, garbage collection, residential telephone service, cell phone service, cable television, and Internet service. 

The taxpayer is allowed the standard amount, or the amount actually spent on housing and utilities, whichever is less. If the amount claimed is more than the total allowed by the housing and utilities standards, the taxpayer must provide documentation to substantiate those expenses are necessary living expenses.

Household Expenses for Shared Households

That brings us back to this case. For taxpayers with shared households, the IRS prorates expenses based on the liable party’s proportional income contribution. However, it’s unclear why this proportional approach applied since Winters and his girlfriend weren’t married.

Critically reviewing the facts, the IRS’s expense analysis seems questionable:

• Winters wasn’t legally responsible for his girlfriend’s support or entitled to her income, so her income should be excluded.
• Prorating expenses based on income reduces allowances below the IRS’s own standards.
• The IRS can only use actual expenses if its standards are inadequate for basic living costs. But Winters’ documented expenses met the standards.
• Nothing indicated Winters failed to minimize expenses or lived lavishly compared to his income.

Unfortunately, Winters failed to raise these arguments in his appeal. However, the case raises potential issues around inconsistent IRS application of its own household expense rules.

The Takeaway

This case illustrates why taxpayers should understand IRS collection processes and advocate forcefully for themselves in appeals. Arguments must be raised for the court to consider them.

With thorough documentation and reasoning applying the IRS’s own rules, Winters may have succeeded in getting his living expenses adjusted upward. Taxpayers facing collections should consult experienced advisors to navigate the complexities. Otherwise, legitimate positions may be overlooked.