How to settle a tax bill with the IRS for pennies on the dollar using an offer in compromise.

It is sometimes possible to wipe your tax slate clean at an enormous discount. If you qualify for something known as the offer in compromise, referred to as an "offer" or "OIC," the IRS has been known to accept as little as 1% of the amount owed on a tax bill and call it even.

There is no legal right to have a valid tax bill reduced by the IRS -- it is entirely a matter of government discretion. In all but a few instances, however, the IRS must at least give a properly submitted OIC fair consideration. Unfortunately, fewer than half the OICs submitted are accepted by the IRS, although you do have the right to take a rejected OIC to the IRS Appeals Office.

OIC Process

Submitting an offer to the IRS is a formal process -- you can't simply call the IRS and say "Let's make a deal." You start by completing IRS Form 656, Offer in Compromise .

There is a $150 application fee for filing an OIC, which you must attach to Form 656. You might be exempt from the fee if your monthly income is below the poverty guidelines. If you claim the poverty guideline exemption, you must submit an Application Fee Worksheet from the Form 656 booklet.

In addition to Form 656, you must submit a Collection Information Statement, or Form 433-A. If you are married and live in a community property state, the IRS may request that your Collection Information Statement include data on your spouse -- even if you alone owe the IRS. Take particular care in filling in this form correctly if you are serious about your OIC. The IRS scrutinizes the disclosures you make in this form much more closely when considering an OIC than when you request to pay your taxes with an installment agreement.

Downside to Submitting an OIC

Completing the forms is just the beginning. After you submit the forms, the IRS will ask you for rafts of financial documentation -- pay stubs, bank records, vehicle registrations, and myriad other items. This is an exhaustive, time-consuming process. Some taxpayers wind up submitting boxloads of documents to the IRS to support their OIC request.

There's another drawback to submitting an OIC. If your OIC is rejected, the disclosures you made about your assets give the IRS all the information it needs to accelerate its collection efforts against you. For this reason, it makes sense not to submit an offer unless it is likely to be accepted.

In addition, remember that interest keeps accruing during the offer in compromise negotiation process, meaning you'll end up owing more than ever if you don't eventually make a deal.

Do You Qualify for OIC Consideration?

Merely wanting to make a deal with the IRS is not enough -- everyone would like to have his tax bill reduced. To qualify for OIC consideration, you must show the IRS that one of the following conditions exists:

• There is some doubt as to whether the IRS can collect the tax bill from you -- now or in the foreseeable future. The IRS calls this "doubt as to collectibility."
• There is some doubt as to whether you owe the tax bill. The IRS calls this "doubt as to liability." This condition is unusual.
• Due to exceptional circumstances, payment of your full tax bill would cause an "economic hardship" or would be "unfair" or "inequitable."

How Much Should You Offer?

According to the IRS, the amount of an OIC must be equal to the "realizable value" of your assets plus the amount of money the IRS could take from your future income. For example, if your assets are worth $17,200 and the amount of your future income that's available to the IRS is $14,800, your minimum offer must be $32,000. For information on calculating the realizable value of your assets and your available future income (which varies depending on whether you offer the IRS payment immediately or over two to five years), see Nolo's Stand Up to the IRS, by attorney Frederick W. Daily.

If the IRS accepts your offer and you will make payments over two years or longer, the IRS may record a Notice of Federal Tax Lien showing your tax debt, if it hasn't already done so. The lien will stay on your records until every last penny has been paid or the statute of limitations for collection has expired, whichever occurs first.

Special Circumstances

What if you determine the offer amount required by calculating the realizable value of your assets and your available future income, and the result is well beyond your ability to pay? Consider making an offer anyway (assuming you aren't worried about the IRS grabbing any assets you didn't reveal). IRS personnel have some leeway to accept less money than is required under strict application of the rules.

The IRS gives special consideration to people with physical or psychological infirmities. In particular, the IRS has always favored offers from people with bleak financial prospects due to advanced age -- over 60 in particular. And the IRS will consider HIV or drug- or alcohol-related problems, as well as a family member's problem if it has a detrimental financial effect on you.