This is a two-part piece. The second piece will be featured in the March TaxStringer.  

During the early days of the COVID-19 pandemic, the IRS halted collection activities. Enforcement activities such as levies on bank accounts and wages as well as federal lien filings had paused. However, as we enter the 2022 filing season, the IRS is now fully back in action. Based on the recent passage of the Inflation Reduction Act, from which the federal government will be funding the IRS with an additional $80 billion over the next 10 years, there are many questions among tax professionals and taxpayers alike regarding how the additional funding will be spent and how the increased budget will affect collection enforcement activities.

This article provides an overview of the IRS collection process and an understanding of the various tools and procedures that can be used to resolve a taxpayer’s liabilities in the least costly or disruptive way possible.

I. The Assessment

The IRS cannot collect on a tax liability unless the tax is officially assessed. Federal income tax debts can arise from a tax self-assessed on a tax return, an IRS audit adjustment, or even a substitute return, which the IRS normally prepares when a taxpayer fails to file a return. The assessment can be for one’s personal activities, activities stemming from a corporation or limited liability company for which one is a responsible party, or simply from personal liability as in the case of a partner in a partnership.

Depending on the nature of the assessment, a taxpayer may be aware that the assessment is coming long before he or she receives a bill or may be shocked to first learn of a liability upon receipt of an unexpected bill and demand for payment. Often, the first notice a taxpayer’s representative has of a taxpayer’s liability is a letter threatening to institute an enforced collection measure requiring immediate action to forestall damage that may be irreparable.

II. Overview of the Collection Process

After a taxpayer files a tax return with a balance due or a final decision is made by the IRS establishing that additional tax is due (such as a notice of deficiency), the IRS will notify the taxpayer of the balance due. Generally, the IRS will first send an initial bill for the amount due including any applicable penalties and interest, referred to as a Notice of Unpaid Taxes (Notice CP14). If no response is received, the IRS will then typically send the taxpayer a Reminder of Unpaid Taxes (Notice CP 501) and, if necessary, a Second Reminder of Unpaid Taxes (Notice CP 503). If the taxpayer does not contact the IRS regarding any of these bills, the IRS will typically issue a Final Notice – Notice of Intent to Levy (CP 504). The Final Notice is the taxpayer’s last chance to contact the IRS before it either files a federal tax lien or initiates levy action against the taxpayer.

If the Final Notice is not responded to, the IRS may file a federal tax lien in the county or counties in which the taxpayer owns property and send the taxpayer a Notice of a Federal Lien Filing and Your Right to a Hearing Under IRC § 6320 (Letter 3172). Alternatively, the IRS could send a Final Notice – Notice of Intent to Levy and Notice of Your Rights to a Hearing (Letter 1058). In most cases, the IRS cannot take enforcement action to seize property and rights to property (including bank accounts, wages, and real and personal property) until it provides a Collection Due Process (CDP) notice to the taxpayer, advising the taxpayer of his or her right to an Appeals Hearing to explore collection alternatives to the proposed levy or seizure (the “CDP Hearing”). Both Letters 3172 and 1058, among other notices, give rise to a taxpayer’s right to request a CDP Hearing.

The CDP procedures provide taxpayers with notice, hearing, and review procedures for forced collection action by the IRS. When the IRS pursues collection action by either lien or levy, IRC §§ 6320 and 6330 grant taxpayers the right to a CDP Hearing with an impartial appeals officer and generally requires the IRS to give the taxpayer notice of the right to a hearing. However, the IRS is not required to provide notice of the right to a CDP Hearing: (1) if a determination has been made that the collection of tax is in jeopardy, (2) before issuing state refund levies, and (3) for certain employment tax levies and federal contractor levies.

In addition to the Letters 3172 and 1058, a CDP notice is also required when the IRS sends the taxpayer a:

• Notice of Jeopardy Levy and Right of Appeal;
• Notice of Levy on Your State Tax Refund — Notice of Your Right to a Hearing; or
• Notice of Levy and Notice of Your Right to a Hearing.

III. The Collection Due Process Hearing

As mentioned above, a taxpayer has a statutory right to request a CDP Hearing after, among other things, either a federal tax lien is filed or if the IRS intends to levy a taxpayer’s property to satisfy a tax debt. A taxpayer must request a CDP Hearing within 30 days of receiving a CDP notice, such as a Letter 3172 or 1058.

In theory, the CDP Hearing request allows a taxpayer to obtain an impartial review by the IRS’ Independent Office of Appeals of the proposed collection action. In practice, however, the CDP notice is often attached to a collection letter early in the collection process and before the taxpayer knows whether he or she will be able to reach an agreement with the IRS.

A CDP Hearing is to be conducted by an impartial appeals officer in the IRS’ Independent Office of Appeals. After the CDP Hearing is conducted a determination is issued, which can be appealed to the United States Tax Court. IRC § 6330(d). Relief from the Tax Court in a collection matter requires the taxpayer to establish that the IRS’ appeals officer abused its discretion. The abuse of discretion appeals standard is a very high bar, and it is difficult for a taxpayer to meet. If a taxpayer does not request a CDP Hearing within 30 days of receiving the Letter 3172 or 1058, the taxpayer can request an Equivalent Hearing, but the resulting determination cannot be appealed to the U.S. Tax Court.

The CDP Hearing request is made on Form 12153, Request for a Collection Due Process Hearing, or a written statement containing similar information. Except in extraordinary circumstances, collection action on the levy is suspended while the CDP Hearing request is pending and for 90-days after a final determination in the hearing is issued. However, if the taxpayer’s request is based on a frivolous position or is made to delay or impede collection, no stay will be instituted and the request for the CDP Hearing will be treated as if it had not been submitted. There will also be no stay if one of the IRC§ 6330(f) exceptions (for jeopardy situations, state income tax levies, federal contractor levies, or disqualified employment tax levies) apply.

If the matter can be resolved by negotiation between the time for making the CDP Hearing request and the scheduled CDP Hearing, the request can be withdrawn. If the request is not withdrawn, the hearing before an impartial appeals officer can take place in a face-to-face meeting, by telephone, or even by written communications (if the taxpayer consents).

A CDP Hearing, or Equivalent Hearing, provides a taxpayer the opportunity to contest the appropriateness of the forced collection action (i.e., lien filing, levy), raise spousal defenses, and offer collection alternatives, including Offers-in-Compromise, Installment Agreements, to be placed in Currently Not Collectible Status, as discussed below See IRC § 6330(c)(2)(A)]. Additionally, a taxpayer may also challenge the underlying tax liability if they did not otherwise have a prior opportunity to do so. See IRC § 6330(c)(2)(B).

In instances where neither a CDP Hearing nor an Equivalent Hearing is available, a taxpayer can seek relief through the Collection Appeals Program (CAP), as discussed below.

a. Spousal Defenses

Although married taxpayers filing a joint return are usually jointly and severally liable for the taxes due on that return, “innocent spouse relief” may be available to the client. Innocent spouse relief is requested by filing Form 8857, Request for Innocent Spouse Relief, or a similar statement. Innocent spouse relief under IRC § 6015(b) or separate liability relief under IRC § 6015(c) must be requested no later than two years after the IRS has begun collection activities. Further, equitable relief under IRC § 6015(f) must be requested within the 10-year period on collections in IRC § 6502 or within the period of limitations on credits or refunds under IRC § 6511.

b. Collection Appeals Program (CAP)

CAP may be useful in instances where the CDP or Equivalent Hearing procedures are not available. The CAP allows a taxpayer faced with a notice of lien, levy, seizure, or denial or termination of an installment agreement to challenge any procedural errors in the collection activity before the proposed collection action is taken.

A CAP hearing must be requested in writing. The IRS prefers that the request be submitted on Form 9423, Collection Appeal Request. The request must explain which of the IRS’ actions the taxpayer disagrees with and the reason for the disagreement. The taxpayer must also offer a solution to his or her tax problem.

Any decision issued by an appeals officer as a result of a CAP is binding on both the taxpayer and the IRS unless there is fraud, malfeasance, concealment, misrepresentation of material fact, an important mistake in mathematical calculation, or other circumstances that indicate that the failure to reopen the CAP decision would be a serious administrative omission.

A CAP appeal is limited to either sustaining the proposed collection action or otherwise directing the IRS to take the appropriate corrective action to modify or abate the collection action. CAP is an expedited process, but as mentioned above the determination is binding on the IRS and the taxpayer and further judicial review is not available to the taxpayer in the event of an adverse determination.

IV. Collection Alternatives

As part of or independently of a CDP Hearing, a taxpayer has numerous options to discharge a federal tax liability. These include entering into an installment agreement with the IRS, making an Offer-in-Compromise (OIC) for the liability, or having the account put into currently not collectible status (“CNC Status”) if the taxpayer cannot pay the liability; these are often referred to as “collection alternatives.” Of course, as further discussed below, there are several considerations that should be made before any of these alternatives are requested.

Generally, but with some exceptions, a collection alternative will not be accepted unless a taxpayer can demonstrate their inability to immediately pay the federal tax debt. As discussed below, major exceptions to this rule apply to guaranteed or streamlined installment agreements, and OICs submitted on the basis of doubt as to liability or equity offers. The IRS uses an objective approach to determine a taxpayer’s ability to pay, referred to as the taxpayer’s Reasonable Collection Potential (RCP). In most instances, a taxpayer seeking a collection alternative must demonstrate their inability to pay to the IRS by submitting information about the taxpayer’s income, assets, and liabilities. When this information is required, the taxpayer typically submits this information on Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, for individual taxpayers, including the self-employed, or on a Form 433-B, Collection Information Statement for Businesses, for business entities. Similar documents, Form 433-A(OIC) and Form 433-B(OIC), along with Form 656, Offer in Compromise, are submitted in the case of an OIC. All of these documents are signed under the penalty of perjury, and a false statement on the form can result in a criminal prosecution. For example, in a recent case, a taxpayer was indicted under IRC § 7206(1) for submitting a false Form 433-A, stating that he had not transferred any assets for less than full value in the last 10 years; however, he had transferred stock to his sons and to one of his affiliated companies for less than fair market value. Every participant who is knowingly involved in filing a false statement is liable for that falsehood.

Forms 433 require taxpayers to list all of their assets (e.g., cash, financial accounts, pension or retirement accounts, life insurance with cash values, real property) as well as monthly income and expenses, including taxes due on income. It is important for taxpayers to accurately list the value of their assets to ensure that their RCP is not incorrectly inflated. Taxpayers often overstate the value of assets on the Forms 433, due to either lack of attention or lack of understanding; they can also simply be overly optimistic. Furthermore, when applying for an OIC, the IRS assesses the equity in a taxpayer’s residential real property based on 80% of the property’s actual value minus any mortgage or other encumbrances on the property, which accounts for the approximate quick sale value. The quick sale value is generally 20%–25% lower than the regular market value and can therefore wipe out a significant amount of home equity.

For the living expense analysis, the IRS allows taxpayers to claim necessary living expenses, which are expenses necessary to provide for the taxpayer and his or her family’s health and welfare and/or production of income. The Forms 433 break down the expenses into categories such as food and clothing, housing and utilities, healthcare, out-of-pocket health expenses, and transportation. Taxpayers may also claim additional expenses that are necessary. For example, although private school tuition is typically not allowed as an expense, tuition for private schooling required by a child’s medical or emotional problem might be.

The IRS uses the national standards to establish minimum allowances for food and clothing based on the taxpayer’s family size, which taxpayers can use without further proof. National standards are also used to determine the minimum allowance a taxpayer can claim for out-of-pocket healthcare expenses, which can be claimed without substantiating how much is actually spent. However, with regard to housing and utilities, the IRS uses local standards, which provide an allowable expense by county. For all categories, higher costs can be claimed but must be documented along with justification for them. Notably, the IRS increased the national and local standards in April 2022, to help taxpayer cope with the rising cost of living due to recent inflation.

The IRS will then calculate the taxpayer’s RCP from the data it receives on the Forms 433. Every collection alternative is based upon the information in the Forms 433 and the RCP derived from them.

A. Currently Not Collectible Status

One type of collection alternative that a taxpayer can request is to be placed in currently not collectible status (CNC Status). A debt is not currently collectible when it would create an economic hardship for the taxpayer. Hardship exists if a taxpayer is unable to pay reasonable basic living expenses, based on the amounts indicated on the Form 433-A.

When the tax debt is determined to be uncollectible, the IRS ceases all collection activity and puts the account into CNC Status. The statute of limitations on collections is not extended by placing the debt in uncollectible status, although interest and penalties will continue to accrue. The IRS is required to release, as soon as practicable, any levy on salary or wages when a taxpayer is placed in CNC Status. CNC Status is generally reviewed for changes every two years.

B. Installment agreements

Another collection alternative is an installment agreement. There are several different types of installment agreements a taxpayer can request based on the amount of their tax debt and past compliance history. In addition to traditional installment agreements, various specialized types of installment agreements may be available, including guaranteed agreements, streamlined installment agreements, express installment agreements, and an extension of time for payment of tax due to undue hardship.

The maximum length of an installment agreement is typically the shorter of 72 months or the time left until the Collection Statute Expiration Date (CSED). However, even if a taxpayer enters into an installment agreement with the IRS, penalties and interest will continue to accrue on the unpaid liabilities over the term of the agreement. Additionally, an installment agreement will not prevent a lien from being filed; however, levies are restricted while an installment agreement is in place.

To enter into an installment agreement, the taxpayer must have filed all returns previously due. Further, once an installment agreement is set up, the taxpayer must stay compliant with all his or her tax obligations and timely file all of his or her income tax returns. If the tax-debtor is self-employed, he or she must remain timely with quarterly estimated tax payments. If the taxpayer has a business with employees, he or she must have timely filed at least the last two quarterly returns for the business and be current on the payroll tax deposits to get an installment agreement.

If the tax liability is $25,000 or less, the IRS does not require a financial statement to be filed. If the tax liability is between $25,000 and $50,000, the taxpayer needs to file only a simplified financial statement, Form 433-F, Collection Information Statement. If the tax liability is over $

As further discussed below, if the IRS rejects a taxpayer’s request for an installment agreement, the taxpayer can appeal such determination to the IRS’ Independent Office of Appeals or to the Tax Court depending on the context in which the taxpayer requested the installment agreement.

Furthermore, under Treasury Regulation Sec. 301.6159-1(e), installment agreements cannot be altered, modified, or terminated after they are approved unless:

• The information provided by the taxpayer to the IRS was inaccurate
• The IRS determines the collection of tax is in jeopardy
• The taxpayer fails to timely pay an installment, pay any other federal tax liability when the liability becomes due, or fails to provide a financial condition updated requested by the IRS; or
• The IRS determines that the taxpayer’s financial condition has significantly changed.
  

If the IRS intends to terminate or modify an installment agreement, it must send a Notice of Termination at least 30 days before. A taxpayer may appeal the modification or termination of an installment agreement to IRS Appeals before the expiration of the 30-day period beginning on the day after the modification or termination is to take effect.

i. Guaranteed agreements

Guaranteed agreements are installment agreements that the IRS is required to enter into and does not have the discretion to refuse. These are available when the taxpayer owes $10,000 or less (exclusive of penalties and interest); has not within the last five years failed to file any income tax returns, failed to pay any income taxes, or entered into an installment agreement; agrees to fully pay the liability within three years; and agrees to file and pay all tax returns during the term of the agreement.

ii. Streamlined installment agreements

Streamlined installment agreements are available for liabilities that are $50,000 or less, when the taxpayer can fully pay the outstanding tax debt by the earlier of 72 months or the time left on the collection statute of limitations.

iii. In-Business Trust Fund Express installment agreements

In-Business Trust Fund Express installment agreements are available for businesses with employees with payroll tax liabilities that are $25,000 or less. The debt must be paid within 24 months or before the CSED, whichever is earlier.

iv. Extension of time for payment of tax due to undue hardship

In extraordinary circumstances, a taxpayer can obtain up to a 30-month extension of time to pay liabilities that would otherwise cause undue hardship. The application is made using Form 1127, Application for Extension of Time for Payment of Tax Due to Undue Hardship. Liabilities that may be extended include those that arise from income taxes, self-employment income taxes, or gift taxes.

Erika Colangelo, JD, is a tax associate in Polsinelli's Tax Group. Erika represents individuals and businesses in all stages of dispute and controversy with the IRS, New York State Department of Taxation Finance, New York State Department of Labor, and New York City Department of Finance, including in audits, collection matters, administrative appeals and tax litigation in courts and tribunals such as the United States Tax Court and the New York State Division of Tax Appeals.