IRS collections – Federal Tax Liens

Kunal Patel


IRS collections – Federal Tax Liens

Anyone who has been in trouble with IRS tax debt probably has some experience with a federal tax lien. Learn about what an IRS tax lien is, how it’s filed, and what you can do to get it released.

How a Federal Tax Lien is Created

After the IRS makes a tax assessment (when you file your return, through an audit adjustment, or an amended return filing), the IRS is required to give notice and demand for payment within 60 days. If the taxpayer fails to pay, a tax lien arises and attaches to all property owned on or after the date of the tax assessment. A lien continues until the underlying tax liability is satisfied. If it is not, then the lien will exist for the entire 10-year collections statute of limitations period.

A lien is only an encumbrance – it does not result in an actual transfer of property. For an actual transfer of property, the IRS must levy upon the property. Levies can either be directed to the taxpayer to seize tangible real and personal property belonging to the taxpayer, or it can be served on third parties such as banks and employers to levy bank deposits and wages. In FY2015, IRS levies on third parties totaled 1,464,026.

What Property is Subject to an IRS Tax Lien?

The general rule is that a federal tax lien attaches to all property and rights to property, both real and personal that belong to the taxpayer under IRC § 6321.

  • Real Property. This includes primary residences, secondary residences, land, and rental properties. The homestead exemption does not apply to a federal tax lien.
  • Personal Property. Personal property can include money, goods, tangibles (e.g. jewelry, cars, tools), and intangible property. Additional personal property subject to a federal tax lien includes bank accounts, insurance proceeds, retirement plans, pension plans, trusts, licenses, and franchises.

Note: For married couples in Texas, a community property state, there are a number of factors that may determine which property is subject to a tax lien, such as 1.) whether the debt was incurred prior to or after marriage, 2.) whether the couple have separate property, and 3.) whether the filing status is married filing jointly or separately.

Filing of a Federal Tax Lien

While is not necessary for a federal tax lien to be filed or recorded to be valid against the taxpayer, the IRS often does file a Notice of Federal Tax Lien with the County Clerk in order to have priority over other creditors.

Procedures for filing: For real property, the lien is filed in the county where the property is located. And for personal property, the lien would be filed in the county where the taxpayer resides.

Procedures for notifying taxpayers: IRC § 6320 requires the IRS to notify taxpayers in writing at their last known address within 5 business days of the filing of a Notice of Federal Tax Lien. While it is required to be sent via certified mail, there is no requirement that the taxpayer must sign or physically accept the delivery to be valid notice.

Relief from a Federal Tax Lien

Every lien that is filed will eventually be released, either after payment, by entering into a payment plan, or expiration of the 10-year collections statute of limitations. For those concerned about their credit scores, a lien release is not enough. A released lien will remain on the taxpayer’s credit history for 7 years after it is released. Combined with the 10 year statute of limitations, that’s 17 years that a lien can affect your credit history!

Fortunately, pursuant to IRC § 6323(j)(1)(D) and clarified in an IRS Office of Chief Counsel memorandum (PTMA 2009-158), the IRS may withdraw a federal tax lien after it has been released. This is not automatic – the IRS must be petitioned to withdraw the lien by the taxpayer. If the IRS accepts, then credit reporting agencies will receive a notice of withdrawal of a Notice of Federal Tax Lien, thereby which they are required to delete any references to the tax lien in the taxpayer’s credit history. It’s essentially as if the lien never existed. Additionally, IRC  § 6323(j)(1)(B) allows the IRS to withdraw a lien when the taxpayer enters into an installment agreement and meets certain requirements.


Often taxpayers with outstanding tax debt are not even aware that the IRS has filed a lien against their property. If you’ve moved or used a PO Box address on your tax return, you may have never received the notice. Regardless of whether you’re aware of the lien filing or not, a federal tax lien can lower your credit score by an average of 100 points and make it impossible to buy or sell a home, get a loan, or finance a car. Additionally, you may face scrutiny during a job application process when the employer conducts a background check and discovers the lien. It can be embarrassing to have a federal tax lien in public records for anyone to access and view.

If you’re dealing with an IRS tax lien, you should know that you do have rights and ways to get relief.

Guide to IRS Penalties

Kunal Patel


Guide to IRS Penalties

There are many different types of penalties that the IRS can impose on individual and business taxpayers. Here are some of the more common IRS penalties.

Failure to File and Failure to Pay Penalty

Legal Authority

Legal authority for the IRS to assess penalties for failure to file and/or pay are provided by:

  1. IRC 6651 – provides for additions to tax for failure to file returns required to be filed to report tax, and for failure to pay tax required to be reported on those returns
  2. IRC 6698 provides for a penalty for failure to file a complete partnership return as required under IRC 6031.
  3. IRC 6699 provides for a penalty for failure to file a S-corporation return as required by IRC 6037.
  4. The penalty for failure to make required payments under IRC 7519(f)(4)(A),

Postmarked Date Rule

Under IRC 7502, any return or payment received after its due date is treated as filed or paid on the postmark date. IRC 7502 also applies to electronic postmarks for e-filed returns. When the due date for filing or paying falls on a weekend or legal holiday, the return or payment is considered to have been filed or made on the dude date if it is mailed in the next succeeding date that is not a weekend or legal holiday.

When the IRS Service Center receives a return, the tax technician should date stamp the return and check the postmark date of the return before applying the stamp. If the postmark date is after the return filing date, then the envelope will be retained as evidence of late filing. If the postmark date is before the filing date, then the tax return due date will be stamped on the return.

I have personally seen mistakes occur. For example, a client had submitted a claim for refund that was postmarked a day or two prior to the date of the refund statute of limitations. The IRS received it a few days after this date and accidentally used the receipt date instead of the postmark date and denied the claim for refund. This is another reason to always send any documents to the IRS via certified mail return receipt, or through a carrier that offers tracking.

Also, the tax return must be signed! If the IRS receives an unsigned return, they will not use the postmark date of that return and will not consider it as filed. I’ve seen a case where the client (prior to coming to us) mailed his return on time but forgot to sign the tax return and wasn’t notified by the IRS until months later. Meanwhile, his account accrued significant failure to file penalties. “IRC 6061 through IRC 6065 require that any return made under the provisions of the internal revenue laws must be signed by the taxpayer (or other such authorized individual) under penalties of perjury. A return that is not signed by the taxpayer (or an authorized individual) fails to meet the requirement to file that return, and may subject the taxpayer to penalties for failure to file.” IRM (04-10-2011)


The IRS provides many types of extensions for individual and business taxpayers; in addition, there are specific extensions for taxpayers that are in combat zone duty, those located in a federal disaster area, and taxpayers suffering undue hardship. IRC § 7508, 7805A, 6061(a). However, an extension to file a tax return does not extend the time to pay (except if you file for an extension due to undue hardship, or taxpayers abroad who are allowed until 6/15 to pay). You should make a tax payment along with your filing extension. You should have your accountant calculate the estimated taxes that you will owe.

Penalty Amount

If you file your federal tax return late and owe tax with the return, two penalties may apply. The first is a failure-to-file penalty for late filing. The second is a failure-to-pay penalty for paying late. The failure-to-file penalty is normally 5 percent of the unpaid taxes for each month or part of a month that a tax return is late. It will not exceed 25 percent of your unpaid taxes. The failure-to-pay penalty is generally 0.5 percent per month of your unpaid taxes. It applies for each month or part of a month your taxes remain unpaid and starts accruing the day after taxes are due. It will not exceed 25 percent of your unpaid taxes.

Estimated Tax Penalties

Taxpayers are required to pay income tax as income is earned, through either withholding or estimated tax payments. Taxpayers who do not have sufficient amounts withheld are fail to make estimated tax payments may be assessed a penalty for underpayment of estimated tax. IRC 6654 (individuals) IRC 6655 (corporate).

Penalty Amount

The penalty is computed by applying the underpayment rate established under IRC 6621 to the amount of the underpayment for the period of the underpayment. In effect, the penalty is the sum of the penalties for each day during which an underpayment exists. The penalty for each day is computed by multiplying the daily rate by the underpayment amount. The daily rate is the rate determined under IRC 6621 divided by the number of days in the calendar year.

Taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and estimated tax payments, or if they paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.

Failure to Deposit Penalty

This is also known as a payroll tax penalty. Employers have an obligation to submit payroll taxes on time and the IRS is very stringent about this requirement. Payments must be both made on time and in full. Failure to do so can be severe, especially if the IRS finds the employer intentionally failed to make the deposits.

Deposit Due date

The deposit due date will depend on the tax form involved and the amount of tax. Taxpayers must make their deposit anytime between the date the payroll liability is incurred and the date the deposit is due. Deposits are due only on business days. A business day is every calendar day that is not a Saturday, Sunday, or legal holiday under IRC 7503.

Penalty Amount

The amount of the penalty depends on how late the payment is and the amount that is past due. For liability amounts not properly or timely deposited, the penalty rates are as follows:

  1. 2 percent for deposits 1—5 days late,
  2. 5 percent for deposits 6—15 days late,
  3. 10 percent for deposits made more than 15 days late. This also applies to amounts paid within 10 days of the date of the first notice requesting payment for the tax due.
  4. 10 percent for required deposits not paid by EFT.
  5. 15 percent ( a 5 percent addition to the 10 percent for late payment in (c) above) for all amounts still unpaid more than 10 days after the date of the first notice requesting payment of the tax due or the day on which the taxpayer received notice and demand for immediate payment, whichever is earlier

Return Related Penalties

There are several types of penalties that can be assessed for filing inaccurate returns:

  1. IRC 6662, Imposition of Accuracy-Related Penalty on Underpayments,
  2. IRC 6663, Imposition of Fraud Penalty,
  3. IRC 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions,
  4. IRC 6707A, Penalty for Failure to include Reportable Transaction Information with Return, and
  5. IRC 6676, Erroneous Claim for Refund or Credit penalty.

Legal Authority

The above IRC sections provide legal authority to the IRS to assess these types of penalties. Unlike some of the prior penalties discussed, return related penalties are not automatically assessed. Rather, they are assessed by an IRS examiner usually during the course of an audit.

Penalty Amount

  1. The amount of the IRC 6662 penalty is 20 percent of the portion of the underpayment resulting from the misconduct. The penalty rate increases to 40 percent in certain circumstances involving gross valuation misstatements, nondisclosed noneconomic substance transactions, and undisclosed foreign financial asset understatements.
  2. The amount of the IRC 6663 penalty is 75 percent of the underpayment due to fraud. See IRM
  3. The amount of the IRC 6662A penalty is 20 percent of the reportable transaction understatement. The penalty rate increases to 30 percent of the reportable transaction understatement where the transaction was not properly disclosed. See IRM
  4. The amount of the IRC 6676 penalty is 20 percent of the “excessive amount.” See IRM
  5. Stacking of IRC 6662, IRC 6663, IRC 6662A, and IRC 6676 penalties is not permitted. The maximum amount of the IRC 6662 penalty imposed on a portion of an underpayment of tax is 20 percent (or 40 percent in certain circumstances) of that portion of the underpayment, even if that portion of the underpayment is attributable to more than one type of misconduct under IRC 6662.

Information Return Penalties

Some taxpayers are required to file information returns to the IRS such as Forms W-2, 1098, 1099, and 1042-S. If you are an employer or hired an independent contractor, and fail to file a W-2 or 1099 for your employee or contractor, you could be subject to penalties under this section.

Legal Authority

IRC 6721 and 6722 provide authority to the IRS to assess penalties for failing to file or incorrectly filing information returns with the IRS and/or for failing to provide a correct information return to a payee.

Penalty Amount

Recently Congress passed the Trade Preferences Extension Act of 2015 which has increased the penalty from $100 to $250 for each form that is not filed or furnished, up to a maximum of $3 million. The penalty for intentionally failing to file has increased from $250 to $500. The law became effective Jan 1, 2016.

Reduced penalties are charged if failures are corrected quickly, but the Act increases the reduced penalties also. For failures that are corrected within 30 days, the reduced penalty is $50 per return (currently $30) and the maximum penalty is $500,000 per calendar year (currently $250,000). For failures corrected after 30 days but before Aug. 1, the reduced penalty is $100 per return (currently $60) and the reduced maximum penalty is $1 million per calendar year (currently $500,000).

Payors rely on payees to provide accurate information to make the filings, such as social security numbers, correct names, addresses, etc. In come cases when payees do not provide accurate information or refuse to provide the information, payors are obligated to initial back-up withholding and deposit the amount with the IRS.

Penalty Abatement

Nearly all penalties can be abated. Taxpayers are usually unsuccessful in trying to abate penalties on their own because they do not understand how to qualify or apply for penalty abatement. Penalty abatement is discretionary and it helps to have a tax attorney present a well-reasoned and thought out request for penalty abatement that is supported by facts and law.

If you have been assessed substantial amounts of penalties by the IRS, contact us. The first step will be to request and review your account transcripts to determine what types of penalties have been assessed and the amount. We will then discuss which ones might qualify for penalty abatement and have the best likelihood of succeeding.

– Law Office of Kunal Patel LLC

IRS “Dirty Dozen” Tax Scams for 2016

Kunal Patel


IRS “Dirty Dozen” Tax Scams

I was inspired to create this post by a few clients that contacted us recently. Read on to learn how to protect yourself from IRS scams. The names below are fictitious to preserve client confidentiality.

Client #1 “Bob”: Bob went to a tax return preparer named “Jimmy” to have his 2015 tax return filed. Bob heard from a friend that Jimmy was a tax pro and would get him the biggest refund. As agreed to, Jimmy prepared the tax return and went over it with him. The preparer then had Bob sign a “refund anticipation loan” so that the refund would be directly sent to the preparer. In exchange, Bob would get his refund immediately from the preparer (minus a small fee) rather than having to wait for the IRS to process the return. A few months later, Bob needed to request a return transcript from the IRS as required for a loan. When he received the transcript he noticed that the refund amount on the transcript was larger than the refund that was on his copy of the return. After a consultation, Bob learned that he was a victim of tax preparer fraud. Jimmy prepared two tax returns for Bob – a fake return and the one he actually filed with the IRS. The fake return had a significantly smaller refund amount than the actual return. And the actual return had overstated deductions that Bob did not qualify for. The preparer pocketed the difference of the refund amounts.

How do you protect yourself from this type of fraud? First, be sure you pick the right tax professional. Second, do not rely solely on word of mouth. Many tax return preparers are popular with their clients because they maximize clients’ refunds by claiming erroneous deductions and credits. Second, steer clear of refund anticipation loans (RAL). Be especially wary of return preparers that are pushy with RALs. Third, review the documents that you are signing and ask questions if you’re not sure.

Client #2 “Jane”: Jane received a phone call from someone claiming to be from the IRS fraud department. The caller told Jane that she was past due on her IRS debt and that if she did not pay immediately, she would be arrested in 45 minutes.

How do you protect yourself from this type of fraud? First, do not give out any personal information to anyone claiming they represent the IRS. The IRS generally does not initiate phone calls to taxpayers, and they certainly will not call threatening to arrest you. IRS communicates through mail, unless you are in the IRS collections process. Even then, this wouldn’t be the first time the IRS has reached out to you regarding past due taxes. You would have received numerous letters from the IRS before IRS collections calls you. Additionally, the IRS would not ask you to wire money or demand payment over the phone. If in doubt, hang up and call the IRS 1-800 number on the latest IRS correspondence you received.

You should report telephone scams to the Treasury Inspector General for Tax Administration. Use TIGTA’s IRS Impersonation Scam Reporting web page to report the incident. You should also report it to the Federal Trade Commission using the FTC Complaint Assistant. Please add “IRS Telephone Scam” to the comments of your report.

The IRS “Dirty Dozen” List

The IRS released their yearly Dirty Dozen tax scams for 2016. The above cases are just a few of the many different types of scams out there. Here’s the rest of them.

Identity Theft: Taxpayers need to watch out for identity theft especially around tax time. The IRS continues to aggressively pursue the criminals that file fraudulent returns using someone else’s Social Security number. Though the agency is making progress on this front, taxpayers still need to be extremely careful and do everything they can to avoid being victimized. (IR-2016-12)

Phone Scams: Phone calls from criminals impersonating IRS agents remain an ongoing threat to taxpayers. The IRS has seen a surge of these phone scams in recent years as scam artists threaten taxpayers with police arrest, deportation and license revocation, among other things. (IR-2016-14)

Phishing: Taxpayers need to be on guard against fake emails or websites looking to steal personal information. The IRS will never send taxpayers an email about a bill or refund out of the blue. Don’t click on one claiming to be from the IRS. Be wary of strange emails and websites that may be nothing more than scams to steal personal information. (IR-2016-15)

Return Preparer Fraud: Be on the lookout for unscrupulous return preparers. The vast majority of tax professionals provide honest high-quality service. But there are some dishonest preparers who set up shop each filing season to perpetrate refund fraud, identity theft and other scams that hurt taxpayers. Legitimate tax professionals are a vital part of the U.S. tax system. (IR-2016-16)

Offshore Tax Avoidance: The recent string of successful enforcement actions against offshore tax cheats and the financial organizations that help them shows that it’s a bad bet to hide money and income offshore. Taxpayers are best served by coming in voluntarily and getting caught up on their tax-filing responsibilities. The IRS offers the Offshore Voluntary Disclosure Program (OVDP) to enable people catch up on their filing and tax obligations. (IR-2016-17)

Inflated Refund Claims: Taxpayers need to be on the lookout for anyone promising inflated refunds. Be wary of anyone who asks taxpayers to sign a blank return, promises a big refund before looking at their records, or charges fees based on a percentage of the refund. Scam artists use flyers, advertisements, phony store fronts and word of mouth via community groups where trust is high to find victims. (IR-2016-18)

Fake Charities: Be on guard against groups masquerading as charitable organizations to attract donations from unsuspecting contributors. Be wary of charities with names similar to familiar or nationally-known organizations. Contributors should take a few extra minutes to ensure their hard-earned money goes to legitimate and currently eligible charities. has the tools taxpayers need to check out the status of charitable organizations. (IR-2016-20)

Falsely Padding Deductions on Returns: Taxpayers should avoid the temptation of falsely inflating deductions or expenses on their returns to under pay what they owe or  possibly receive larger refunds. Think twice before overstating deductions such as charitable contributions and business expenses or improperly claiming such credits as the Earned Income Tax Credit or Child Tax Credit. (IR-2016-21)

Excessive Claims for Business Credits: Avoid improperly claiming the fuel tax credit, a tax benefit generally not available to most taxpayers. The credit is generally limited to off-highway business use, including use in farming. Taxpayers should also avoid misuse of the research credit. Improper claims generally involve failures to participate in or substantiate qualified research activities and/or satisfy the requirements related to qualified research expenses. (IR-2016-22)

Falsifying Income to Claim Credits: Don’t  invent income to erroneously qualify for tax credits, such as the Earned Income Tax Credit. Taxpayers are sometimes talked into doing this by scam artists. Taxpayers are best served by filing the most-accurate return possible because they are legally responsible for what is on their return. This scam can lead to taxpayers facing big bills to pay back taxes, interest and penalties. In some cases, they may even face criminal prosecution. (IR-2016-23)

Abusive Tax Shelters: Don’t use abusive tax structures to avoid paying taxes. The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them. The vast majority of taxpayers pay their fair share, and everyone should be on the lookout for people peddling tax shelters that sound too good to be true. When in doubt, taxpayers should seek an independent opinion regarding complex products they are offered. (IR-2016-25)

Frivolous Tax Arguments: Don’t use frivolous tax arguments in an effort to avoid paying tax. Promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims Even though they are wrong and have been repeatedly thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law or disregard their responsibility to pay taxes. The penalty for filing a frivolous tax return is $5,000. (IR-2016-27)

Unreported Income

Kunal Patel


IRS Income Examination Process

How does Uncle Sam know that you haven’t reported income if you don’t receive W-2s or 1099s? And you’re also clever enough not to deposit your unreported income in your bank account, so there is no “paper trail.” What then? The IRS uses what are called “indirect methods” of uncovering this income during IRS income examinations. Don’t worry, the IRS won’t come after you for the $100 winnings you didn’t report from your office fantasy football league challenge. The materiality threshhold is generally $10,000 for most taxpayers.

Direct vs. Indirect Methods

A direct method for the IRS to look for potentially unreported income would involve looking for direct evidence of omitted income such as cancelled customer checks, public records, deeds, etc. An indirect method would involve the IRS reconstructing your financial records. Indirect methods are used when there is no “paper trail.”

Why Would the IRS Use an Indirect Method?

When you are audited by the IRS, it almost always includes a “minimum income probe”, which is required under Internal Revenue Manual (IRM) This applies to both business and non-business returns. Non-business includes individuals, self-employed/sole proprietors, and disregarded LLCs. A large majority of taxpayers fall into this section. When the IRS suspects a large amount of unreported income during the minimum income probe, then the scope of the income probe is expanded.

A minimum income probe of an individual return consists of:

  • Matching income reporting documents (W-2s, 1099s, etc) with the tax return
  • Asking a standard list of income questions during your initial interview. The examiner will note your responses on the “initial interview questionnaire.” You will be asked about sources of income and your record-keeping practices. A taxpayer who intentionally lies on the questionnaire would be a prime candidate for a civil fraud penalty.
  • Financial status analysis: This is a spreadsheet in which the examiner enters sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures. It’s common practice before an audit for the IRS to complete a public records check to determine what assets you own and when they were purchased. If you purchased 3 brand new BMWs in 2014 and you’re being audited for that year, the purchase price of those vehicles (or a close approximation) would be entered into the expenditure side.

If the T-Account does not show a material imbalance, then the examiner should stop here. And if he doesn’t, get a tax attorney! The examiner is not allowed to continue examining your income under the minimum income probe section of the IRM.

If the T-Account shows a material imbalance, additional questions will be asked of you to reconcile the difference. For example, you received a $100,000 nontaxable inheritance from your “nana”, which would explain the 3 BMWs you purchased. The examiner will likely ask you for proof such as probate records. A lie here also makes you a candidate for the civil fraud penalty.

If the T-Account is not reconciled during the audit of a non-business return, the examiner will request bank statements for all your accounts and conduct a bank deposit analysis. Here, the examiner is looking for unexplained cash deposits. If additional income is found here that resolves the T-Account, then your financial status audit should end. However, if the income still is not reconciled, then the IRS will use an indirect method. See further below, “Results of Minimum Income Probes.”

A minimum income probe of an individual “business” return includes the following:

  • Financial Status Analysis – Prepare a financial status analysis to estimate whether reported income is sufficient to support the taxpayer’s financial activities. See IRM
  • Interview – Conduct an interview with the taxpayer (or representative) to gain an understanding of the taxpayer’s financial history, identify sources of nontaxable funds, and establish the amount of currency the taxpayer has on hand. Consider possible bartering income as part of the minimum income probes. See IRM
  • Tour of Business – Tour the business site and review of the Internet website to gain familiarity with the taxpayer’s operations and internal controls, and identify potential sources of unreported income. However, a tour of the physical business site is not required for office audit cases but may be conducted if appropriate and with manager approval. See IRM
  • Internal Control – Evaluate internal controls to determine the reliability of the books and records (including electronic books and records), identify high risk issues, and determine the depth of the examination of income. See IRM
  • Reconciliation of Income – Reconcile the income reported on the tax return to the taxpayer’s books and records. An analysis of the IRP information in the file should also be completed to ensure all business and/or investment activities reflected on the IRP document are properly accounted for on the tax return. See IRM
  • Testing Gross Receipts – Test the gross receipts by tying the original source documents to the books. See IRM
  • Bank Analysis – Prepare an analysis of the taxpayer’s personal and business bank and financial accounts (including investment accounts) to evaluate the accuracy of gross receipts reported on the tax return. See IRM
  • Business Ratios – Prepare an analysis of business ratios to evaluate the reasonableness of the taxpayer’s business operations and identify issues needing a more thorough examination. See IRM
  • E-Commerce and/or Internet Use – Determine if there is Internet use and e-commerce income activity. See IRM

Results of the minimum income probes

After completion of the minimum income probes for both business and non-business returns, the examiner must evaluate the information collected to this point and determine the scope of the examination of income, using the following criteria:

The results show that the taxpayer reported all taxable income from known sources, the books and records can be reconciled to the tax return, all financial activities are in balance, and the bank deposits do not exceed reported income. The examination of income may be limited to the Minimum Income Probes. The results and conclusions reached should be documented in the examination workpapers.
The results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, the books and records cannot be reconciled to the tax return, a material imbalance in the financial status analysis that cannot be reconciled, excess unexplained bank deposits, or inadequate internal control. A more in-depth examination of income is warranted. See IRM for suggested guidelines for an in-depth examination of income.

A “more in-depth examination of income” would depend on the taxpayer and the type of business being conducted. A preliminary step might be to contact 3rd parties (for example, business associates) to obtain information or evidence to reconcile income issues. It may also involve reviewing your books and records.

A formal indirect method to make the actual determination of tax liability may be pursued when the taxpayer’s books and records are missing, incomplete, or irregularities are identified; or the financial status analysis indicates a material imbalance after consideration of specific adjustments identified during the examination.

Results of the in-depth examination of income

After completion of the in-depth examination of income, the examiner will decide the next step using the following decision criteria:

The taxpayer or third parties have successfully explained the reason for the understatement. Document the results in the workpapers and conclude the examination of income without adjustment.
The adjustments to income and understatement meet the criteria for referral to Criminal Investigation. A referral should be made to Criminal Investigation.
The taxpayer agrees to the proposed adjustments to income. There is no indication of additional unreported income. Document the results in the workpapers and make the adjustment, resolve other issues, and close the case agreed.
The taxpayer does not agree to the proposed adjustments to income and the adjustments are not based on estimated personal living expenses derived from BLS data or comparable statistics. Document the results in the workpapers and close the case unagreed.
The taxpayer does not agree to the proposed adjustments to income and the adjustments are based on estimatedpersonal living expenses derived from BLS data or comparable statistics. Consider using one of the formal indirect methods to determine the actual amount of unreported income. NOTE: A case should not be closed unagreed if adjustments to income are based on estimated Personal Living Expenses.

Formal Indirect Methods of Determining Income

Authority to use formal indirect methods come from two sources
  • Internal Revenue Code. IRC 446(b) provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
  • Case law. If the examiner has a reasonable indication that unreported income exists, the Service has been granted the authority, through the development of case law, to use a formal indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The “formal” indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954).

When the IRS will use an indirect method?

The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer’s tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.

The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.

  • MOST COMMON for non-business taxpayers. A financial status analysis that cannot be balanced; i.e., the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference. This was discussed above under “minimum income probes.”
  • Irregularities in the taxpayer’s books and weak internal controls.
  • Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry.
  • The taxpayer’s bank accounts have unexplained items of deposit.
  • The taxpayer does not make regular deposits of income, but uses cash instead.
  • A review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income.
  • There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.
  • No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. See IRC 446(b).

There are 5 types of indirect methods

  • Source and Application of Funds Method: The Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the adjustment to income.
  • MOST COMMON for non-business taxpayers. Bank Deposits and Cash Expenditures Method: Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately.
  • Markup Method: The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability. It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s gross receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit, or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. If known, use of the taxpayer’s actual markup is required.
  • Unit and Volume Method: In many instances gross receipts may be determined or verified by applying the sales price to the volume of business done by the taxpayer. The number of units or volume of business done by the taxpayer might be determined from the taxpayer’s books as the records under examination may be adequate as to cost of goods sold or expenses. In other cases, the determination of units or volume handled may come from third party sources.
  • Net Worth Method: The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.


The IRS is thorough when it comes to examinations of income, and examiners are expected to document their findings in detail. The reason is that the IRS has the burden of proof when it comes to income (as apposed to deductions, for which taxpayers carry the burden of proof). This is why it is important to be represented by a tax professional for an IRS audit. For complex income issues, it’s even more important to hire a tax attorney who understands the IRS process. Even after the audit has ended and adjustments have been made, it’s not too late to hire an attorney. There’s a good chance the examiner did not properly document the income examination, made procedural errors, or made substantive errors. The first thing a knowledgeable attorney should do after a contested audit is request a copy of the examiner’s workpapers under the Freedom of Information Act (aka FOIA request).

Choosing a Tax Professional

Kunal Patel


Choosing a Tax Professional

Who should you hire when you have a tax problem?

Enrolled Agent (EA)

An enrolled agent is authorized by the IRS to represent taxpayers before the IRS for audits and collections. EAs can advise and prepare tax returns. While there is no educational requirement to become an EA, there is a short exam administered by the IRS that a person must pass in order to become an EA.

Certified Public Accountant (CPA)

The educational and licensing requirements for obtaining a CPA are:

  • 5 years of education (bachelors and usually a masters)
  • A passing score on the CPA exam

CPAs do not all specialize in tax. The accounting profession is broken down into internal audit, tax, and consulting. Even within tax, CPAs can specialize in individual, corporate, state and local, and international tax. CPAs prepare returns, ensure you are in compliance with tax code, and maintain business and financial records. A CPA is a great choice if you are current on your taxes and do not have outstanding tax issues.

Tax Attorney (JD)

The requirements for a licensed attorney are as follows:

  • 7 years of education (bachelors and juris doctorate, JD)
  • Passing score on the bar exam

Attorneys can specialize in estate planning, personal injury, criminal law, bankruptcy, immigration, and more. Some may decide to specialize in two or three areas. There is no formal requirement for an attorney to call themselves a “tax attorney” or “immigration attorney.” As with CPAs, you want to ensure that the attorney has experience in the specific area of tax for which you are seeking help. Tax is probably the most specialized of the different practices. Some lawyers will take an additional 1 year of law school to earn a tax LLM in order to learn this specific body of law. However, for attorneys that have tax experience, an LLM is unnecessary.

Attorneys are trained to advocate for your legal rights and will fight to ensure that your rights before the Internal Revenue Service are protected. A good tax attorney should have a solid understanding of IRS procedures for tax controversy cases.

Situations Where you may Need a Tax Attorney

  1. Audit representation – An EA, CPA, or attorney can represent you in an audit, but only an attorney can litigate your case in tax court if needed. There are some exceptions whereby an EA or CPA can take an exam administrated by the US tax court, but only a 100 have passed nationwide in the past 16 years combinedSource. Cases are very rarely litigated and are usually settled prior to trial by IRS Appeals; however, the IRS knows that if you’re represented by an attorney that the case has the potential to go to litigation. The IRS is required to consider the hazards of litigation in determining an appropriate settlement. You have much more leverage with attorney representation.
  2. Potential fraud – If you need attorney-client privilege to discuss a potential tax fraud issue. Attorneys can maintain attorney-client privilege and cannot be forced by a third-party, including government entities, to provide confidential information. Under federal law, CPA/accountant-client privilege is not recognized. Enrolled agents may have limited privilege in connection with a tax audit or collections, but it does not extend to tax return work-papers or to criminal proceedings. In order to resolve your issues it is important that you are able to discuss freely with a tax professional without worrying whether the information you provide may be used against you by the IRS, whether in a civil or criminal investigation.
  3. Tax debt – If you owe back taxes, only attorneys can represent you in bankruptcy proceedings. Many non-attorneys in this field are not even aware that federal taxes can be discharged in a Chapter 7 bankruptcy discharge. However, for small tax due balances (under $50K) or where a Chapter 7 is definitely not a option for you, a CPA specializing in tax debt cases should suffice.
  4. Tax return delinquency – If you have not filed your tax returns for many years, you could be subject to fraudulent failure to file penalties and even criminal prosecution in extreme cases.

  5. Unreported foreign accounts – The IRS aggressively pursues individuals who have unreported foreign income and assets, assessing civil and criminal penalties in some cases. There are offshore compliance options for such individuals that a tax attorney can guide you through to minimize your risks.

“Tax Professionals” You Should Always Stay Away From

There is an abundance of individuals that call themselves “tax professionals” that you should never hire. The IRS will almost always hold you responsible for additional taxes, penalties, and interest, regardless of the person who prepared the returns.

Tax resolution firms. “Tax resolution” firms advertise heavily on television, online, and on the radio, promising relief which they can not deliver. They have generic-sounding business names and don’t use any of the owners’ names in the business name. As a result, if the company goes under or enough complaints are filed, they can just shut down the business and open up another with no personal accountability. These firms use high-pressure sales techniques to extract substantial retainers. Unlike lawyers or CPAs, these firms are not subject to any professional regulations. They are allowed to charge whatever fees they are able to extort from their clients. Some common characteristics of these firms are to use BBB accreditation and hundreds of fake online reviews to convince clients of their legitimacy.

Here’s an example of a marketing video for a tax resolution firm that went out of business. They marketed to those with tax debt of greater than $20,000 and suggested they could reduce their debt to $1,500 or less. After being sued by the FTC and thousands of clients they ripped off, the owners probably still walked away with a substantial amount of money. If you’re in Houston, you may also have heard of Tax Masters. They went out of business and the owner spent jail time for tax fraud, and the clients who went to them were left on the hook. Here are some more examples of resolution firms that have been sued and gone out of business:

– American Tax Relief
– Roni Deutch “the tax lady”
– JK Harris

We get a lot of fallout clients from companies such as these, but unfortunately for many clients, by the time they come to us they’ve already spent thousands of dollars without any results.

Unregistered tax preparers. Unregistered tax preparers have no professional certifications and have not been able to demonstrate any sort of tax competence. These tax preparers will seek to maximize your refunds without adequate support in order to get your repeat business. Many will outright steal part or all of your tax refund. While the IRS has been vigilantly trying to shut down these businesses, it’s hard to catch “phantom” unregistered tax preparers who prepare returns but do not sign as the tax return preparer on the tax returns. This makes these individuals hard to detect. You could end up owing a substantial amount of money to the IRS if false deductions and credits were taken. Within the group of unregistered tax preparers, there are businesses called “notario publicos” or commonly just “notarios“. Notarios prey especially on the Hispanic population and take advantage of immigrants’ poor understanding of U.S. law. They mislead and steal from customers. They will often tell their clients that they are attorneys or CPAs. If you’re unsure of a person’s credentials, you can look up their information as follows:

EA verification  |  CPA verification (TX)   |  Attorney verification (TX)

When you are ready to work with an experienced attorney to put your tax problems behind you, give us a call (281) 746-6066.

Rental Property Losses

Kunal Patel


Rental Property Losses

It is not uncommon for real estate investors to have rental property losses. The goal for many investors is not cash flow, but rather to hold on to the property for future appreciation.

The deductibility of net rental losses on your personal tax return depends on many factors.

General Rule: Rentals are Passive Activities

Under IRC § 469(c)(2), rental income and losses are considered to be passive income/loss, and are therefore subject to passive activity rules. Passive losses can only be deducted against passive income. For example, if your rental home produces a $15,000 loss on Schedule E, you are generally not able to offset your other (non-passive) income against this loss. The loss is carried forward to the next year.

Exception 1: The taxpayer actively participates in a rental real estate activity and qualifies for the $25,000 special allowance.

Exception 2: There is a qualifying disposition under IRC § 469(g). A qualifying disposition would be a sale of the property.

Exception 3: The taxpayer meets the requirements of IRC § 469(c)(7) for real estate professionals.

$25,000 Special Allowance Loss

A taxpayer may deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and his modified adjusted gross income is less than $100,000.

Active participation test: As long as a taxpayer participates in management decisions in a bona fide sense, he actively participates in the real estate rental activity.  There is no specific hour requirement.  However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager. Most taxpayers are able to meet this test if they can show they made important management decisions in regards to their rental property. You can have a management company if you are making the key decisions, such as accepting tenants, signing the contract, making the final determination on the rental price, etc.

Modified adjusted gross income (MAGI) is calculated by taking your Adjusted Gross Income and subtracting:

  • Any passive loss or passive income, or
  • Any rental losses (whether or not allowed by IRC § 469(c)(7)),  or
  • IRA, taxable social security or
  • One-half of self-employment tax (IRC § 469(i)(3)(E)) or
  • Exclusion under 137 for adoption expenses or
  • Student loan interest.
  • Exclusion for income from US savings bonds (to pay higher education tuition and fees)
  • Qualified tuition expenses (tax years 2002 and later)
  • Tuition and fees deduction
  • Any overall loss from a PTP (publicly traded partnership)

The full $25,000 allowance is available for taxpayers whose MAGI is less than $100,000.  For every $2 a taxpayer’s MAGI exceeds $100,000, the allowance is reduced by $1.

Qualified Disposition

In the year that you sell your rental property, you can deduct all of the carryover passive losses that you accumulated during the rental period. For example, Bob has $100,000 of W-2 wages in year 10. From years 1-9 he had $30,000 of passive loss carryovers from his rental property because they were not deductible on his tax returns. In year 10 he sells the rental property for a gain of $10,000. He therefore has total income of $110,000 (the W-2 wages and gain from the sale). However, his net income (before deductions) will be $80,000 since the $30,000 passive loss carryover will be applied.

Real Estate Professional

If you are considered a real estate professional, then your rental income/losses are not subject to passive activity loss limitations and all losses can be fully deducted on your tax return. In order to be considered a real estate professional, you must meet the material participation test, which involves meeting at least one of the following:

  1. The taxpayer works 500 hours or more during the year in the activity.
  2. The taxpayer does substantially all the work in the activity.
  3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
  4. The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
  5. The taxpayer materially participated in the activity in any 5 of the prior 10 years.
  6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
  7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

If you are a W-2 wage employee or have another significant source of income, and you do not spend significant time managing the rental property, you most likely will not meet the test. Real estate agents or those with real estate businesses are generally able meet at least one of the requirements.

Whether you are able to deduct your rental loss in the current year or not, the losses are not “lost.” You can carry them forward to future years and deduct them fully when you sell the property. It is important to keep track of your loss carryovers and to log the time you spend participating in rental activity if you are a real estate professional.

Hire an Independent Contractor or an Employee?

Kunal Patel


Hire an Independent Contractor or an Employee?

Your business is growing and you need help. Do you hire an employee or an independent contractor?

Difference between an employee and independent contractor

It can be at times difficult to make a clear-cut distinction between an employee and independent contractor. The term independent contractor has been defined by common law, the Fair Labor Standards Act, and court cases. The IRS looks at the degree of control and independence of the worker. The tests for making this determination fall into three categories:

  1. Behavioral: Does the company control or have the right to control how the person does her job?
  2. Financial: How is the worker paid, how are expenses reimbursed, and who provides the the tools, etc?
  3. Type of relationship: Are there written contracts or employee-like benefits? Will the relationship continue, and is the work performed a key aspect of the business?

The IRS has an extensive 20 factor test for determine whether the person is an employee or independent contractor. Basically, if you are directing the person how to do the work, providing significant training, and paying a guaranteed set wage amount, you likely are in an employer-employee relationship.

The pros and cons of employee vs. independent contractor

There are major benefits to having a worker classified as an independent contractor (IC).

  1. Financial. When you hire an employee you will pay a number of expenses that you wouldn’t if you hired an IC, such as employer-provided benefits, office space, and equipment. You must also make contributions on behalf of the employee, including your share of the employee’s Social Security and Medicare taxes (7.65%), state unemployment compensation insurance, and workers’ compensation insurance. These costs could increase your payroll costs by 20 to 30%.
  2. Staffing flexibility. An independent contractor is generally hired for a specific task or project and the relationship ceases at that point. There is no headache of hiring and terminating an employee. In addition, independent contractors are already trained and can be productive on the job almost immediately.
  3. Reduce your exposure to lawsuits. Minimum wage laws, employment discrimination laws, right to form a union, and right to take time off to care for a sick family member or new child are not applicable to ICs as they are to employees

If after applying the above three factors, it is not clear whether the person qualifies as an employee of IC, you may file a Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding” with the IRS. The form can be filed by either the employee or the worker and can take up to 6 months for the IRS to make a determination. This can be useful for business owners who repeatedly require the same services.

The downside to hiring an independent contractor is that you do not have as much control over the work that is performed, your right to terminate the IC is not at will, and you may b at greater risk for government audits by the IRS or Department of Labor.

Forms and taxes

If you’ve made the decision to hire an independent contractor, the first step would be to have to worker fill out a Form W-9. This is used to request the correct name and SSN/EIN of the worker. This form should then be kept in your files for future reference if required by the IRS. If you’ve paid the person more than $600 during the year, you must fill out a Form 1099-MISC. The 1099-MISC must be provided to the IC by January 31st of the year following the payment and you must mail a copy to the IRS by February 28th.

If you have hired an employee, there are several forms and taxes for which you are responsible as the employer, including:

  1. Federal income tax withholdings. You should have your employee fill out Form W-4 prior to employment in order to determine the correct amount of taxes that should be withheld from his or her paycheck.
  2. Social Security and Medicare taxes. Employers must withhold part of social security and Medicare taxes from employees’ wages and pay a matching amount. There is also an additional Medicare Tax amount that must be withheld if the employees’ salary exceeds a certain threshold.
  3. Federal Unemployment tax. Employers pay a 100% of this tax. The employee does not pay any portion of this.
  4. State Unemployment tax.

These taxes must be deposited by the employer with the IRS according to two schedules, monthly and semi-weekly. At the beginning of the calendar year you will need to determine the correct schedule to use. The state unemployment tax is deposited with the Texas Workforce Commission.


There some strong advantages to hiring an independent contractor. But employers would be well-advised to understand the importance of classifying their workers correctly. Misclassification can result in having to pay back state and federal taxes for unemployment, disability, social security, and Medicare, as well as expenses, overtime, and retirement benefits.

It is important that you make the correct determination the first time to avoid costly mistakes. The Law Office of Kunal Patel, LLC can guide you through every stage of this process and save you time and money down the road.

Incorporating your Small Business

Kunal Patel


Incorporating your Small Business

Why Should you Incorporate?

So you’ve set up your small business or sole proprietorship and you’re ready for business. The last things on your mind are taxes or potential lawsuits. But as they say “an ounce of prevention is worth a pound of cure.” Advantages of incorporating your small business are:

  1. Personal asset protection. The owner(s) have limited personal liability for corporate debts and obligations and generally are only subject to lose their investment in the business, but not their personal assets.For example: an independent cab driver who is sued for negligent driving would be personally liable if the damage exceeds what the insurance would cover. His personal bank account, investments, and other assets are at risk. Now if he had incorporated his business (e.g., L.L.C.), only his business assets would be at risk. His cab, business bank account, etc.
  2. Tax benefits. Losses are fully deductible for corporations, but for a sole proprietorship (i.e., an unincorporated business) his losses may be limited. There are also other tax benefits associated with various forms of corporate entities. Your attorney can determine which type of entity would be best for you.
  3. Business credibility. Adding the magic three letters, Inc. or L.L.C. after your business name adds instant legitimacy and credibility.

How do you Incorporate?

You must file the appropriate documents, such as the certificate of formation or bylaws, with the Texas Secretary of State.

In the certificate of formation, Texas requires the name of the corporation, initial directors (if applicable), purpose, duration, and the name and address of the corporate registered agent. You can choose who you designate as your registered agent, but it is beneficial to appoint your attorney as the agent. With a lawyer serving as the registered agent for your corporate entity, you will have the peace of mind that you will receive timely and prompt notice if your corporate entity is served with a summon and an attorney will be able to immediately to review and assess the lawsuit and provide you with legal advice on how to answer the summons.

LP, LLP, LLLP, LLC, Inc…what do I choose?

There are several ways of incorporating your small business.

Sole Proprietorship

A self-employed individual by default is a sole proprietorship. If you have not incorporated you are operating as a sole proprietor and have full personal liability for your business. Running a business without limited liability protection is like driving a car without insurance.

General Partnership

If you are a partnership and have not incorporated, you are by default a general partnership. Each partner in a general partnership is personally jointly and severally liable for their business liabilities. Owners report their share of income/losses on their own tax return and they are personally liable for their business. Just as a sole proprietorship, this not a recommended form since there is no liability protection for the owners.

Limited Partnership

A limited partnership consists of general and limited partners. General partners have personal liability for business debts but can raise funds without having outside investors manage their business. However, the general partners can limit their liabilities by forming a limited liability limited partnership. Limited partners are also protected from personal liability as long as they do not participate in management of the business. This form is commonly found in companies that invest in real estate because it is more attractive to lenders. Lenders do not like limited liability because it provides them less protection for their investment in your company.


Fringe benefits can be deducted as business expenses and owners can split profits among themselves and the corporation. This is generally the most expensive and burdensome to set up. It is rarely recommended for small businesses.

Limited Liability Partnership

This is similar to a limited partnership, except general partners are only liable for their own debts, and not the actions or debts of their fellow partners. This may be a good option for professional services firms where the members operate independently but under the same trade name.

Limited Liability Company

An L.L.C. is a hybrid of partnership and corporation that combines the best aspects of both entities. It offers the most flexibility in terms of operation and tax planning, as well as limited liability protection for all member(s). Also, unlike an L.L.P, an L.L.C. can have just one member. If it is a sole member L.L.C., you can choose to have it taxed as a separate entity or have the income and expenses “flow through” to your personal tax return. This is often the most recommended type of structure for self-employed individuals and small businesses.

The Best Structure for Your Business

Ultimately the best option for incorporating your small business will depend on a number of factors, such as the number of owners, type of business, how the owners wish to allocate business income/losses, long-term goals, whether you will raise capital through debt or equity, etc.

Beware of companies that will incorporate your business for a low fee using cookie-cutter templates. They will fill out the necessary paperwork, but they will not be able to advise you on the best entity formation for your needs. You need a qualified attorney that will review your situation to tailor the best choice for your business.


Attorneys’ Fees – Are they Deductible?

Kunal Patel


Attorneys’ Fees – Are they Deductible?

The good news for taxpayers is that attorneys’ fees in relation to tax services for individuals and small business issues are deductible!

Basic Rule

The basic rule is that attorneys’ fees are taxable if incurred to:

  1. Produce or collect taxable income; or
  2. Help determine, collect, or obtain a tax refund.

Simply put, you can deduct an attorney’s help to make money that you’ll have to pay taxes on; or if an attorney helps you with a tax matter such as an audit, back taxes, etc. For small businesses, you can deduct incorporation fees, tax planning, bookkeeping services, etc.

Examples of Deductible Attorneys’ Fees

Examples of fees that would be deductible are:

Examples of Non-deductible Attorneys’ Fees

Attorney fees such as the following are not deductible:

  • Filing a personal injury lawsuit
  • Drafting a will or settling a probate matter
  • Obtaining custody of a child
  • Non-tax issues in a divorce
  • Name changes
  • Civil suits that are not work or business related

Can You Settle Your IRS Debts?

Kunal Patel


Can IRS Debts be Settled?

A common misconception is that you cannot discharge federal tax debt in Chapter 7 bankruptcy. In fact you can both discharge some of your tax debts under Chapter 7 Bankruptcy, as well as settle your debts with an Offer in Compromise. However, it’s not as easy as the “tax resolution” companies often advertise with their promises of “0% down” and settling your debt for “pennies on the dollar.”

Chapter 7 Bankruptcy

Tax debt is dischargeable in Chapter 7 bankruptcy if they meet specific requirements under the Bankruptcy Code. These requirements are often called the 3-year, 2-year, and 240-day rules.

  1. The 3-year rule. The return was due at least three years ago before you file for bankruptcy. For example, Bob’s 2010 return was due on April 15, 2011. The earliest he can file for bankruptcy for his 2010 tax debt is April 15, 2014. Note that a tax return extension will also extend the 3-year rule.
  2. The 2-year rule. The return must be filed at least two years before the bankruptcy filing. For example, Bob’s 2010 return was due on April 15, 2011, but didn’t actually file his tax return until October 31, 2011. The earliest he can file for bankruptcy for his 2010 tax debt is October 31, 2013.
  3. The taxes were assessed at least 240 days ago. For most taxpayers, the taxes are considered assessed as of the date the return was filed. However, if you file an amended return or are audited and owe additional taxes, then the 240 days on the additional tax begins to run when the additional taxes are assessed.

Even if you meet the above, the tax debt is not dischargeable if:

  1. There is a tax lien. A tax lien filed prior to bankruptcy will continue to attach to your property.
  2. The tax is a “trust fund” tax such as FICA, Medicare, and other mandatory withholdings (applies to businesses with employees).
  3. The IRS has determined there is tax evasion or fraud.

A note on tax liens. As mentioned above, bankruptcy does not release a tax lien. However, if you meet the 3-2-240 requirements, you can request for IRS to release the lien, which they may do if the taxes have been discharged and there is little property for the lien to attach. If you still own significant property after the discharge, then the IRS will likely not remove the lien. However, it is possible to negotiate the tax debt on the lien.

Offer in Compromise

If paying your existing tax debts will cause significant financial difficulty, the IRS will settle your tax debt through an Offer in Compromise (OICs). The IRS wants to get the most it can in a reasonable amount of time, and if that means negotiating the debt they will.

Pre-Qualifiers for Filing an OIC

  • You must not be in an open bankruptcy proceeding
  • You must have filed all required federal tax returns
  • You must make all estimated tax payments
  • If you are self-employed, you must have submitted all required federal tax deposits

Requirements for Filing an OIC

  • 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.”
  • due to exceptional circumstances, payment of your full tax bill would cause an “economic hardship” or would be “unfair” or “inequitable.”
  • There is some doubt as to whether you actually owe all or some of the debt. The IRS calls this “doubt as to liability.”

After you and your attorney have identified which condition(s) exists, you can start your application by completing IRS Form 656. There is a $186 application fee. In addition to the form, you will need to provide the following:

  • Financial information by filling out Form 433-A/F (individuals) or 433-B (businesses). It is extremely important to be truthful and accurate on this form.
  • Various documents to verify your income and financial assets – bank records, vehicle registration, pay stubs, etc.

How much should you offer?

You will calculate your minimum offer amount by following the instructions on Form 433. Without going into details, the formula will take into consideration the net realizable value of your assets (i.e, how much your assets would be worth if they were sold) and your excess monthly income after subtracting your monthly expenses from your monthly income.

Special circumstances

Special consideration is given to those with physical and psychological impairments, bleak financial prospects due to advanced age (over 60), drug or alcohol related problems, or a family members problem if it affects your finances. To bring these issues to the attention of the revenue officer, you will attach a letter with supporting documents (e.g., medical records).

What if your offer is rejected?

IRS will reject offers for usually one of two reasons:

  1. The offer is too low
  2. You have been convicted of a serious crime in the past

If the offer is too low, the IRS will state the acceptable amount. You can also request a copy of the Revenue Officer’s report through a Freedom of Information Act (FOIA) request.

If you wish to increase your offer, you can do so within a month by simply writing a letter without having to resubmit your application.

The second option is to appeal your rejected offer. You can further negotiate with the assigned Revenue Officer and if that fails, you can submit IRS Form 13711 to start a formal appeal.

Offer-in-Compromise vs. Chapter 7 Bankruptcy

As you recall above, one of the conditions for applying for an OIC is that you are not in an open bankruptcy proceeding. You can both apply for an OIC and file for Chapter 7, but not at the same time.

Applying for OIC before Chapter 7 filing

Under Internal Revenue Manual, when a taxpayer or representative states during an offer investigation that a bankruptcy petition will be filed if the taxpayer’s offer is not accepted, the offer examiner/offer specialist must determine whether the potential for a bankruptcy filing actually exists and the impact the possible bankruptcy filing may have on the collection of the outstanding tax liabilities.

The IRS will consider how likely it is for you to file for bankruptcy – have you filed in the past, is IRS the sole creditor, would the taxes be dischargeable in bankruptcy, etc. If the Service determines there is potential for a Chapter 7 filing, then the Service will negotiate your tax debt. Under no circumstance, however, will the IRS accept a settlement that would be less than what it would recover under a Chapter 7 bankruptcy.

Warning! The OIC process will suspend the 3-2-240 time period, thereby adding time to the 3-2-240 requirements while the OIC is pending. Additionally, indicating to the IRS that you are considering filing bankruptcy requires the OIC offer examiner to determine whether the IRS should file a notice of federal tax lien to protect the government’s assets. As you recall above, a lien is not automatically released after a bankruptcy discharge.

Applying for OIC after Chapter 7 discharge

Once the discharge is entered, the Service will be able to determine which taxes are discharged and will be able to make a determination of Doubt as to Collectibility under its administrative OIC procedures.

Which one should I choose?

There are many factors in determining which option would be best for your situation, such as:

  • Has the IRS filed a lien?
  • How quickly do you need debt relief?
  • Is the IRS debt itself causing financial problems, or do you also have other debt?
  • Which option will have the lowest settlement payment?
  • Which one will be most likely successful?

Since 2012 the IRS has been more willing to compromise with taxpayers on debts. Up to 40% of OICs have been accepted in recent years. You should seek the assistance of an experienced tax attorney to ensure the greatest chance of your OIC being accepted. We can help you determine whether a Chapter 7 or 13 filing or an offer in compromise would be more beneficial for you.