Will the IRS really keep my tax refunds if I get an Offer in Compromise?

Dear Tax Guide, My wife and I recently applied for an Offer in Compromise, and we just received a letter from the IRS requesting additional supporting documentation. We plan to make monthly payments if our OIC is accepted. We have been told that the IRS will keep our future tax refunds (which are usually between $3,000 and $5,000), and that the IRS will not apply this money to the OIC offer amount but rather applied to the pre-offer tax liability. Do you know if this is true?

Dear Reader, The offer in compromise process has got to be one of the most confusing and frustrating experiences that taxpayers go through. Here's the straight scoop on your tax refunds when applying for an Offer in Compromise.

First, the IRS will in fact keep any tax refunds while your offer in compromise is being processed, and will keep any tax refunds in the year your offer is approved. In fact, this is part of the OIC contractual agreement, which I have summarized in my article, Offer in Compromise Essentials. Here's the bottom line:

• You agree to let the IRS keep any tax refunds, payments, and credits applied to your tax debts prior to submitting your Offer in Compromise.
• You agree to let the IRS keep any tax refunds that would have been payable to you during the calendar year that your Offer in Compromise is approved.

What does this mean? It means that before your Offer in Compromise is approved, that the IRS will keep any tax refunds and apply the refunds to your outstanding tax debts. Also, after your Offer in Compromise is approved, that the IRS will keep any tax refunds in the same calendar year. For example, if your OIC is approved in January 2006, the IRS would keep a tax refund that would have been issued in April 2006.

These refunds may not be counted as part of your total offer in compromise payment amount. Also, you may not apply any tax refunds towards next year's estimated taxes. This makes tax planning a little trickier. But here's what I suggest.

Use your tax refunds to pre-pay certain taxes. For example, can you sell some profitable investments and generate some capital gains? Or perhaps you can convert some of your traditional IRA into a Roth IRA? Or perhaps you can pay more self-employment taxes by having fewer business expenses? I know it sounds weird, but try to reduce your refund by increasing your tax liability. You want your refund as close to zero as possible, because after all, you aren't going to see that money anyway.

Adjust your paycheck withholding or estimated tax payments. Try to estimate your taxes using the recently published 2006 tax rates. Try to keep your withholding and/or estimated payments on target to be as close to your tax liability as possible. Again, you are going to lose your refund anyway, so try to achieve a refund amount as close to zero as possible.

I used these strategies for a recent client of mine whose Offer in Compromise was approved. She paid fewer business expenses in order to increase her self-employment taxes. This not only reduced her tax refund, it actually will help her out in retirement by boosting her Social Security amount. I have another client who isn't self-employed. We are going to convert part of her traditional IRA to a Roth IRA, and pay the tax on the conversion. Not only does this eliminate her tax refund, it will provide tax-free withdrawals from her Roth in retirement. You may want to seek the advice of an experienced tax professional for other tips on how to handle your tax situation.

Additional Information:
Offer in Compromise Essentials
Preparing IRS Form 656, Offer in Compromise
Preparing IRS Form 433-A, Collection Information Statement
Interview with David Bauman of JK Harris providing inside tips on filing an offer in compromise