An Offer in Compromise (OIC) allows taxpayers to settle their tax debt for less than the full amount owed when full payment would cause financial hardship or when collection is unlikely. Occasionally, the IRS requires a collateral agreement as part of an OIC to protect their interest should your financial situation improve after settling your tax liability.
What is a Collateral Agreement?
A collateral agreement is a separate contract linked to your OIC that obligates you to pay additional sums if your income or assets increase beyond specified thresholds during a set period (usually 5 to 10 years). It functions as a future safeguard for the IRS, ensuring they receive fair compensation if your ability to pay improves after the initial settlement.
Why Does the IRS Require Collateral Agreements?
The IRS primarily includes collateral agreements in OICs based on “Doubt as to Collectibility,” where they believe taxpayers can’t pay the full debt now but may have the capacity to pay more later. If there’s potential for your income or asset values to rise substantially, the IRS implements collateral agreements as a contingency to recoup additional amounts.
Types of Collateral Agreements
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Future Income Collateral Agreement: This common type requires you to pay a portion of income exceeding an agreed threshold during the agreement period. For example, if the agreement sets the threshold at $75,000 annual income, and you earn $90,000 in a year, you may owe a percentage of the $15,000 excess.
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Increased Asset Value Agreement: In this less frequent type, if you sell an asset (like real estate or stocks) for more than its value at OIC acceptance within a specified period, you pay the IRS a portion of the gain.
How a Future Income Collateral Agreement Works
Under this agreement, you agree to report yearly income to the IRS by submitting tax returns. If your income exceeds the set threshold in any year, you must pay a negotiated percentage of the excess to the IRS. This obligation typically lasts 5 to 10 years after your OIC acceptance.
When You Might Encounter a Collateral Agreement
- Your OIC is based on financial inability to pay (“Doubt as to Collectibility”) with potential for future income or asset growth.
- You offer significantly less than what the IRS estimates it could collect.
- You own assets likely to appreciate, such as real estate.
- Your current financial hardship is viewed as temporary.
Common Misconceptions
- It’s not a lien on your property but a promise to pay more if conditions are met later.
- Not every OIC requires a collateral agreement.
- It does not imply dishonesty but is a protective measure by the IRS.
- Additional payments only occur if your financial thresholds are exceeded.
Tips for Handling Collateral Agreements
- Carefully review all terms, including payment percentages and duration.
- Negotiate terms where possible, such as income thresholds or length.
- Consult a tax professional or enrolled agent to understand implications.
- Be honest in all disclosures to avoid severe penalties.
Real-World Example
Sarah owes $50,000 in taxes but offers $10,000 via OIC due to low income. The IRS includes a future income collateral agreement. If Sarah later earns over $60,000 annually, she pays 20% of the excess income to the IRS for seven years, ensuring the IRS recoups additional funds as her financial situation improves.
For more details on Offers in Compromise, see FinHelp’s Offer in Compromise (OIC) guide.
Authoritative Resources
Refer to IRS Publication 593 and IRS Form 656 instructions for official guidance on Offers in Compromise and collateral agreements. The IRS website also details Offer in Compromise requirements.
This explanation provides an accurate, clear, and practical understanding of collateral agreements connected to OICs, helping taxpayers make informed decisions when settling tax debt.