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Some California taxpayers with significant tax debts may have entered into–or contemplated entering into–an offer in compromise with the Internal Revenue Service. An OIC is the exclusive way for taxpayers to satisfy their debts with the IRS for less than the total amount owed. But the amount offered to settle the debt and any additional terms that become part of the agreement are vitally important. Taxpayers must analyze very closely exactly what they agree to, otherwise they could face unintended consequences.

One couple discovered that for themselves recently. By 2007, they had accumulated nearly $30,000 in tax debt. They negotiated an OIC with the IRS in which they would have to pay $2,000. But that was not all. They also agreed that if they received any tax refunds in 2008 resulting from “overpayments” made during 2007 or before, then the IRS could take those refunds to satisfy the debt as well.

On their income tax return for 2007, the couple took two credits and also claimed money from the federal government’s stimulus package. When the IRS kept the couple’s refund, they took the agency to court. The case went all the way to the U.S. Court of Appeals for the Second Circuit, which recently released its ruling in favor of the IRS.

The couple’s legal argument focused on the plain meaning of the terms “overpayment” and “refund.” They asserted that money refunded due to tax credits does not represent an overpayment of tax and therefore should not be forfeited to the IRS under the terms of the OIC. Tax credits are used by the government to effect certain policies, such as helping those with low incomes. They are also especially helpful to taxpayers because they reduce a person’s tax liability dollar for dollar, and some can be refunded.

But the court did not agree. The court ruled that the terms in question should be viewed not according to their plain meaning, but according to the definition given them by the Internal Revenue Code. A section of the Code states that an overpayment of tax includes refunded credits that are more than the amount of tax a person owes. Therefore, the IRS’s withholding of the couple’s refund was proper.

While OICs can be quite beneficial, it is important to understand the legal implications of any agreement with the IRS.

Source: Journal of Accountancy, “Terms in OIC agreement take meaning from Code, court holds,” Alistair M. Nevius, May 3, 2012.