What Is an IRS Letter of Compromise & How Do You File?

The Internal Revenue Service (IRS) term for a “letter of compromise” is an Offer in Compromise (OIC). An OIC is a formal agreement that allows a taxpayer to settle their outstanding tax liabilities with the IRS for a lower amount than what was originally owed. This program is a potential resolution for individuals and businesses experiencing significant financial distress who cannot fully pay their tax debt.

The OIC program is not a universal solution, as it is intended only for specific situations of financial hardship or dispute. Qualifying taxpayers can get a fresh start, but understanding the grounds for an offer and its strict eligibility requirements is necessary to determine if it is a viable option.

Determining Eligibility for an Offer in Compromise

Before the IRS will consider an Offer in Compromise, a taxpayer must meet several prerequisites.

• All required tax returns must be filed.
• All necessary estimated tax payments for the current year must be made.
• If the taxpayer is an employer, they must have made all required federal tax deposits for the current and preceding two quarters.
• The taxpayer cannot be in an open bankruptcy proceeding.

Once the basic requirements are satisfied, the IRS evaluates an OIC based on one of three grounds. The most common is “Doubt as to Collectibility,” which applies when a taxpayer’s income and assets are less than the full amount of the tax debt. The IRS determines it is unlikely to collect the full liability. For example, a taxpayer with a $50,000 tax debt, $10,000 in assets, and a low income covering only basic living expenses might qualify.

A less common basis is “Doubt as to Liability.” This ground is used when there is a legitimate dispute over whether the tax debt is correct. The taxpayer must provide evidence showing the assessed tax is incorrect, such as proof that the income was correctly attributed to another person.

The final ground is “Effective Tax Administration.” This applies when a taxpayer can technically pay the full amount, but doing so would cause significant economic hardship. It can also be used if public policy or equity considerations justify a compromise. For instance, an elderly taxpayer with a serious medical condition may qualify if paying the debt would require liquidating assets needed for basic living and medical costs.

Information and Forms for Submission

Applying for an OIC requires completing specific IRS forms. The application package is built around Form 656, Offer in Compromise, and a Collection Information Statement. Individuals and self-employed taxpayers must complete Form 433-A (OIC), while businesses use Form 433-B (OIC).

Form 656 is the formal offer document where the taxpayer specifies the proposed payment amount and the legal grounds for the compromise. The more involved part of the application is Form 433, which is a detailed financial disclosure. On this form, the taxpayer must provide a verifiable accounting of their entire financial situation, including all sources of income.

Form 433 also demands a complete breakdown of monthly living expenses and a full inventory of all assets. The IRS uses national and local standards for allowable living expenses to evaluate the taxpayer’s claimed costs. Any expenses that exceed these standards must be justified. Assets that must be listed include cash, bank accounts, real estate, vehicles, and retirement accounts.

The IRS uses the data from Form 433 to calculate the taxpayer’s “Reasonable Collection Potential” (RCP). The RCP is what the IRS believes it could collect from the taxpayer’s assets and future income. The minimum offer amount must be equal to or greater than the calculated RCP. The application package must also include a non-refundable $205 application fee, though this may be waived for taxpayers who meet low-income certification guidelines.

The Application and Review Process

After completing all forms, the taxpayer submits the application package. The package must include the completed Form 656, the appropriate Form 433 with all attachments, the application fee, and an initial offer payment. The amount of this initial payment depends on whether a lump-sum or periodic payment option is selected.

For a lump-sum offer, the initial payment is 20% of the total offer amount. For a periodic payment offer, the first monthly payment must be included with the application. These initial payments are non-refundable and are applied to the tax liability even if the offer is rejected. Low-income taxpayers may be exempt from the application fee and the initial payment. The IRS will send a letter acknowledging receipt of a processable application.

The case is assigned to an OIC examiner for review, which can take several months. During this period, the IRS is prohibited from taking levy actions against the taxpayer’s property. The examiner verifies the details on Form 433 and confirms the RCP to determine if the offer amount is acceptable.

After the review, the IRS may accept the offer as submitted. The IRS may also reject the offer if it determines the taxpayer can pay more or does not meet eligibility criteria. If an offer is rejected, the taxpayer has 30 days to file an appeal with the IRS Office of Appeals. The IRS may also return an incomplete application, allowing the taxpayer to correct it and resubmit.

Post-Acceptance Responsibilities

Acceptance of an OIC begins a compliance period. The taxpayer must first pay the agreed-upon offer amount according to the terms on Form 656, either as a lump sum or through periodic payments. The IRS will not release any federal tax liens until the offer amount has been paid in full.

The taxpayer also enters a five-year compliance period starting from the OIC acceptance date. During these five years, the taxpayer must file all required tax returns on time and pay all new tax liabilities in full and on time. Any refunds due for tax years ending during the calendar year the offer is accepted will be kept by the IRS and not applied to the offer amount.

If the taxpayer defaults on the payment terms or fails to stay current with tax obligations during the five-year compliance window, the IRS can void the OIC. When this happens, the original tax debt, including all penalties and interest, is reinstated in full, minus any payments already made. The IRS can then resume collection actions for the restored liability.