Under the right circumstances the IRS will apply administrative procedures to override the general rule required by IRS 6402 to offset the refund of a taxpayer to satisfy an outstanding liability. This administrative process, known by the catchy name of offset bypass refund or OBR can provide significant assistance to a taxpayer struggling with a financial hardship. Even though not required to do so by the code, the IRS will step back from taking the refund and allow it to go to the taxpayer despite outstanding tax liabilities. While this is not the season for OBR activity at the IRS — the normal season is tax filing season, particularly the early part — this may provide the best time for a discussion of the topic since the season will be upon us shortly. When requesting an OBR, it is critical to know whether the client has other debts subject to offset since the client generally does not achieve the goal of OBR if they do not receive the refund due to other offsetting debts. This post will explain OBR: the procedures for making the request and the offset rules that can apply to thwart such a bypass.
When someone owes federal taxes, section 6402 authorizes the IRS to offset a refund due to that person to pay for the outstanding balance. While governed by statute, the concept of an offset has ancient roots and provides a logical method for a creditor to recover a debt. Every year the clinic is contacted by taxpayers complaining that they did not receive their tax refund. When we obtain the transcript of their account, we can see that the IRS did allow the refund, but the refund was applied against an outstanding tax debt or, in some cases, against an outstanding debt owed to a third party authorized to receive a federal tax refund. When the IRS makes an offset to pay an outstanding federal tax debt, it notifies the taxpayer it has done so. This correspondence may not be sufficiently clear for some individuals or they may have changed their addresses and not received it. If the IRS applies 6402 to use the refund to pay a debt other than a federal tax debt, the taxpayer usually does not get a notice until September of the year the return is filed and that notice does not come from the IRS but from the Bureau of Fiscal Service described below.
Sometimes a taxpayer with past due federal tax obligations faces a severe financial hardship at the time of filing a return claiming a refund. The hardship may be a pending cut-off of electricity, eviction, foreclosure, need for heating oil, or other basic life needs. The taxpayer could use the tax refund to avert these crises, but the tax refund will not come to them because of the outstanding liability. In these circumstances, the IRS can override, or “bypass,” the offset and send the taxpayer the refund. In order to have the IRS override the refund, the taxpayer must contact the IRS and set up the bypass before filing the tax return. Failure to receive approval for a “bypass” before the posting date of the original return forecloses the opportunity to bypass the offset. See IRS Clarifies Procedures for Issuing Offset Bypass Refunds. If the tax refund has already been applied to the prior tax obligation, the IRS will not reverse the offset unless there was a clerical error. See IRM 188.8.131.52.21(5) (Note).
OBR is governed by IRM 184.108.40.206.11.1. In order to request an offset bypass refund, the taxpayer, or representative, should make the request when the return is filed. The request must occur prior to assessment. The request needs to demonstrate the financial hardship the taxpayer faces. The amount of the offset limits the amount of the OBR. For example, if the taxpayer would receive a $1,000 refund and the taxpayer demonstrates a $600 hardship in order to pay the rent and avoid eviction, the OBR will be $600 and not the entire amount of the refund available. The balance of the refund will go to pay the past due tax liability under the normal offset rules. Although the Taxpayer Advocate Service is usually associated with OBR the OBR need not go through TAS. If the IRS fails to make the properly requested OBR before assessment, the IRS can reverse the offset and pay the taxpayer the amount it would have paid based on the taxpayer’s demonstrated hardship.
Going back to the clinic’s case that I mentioned at the outset, we found that the client had not filed tax returns for the past few years. However, when a taxpayer requests the IRS to permit a collection process other than the one normally taken, the IRS generally requires that the taxpayer be compliant with their return filing obligations. The only broad exception to this rule is the hardship exception to having the account placed in currently not collectible status discussed in Vinatieri v. Commissioner. However, since we intended to file an Offer in Compromise for this particular client, we needed to prepare the old returns. These returns, if filed, would generate about a $1300 refund for the taxpayer. This refund amount was enough to satisfy the client’s federal tax obligation and eliminate the need for an offer in compromise. However, the client’s financial situation was so dire that we decided the best option for him involved submitting the returns, requesting an OBR and then submitting an OIC afterwards. This way, the client would both get the refund and clear his federal tax debt. However, in contacting TAS about using this procedure, we learned that the client had other outstanding debts subject to the Treasury Offset Procedure (TOP). These other debts prevented the IRS from granting the OBR since the IRS also forbids “bypasses” if the taxpayer also has a TOP debt (i.e., federal agency nontax debt, state income tax obligations, unemployment compensation debt, or child support). See IRM 220.127.116.11.21(2)(Note) and IRM 18.104.22.168.5.
We then needed to learn the nature and amount of the debts subject to the TOP offset in order to determine how to move forward with his case. We hoped that we would be able to resolve these debts before trying again for a “bypass.” The IRS transcript of account, which provides a picture of a taxpayer’s status for federal tax debts, does not show how much debt a taxpayer owes to the parties entitled to obtain an IRS refund through the procedures of 6402 nor does it identify those parties. To find out this information, you need another type of power of attorney, one for the Bureau of the Fiscal Service an agency of the Treasury Department. You can contact this Bureau via a toll free number 800-304-3107 but if you represent a taxpayer you need a signed Authorization for Release of Information from your client. Once you have the release form for the Bureau, you can contact it and find out what other parties have “dibs” on your client’s refund. However, the Bureau can only tell you identity of the other parties; it does not have any information regarding the amount owed or the reason for the debt. Each individual party would then need to be contacted to find out the specifics for the debt owed.
Our research led us to the conclusion that three other agencies had placed a marker on our client’s refund. One of the other parties was the state taxing authority. We thought we might be able to work with that debt to reduce or eliminate it through a state procedure. However, another one of the debts was child support and the amount of the debt was significant. Although there may be a mechanism for addressing past due (or way past due) child support, a quick consultation with a supervising attorney at the Legal Services Center of the clinic handling those types of cases convinced us that accomplishing a reduction of that debt would be very difficult and would place us way outside the comfort zone of our practice area. So, we concluded that a refund bypass would serve no purpose here. Because the refunds generated by the returns we had prepared would eliminate his federal tax liabilities, we returned to the simple plan of filing the returns and knocking one creditor off of his list.
Section 6402 creates a hierarchy of payment of refunds similar to the hierarchy for payment of unsecured claims in section 507 of the bankruptcy code. Refunds of federal taxes first go to satisfy federal tax debt. Only when that debt no longer exist, does money go to other parties entitled to receive the federal tax refund before the taxpayer. The statutory scheme in section 6402 first pays the refunds to the agency seeking money for child support. In that way, the Internal Revenue Code now also mirrors the bankruptcy code. If you look at the priority payment hierarchy of bankruptcy code 507, you see that the number one priority-unsecured-claim is child support and alimony. However, it was not always this way. In 1978 when the current bankruptcy code was passed, no priority was given to child support and alimony. “Deadbeat dads” filing bankruptcy generally discharged these unsecured claims with little or no payment. In 1994, when the first major bankruptcy reform act occurred with respect to the new bankruptcy code, child support and alimony made it into the code section creating priority claims but only as the seventh priority. In 2005, when the last major bankruptcy reform occurred, alimony and child support moved to the number one spot. It is interesting to see how this particular type of debt moved up over the course of one generation from an afterthought to the top priority. It is also interesting to note that it moved to the number one spot in section 6402. This says a lot about our social priorities and how they have changed.
If a taxpayer due a refund does not have the refund taken by the IRS or by a child support agency, then it must next pass the gauntlet of other federal debts. The statute does not list the federal debts able to be offset by the federal government but you can find it on Page 3 of this GAO Report. The one I see the most often is student loan debt. After federal debt, comes state debt. The list of state obligations varies by state. You can find a list here. Only after the IRS fails to find any debts from these lists does it send a taxpayer the requested refund. Anyone actually receiving the full amount of their refund should feel some sense of financial well-being vis-a-vis a broad spectrum of the government because it means they have a clean bill of health for many agencies.
Many times OBR will not help taxpayers in financial hardship because of their non-tax debts. This seems a little counterintuitive and counterproductive because the IRS is the senior creditor in this situation and it is generating the refund. As the senior creditor, it should have the ability to decide if the person has sufficient need for the refund and to send the refund even if other creditors exist lower in the 6402 queue. As a practical matter, convincing both the IRS and the other creditors, many of whom have a different process or no process for allowing the demonstration of hardship, is a task neither the taxpayer nor a representative can accomplish. So, the person with a hardship ends up fully paying or reducing their debt to the one party that would have waived this payment while the other parties who force the failure of the refund bypass still receive little or nothing on their debt. Perhaps the IRS should receive authority to speak for the queue.