Is the Portion of IRS Tax Debt Forgiven with an Offer in Compromise Taxable?

If you are struggling to pay your back taxes, an Offer in Compromise (OIC) to settle for less with the IRS is one of the most popular tax relief options.

One question delinquent taxpayers frequently ask when they submit an offer is whether the tax debt amount forgiven by an Offer in Compromise is tax-free.

We will review how the IRS considers forgiven debt and how that applies to OIC settlement amounts.

Does the IRS Generally Consider Forgiven Debt as Taxable Income?

Yes, the IRS treats most forgiven debt as taxable income. If you have a settlement with a creditor for canceled or forgiven debt, you must report the amount on your federal return as income and pay taxes on it.

However, this rule does not apply to tax debt “forgiven” by the IRS for an OIC (see below).

Are There Any Exceptions to Forgiven Debt Being Taxable?

Yes, here are a few examples of exemptions to forgiven debt being taxable:

• Debt canceled as a gift or inheritance is not considered income.
• Qualified student loans forgiven in a profession will not count as income.
• Qualified educational loans canceled for healthcare workers are not considered income.
• A qualified purchase price reduction a seller gives to a property buyer is not counted as income.

In each of these scenarios, the canceled or forgiven debt does not need to be reported as income on your 1040 tax return. Keep in mind general conditions that apply to debt forgiveness by a creditor do not necessarily apply to OIC tax debt forgiveness.

Does the IRS See an Offer in Compromise as “Debt Forgiveness” for Taxes?

As we have discussed, an Offer in Compromise is technically NOT considered debt forgiveness by the IRS. It is instead a legal settlement between the taxpayer and the IRS to resolve the taxpayer’s back taxes for a lower amount than the total balance due.

Offer in Compromise agreements can require the taxpayer to pay a lump sum or make monthly installment payments to pay off the OIC settlement amount.

Will the IRS Tax the Amount of Your Full Tax Liability It Forgives With an OIC Settlement?

The portion of IRS tax debt forgiven with an Offer in Compromise is not taxable as income. When the IRS accepts an OIC, they agree to settle a taxpayer’s debt for a fraction of the original amount owed.

This forgiven amount is not considered taxable income because the IRS treats it as if the taxpayer never had the money in the first place.

So, the IRS does not require you to report an OIC settlement amount as income or pay taxes on it.

However, although the forgiven tax debt itself is not taxable, payments made as part of the OIC process may have tax implications.

For example, if you resolve your tax debt with an Offer in Compromise but withdrew funds early from a retirement account to make your OIC payments, you may have to pay an early withdrawal tax penalty.

Does the IRS Issue Tax Forms or Require You to Report Forgiven Tax Debt from an Offer in Compromise?

Since the canceled tax debt from an OIC is not taxable, the IRS does not issue tax forms specifically for reporting the forgiven amount. No 1099-C form will be sent for tax debt forgiven by an Offer in Compromise.

What Is a 1099-C?

A 1099-C is a tax form to report canceled debt. When a creditor forgives a debt owed by an individual or business, the forgiven amount is considered taxable income in many cases.

Creditors send form 1099-C to the taxpayer and IRS to show the amount of debt canceled that needs to be included on a tax return.

If you have back taxes you owe the IRS and want to learn more about whether you qualify for an Offer in Compromise settlement, a tax expert can help you navigate the OIC process to reduce your tax liability.

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