The term “income averaging”, when used to determine a taxpayer’s reasonable collection potential for Internal Revenue Service (IRS) collection purposes, refers to the use of an average of the taxpayer’s past income in lieu of the taxpayer’s current earnings. Specifically, the current earnings of the taxpayer are substituted with an average of the taxpayer’s historical earnings.
When submitting a Collection Information Statement (CIS) to the IRS on behalf of a taxpayer that owes IRS back taxes, a practitioner should be aware of the earning history of the taxpayer and be able to explain any fluctuation of current income from the prior years’ earnings. Hence, fluctuation in income is the key element that may trigger the use of the taxpayer’s earning history for CIS analysis purposes. The Internal Revenue Manual specifically identifies the possible use of income averaging to determine the income of self-employed, commissioned sales, or sporadically employed taxpayers. See Internal Revenue Manual Sections 188.8.131.52.2(6)(09-01-2005); 184.108.40.206(5)(09-01-2005); and 220.127.116.11(6) (09-01-2005).
On one hand, averaging of income is a logical basis for determining income when there is fluctuation in income because a taxpayer’s earning history is normally representative of that taxpayer’s earning potential in the future. Yet, on the other hand, changes in circumstances may warrant deviation from use of a taxpayer’s earning history. Therefore, income averaging may be used by either the IRS or the taxpayer as the basis for deviating from the current income shown on the CIS.
The Internal Revenue Manual expresses that “[J]udgement should be used in determining the appropriate time to apply income averaging on a case by case basis. All circumstances of the taxpayer should be considered when determining the appropriate application of income averaging…” Internal Revenue Manual Section 18.104.22.168(6) (09-01-2005). In practice, the IRS will selectively choose the scope of time that will be used to average a taxpayer’s income. This is because there is no requirement that a specific amount of time be used in every case. Although Internal Revenue Manual Section 22.214.171.124(5) (09-01-2005) states that an income average of three years is usually applied where the taxpayer has sporadic employment history (emphasis added), the use of three years is not required. The average of more or less years may be more representative of the taxpayer’s true earning potential. Therefore, the special circumstances showing why the amount of time selected to be averaged by the IRS is not representative of the taxpayer’s true earning potential must be logically presented to the IRS.
Fluctuation in income is normally most apparent in taxpayers that are self-employed or commissioned sales persons. This is because these taxpayers do not have set wages. Therefore, their net earnings are a product of their gross earnings minus their expenses paid to earn such income. Their gross earnings are normally at the mercy of the market of their trade. Since there is the potential that their income may either increase or decrease – sometimes, substantially in either direction – it may be argued that a larger scope of time needs to be analyzed to determine the taxpayer’s true earning potential. This can be to the taxpayer’s detriment or benefit.
The common example is where the taxpayer’s current self-employed or commissioned earnings are higher than their income history. The IRS will likely argue that the taxpayer’s current earnings shows a potential for continued success and that the taxpayer’s earning history is not representative of their current or future earning capacity. Depending on the type of resolution sought, the taxpayer may be able to counter the IRS’s position by demonstrating that their earnings have historically been less than their current earnings. The data of the taxpayer’s earning history coupled with facts explaining the reason for the fluctuation in income may be a basis for disputing the IRS’s position.
Alternatively, the same IRS collection agent would likely argue the opposite position when the current earnings for a selfemployed taxpayer show a decrease from the earning history. Hence, the earning history, when averaged, is a more accurate representation of the taxpayer’s earning potential because the taxpayer has a history of being able to earn more money than they are currently earning. Again, an alternative position lies in the factual presentation available to the taxpayer such that the earning history has no basis on the current or future earnings of the taxpayer. Both positions are disputable with similar logic.
As indicated above, in the case of a taxpayer that holds sporadic employment, a three-year average is usually used when determining the taxpayer’s collection potential. Internal Revenue Manual Sections 126.96.36.199(5) (09-01-2005)(emphasis added). The justification for such application of income averaging is that the taxpayer’s periods of earnings are, or can be, offset by their periods of unemployment. Facts specifying the frequency of employment and type of earnings during the subject period are the special circumstances that will allow the taxpayer to utilize or dispute the use of income averaging.
In situations where a taxpayer has zero income, a non-collectible status is the preferred resolution to an offer in compromise because such resolution is to be based on the current earning potential of the taxpayer. Whereas, the analysis performed for purposes of an offer in compromise requires a determination regarding the taxpayer’s future earning potential. For purposes of an offer in compromise, the IRS will seldom agree that the taxpayer’s income is completely zero and will remain zero for the future income period. Often, the IRS will impute income to the taxpayer, such as the prior year’s income, disability income, government benefit income, minimum wage income, income averaged over a period of time, bank deposit income, average income of similarly educated persons, or some other basis (reasonable or unreasonable). Depending on the taxpayer’s earning history, there may be a benefit to presenting the income average of the taxpayer as a reasonable calculation of the taxpayer’s earnings so that the IRS does not need to get creative when imputing income to the taxpayer.
To ensure the appropriate tax settlement for each a taxpayer’s unique situation, an analysis comparing the taxpayer’s current earnings to their earning history should be utilized when the taxpayer’s income fluctuates or is inconsistent. Such analysis will allow the practitioner to develop a tax resolution strategy that will apply the taxpayer’s special circumstances to the most beneficial financial analysis.