If you owe the IRS more in taxes than you can comfortably pay, then you may be able to negotiate an offer in compromise. An offer in compromise is pretty much what it sounds like: a compromise on your existing tax bill, meaning you agree to pay part of what you owe, and the IRS agrees to forgive the rest.
Offer in compromise requirements
Before you can start the offer in compromise process, you'll need to meet certain requirements. First, you must have filed all required tax returns. Second, you must have received at least one bill from the IRS for your existing tax debt. And third, you must have made all estimated tax payments for the year and (if you're a business owner) made all your payroll deposits as well.
You also need acceptable grounds for making the offer. The IRS will accept one of three official grounds: doubt as to collectibility, effective tax administration, and doubt as to liability. The most frequently used of the three reasons, doubt as to collectibility means that the IRS isn't sure it will ever be able to collect the full amount of your tax bill. Effective tax administration is a fancy way of saying that you have some special circumstance that would make paying your tax bill in full an economic hardship for you, even if you technically have enough assets and/or income to cover the debt. Finally, doubt as to liability means that you can prove you shouldn't owe the taxes at all. This last option is so rarely successful that it's usually not even worth trying.
Filling out the paperwork
Getting started with an offer in compromise means filling out a whole lot of paperwork. First, there's Form 656, the main Offer in Compromise form. It asks for basic information about you and your debt, asks you to select one of the official grounds, and allows you to make a payment offer in the form of either a single lump sum or a periodic payment plan running anywhere from six to 24 months.
Next, you get to fill out Form 433-A (or Form 433-B, if you're requesting an offer in compromise on business taxes). This form requires you to disclose your assets, income and expenses in excruciating detail. Tedious as this form is, you have to fill it out as completely and accurately as possible, as this is the information the IRS will use when deciding whether or not to approve your offer.
You can find Form 656 and both varieties of Form 433 on the IRS website.
How much to offer
What the IRS is looking for at this point is an offer equal to either the value of your assets (meaning they expect you to sell everything you own and use the money to pay your tax bill) or your disposable income (meaning the amount of your monthly income that's left over after subtracting your monthly expenses). Form 433 provides a formula that you can use to plug in your income and asset information and spit out an offer to make to the IRS.
If you use the Form 433 formula and the result is more than you're willing to pay, then you'll need to try the "special circumstances" approach. The best way to do so is typically to attach a letter to your paperwork explaining why you can't pay as much as the formula indicates. For example, you might tell the IRS about a serious medical condition you have that will hinder your ability to bring in income and will also result in higher expenses in the near future. If you have medical records or other proof of your condition, attach copies of these documents to the letter.
Yet more paperwork
Once you've filled out the forms, the IRS will want to see some proof of the information you just provided. The agency will typically ask for pay stubs, bank statements, deeds and registration forms for your assets, loan documents, and anything else they can think of. Pulling together and sending in all this paperwork can take quite a lot of time and effort on your part, but it's a necessary part of showing that your offer is a valid one.
If the IRS turns down your offer
If the IRS accepts, you have only to start sending them payments according to the plan you proposed. But if they reject your offer, that doesn't mean you're completely out of luck. The rejection letter will state why your offer was turned down (almost always because it was too low). You can then resubmit your offer at a slightly higher amount. If you send in the new offer within a month of the old one and your circumstances haven't changed, you won't need to fill out all those forms again; just send a letter with the revised offer and payment plan.
Alternatively, you can appeal the decision. A formal appeal requires you to fill out and send in Form 13711 within 30 days of the date on the rejection letter. The IRS will either send your request to the Appeals Office or respond with an offer of their own. You also have the option of calling the officer who signed the rejection letter and asking him or her to reconsider. You may be able to negotiate with the officer directly, rather than going through the standard appeals process.
Whatever approach you choose, hang on to your patience and remember that if all goes well, you'll be able to significantly reduce your tax debt and get a particularly nasty creditor off your back.