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Tax debt settled for pennies? Don't count on it

April 15 can be a day of fear, loathing or even downright panic – and that can work to great advantage for companies anxious to separate people from their money. While confused consumers are profitable consumers, frightened consumers are a gold mine.

That's why, as tax day approaches, you are hearing seemingly nonstop advertisements for companies that claim magical powers to wipe away tax debt.  The ads bear a striking resemblance to those credit card debt settlement companies I've written about, but there's this extra punch to their offers: While credit card firms can be intimidating, most Americans are terrified of the IRS.

That's why promises to "end the nightmare" and erase debt for "pennies on the dollar" can be quite persuasive.

As with many unscrupulous offers, the reason this one is so pervasive is because there is a grain of truth to the claims. Yes, in extreme circumstances, the IRS will settle old debts for a tiny percentage of the outstanding balance. But in most of those cases, the consumer is either near death or completely unemployable and without any valuable assets.

Instead of describing these long odds, many tax debt settlement companies sweet talk clients. Then they take large up-front payments -- prices start at $3,000 and climb fast from there – but do little or nothing to help with the tax problem, according to Illinois Attorney General Lisa Madigan.

"These companies help virtually no one," Madigan said.

Madigan and 17 other state attorneys general  sued tax debt firm J.K. Harris in 2008, accusing it of misleading consumers. The firm -- one of several tax debt firms to be hit with class-action lawsuits -- paid $1.5 million to settle the case but admitted no wrongdoing.

Firms often advertise that they have local offices staffed with former IRS employees, which is usually quite a stretch of truth, she said.

"Maybe they'll have one former IRS person, but most (employees) don't have that experience," she said.  And many of the local offices are really just mailboxes or empty conference rooms.

Firms that advertise tax debt settlement services are selling a legitimate IRS procedure called an "offer in compromise." If IRS debt collectors determine that the federal government has no chance of collecting on a tax debt, the agency will consider settling for a lesser amount. But the process is long, drawn out and relatively painful. No one can quickly obtain a "pennies on the dollar" settlement with the IRS, Madigan warned.

Back in 2004, the IRS issued a warning about such debt relief claims.

"We are increasingly concerned about unscrupulous promoters charging excessive fees to taxpayers who have no chance of meeting the program's requirements," said IRS Commissioner Mark W. Everson in a statement. "We urge taxpayers not to be duped by high-priced promises."

The agency did not respond to requests to be interviewed for this story. But in 2007, it told CNBC that it rejected nearly three-quarters of the 46,000 settlement offers it received.

Larry Lawler is a tax debt expert and executive director of the nonprofit American Society of Tax Problem Solvers, which advocates for tax experts that help consumers with debt. While freely admitting some firms that aggressively advertise are trying to dupe consumers, he says a few bad apples have given his industry "a black eye that is underserved."

Many tax debt agents offer legitimate help to consumers, he said, though that help rarely results in debt forgiveness. He said nine out of 10 of the clients he personally represents must pay their entire tax bill, but he helps them reach an affordable installment plan with the IRS.

Settlement offers are far more lucrative for tax debt solution companies, he said. Even the most complex installment arrangement earns his firm only about $1,700, while tax settlement companies frequently charge $6,000 or more for a settlement that lessens the tax debt, he said. That's often the last few thousand dollars the debtors have.

"So they push for the easy sell and thing they can make a quick buck on," he said. "There are people out there with real, legitimate tax problems ... and there are charlatans out there, raping people, taking their money and not doing the job."

HerbboxIn some cases, tax debt firms don't even bother to fill out the forms correctly. The Internet is awash in complaints from consumers who never talk to the same agent twice or say that settlement firms raided their bank accounts after they signed over a power of attorney.

Many firms also have poor Better Business Bureau ratings.  For example, American Tax Relief – which advertises nationally, currently has an "F" rating from the Los Angeles office of the Better Business Bureau. The firm did not return a phone call requesting comment.

Calling a tax debt assistance company is tempting for many consumers because it is daunting to deal with the IRS, Madigan said.

"While many people have spoken to credit card companies at some point, most people haven't picked up the phone to call the IRS," she said. "And most believe if you are having a problem with taxes, the best thing you can do is engage an expert. That's what these advertisements are promising people, but not delivering."

Lawler said that despite the mine field of tax settlement firms, consumers often do need professional help to address their tax debt -- and ignoring it simply makes things worse. In an attempt to help consumers find honest help, his agency offers a certification program, though so far only about 100 professionals around the country have completed it.

But he said consumers can spot trouble with relative ease.  Any tax debt agent who suggests during an initial 30-minute conversation that a consumer can submit an offer in compromise is probably selling snake oil, he said.

"You can't tell someone they are a good candidate in an initial meeting, he said. "You have got to do an extensive financial analysis."

That's because the IRS requires documentation of every asset and expense, in great detail.  "I always tell people a consumer can't hire someone to do an offer of compromise," Lawler said. "They must hire you for help finding the best solution to their tax problem, whatever that is. ... The vast majority of cases are not good candidates for an offer in compromise."

Jeffrey Rogyom is a tax lawyer in Maryland who recently penned a top 10 list of ways to spot a potential tax debt scam. Among the red flags on his list:

  • The agent never asks why you owe the IRS money.
  • They advertise so much you know their name.
  • Your first payment "strangely reflects how much cash you have."
  • The firm uses a "phantom office."  He recommends Googling the address to see if it's a real office complex or something more suspicious.

"These companies promise you the world, that's how they make their money," he said. "For some people (settlement) is a great option, but many people really need to be told they should file for an installment plan."

The tax debt business, however, is a murky  world, Lawler said. Some clients are more interested in evading taxes that paying their debts, while others cite constitutional arguments for not paying federal income taxes.  If they try to do either, Lawler said, he "shows them the door."  And while "99 percent" of consumers never set out to avoid paying taxes, the spectrum of tax relief clients runs from saints to sinners, making his a complicated business.

"I tell people our clients have not paid their taxes, owe the government a bunch of money, but we love them and we want a bunch more of them," he said.

Lawler said consumers with tax trouble would be better off ignoring the radio advertisements and working with someone they can meet face-to-face.

"You really should go to someone who's local, someone where you  can knock on their door and talk to them, who will answer the phone, who's been in the community a long time," he said.

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