Individuals and businesses that have outstanding tax balances due can face severe penalties from the IRS, including the eventual seizure of personal or business assets in some cases. To handle this dilemma—which can trigger a significant financial crisis—a new type of business has sprung up to help delinquent taxpayers cope with their tax debts.

Known commonly as tax settlement firms, these entities claim that they can either drastically reduce or completely eliminate whatever the client owes the IRS.But can these firms really deliver what they promise? This article examines how tax settlement firms work and their success rate.

(The auditor's review isn't always the last word. Many taxpayers who are audited can successfully appeal their audits and save thousands of dollars. Check out "How to Appeal Your IRS Audit.")

What Are Tax Settlement Firms?

The tax settlement industry mirrors other debt settlement firms in some respects. Most firms that specialize in tax settlements claim to have a litany of tax experts available who are former IRS employees who can go to bat for clients. In reality, this may be a substantial misrepresentation—at least in some cases. Although there may be a few lawyers and a handful of people in the company who worked for the IRS at some point, the majority of employees probably haven't. In fact, the majority of employees may be little more than minimum-wage customer service representatives.

(Learn more about debt settlement in "A Guide to Debt Settlement.")

What They Offer

Most tax settlement firms promise to send their experts to the IRS to negotiate on behalf of the client, where they can presumably persuade the IRS to accept a much smaller amount, such as for pennies on the dollar. In reality, this is virtually impossible to do, and the IRS very, very seldom accepts any real reduction in the amount of tax owed unless the taxpayer is near death or totally unable to obtain any type of gainful employment and has absolutely no assets whatsoever that could be used in a meaningful way to cover the required tax liabilities. The best that everyone else can hope for is perhaps an extension of time to pay their taxes.

(For more insight on getting an extension, see "When You Can't Pay Uncle Sam.")

Offer in Compromise

Tax settlement firms use an accepted IRS procedure known as an "offer in compromise" in an effort to reduce their clients' tax bills. This is a special agreement that some taxpayers can make with the IRS to settle their tax debts for a lesser amount than what is owed. The taxpayer must supply substantial information to the IRS about his or her current assets and liabilities as well as projected future income.

However, the number of offer-in-compromise applications that get approved is generally very low. In order to have such a reduction approved, taxpayers must prove that the total amount owed is incorrect, the probability of being able to pay back the full amount is very low or paying back the full amount will result in tremendous financial hardship. Qualifying for one of these offers may be more difficult than qualifying for Medicaid, and no spend-down strategy is available for this. Offers-in-compromise also typically take at least several months to complete.

Tax Settlement Firm Price Tag

The majority of tax settlement companies will charge their clients an initial fee that can easily run anywhere from $3,000 to $6,000, depending upon the size of the tax bill and proposed a settlement. In most cases, this fee is completely nonrefundable. This fee quite often mysteriously mirrors the amount of "free cash" that the client has available.

Clients have also complained to the Better Business Bureau (BBB) that some of these firms have not produced any of the promised results and in fact, the organization was a scam. Many firms also materially misrepresent their fees to clients, perhaps charging them a lower amount, to begin with, and then coming back for more once they are deeply involved in the process.

Settlement Firm's Success Rate

As stated previously, the IRS rejects the majority of offers-in-compromise that it receives each year. Therefore, the number of clients who get satisfaction from tax settlement companies is probably somewhere below 10% and most of them are virtually destitute financially. The vast majority of potential settlement clients need to work out payment plans with the IRS that will allow them to clear out their tax balances over time while keeping their assets—and dignity.

Who's For Real?

There are several red flags that should warn away prospective customers considering hiring a tax settlement firm. Any firm that promises a drastic reduction of a customer's taxes without first getting a detailed financial background on that person is likely going to end up being a scam. Any tax agent who does not ask a customer why the client owes the IRS money is not conducting the full due diligence process that would be required for a proper appeal.

Any reputable firm will first obtain the necessary financial data from its customers and then give them a realistic assessment of what they can do for a reasonable fixed fee. Prospective clients would be wise to find a local firm that's been in business for several years and has a presence in the community.

Warnings from the IRS

The IRS is probably the most difficult of all creditors for many taxpayers to deal with. It has the legal power to seize assets and to push forward with extreme collections measures, and therefore many delinquent taxpayers find the agency much more intimidating than private debt collectors or credit card companies. Tax preparation firms play heavily upon this fear, promising a lifeline of professional help that can make their problems go away. Don't be fooled by misleading claims from these outfits that first require substantial up-front payments.

The IRS itself previously issued warnings to the public about fraudulent firms, citing many of the problems listed here. (If you can't pay your taxes, know that the IRS has many avenues for collecting what you owe.

To learn more, see "IRS Asset Seizures: Could It Happen To You?") To understand the process, start by reading "Publication 594, 'The IRS Collection Process.'" It also offers a detailed description of the Offer in Compromise process and a description of the collections process. Compare that information to anything you are told by a tax settlement firm to make sure you have been given correct information.

The Bottom Line

The tax settlement business is fraught with peril at every turn. Those seeking assistance with their unpaid tax balances should have their tax or financial advisor refer them to a qualified tax attorney who has years of experience dealing with this issue. They should also be prepared to undergo extensive financial analysis and bureaucratic process that may stretch out for months. Most of all, they should be prepared to hear the word "no" from the IRS in the end.