How Reasonable Collection Potential affects your Offer in Compromise

18 July 2015
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The Offer in Compromise

An offer in compromise (OIC) is an agreement between a taxpayer and the Internal Revenue Service (IRS) that settles the taxpayer’s tax liabilities for less than the full amount owed. Taxpayers who can fully pay the liabilities through an installment agreement or other means, will not be eligible for an OIC in most cases.

In order to be eligible for an OIC, the taxpayer must have:

1. filed all tax returns;
2. made all required estimated tax payments for the current year
3. made all required federal tax deposits for the current quarter, if the taxpayer is a business owner with employees.

How do I know if my offer will be enough?

In my experience it is not possible to know if your offer will be accepted (about 1 in 4 are), but it is possible to know if it will be rejected before you even file. In most cases, the IRS will not accept an OIC unless the amount offered by a taxpayer is equal to or greater than the reasonable collection potential (RCP). The RCP is how the IRS measures the taxpayer’s ability to pay. The RCP includes the value that can be realized from the taxpayer’s assets, such as real property, automobiles, bank accounts, and other property. In addition to property, the RCP also includes anticipated future income less certain amounts allowed for basic living expenses.

How does the RCP Calculation work?

Lets take a look at a hypothetical business owner. Ned used to be a top salesman at a high flying software company, but he was laid off and is now self-employed. Ned owes the IRS $190,000 in back taxes. He has a home worth $265,000, but he owes $165,00 on it. He runs a successful lawn care business and nets about $84,000, after business expenses. He owns two trucks and some lawn care equipment worth about $38,000. He also owns an old sports car worth about $12,000. He has a 401(k) account with about $50,000 in it, but he has borrowed about $20,000 to cover out-of-pocket medical expenses from an injury. Ned’s living expenses are $5,250 a month.

Let’s calculate Ned’s RCP:

Step One – Asset Evaluation

1. Ned’s home is worth $265,000 but the quick sale price of his house (FMV x .80) is only $212,000. After allowing for his first mortgage debt, he has $47,000 of equity available. For offer purposes, we will count $47,000.

2. Ned’s two trucks and business equipment all generate income for his business. Under current IRS rules, equity assets that produce income will not be factored into an offer because the income steam produced by those assets will be picked up in the future income calculations (see below).

3. Ned’s car is worth $12,000, but the quick sale value is (FMV x .80) is only $9,600, which we will use for offer purposes.

4. Ned’s 401(k) is worth $50,000, but we can argue that the liquidation value of this asset is about 70%, which gives us a value of $35,000. Since Ned also has a loan of $20,000 against the account, there is only $15,000 of asset value here for offer purposes.

Ned’s total asset value for offer purposes is $71,600; this figure represents the asset based component of his RCP.

Step Two – Future Income

Ned is making a nice living from his lawn care business, but he is not getting rich. Nonetheless, the IRS still looks at his income when calculating RCP. Ned makes $84,000 a year or $7,000 a month, and his allowable monthly expenses are $5,250, leaving him with $1,750 a month. Assuming Ned wants to pay off the IRS quickly (within 5 months), the IRS will only look at 12 months of future income (12 x $17,50) or $21,000, otherwise they will multiply his remaining income by 24.

Ned’s Recommended Offer Amount

If Ned wants a reasonable chance a settling with the IRS, his offer should be $92,000 (his RCP).