In my last blog post I talked a bit about the three types of offers-in-compromise. Offers as to doubt as to collectability make up a large majority of offers made to the IRS. The key to making a successful offer based on doubt as to collectability is the concept of reasonable collection potential. If your offer amount exceeds what the IRS calculates as your reasonable collection potential than you have a fair chance of it being accepted.
“Pennies on the Dollar”
It is unfortunate but there is this persistent myth, promoted by unscrupulous tax firms, that an offer should be some made up “percentage” of the taxes due. Only a couple of weeks ago I had a potential client in my office, who wanted to file an offer, ask me point blank, “So how much should I offer? 10% or 15% of what is due?” The gentleman owed about $50,000+ in taxes but unfortunately for him he had a moderately successful business, a home (owned free and clear), several pieces of land, and a very nice car. All told, I think he was worth about $300,000 to $400,000. If this gentleman owed you, rather than the IRS, $50,000 would you accept $5,000 or $7,500 to settle his debts? Hell no! Right?!
Unscrupulous tax resolution firms prey on the fears and anxieties the uninformed. Be careful out there! An honest tax firm will never tell you that an offer-in-compromise is right solution for your tax debts unless it has done the work to calculate your reasonable collection potential. If a tax firm promises to settle your tax debts and you haven’t even given them your information you should run, not walk, in the other direction! Ok, I am getting off my soap box now.
What is Reasonable Collection Potential
Reasonable collection potential is the sum of the taxpayer’s equity in assets and net monthly household income. I am going to try and explain both separately. It gets a bit complicated but I have an example at the end which I hope will bring it all together.
Equity in Assets
The IRS looks at all of things you own. Cars, checking and savings accounts, real estate, retirement plans, insurance policies and cash in your wallet are all examples of assets that are included. Equity in assets also includes things that may not immediately come to mind as assets such as a taxpayer’s interest in a trust or estate, a fractional interest in a piece of property (e.g. the family camp), and unsettled lawsuits. So care has to be taken when calculating this first component to think of everything you own.
The IRS understands that for the most part that if you were to sell your assets to pay your taxes that it will not sell at 100% of value. The IRS only looks at an assets “quick sale value” when determining reasonable collection potential. This can change depending on the nature of the asset but for the most part quick sale value is 80% of fair market value. Cash is cash so there is no discount to value. On the other hand, retirement plans or individual retirement accounts often are taxable upon distribution so it may be worth around 70% of fair market value.
Now this is where an experienced tax professional can make a difference. The IRS also allows certain exemptions against the already reduced value of assets. Here are two quick examples: one, the IRS allows up to $1,000 reduction against the balance in your bank accounts; two, you are allowed a $3,450 exemption against the value of one automobile ($3,450 in each vehicle, up to two, if you file a joint offer).
Summarizing everything, your equity in assets is the fair market value of everything you owe, reduced to quick sale value and then further reduced by any applicable exemptions. Once you have this amount, you need to calculate your net monthly household income.
Net Monthly Household Income
Net monthly household income is your gross monthly income, from all sources – taxable or not – less your allowable expenses. Let me pause here for a moment. Allowable expenses are not the same as your actual out-of-pocket expenses. The IRS only allows you to reduce your actual income by what it considers a reasonable amount of expenses.
The idea is that you should only be allowed a minimum level of expenses to reduce your income when you owe the IRS. It provides a list of expense amounts based on local and national standards. These allowable expenses are based on the average amounts people spend nationally or in your local area. As you can imagine this may be skewed if you live in an area where the rich live among the very poor. The IRS does have some discretion to deviate from the standards but it is an uphill battle.
While the IRS can be miserly about most expenses it also does allow for some expenses to be deductible in full. If you have health insurance or court ordered payments than those expenses will be allowed as deductions against your monthly gross income. I will be discussing allowable expenses in my next blog post so for now just understand that the IRS is going to set limits on how much you can deduct from your gross monthly income.
Bringing It All Together
First, you will multiply your net monthly household income by a factor of 12 or 24. The factor used depends on how you intend on paying the offer. You multiply your net monthly household income by 12 if you are making a lump sum offer (payable in up to 5 monthly payments) and by 24 if you are making a periodic payment offer (payable in 6 to 24 monthly payments).
Second, you will add the net monthly household income (times 12 or 24) to the amount of your equity in assets. This is your reasonable collection potential.
Your offer needs to be equal to or exceed your reasonable collection potential to be successful. There are situations where the IRS may still reject such an offer but that is for another post. For now I hope you can see why reasonable collection potential is so important to understand if you are considering making an offer-in-compromise to settle your tax debts.
A “Quick” Example of Reasonable Collection Potential
Robert Smith was a successful business owner right up until 2008-2009 when things took a turn for the worse. He was a self-employed mortgage broker making very good money. As the economy turned sour however he needed money to pay his bills so he stopped paying his estimated taxes. Eventually he had to close down his business and he ended up unemployed and with a very large tax bill.
For purposes of this example let’s say he owes $200,000 in federal taxes, including interest and penalties. Unable to find good paying work he struggles to pay his bills and he cannot afford to pay his back taxes. He loses his home through foreclosure and he has to trade in his nice wheels for something more economical. After years of struggling he comes to my firm to get relief.
When we go over his situation he tells me that he has about $500 in his bank account, a car worth maybe $5,000 and some personal property of very little value. He makes about $2,000 a month at work. Using the IRS tables I determine his monthly allowable expenses are $1,800.
Robert’s reasonable collection potential is either $2,950 or $5,350, depending on what payment plan he uses (either lump sum or periodic payment). Here is how I calculated the amounts. Net monthly household income is $200 ($2,000 gross income less $1,800 in allowable expenses) times 12 or 24. Add to that amount $550 for equity in assets.
Here is how I came to $550 equity in assets. First add together the $500 in the bank plus $5,000 for Robert’s car (ignore his other property). Second, reduce the car to its quick sale value of $4,000 ($5,000 x 80%). The cash in the bank is not reduced to quick sale value, cash is cash. Finally, apply the IRS exemptions to the assets. A $1,000 exemption in applied to the money in the bank, reducing it to $0; an additional exemption of $3,450 is applied to his car, reducing it to $550.
Based on the above, Robert may be able to settle his tax debt for either $2,950 or $5,350. While the calculations can be complicated, the results are simple enough to understand. Potentially, settling over $200,000 in unpaid taxes for less than $10,000 is an amazing result. Everyone’s situation is different so you may not get such good results but it is possible. You can also see very clearly that some thought has to go into determining if you are an offer candidate.
If you have any questions please contact my firm. I help Maine taxpayers in trouble to resolve your tax debts. If you or someone you know in the Portland, Maine area wants more information on whether or not you qualify for an offer-in-compromise, please feel free to contact me directly at 207-299-0515 or by filling out my contact form. A Maine tax attorney can help you consider your options.