By William Brighenti, CPA
An Offer in Compromise is an agreement between the taxpayer and the government that settles a tax liability for payment of less than the full amount owed. The Internal Revenue Service will generally accept an Offer in Compromise when it is unlikely that the tax liability can be collected in full and the amount offered reasonably reflects collection potential. Consequently, it is essential to do the math before deciding to pursue an Offer in Compromise, since if it is not unlikely that the tax liability can be collected in full and/or the amount offered does not reasonably reflect what the IRS could potentially collect from you through liens on and seizure of your assets as well as garnishments on your wages, you will not only waste valuable time processing this lengthy, detailed application, but may incur thousands of dollars in costs in hiring professionals to assist you, and incur needless application fees and installment payments if other alternatives are available and preferable.
There are other alternatives to pursuing an Offer in Compromise in order to settle a tax assessment, including installment agreements, partial installment agreements, penalty and interest abatement requests, bankruptcy, etc. The ideal alternative depends on the individual circumstances of the taxpayer, including the amount of the tax liability as well as the ability of the taxpayer to pay it. Assuming that all of these alternatives already had been considered and found wanting, the key in deciding whether an Offer in Compromise should be pursued is determining the amount of the offer that is required in an Offer in Compromise submission in order to be acceptable to the Internal Revenue Service. There is a mathematical algorithm consisting of variables and parameters that needs to be calculated to determine your offer. It is not simply a number picked out of the air or “pennies on the dollar.” The process of determination is rigorous and driven by a mathematical procedure to minimize frivolous offers. You do not want to initiate a negotiation with the IRS with a ridiculous offer. Not too long ago the Internal Revenue Service issued an alert to taxpayers to beware of promoters’ claims on television and the Internet that tax debts can be settled for “pennies on the dollar” through their professional services, inappropriately advising indebted taxpayers to file an Offer in Compromise application with the IRS. The IRS characterized such advice as bad, only costing taxpayers additional money and time.
The purpose of this article is to explain how the amount of an offer is determined; however, it is not meant to encourage any unprofessionally trained taxpayer to prepare his own Offer in Compromise. If such were the intent, then this article, in effect, would be guilty of leading sheep to a slaughter. Only an experienced professional should be entrusted to undertake the actual final preparation of the application since its processing and terminology are subtle, detailed, and complex. Moreover, a great deal of supportive documentation needs to be obtained and included. Finally, too much is at stake to the taxpayer.
Your first step in deciding whether to pursue an Offer in Compromise is to estimate what the IRS terms your “Reasonable Collection Potential” (RCP). This is essentially the heart of any Offer in Compromise and will be the basis of the Internal Revenue Service’s decision as to whether to accept or reject your offer, since the IRS requires that your offer equal or exceed your RCP. The Reasonable Collection Potential, in essence, is what the IRS reasonably and potentially could expect to collect from you from the attachment of your wages and income as well as from the seizure of your assets in order to settle the tax assessment against you. It equals your Realizable Value (RV) of all of your assets after paying off the Loan Balance (LB) remaining on any asset plus typically four to five years (depending upon the terms of your offer) of Disposal Income (DI), which equals Monthly Income (MI) less Necessary Living Expenses (NLE). If your offered amount is below the RCP, it ordinarily will be rejected, unless you can demonstrate extreme hardship.
The Realizable Value (RV) of your Monetary Assets (MA)–such as cash, bank balances, investments, life insurance cash value, and accounts/notes receivable–are ordinarily their face or Current Values (CV). The Realizable Value of your Non-Monetary Assets (NMA)–such as real property, vehicles, personal assets, furniture and personal effects, business assets, books and tools–require the following computation:
RVNMA = FMV x 80% – LB
NMA = Non-Monetary Assets;
FMV = Asset’s fair market value determined by appraisals, book values, written estimates, published valuations, etc.;
80% = IRS's discount factor representing what you could reasonably expect from the sale of an asset if you sold it quickly typically in ninety days or less;
LB = Loan Balance remaining on any asset as of the date of your offer.
In addition to discounting the fair market value of furniture, personal effects, books, and tools, you are also entitled to exempt $7,900 from your Realized Value of furniture and personal effects and $3,950 from that in books and tools, as long as the exemptions do not decrease your computed equity in each of these two asset classifications below zero.
The Internal Revenue Service expects you to include in your offer the payment of the RV of your personal and business assets since it reflects your accumulated wealth and, as such, usually a significant component of your Reasonable Collection Potential. The IRS, in effect, expects you to pay a portion of your tax assessment by liquidating assets, obtaining loans from lending institutions on your equity in your assets, borrowing on your home equity through a second mortgage or reverse mortgage, borrowing on any available balances on credit cards, borrowing funds from family members, friends, and others.
In addition to offering your equity in all of your assets, the IRS ordinarily requires 4 or 5 years (contingent upon the payment terms of your offer, theoretically up to 10 years) of monthly installment payments of an amount representing your monthly disposable income. If you agree to full payment of your offer within 5 months, you would make 48 installments; if you agree to full payment of your offer within 24 months, you would make 60 installments; if you agree to full payment of your offer over the remaining statutory period of collection (120 months less the number of months since the date your liability was assessed), you would pay an installment each month in the remaining statutory period for collecting the tax.
Now you are ready to reduce the concept of the minimum offer represented by the Reasonable Collection Potential in an Offer in Compromise to the Internal Revenue Service to the following algorithm:
RCP = ∑MACV + ∑ NMA(FMV x 80% – LB) – $7,900FPE – $3,950BT + #MO x DI
MA = Monetary Assets;
CV = Current Values;
∑MACV = Your total equity in Monetary Assets;
FPE = Exemption for furniture and personal effects, limited to RV or $7,900, whichever is less;
BT = Exemption for books and tools, limited to RV or $3,950, whichever is less;
∑ NMA(FMV x 80% – LB) = Your total equity in Non-Monetary Assets before exemptions;
#MO = Number of MOnthly installment payments (48, 60, or 120 – # of months since assessment);
DI = Disposable Income = Monthly Income (MI) – Necessary Living Expenses (NLE).
Monthly Income (MI) includes your average or current monthly wages, interest, dividends, pensions, social security, child support and alimony, Schedule C’s line 31 net profit divided by 12, Schedule E’s line 26 total rental and royalty income divided by 12, total distributions reported on Schedules K-1 divided by 12, etc.
NLE includes monthly allowances for food, clothing, housekeeping supplies, personal care products, rent or mortgage payment, property taxes, residential insurance, maintenance, dues, fees, utilities (gas, electricity, water, fuel, oil, trash collection, telephone), lease/loan payments on vehicles, vehicle operating costs (maintenance, repairs, insurance, fuel, registrations, licenses, inspections, parking, tolls), mass transit fares (bus, train, taxi, ferry), health insurance, out of pocket health care costs (medical services, drugs, medical supplies – e.g., eyeglasses, hearing aids, etc.), court order payments, child/dependent care, life insurance, income and FICA taxes, secured debts.
Regarding food, clothing, housekeeping supplies, and personal care products, the IRS furnishes a table of total monthly national standards for these expenses and is presented below; the use of these values obviates any verification and substantiation on your part. The amounts are based on surveys of consumer expenditures prepared by the United States Department of Labor’s Bureau of Labor Statistics.
Apparel & Services
Personal care products & services
Over Four Persons Amount
For each additional person, add to four-person total allowance:
Unless higher amounts can be substantiated as “necessary” living expenses with all required supporting documentation, it typically is advisable to use the amounts listed above for the corresponding expenditures for the expense category, “Food, Clothing and Misc.” on Form 433-A, the Offer in Compromise’s Collection Information Statement.
Copies of documents of all other income and expense items, including your prior year tax returns, need to accompany your Offer in Compromise in order to substantiate and verify these amounts to the Internal Revenue Service.
As you can see from all of the above, there is a precise formula used by the IRS in the determination of your Reasonable Collection Potential and, consequently, the minimum amount of your offer. It is unlikely that a "pennies on the dollar" value would be derived from this computation, and you would be advised not to submit any offer that could be construed as frivolous. Before deciding on submitting an Offer in Compromise and engaging expensive professionals to prepare the application, it might be prudent for you to calculate your Reasonable Collection Potential, or minimum offer, using the above algorithm. It is suggested that you set up the above algorithm and formulas in an Excel spreadsheet, enter the values of all of the requisite variables and parameters, and see how your calculated offer would vary using different assumptions, estimates, and data sets. Moreover, if you are undecided about which of the three basic payment terms you should select, just insert 48, 60, and 120 – number of months since your tax assessment, into the algorithm to see their impact on your offer. This exercise alone may minimize errors of omission, incorrect estimates, and miscalculations in judgment, resulting in significant tax savings. Although precise numbers may not be readily available for some of your living expenses and the like, at least guesstimates may be sufficient to assist you enough in arriving at an intelligent decision as to whether an Offer in Compromise is the appropriate economic course of action for you to pursue in the settlement of your tax liability assessed by the Internal Revenue Service.
This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice. For further information, please consult appropriate professional advice from your attorney and certified public accountant.
Have a tax or an accounting question? Please feel free to submit it to William Brighenti, Certified Public Accountant, Hartford CPA Accountants. For information and assistance on any tax and accounting issue, please visit our website: Accountants CPA Hartford.