Reasonable Collection Potential
Thousands of taxpayers owe the IRS far more in back taxes than they can possibly pay in their lifetimes. If you are one of these people, take some comfort that you are not alone. The IRS knows that most, if not all, of these taxpayers will stop filing returns and stop paying even current taxes, hoping that somehow the IRS will not find them or never pursue them. When the certified mail from the IRS arrives, they put them into a drawer, pretending that the problem just doesn’t exist. Unfortunately it does exist, it isn’t going away and it needs to be confronted before it grows into an even bigger problem.
One of the possible approaches to resolving this long standing situation is to offer the IRS a lower amount to completely settle the tax debt, an offer in compromise. You have seen on TV (and I am sure been tempted to call) tax relief hucksters promising to reduce your tax debt by up to 90%! Who could resist that? It depends upon two concepts which require extensive explanation. The first concept is called “economic hardship” and the second is “reasonable collection potential (RCP).” This article will cover the latter term – RCP.
If you are contemplating making an offer to the IRS to settle your tax debt, you will need to compute the RCP because if you make an offer that is LESS than RCP it will be declined (unless you can demonstrate “economic hardship”). Simple example – you owe $100,000 in back taxes. You do not compute RCP but simply make an offer of $15,000 to settle the debt. The IRS computes your RCP (from the documents that you must send with the offer) and it is $45,000. Your offer will be declined and you will be asked to raise your offer above the $45,000 RCP threshold. Of course $45,000 is much higher than you can possibly afford and you cannot raise your offer to that amount. You have now wasted money and time in getting your problem resolved. Had you computed your own RCP, you would have determined that an offer of $15,000 would be useless.
So how does the IRS (and you) compute RCP? Simple – discretionary income, both present and in the future, plus the quick sale value of the net equity in your assets. A mouthful to be sure, let’s break it down into English.
STEP 1 – Compute Discretionary income
Presuming that you have some income, let’s start there. You and your spouse work for a living, and each week you both receive your paychecks. That’s it, no other income. The IRS knows that you will need this income to pay your mortgage, car loan, insurance, taxes, food, medical expenses, child support, alimony, gas, electric bill, telephone, etc. The list seems endless. The IRS will add up your allowable expenses (forget that $2000 monthly expense for movies and theater and your son’s astronomical tuition at private school) and subtract them from your income. What remains after this simple mathematical operation is your discretionary income. In the case of Harry and Sally, (after they met, got married and failed to pay their taxes) their combined income was $5,000 a month and they had allowable expenses of $4,000 a month. Discretionary income - $1,000 a month.
The IRS will now look at how much longer it can pursue them for this debt under the law. You should understand that the IRS is limited in the amount of time that it can try to collect your tax debt. The IRS calls this the Collection Statutory Expiration Date, (CSED) we mortals call it the statutory limitations period. The good news is that after that date, the IRS cannot touch you for these back taxes. The bad news is that it is a pretty long time. The IRS will check how many more months remain that they can chase you and possibly levy your stuff. In Harry and Sally’s case, the IRS had 75 months remaining – a little over six years. The IRS will then take the $1000 in discretionary income and multiply it by the 75 months remaining in the CSED to come up with $75,000. Pretty simple math so far.
The calculation above only considers past and current income, it does not consider future income. If during the next 75 months Harry and Sally will receive more income, the IRS will factor that in as well! It seems that Harry’s car note of $500 per month will be fully paid off in 25 months. Presumably this means that in 25 months from now, Harry and Sally’s combined income will increase by $500 per month. At that time there will be 50 months remaining in the CSED (75 – 25 = 50, get it?). The IRS will multiply that 50 times the $500 and come up with $25,000 which they will add to the RCP. Total RCP is now $100,000.
Any other future income from inheritances, insurance payouts, trust payouts, etc, will likewise be factored into the IRS’ calculation. Since Harry and Sally had no other future income expected, the first half of their RCP calculation is $100,000.
STEP 2 – Compute the Net Equity in Your Assets
The second half involves a look at their net assets, what they own minus what they owe against it. For most of us, this is basically our house. The IRS uses the concept of “quick sale value” (QSV) to factor in your house. Take the fair market value of your home and multiply it by .8 or eighty percent. If Harry’s home is worth $400,000 then the QSV is $320,000. Subtract from $320,000 mortgage of $300,000 and you come up with $20,000. Presuming that their home is the only real thing of value they have, the total net equity in assets will be $20,000.
The final step in computing the RCP is to add the $100,000 from Step 1 to the $20,000 from step 2 and voila - $120,000.
The only question now is – How much do Harry and Sally owe? If they owe a million dollars then they can make the IRS an offer of $120,001.00 and have a chance of success. If they offer $119,999, the IRS will decline the offer and ask them to raise it above their RCP.
I hope you made it this far because what comes next is vitally important! The IRS knows that when you make an offer to resolve your tax debt, the chances are that you will not be able to pay your offer in a lump sum, but will have to make payments over time. The IRS Offer in Compromise program permits that and offers three payment options – (1) lump sum payment (2) short term payments not to exceed 24 month and (3) long term payments over the statutory collection period. Your RCP will be determined by which of the three payment options you choose. The scenario above is for those of you who wish to make long term payments. If you choose one of the other options, the RCP will be less! In other words, the longer you drag out your payment schedule the more you will have to offer. Makes sense doesn’t it? If you can give the IRS the full amount NOW then they will be willing to take less.
What if I do not own a house and my furniture is old, I have no jewelry and my car is a 1992 Honda Civic worth $300 on a good day? If this describes your situation then the second part of the calculation will be zero. What if my allowable expenses really and truly exceed my income? If this describes you then the first part of the equation will be zero. What if I have no assets, my income does not cover all my expenses and I owe the IRS a lot of money? At that point you can ask the IRS to declare your debt uncollectible. You will have to fill out some forms, but you may succeed in convincing the IRS that you will never have the wherewithal to pay the debt within the time they have to collect it. You should be aware that even in uncollectible status, the interest and penalties will continue to accrue.
Arthur Weiss, Esquire
Law Office of Arthur Weiss, P.C.
3130 E. Broadway, Ste. 160
Tucson, AZ 85716