Make
an Offer that the IRS Can't Refuse
How
to calculate an offer in compromise acceptable to the "Don"
by William Brighenti, CPA, Consigliere of Goombas to the IRS |
|
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”. It is what it
is. The process of determination
is rigorous and driven by a mathematical procedure to minimize
frivolous offers. And you do not want to initiate a negotiation with
the IRS with a ridiculous offer. Would you
consider offering Don
Corleone an insulting few sheckles in payment of a debt?
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 Don has spoken.
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. Recall the fate of Luca Brasi.
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, which has as much of a chance of being
accepted by the IRS as Paulie's apology to Michael Corleone.
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
Where,
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/or the mafooch.
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
Where,
MA = Monetary Assets;
CV = Current Values;
∑MACV = Your
total equity in Monetary Assets;
∑ NMA(FMV
x 80% – LB) = Your total equity in Non-Monetary Assets before
exemptions;
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;
#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.
Expense |
One
Person
|
Two
Persons
|
Three
Persons
|
Four
Persons
|
Food
|
$285
|
$537
|
$626
|
$752
|
Housekeeping
supplies
|
$28
|
$66
|
$61
|
$74
|
Apparel
& Services
|
$86
|
$162
|
$209
|
$244
|
Personal
care products & services
|
$31
|
$55
|
$59
|
$65
|
Miscellaneous
|
$87
|
$165
|
$197
|
$235
|
Total
|
$517
|
$985
|
$1,152
|
$1,370
|
More
than four persons
|
Over
Four Persons Amount
|
For
each additional person, add to four-person total allowance:
|
$262
|
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 unless you wish
to "swim with the fishes". 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, or 120 less the 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; more importantly, it may minimize the risk of your offer being
rejected by the IRS. 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 a preliminary 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. Of
course, upon the formal filing of your offer, guesstimates will not
suffice:
complete, accurate, substantiated, and honest information compiled in
"good faith" will be required in order to enhance the prospect of your
Offer in Compromise of being accepted by the Internal Revenue Service.
In bocca al lupo!
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.
If and only
to the extent that this publication contains contributions from tax
professionals who are subject to the
rules of professional conduct set forth in Circular 230, as promulgated
by the United States Department of the Treasury, the publisher, on
behalf of those
contributors, hereby states that any U.S. federal tax advice that is
contained in such contributions was not intended or written to be used
by any taxpayer for the purpose of avoiding penalties that may be
imposed on the
taxpayer by the Internal Revenue Service, and it cannot be used by any
taxpayer for
such purpose. The above tax advice was
written to support the promotion or marketing of the accounting
practice of the publisher and any transaction described herein. The taxpayer recipients of this offering
memorandum should seek tax advice based on their particular
circumstances from an independent
tax advisor.
|