Once upon a time, the IRS found it needed a method for determining just how much money they could reasonably expect to wring out of a tax debtor. The answer was the Reasonable Collection Potential or RCP formula. This formula works on two basic ideas – first, a taxpayer might have equity built up in assets that they currently own which could be paid over to cover the debt. And secondly, the taxpayer will have future earnings, a portion of which, could also be used to cover the debt. The total of these two amounts is the RCP amount that the IRS wants as a minimum in any Offer-in-Compromise.
Cash, Near Cash, and Other Assets
- The IRS is interested in the owned assets that cash or could be easily turned into cash which could then be paid over to them. The primary targets are:
- Cash in a bank or under a mattress
- Investment accounts including retirement accounts
- Cash value of life insurance
- Real estate such as your personal residence
- Vehicles
- Collectables such as artwork or that 1942 Sherman Tank that seemed like a good at one time
Non-cash assets must first be valued. An easy starting point for real estate is Zillow for houses or Kelly Blue Book for vehicles. The IRS then reduces that value by 20% in order to come to the “quick sale” value. Next, any lender claims against that asset are subtracted to leave the balance that the IRS can reasonably expect to be theirs.
Knowing that the IRS is closing in on them, some taxpayers will try to get the jump and liquidate some of their assets and either hide the cash or use it to pay some other higher priority debt. Maybe they will sell off some stocks and use the cash to invest in their brother-in-law’s business. Not a great idea. The IRS has seen all these tricks and will look back for 3 tax years to search for these sales. Any amounts that could have been paid over to them will be added to the RCP amount when it comes to accepting an Offer-in-Compromise. Naturally, the taxpayer’s credibility with the IRS will decline to make a deal just that much harder to get accepted.
Future Cash
This is not future income for the rest of the taxpayer’s life. Rather it’s the expected cash flow over the remaining period of time that the IRS has to collect before the Statute of Limitations runs out.
It all starts with monthly gross income from all sources including wages, business income, social security, pensions, alimony, child support, etc. This is about cash flow and the labels of taxable and nontaxable are not applicable. The IRS is going to want to look at this from a household point of view. Also, when it comes to wages, the IRS is going to use the gross income numbers and not the cash take-home pay.
Now comes the hard part – how much does it cost the taxpayer for living expenses? Mostly this is done with tables that can be summarized as follows:
| Class | Actual or Allowable |
|---|---|
| Housing & Utilities | Lessor of Actual or Local Standard Table |
| Food, Clothing and Misc | National Standard Table |
| Auto Ownership | Lessor of Actual or National Standard |
| Auto Operating Costs | Local Standard |
| Public Transportation | National Standard |
| Health Insurance | Actual |
| Out-of-Pocket Health Care Costs | Higher of Actual or National Standard |
| Court Ordered Payments | Actual |
| Child Care Payments | Actual |
| Life Insurance | Actual Reasonable Costs |
| Current Year Taxes | Actual |
| Secured Debts | Actual |
| Delinquent State Taxes | Percentage of State v. Federal |
The totals from the various categories are then added up and then deducted from cash inflow number to come up with a monthly free cash flow amount. This number is then multiplied by the number of months remaining in the Statute of Limitations. Finally, this result is added to the asset sale number to come up with the Reasonable Collection Potential Amount.
RCP Strategies (also known as gaming the system)
Generally, we want the formula to show the least amount of free cash available for payment to the IRS. Let’s also remember that the IRS is used to people misrepresenting their financial position and as a result they are going to demand documentation to back all of these numbers up.
Here are a few ideas that can be considered when getting ready to submit this information to the IRS:
- Question the values that come out of Zillow and Kelly Blue Book. If they seem out of whack, try and find some other valuation method.
- If current income in-flows are temporary and scheduled to go away, document that fact.
- If you have an older car and no car payment, the cost of repairs could likely exceed the table amount allowed. Replace the old clunker with a new car. The new car payment will be an allowable deduction and your actual repair costs will likely be less than the table amount for operating expenses.
- If you are not covered by health insurance, go get some. The IRS is going to want to see that you have been paying this premium for at least 3 months.
- Reasonable life insurance premiums are allowable. If you don’t have life insurance, go get some.
- Court Ordered Payments reduce the amount of RCP, but only if you are actually paying them. The IRS wants to see at least three months of payments.
- Florida is not a community property state, so tax debts are separable if you filed married filing separate or did an injured spouse claim. The household income will still have to be reported in this case, but the IRS will allocate the joint costs between the two in order to calculate the debtor’s separate free cash flow.
- Florida does not have an income tax, but it’s still possible that you owe income tax to another state. It’s probably going to work out better if you make a payment plan with the state first and get their debt ahead of the IRS’s claim.
Showing a reduced Reasonable Collection Potential means that the IRS might be willing to take less than full payment in an Offer-in-Compromise or maybe even put the taxpayer in Uncollectible Status.
I look forward to serving you, saving you money, and releasing you from much of the stress and anxiety of dealing with the IRS. Please call 352-317-5692 or email jim@taxrepgainesville.com for your free phone consult.