IRS Reasonable Collection Potential (RCP) and Offer In Compromise (OIC)
How the IRS Determines Eligibility to Settle Taxes
When taxpayers facing significant tax debt hear about the offer in compromise program, they often jump right into the application process, hoping to decrease the amount they have to pay. However, the IRS has a stringent process for considering offer in compromise applications, and what you can reasonably pay is the primary determining factor.
This factor is called the Reasonable Collection Potential (or RCP), and it considers a wide range of details from your financial disclosure. By estimating your RCP and figuring out how it may affect your offer in compromise application, we can help you decide if an offer in compromise or another type of relief is the best option for you.
Key Takeaways
- The IRS uses your income and assets to calculate your Reasonable Collection Potential—how much they believe they can collect from you.
- Your RCP plays a big role in determining whether or not your offer in compromise application is accepted.
- If you don’t qualify for an offer, other options, including a partial payment installment agreement or currently not collectible status, may be available to you.
- Working with an attorney can help you more accurately calculate your RCP.
What the Reasonable Collection Potential Is and What It Means for Your Offer in Compromise
A taxpayer’s Reasonable Collection Potential is the amount the IRS believes it could collect from you. This is more important than the amount of your debt. If the IRS determines it can only collect $2,000 from you, it doesn’t matter if you owe $5,000 or $50,000—they know they won’t be able to get the full amount.
There are two main components to a taxpayer’s RCP. The first is the net realizable asset value, or the actual monetary value of your assets if you sold them. The second is your future income, which is based on the disposable income you have after allowable expenses are removed.
The RCP’s Role in an Offer in Compromise Application
The RCP plays a big role in determining whether or not your offer in compromise application is accepted. It reflects the minimum amount the IRS is willing to accept for your current tax debt. If you offer less than your Reasonable Collection Potential, the IRS is very likely to reject it. It’s incredibly important to accurately calculate your RCP because of its importance in your application.
If you underestimate the Reasonable Collection Potential, the IRS will likely discover that during their review process and reject your offer. If you overestimate your Reasonable Collection Potential, you could end up on the hook for more than you can (or should) reasonably pay.
Calculating Your Reasonable Collection Potential
By looking at the two factors that contribute to a taxpayer’s Reasonable Collection Potential, you can calculate your RCP and see how it compares to what you were hoping to pay.
Assets
The IRS looks at all of your assets and calculates their net realizable value, which is the estimated selling price of an asset after subtracting any debts owed and costs associated with its sale. For example, if you own a home, the net realizable value would be the market price minus your current mortgage on the home and any other selling expenses.
One important clarification: the IRS tends to use the quick sale value of your assets, rather than the total value. This is generally 80% of the full market value of an asset and reflects what you would need to sell at in order to sell it quickly. Let’s look at an example, assuming that your home is worth $500,000 and you have a $450,000 mortgage. The IRS would take off 20% right away, bringing down your home’s value to $400,000. If you subtract your $450,000 mortgage, you would actually have no equity to include in your RCP.
Income
The agency will also estimate how much it can get from you over time based on how much money is left after your basic monthly living expenses are accounted for. However, the IRS doesn’t use your actual expenses. Instead, the agency refers to both national- and state-level living expenses to determine how much should be excluded from your income.
Certain types of expenses are determined on the national level and others on a state-by-state or even county-by-county basis. If your actual expenses exceed the standard, the IRS uses the standard. If your expenses are lower than the standard, the IRS uses your actual expenses, but there are a few categories where you get credit for the full standard amount even if you don’t spend that much.
To determine your income, the IRS uses all of the money coming into your home – wages, business income, alimony, child support, etc. You are allowed to not include required deductions from your paycheck for taxes, but not for optional deductions such as retirement savings.
Finally, the IRS subtracts your allowable expenses from your income. Anything left over after these expenses are paid for is considered your disposable income.
Basic Formula
There are two formulas: one for the lump sum offer in compromise payment and one for the periodic payment offer in compromise.
Lump sum offer in compromise: Equity in Assets + (Monthly Disposable Income x 12)
Periodic payment offer in compromise: Equity in Assets + (Monthly Disposable Income x 24)
Allowable Living Expenses
When calculating your disposable income, the IRS uses a list of categories to determine which allowable living expenses will be included in its final calculations. Categories calculated at the local level include:
- Housing and utilities
- Transportation
Categories based on national standards include:
- Out-of-pocket healthcare expenses
- Food
- Housekeeping supplies
- Apparel and services
- Personal care products and services
- Miscellaneous
The amount you are permitted is based on your family size. For example, a family of four is allowed $1,255 for food per month. That means $1,255 of your monthly income will be subtracted from the total, decreasing your disposable income.
There are significant differences in state-level expenses, so it’s important to make sure you are looking at your county for accurate deductions. We’ll look at housing expenses as an example of how much these may vary. The allowed amount for a family of two is $3,495 in King County, Washington; $4,667 in New York County, New York; $1,974 in Brown County, Wisconsin; and $1,373 in Ripley County, Missouri.
Collection Potential and Its Role in Denied Offer in Compromise Applications
When an offer in compromise application gets rejected, it’s often because an applicant’s belief of what a fair payment would be is at odds with what the IRS thinks they are able to pay. This often happens when people include luxury or non-essential expenses in their budget. The IRS specifically excludes certain expenses, such as private school tuition and college expenses, from their calculations.
Additionally, the IRS uses total household income when determining a taxpayer’s Reasonable Collection Potential. Even if you are calculating an offer for a tax debt that your spouse is not liable for, their income can work against you when the IRS calculates your RCP.
When taxpayers decide what their offer will be, it’s important to take the RCP into account and use that as the baseline for your offer. You may look at your budget and feel like you only have $100 left over every month, but if the IRS believes you have $400 per month to put toward your tax debt, that’s a significant gap you will need to overcome.
When an Offer in Compromise Isn’t the Best Option
There are situations where an offer in compromise isn’t the best option and there are a few downsides to this program. However, since this resolution option is so widely advertised, people often think that it’s the best option for everyone. But if your RCP is higher than you expected, another type of tax debt relief may be a better option for you.
If your financial situation is severe enough that you cannot afford any payments toward your debt after your basic living expenses each month, you may want to look into currently not collectible status. This is a temporary pause on all collection efforts. The IRS reviews your financial status from time to time to see if your circumstances have changed enough to warrant restarting payments. If your circumstances don’t change, the clock may run out on your tax debt.
Another option that is somewhat similar to an offer in compromise is a partial payment installment agreement. This option is similar because it’s intended for those who cannot afford to pay in full but are able to pay something. Your monthly payments are reduced to an amount that’s in line with your income and expenses, and if your financial situation changes, you may be expected to resume normal payments. Once the Collection Statute Expiration Date passes, any remaining tax debt is written off.
Comparing Tax Resolution Options Based on Your Collection Potential
| Option | When it Works Best | Based on Collection Potential? | Pros | Cons |
|---|---|---|---|---|
| Offer in compromise | Low income, low assets, financial hardship | Yes | Pay less than what is owed and debt is resolved fairly quickly | Difficult to qualify and must meet strict IRS qualifications |
| Currently not collectible status | No disposable income and proof of economic hardship | Yes | No payments or enforced collection actions | Penalties and interest continue accruing, and payments may have to resume if financial situation changes |
| Partial payment installment agreement | Some disposable income but not enough to pay off debt in full by expiration date | Yes | Affordable monthly payment and partial relief from tax debt | No immediate resolution and payments may increase if your financial status changes |
| Full installment agreement | Can afford full debt over time but not all at once | No | Easy to set up and avoids enforced collections | Requires full payment of debt |
The Benefits of Working With a Tax Professional
Qualified tax professionals can help you navigate complex tax resolution options and figure out which specific one is best suited to your situation. At this point, you’ve likely already gotten at least a rough estimate of your RCP. But working with a tax professional may allow you to zero in on areas within your expenses and assets to find ways to reduce your RCP.
An attorney may help by:
- Demonstrating to the IRS that the allowable living expenses standards do not allow you to provide for your basic living expenses while still paying toward your debt. In some cases, the IRS does allow for actual expenses.
- Proving that you need to spend more in certain categories – for example, more in the healthcare and groceries categories due to a health concern with specific dietary requirements.
- Using liquidation formulas and value comps to reduce asset values and your RCP
- Figuring out if there are assets that can be excluded from your RCP calculation – for example, assets used in your business
- Identifying situations where it improves your offer to buy a car – for taxpayers without cars but with enough extra income to cover a car payment, this can help them to take advantage of the car allowance instead of paying that extra money to the IRS
- Determining whether or not requesting an OIC later, during a period of financial insecurity, may be a better option for you
- Utilizing the Internal Revenue Manual if the IRS uses unrealistic or aggressive valuations
Finding the best way to handle your debt isn’t about trying to force your tax situation into the limitations of your chosen relief method. It’s about considering all potential relief options and figuring out which one will allow you to pay the lowest amount while being compliant with all IRS requirements and laws. If your RCP is too high for an offer in compromise, our team can help you explore other options and apply. If your RCP seems practical and manageable to you, we can help you navigate the application process for an offer in compromise.
Need help calculating your RCP or figuring out if an offer in compromise is the right option for you? Reach out to Seattle Legal Services today. Call us at 425-428-5262 or contact us online to schedule a consultation now.
Frequently Asked Questions
What is my Reasonable Collection Potential?
Your Reasonable Collection Potential is the amount the government believes it could collect from you, based on your income and assets. It plays a major role in whether or not the IRS accepts your offer in compromise and how much your settlement is.
What if my RCP is higher than my offer amount?
If you submit an offer amount that is lower than your RCP, odds are very good that the IRS will reject your offer. Working with a tax professional can help you calculate an accurate RCP that is truly in line with what you can pay.
Can I challenge the IRS’s calculation of my RCP?
Yes. If your offer is rejected and the IRS’s calculation of your RCP is inaccurate or inflated, you can appeal their decision and provide evidence backing up the numbers you provided.
Does a low RCP guarantee acceptance of my offer in compromise?
No. A low RCP definitely helps your odds of an accepted offer in compromise, but the IRS will still consider factors like your history of tax compliance, whether or not they think you will be compliant in the future, and if your offer is in the best interests of the government.
Does Washington State use reasonable collection potential?
Yes, if you apply for a Rule 100 Settlement in Washington State, the DOR will determine your reasonable calculation potential to determine your settlement amount. However, they may use different verbiage and a slightly different formula than the IRS.
Sources:
https://www.irs.gov/businesses/small-businesses-self-employed/collection-financial-standards
https://www.irs.gov/pub/irs-sbse/all-states-housing-standards.pdf