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Fresh Start and Net Equity

When submitting an offer-in-compromise with respect to settling amounts due to the IRS for a lower amount, the IRS focuses on a term known as “Reasonable Collection Potential.” In doing this calculation, the IRS reviews two key components: One is the net equity of assets that the taxpayer owns at the time of the offer and the other is the expected earning potential of the taxpayer. For this posting, we’ll focus on net equity.

At the sake of oversimplifying, net equity for OIC purposes is cash plus quick sale value of assets that you can “tap” into. For example, you may have an individual retirement account. An individual can usually cash out an IRA, less any early withdrawal penalties and related taxes. So this cash (less penalties and taxes) would be included in your net equity. On the other hand, if you had an interest in a retirement account with your employer that you currently have no access to, this would not be included.

A couple of other points to keep in mind when calculating your net equity for OIC purposes:

  1. Non-cash items (real estate, autos, etc.) are discounted by 20% of fair market value, which the IRS considers to be the quick sale value.
  2. Cash amount are calculated by using the average cash balance over the past 3 months, reduced by one month’s worth of allowable expenses and then further reduced by $1,000 (not to go below zero). We’ll talk about allowable expenses in a future posting.
  3. In addition to the 20% discount, auto values are reduced by debt on the vehicles. The net amount (auto value less debt) is then further reduced by a $3,450 exclusion (not to go below zero). The $3,450 exclusion can be used for 2 vehicles per household as long as the vehicles are used for work, production of income or family welfare.
  4. Business taxpayers can exclude income-producing assets. The thinking here was to eliminate the double-dip of the IRS getting both the value of the asset and the income in the calculation to come up with the reasonable collection potential. The IRS has been provided some discretion here to include the value of the asset and exclude the income it produces, if it so deems.
  5. As a general rule, the net equity of an asset cannot go below zero. So if you have real estate that is underwater with a mortgage greater than the quick sale value, you would report zero equity.
  6. Unsecured debt is normally not allowed as a reduction in determining your reportable net equity.

As you can probably tell, there are some planning opportunities that you can take advantage of when preparing an offer-in-compromise, so it is not just as simple as preparing a  form. Some thinking and strategizing can go a long way in saving dollars when submitting an OIC. 

Daniel Gibson provides accounting, tax planning and consulting services to real estate and services industries and is a member of the AICPA and New Jersey Society of Certified Public Accountants.

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