The owner of a small business must determine how to deal with assets he or she owns when determining the reasonable collection potential under an offer in compromise. The reasonable collection potential consists of the taxpayer’s future income and the next equity in assets that may be used to pay toward outstanding tax liability under an offer in compromise.
But how does a taxpayer calculate reasonable collection potential when the taxpayer uses the assets to create income? For example, the taxpayer owns an LLC in which the taxpayer receives distributions or even wage income if the LLC is taxed as a corporation. The LLC has business assets, such as construction equipment.
For normal assets such as vehicles, valuables and other real and personal property, to calculate the net equity in assets, the taxpayer would determine the quick sale value of the assets by taking 80% of the fair market value of the assets and devoting that amount to the offer in compromise.[1]
But for income producing assets like the LLC in the example above, the taxpayer need not to always pay over the net equity in the assets. Instead, the IRS employes a special rule for income producing property:
As a general rule, equity in income producing assets will not be added to the RCP [reasonable collection potential] of a viable, ongoing business; unless it is determined the assets are not critical to business operations.[2]
Therefore, the IRS analyzes income-producing assets to determine if the assets are essential for the production of income.[3] If there is no equity in the asset, there is not adjustment to the reasonable collection potential. If there is equity but the asset does not produce income, the equity in the asset is considered under the reasonable collection potential. If there is both equity and the asset is used for the production of income, the IRS compares the value of the income stream to the available equity in the asset.[4][5]
In the case of both equity and income stream, the taxpayer should be prepared to argue the general rule that equity from income producing assets is not added to the reasonable collection potential. Since the income from the asset is already being used to determine future income, it would be an unfair double counting to also require the net equity value be added to the reasonable collection potential.
The IRS may only have one or the other: the income or the equity in the asset. And the stated general rule of the IRS is that the taxpayer is permitted to keep the asset and pay over the income stream, after first taking into account all of the taxpayer’s allowable expenses.
About the author: Jared M. Le Fevre is a tax attorney and partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal and state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions. what effect the notice may have on taxpayer rights.
[1] Internal Revenue Manual, 5.8.5.4.1.
[2] Internal Revenue Manual, 5.8.5.13(3).
[3] Internal Revenue Manual, 5.8.5.13(1).
[4] Internal Revenue Manual, 5.8.5.13(2).
[5] However, the general rule does not apply to real property receiving rental income. The equity in real property is included in the reasonable collection potential, with an adjustment made to the income it produces. Internal Revenue Manual, 5.8.5.13(3).