IRS Law Blog

You owe the IRS and would like to put past mistakes behind you and get a fresh start.  You may have heard a lot about the IRS offer in compromise program – popularized by those deep-voiced TV and radio advertisements that makes it sound like you just call the IRS, offer a number, they say yes, and your done.  Simple, right?

The IRS offer in compromise program is legitimate, and it works, but it’s not that simple. The IRS has a formula that they use in analyzing an offer in compromise.  The IRS looks at two pools of money in an offer in compromise: (1) How much does the IRS think you can pay them monthly if they put you on an installment agreement? and (2) What is the value of the equity in your assets?

In this post, we will focus on how the IRS values the equity in your assets.

Let’s start by defining the asset-equity formula the IRS uses in an offer in compromise, then apply it to four examples:  your house, your car, your household goods, and your bank accounts.

The IRS Formula in valuing assets in an Offer in Compromise.  The IRS’s goal is to arrive at what the net equity is in your assets.

Net equity is defined by the IRS to be the fair market value of the asset, (1) reduced by 20% to arrive at what is known as quick sale value, (2) reduced by any mortgages or bank loans against the asset and (3) reduced by any property exclusions available in the Internal Revenue Manual or Internal Revenue Code.  Let’s break that down, step by step.

Reduction to quick sale value.  The IRS uses the 20% reduction to quick sale value to arrive at the price you would receive if you sold an asset under duress and without time to get the best price.

Reduction for mortgages and bank loans.  If there are liens, mortgages, or encumbrances on the asset – say, a mortgage on your house or a loan on your your car – the value of the mortgage or loan is subtracted from the quick sale value.  They do not use the fair market value, but rather the lower quick sale value.

Reductions for property exclusions.  The Internal Revenue Manual and Internal Revenue Code also provide exclusions (sometimes known as exemption) in the value of your property.  These exclusions are provided on public policy grounds to protect the value of basic necessities.

Now let’s apply those rules to your house, car, household goods and bank accounts.

1.     Equity in houses.  Let’s say your house is worth $150,000 – that’s the fair market value, what you could sell it at today to a willing buyer. But remember that the IRS works off a lower valuation number, quick sale value.   To arrive at quick sale value, $150,000 fair market value is reduced by 20%, putting a $120,000 value on your house for purposes of the IRS “equity” valuation analysis.

Examples:

If you owe $120,000 or more on your mortgage, there is no equity in your house (remember, quick sale value of $120,000), and you offer the IRS nothing for it in settlement.

If you owe $115,000 on the mortgage, then there is $5,000 of IRS equity in your house ($120,000 quick sale value – $115,000 mortgage), and the starting value of your compromise is $5,000.

There are no exclusions or exemptions in the Internal Revenue Manual or Internal Revenue Code as to equity in houses.

2.    Equity in vehicles.  The same methodology for equity in houses is used for equity in cars: Fair market value, reduced by 20% to arrive at quick sale value, then offset by any bank loans owed on the car.

However, Internal Revenue Manual 5.8.5.11 permits an additional exclusion of $3,450 for vehicles, airplanes and boats from the net equity.

Let’s put this to an example.  Say your car is worth $10,000, and you owe $4,000 on a loan against it.

The IRS valuation formula:  $10,000 less 20% quick sale value reduction = $8,000. Subtract the $4,000 loan and you arrive at net equity of $4,000.

This $4,000 net equity, however, is subject to further exclusion of up to $3,450 from Internal Revenue Manual 5.8.5.11.  This leaves equity for purposes of an IRS financial analysis of $550.  ($4,000 – $3,450 additional exclusion = $550.)

The value of your $10,000 car to the IRS is $550 in an offer in compromise.

3.     Equity in household goods/personal possessions.   Same as houses and cars – take what your stuff is worth at a garage sale, and take the 20% reduction to arrive at quick sale value.

The IRS will allow an additional exclusion from the quick sale value of $6,250 per person from the value of your everyday household goods.  This exclusion is in the Internal Revenue Code Section 6334(a)(2), which protects your everyday belongings from the IRS at values up to $6,250 per person.

Example if your household goods are worth $8,000 at a garage sale:   $8,000 fair market value, less 20% quick sale reduction = $6,400.

If the household goods are jointly owned, then there would be a $12,500 exclusion ($6,250 per person x 2) deducted from the $6,400 quick sale value, and no equity for the IRS in an offer in compromise.

If only you own the household goods, then only one $6,250 exclusion applies, and the net equity would be calculated as follows: $6,400 quick sale value, less $6,250 additional exclusion = $150.

The net equity for the IRS of your $8,000 of household goods would be $150 in an offer in compromise.

4.    Equity in cash in bank accounts and cash on hand.  The IRS considers the cash in your checking account and cash on hand as an asset in valuing a compromise.

Generally, the IRS will review your last three months’ bank statements if you are employed (last six months if you are self-employed), and calculate the average daily balance over that time frame.   That average daily balance, plus any cash you have that is not in the bank, is an asset that the IRS adds to the value of your compromise.

However, Internal Revenue Manual 5.8.5.6 permits an automatic exclusion of $1,000 from the average daily balance for your living expenses.

What if your monthly living expenses are greater than $1,000/month?  In these situations, the IRS will allow additional exclusions from the bank account balances up to the expenses that fall within the IRS’s allowable living expense guidelines.

Example:  Your average bank account balances is $4,000, and you have $3,000 in monthly IRS allowable living expense.  The IRS will subtract the $3,000 from the $4,000 cash balances, and then subtract another $1,000 from the automatic exclusion.

In this example, your bank account balances have no value to the IRS in an offer in compromise.

If you are considering an offer in compromise, be careful to properly use and understand the reductions and exclusions the IRS allows in your property.   Proper application of the valuation tools is essential to the best success in settling with the IRS.