Lesson From The Tax Court: The Concept Of Reasonable Collection Potential

"Him that makes shoes go barefoot himself". 
        -Robert Burton, The Anatomy Of Melancholy (1641)

One key concept for submitting a successful Offer In Compromise (OIC) is something called the Reasonable Collection Potential (RCP).  RCP is not a hard-and-fast calculation.  It contains lots of wiggle room for savvy taxpayers.  But there are limits.  Jerry R. Abraham and Debra J. Abraham v. Commissioner, T.C. Memo. 2021-97 (Aug. 3, 2021) (Judge Urda), teaches a very useful lesson in both the extent of, and limits to, the wiggle room in RCP calculations.

The irony in this case is that the taxpayer is a very savvy, experienced and successful tax attorney who specializes in OICs.  So he definitely knew what he was doing.  Yet he was unable to secure for himself what he undoubtedly secures for clients.  You could call this the case of the barefoot shoemaker.  Why that is so is the lesson for us all.  Details below the fold. 

Law: The Legal Compromise About Offers In Compromise
Professor Keith Fogg and I have had several conversations recently about OICs, both in our respective blog posts (here’s a nice post he wrote) and the old-fashioned way: on the phone.  Keith and I both worked in IRS Office of Chief Counsel and are both now in academics, although Keith still does real lawyering as Director of the Harvard Clinical programs.  Thus, he still has a from-the-trenches viewpoint, while I just look out of my ivory tower (brick, actually).

Our conversations reflect a larger conversation between Congress, the IRS, and the courts, about the purpose and scope of OICs in tax administration.  The conversation has been about both the proper criteria for allowing taxpayers to compromise their debt as well as the proper decision-maker and the proper standard and scope of review of that decision.  I gave a brief history in Lesson From The Tax Court: CDP Settlement Officer Must Work Previously Rejected OIC, TaxProf Blog (May 24, 2021).

The result of these conversations is an OIC program that is itself full of compromises, as the needs of the tax system as a whole are balanced against the needs of individual taxpayers.  Thus, the general rule leaves decisions about OICs to the discretion of the IRS.  The basic statutory rule is in §7122(a) and is one of discretion: the IRS “may compromise any civil or criminal case arising under the internal revenue laws....” (emphasis supplied).  Further, if the IRS determines that any portion of an OIC submission “reflects a desire to delay or impede the administration of Federal tax laws,” §7122(g) permits the IRS to “treat such portion as if it were never submitted and such portion shall not be subject to any further administrative or judicial review.” 

At the same time, both Congress and the courts limit the IRS's discretion.  For example, §7122(c)(3) says that the IRS “shall not reject an offer-in-compromise from a low-income taxpayer solely on the basis of the amount of the offer.”  Similarly, the Tax Court has ruled that Appeals must review an OIC on the merits in a CDP hearing even when that same OIC was previously determined to be frivolous per §7122(g).  See Mason, et. al, v. Commissioner, T.C. Memo. 2021-64.  I blogged about the Mason case here and Keith Fogg blogged about it here.

Finally, discretion can be abused.  Thus, while all OICs get worked initially by one of the IRS Centralized Offer in Compromise (COIC) units, a rejection always gets reviewed by the Office of Appeals.  Generally, that’s that.   Taxpayers cannot get judicial review when Appeals affirms a rejection made regarding an OIC originally submitted directly to the COIC by the taxpayer.

To get judicial review of an OIC rejection, a taxpayer must make the OIC offer as part of a CDP proceeding.  Even there, however, the Settlement Officer (SO) in Appeals will not actually work an OIC (unless Judge Holmes orders them to).  Rather, as part of the Office of Appeals’ never-ending attempt to morph into a mini-me Tax Court, the SO will refer the OIC to the COIC and then, if the taxpayer disagrees with the result, the SO will “judge” whether COIC properly evaluated the OIC.  While Mason seems to say that a taxpayer can force Appeals to give a merits review to an OIC previously rejected as being frivolous, the Tax Court has also held that Appeals is not required to review an OIC that was previously rejected on the merits.  A taxpayer does not get two bites at the same OIC apple.  See Galloway v. Commissioner, T.C. Memo. 2021-24 (Feb. 24, 2021), which I blogged about here.  But OICs initially proposed as part of the CDP process are treated as oranges, not apples, and so taxpayers can, eventually, get to Tax Court if they cannot get a favorable decision from either COIC or Appeals.

Law: The Role of Reasonable Collection Potential (RCP)
Section 7122 gives the basic statutory parameters for OICs and Treas. Reg. 301.7122-1 further structures the OIC program into three types of OICs: compromises based on doubt as to liability (DATL); compromises based on doubt as to collectability (DATC) and compromises to promote effective tax administration (ETA).

The regulations provide that a DATC determination “will include a determination of ability to pay. In determining ability to pay, the Secretary will permit taxpayers to retain sufficient funds to pay basic living expenses.”  Treas. Reg. 301.7122-1(c)(2).  The regulations also provide that even when collection in full could be achieved, and thus there are no grounds for a DACT OIC, the IRS could nonetheless accept an ETA OIC when either “collection of the full liability would cause the taxpayer economic hardship within the meaning of § 301.6343-1” or when “compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability.”  Treas. Reg. 301.7122-1(c)(3).

The alert reader will quickly notice that the phrase “reasonable collection potential” is nowhere to be found in either the statute or the regulations.  Yet it is central to how the IRS evaluates OICs.  The concept of RCP is what operationalizes the DATC OIC determination and draws the line between DATC OICs and ETA OICs.

To figure out what RCP means and how the IRS uses it, one must consult the IRM.  You find it first mentioned in Policy Statement 5-100 (IRM 1.2.1.6.17) which states that “The Service will accept an offer in compromise when it is unlikely that the tax liability can be collected in full and the amount offered reasonably reflects collection potential.”

The more detailed rules for processing OICs are found in IRM Part 5, Chapter 8.  The RCP sets the default for acceptance or rejection of an OIC.  That just means that generally a DATC offer that equals or exceeds the RCP will be accepted.  See IRM 5.8.1.2.2(4)(“In most cases, when the offered amount exceeds the RCP, the acceptance should be for the amount offered.”)

But the IRS retains discretion to either accept an offer that is less than the RCP or reject an offer that is more than the RCP.  See IRM 5.8.4.2 (explaining rules for evaluating ETA offers and IRM 5.8.11.3.1 (explaining rules for evaluating DATC offers under the ETA rules, which the IRM calls “Doubt As To Collectability with Special Circumstances” (DATCSC).  See also IRM 5.8.7.7.2. (explaining that offers may be rejected based on public policy considerations if acceptance of the offer in any way may be detrimental to the interests of fair tax administration, even though it is shown conclusively that the amount offered exceeds the reasonable collection potential and is greater than could be collected by any other means, regardless of reasonable collection potential).

I like the following two examples in IRM 5.8.4.4 that show some of the balancing that goes into the discretion to accept or reject an OIC.   You see that RCP is the foundational step.

Example 1: Accepting an OIC for the RCP amount even though there is greater collection potential via a Partial Pay Installment Agreement (PPIA).

The outstanding tax liability is $50,000 and the taxpayer submitted an offer in the amount of $15,000. The taxpayer is unable to full pay via an IA within the CSED, yet a PPIA has the potential to collect $25,000. Although the amount potentially collectible via the PPIA would exceed the offer amount, the requirement for the taxpayer to remain in compliance for five years, the benefit of the government receiving the funds at an earlier date and consideration of the additional costs incurred to monitor the PPIA provides that the taxpayer's offer should be accepted unless other circumstances, i.e. public policy, weigh against acceptance.

Example 2: Rejecting an OIC because there is a greater collection potential via a PPIA.

The outstanding tax liability is $200,000 and the taxpayer submitted an offer in the amount of $36,000. The taxpayer is unable to fully pay the tax liability via an IA within the CSED. The taxpayer's RCP is $36,000 which is based solely on their future income of $1,500 per month. Based on the calculation of RCP the taxpayer's offer may be acceptable, yet there remains over 9 years on the CSED, so the government would potentially receive over $ 162,000 from a PPIA, if the taxpayer would sustain payments over the remaining months of the CSED. If the taxpayer submits payments over a 48 month period, the amount received would be double the RCP. In this instance, the fact the government has the potential to receive substantially more than RCP and the associated monitoring costs incurred, provides that acceptance of the taxpayer's offer is not in the government's interest. The offer should be rejected on that basis, unless special circumstances are present which allow for acceptance under ETA or DATCSC.

Determination of RCP involves making decisions about four components of a taxpayer’s financial condition: (1) assets collectible from the taxpayer; (2) the taxpayer’s potential future income (after allowing for reasonable expenses); (3) assets collectible from third parties (under nominee, alter ego, or transferee theories); and (4) assets not collectible by the IRS but within control of the taxpayer (such as assets or income in a foreign country).  Importantly, the calculation of RCP may, but does not have to, account for the costs of collection by levy or court action, and it may include the value of assets that the taxpayer thought they had successfully “protected” by transfer to a third party.  See IRM 5.8.4.3(2).

The first two components (income and assets) are generally the most important ones and form the basis of most disputes between taxpayers and the IRS about a taxpayer’s RCP.  That is what happened in today’s case.  Let’s take a look.

Facts
Mr. Abraham is a successful tax lawyer, a partner in the firm of Abraham & Rose, PLC, which he founded in 1995. The firm has at least two websites.  This one website explains that Mr. Abraham “served the IRS as a Revenue Officer, Special Procedures Advisor and as an Estate and Gift Tax attorney” before starting his own practice.  This other website boasts that the firm’s  “tax attorneys specialize in the representation of delinquent taxpayers before the IRS” and “can help you by negotiating Offers-in-Compromise, IRS settlements, or sophisticated bankruptcies for all types of taxes. We have saved our clients millions of dollars in tax debts, penalties, or IRS interest.”  Indeed, one sees in this reported case (Dombrowski) that Mr. Abraham did an outstanding job in protecting a client from third-party collection.  He was able to fend off the government motion for Summary Judgement and also nuke one of its theories for 3rd party collection.

But what he could do for his clients he could not do for himself.

The tax years at issue are 2012 through 2016.  In those five years Mr. and Ms. Abraham filed returns but did not pay all the taxes they self-reported.  Sometime in 2019 (the opinion is silent on the date) the IRS filed a Notice of Federal Tax Lien and sent the required CDP notice.  The Abrahams timely requested a CDP hearing, at which they offered a DATC OIC of $50,000.  The opinion does not tell us what the amount of their liability was at that time, but it does say that by August 7, 2020 their liabilities totaled over $204,000.

As you would expect from a practitioner with his experience, Mr. Abraham filed all the right stuff, providing extensive documentation about financials (although he left out some minor stuff that the IRS found later).  In April 2019 the Office of Appeals SO assigned to the case sent the OIC to the COIC for evaluation.  After looking at income and assets, the Offer Specialist rejected the OIC, figuring that the Abrahams could actually fully pay the outstanding liability within the remaining CSED.

As to income, the Specialist looked at what Mr. Abraham reported having received from his law firm and determined that his tax returns showed steady income.  The Specialist calculated a monthly gross income of over $31,000.  I’d like that.  Against that income the Specialist allowed monthly expenses of $17,000, leaving monthly disposable income of $14,000.  The IRM says to multiply that by 12 to determined RCP.

As to assets, the Specialist determined the IRS could collect $60,000 from bank accounts, $5,000 from a car (the Abrahams leased two other cars), and $134,000 from their home.  It does not appear that the Specialist included any amount for the value for Mr. Abraham’s interest in the law firm.  That would seem required by IRM 5.8.5.27 but I could be mis-reading that provision.  I would welcome any comments on that.

Even so, do the math.  Projected income in 12 months of $168,000.  Collectible assets of over $200,000.  Total RCP of $368,000.  The OIC of $50,000 was way below that.  No wonder the SO, agreeing with the Specialist’s rejection, issued a Notice of Determination in December 2019, saying that the Abrahams could fully pay their liabilities in as little as 33 months.   Both the Offer Specialist and the SO offered Mr. Abraham a 72 month installment agreement which I calculate to be about $2,900 per month.  Mr. Abraham did not accept that deal.   He instead petitioned the Tax Court.

Lesson:  The Shoemaker Gets The Boot
Mr. Abraham, no stranger to CDP litigation, cobbled together two arguments in Tax Court on why the SO had abused her discretion in rejected the $50,000 OIC.  They did not wear well with Judge Urda.

First, Mr. Abraham attacked the numbers used to calculate the RCP.  He said the IRS should have counted the expenses needed to support all four of his children who lived with him (ages 16, 18, 21 and 25) even though at the time of the OIC, only two of the children qualified as dependents.  He also said the IRS should have counted the $3,000 he spent monthly on unspecified religious education expenses for two of his children.  He said that the IRS should have deducted from the RCP approximately $61,000 that he needed to pay off other tax liabilities, liabilities that were not before the Court in this proceeding.

Judge Urda refused to decide whether the IRS erred in calculating the RCP because even if Mr. Abraham was correct in all respects, “the RCP would still be $294,431—nearly six times their $50,000 OIC.  Given that ... we would uphold the settlement officer’s decision to reject the OIC.”

Mr. Abraham then claimed that he could show the kind of special circumstances to transform the OIC DATC into an OIC ETA.  He claimed that both his age and his lack of robust retirement savings meant he and the missus would suffer terrible economic hardship if the IRS tried to collect what he owed for the years at issue.  He noted that he was 63 years old, had only $20,000 in IRA’s and was not eligible for government pension or Social Security, having made a lump-sum election when he had left the IRS in the 1990's.

Judge Urda held that neither of these were the kind of special circumstances that support an OIC ETA.  As to age, 63 is not old!  Mr. Abraham offered no reason to think he was infirm or unable to continue his top-drawer representation of taxpayers beset by the IRS collection machines.  Heck, he had pulled down $318,000 from his firm in 2018 alone and gave no reason to think that would diminish over time.  Writes Judge Urdra “The Abrahams fail to explain why, given Mr. Abraham’s level of education and the nature of his work, his age would suggest a significant diminution of his income.”  Op at 17. (emphasis supplied).

As to retirement assets, the fact that he would not get Social Security did not show the kind of economic hardship required to overcome the RCP default.  Notably absent from both the OIC analysis and the opinion is any discussion of what, if any, retirement vehicles or insurance was associated with his law firm.  Nor, for some reason, did the Offer Specialist give any valuation for Mr. Abraham's interest in the law firm.

In sum, Judge Urda rejects the special pleading, concluding that neither his “age nor his ineligibility for benefits from his long-ago Federal service suggest that the Abrahams would face looming economic hardship if the IRS were to collect an amount equal to the RCP.”

Bottom line: proper calculation of the RCP is key to a successful OIC effort.  When the calculation comes up as lopsided as it was in this case, it is probably best to not waste the client's money on going to Tax Court.  The best advice to such a client is to just suck it up and pay.   

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each week for a new Lesson From The Tax Court.