This chapter provides instructions for analyzing the taxpayer's financial condition.

An interview should be conducted in order to determine the appropriate case resolution. Request full payment of the tax liability. Encourage taxpayers to pay off the tax liability as quickly as possible. If taxpayers are unable to pay in full (and do not qualify for a Guaranteed or Streamlined Installment Agreement) secure a complete Collection Information Statement.

The analysis of a taxpayer's financial condition provides a basis to make one or more of the following decisions:

The taxpayer's financial information may be secured on:

National and local standards are guidelines established by the Service to provide consistency in certain expense allowances such as groceries and household expenses, medical expenses, housing and transportation. Reference to these standards will be found throughout this section. Exhibit 5.15.1-2 provides instructions for on-line access to the actual standards.

The standard amounts set forth in the national and local guidelines are designed to account for basic living expenses. In some cases, based on a taxpayer's individual facts and circumstances, it may be appropriate to deviate from the standard amount when failure to do so will cause the taxpayer economic hardship (see Note below bullet list). The taxpayer must provide reasonable substantiation of all expenses claimed that exceed the standard amount.

Document the case file accordingly. For example:

(See 26 C.F.R. 301.6343-1(b)(4))

Analysis and verification of a Collection Information Statement (CIS) should take place shortly after obtaining the CIS. The ability to pay determination based on a thorough financial analysis will be communicated to the taxpayer within a reasonable amount of time after obtaining the CIS.

Collection Information Statements submitted by taxpayers should reflect information no older than the prior six months. If during the investigation of the case, the information becomes older than 12 months, update the information. If there is reason to believe that the taxpayer's situation may have significantly changed, secure a new Collection Information Statement.

Secure, review and discuss the financial statements in person whenever possible. While some aspects of the financial statement review process, such as securing financial information, can occur by phone or correspondence, a face-to-face meeting with the taxpayer and/or their representative is preferred to effectively facilitate the verification/validation of the financial statements provided. This face-to-face interview should be conducted at the taxpayer’s business, residence or in the office unless the taxpayer is physically unable to meet with the revenue officer. The physical verification of the business assets is required at some point early in the financial statement review process and should be conducted in the presence of the taxpayer and/or representative.

Emphasize to the taxpayer how much the Service expects from them rather than how the Service expects them to spend their money.

Analyze the income and expenses to determine the amount of disposable income (gross income less all allowable expenses) available to apply to the tax liability.

Analyze assets to resolve the balance due accounts.

In some cases, payments on expense items are not due in regular monthly increments. Average necessary living expense items with varying monthly payments over 12 months.

One Year Rule: Taxpayers who cannot full pay their accounts within five years may be given up to one year to modify or eliminate excessive necessary expenses. By modifying or eliminating some conditional expenses, a taxpayer may be able to full pay the liability plus accruals within the five-year limit. This would enable a taxpayer to retain some conditional expenses.

Five Year Rule: All expenses may be allowed if:

Agreements will be based on a taxpayer's maximum ability to pay, i.e., how quickly a taxpayer can fully pay the tax liability. Do not automatically allow agreements based on the five-year maximum if expenses are unreasonable ( See IRM 5.15.1.2.(5)). Also review Q&A section at the end of this IRM for additional guidance on allowable expenses.

When conducting interviews to secure and/or review financial statements, ask pertinent questions to determine as much as possible about the taxpayer's financial condition and document the results. For example:

Observe and document the physical layout of the business, the number of employees, the type and location of equipment, machinery, vehicles and inventory. A brief tour of the business premises may help to gauge the business operation and the condition of assets.

A thorough verification of the Collection Information Statement (CIS) involves reviewing information available from internal sources and requesting that the taxpayer provide additional information or documents that are necessary to determine reasonable collection potential. Consider contacting third parties to verify or obtain information (see IRM 5.1.17).

Collection issues that have been previously addressed during a balance due investigation by field personnel in the preceding 12 months will not be re-examined unless there is convincing evidence that such reinvestigation is absolutely necessary.

A taxpayer is not required to substantiate expenses that are categorized as National Standards unless they exceed the Standard.

A taxpayer may be required to substantiate expenses that are categorized as Local Standards or Other Expenses ( See IRM 5.15.1.10).

Substantiation of expense amounts could include the following items: bank statements, credit cards vouchers, rent/lease receipts and leases, payment coupons, court orders, contracts, and canceled checks. Document how obligations are being met and the source of funds. Taxpayers who own real estate should provide documents showing the monthly payment, the purchase price, date of purchase, and the principal amount due. When obtaining documents for substantiation, ask the taxpayer for copies, not original documents. If necessary, secure telephone numbers and contact names of creditors. These can be used if verification is necessary.

When analyzing expenses for a business taxpayer, ensure that business expenses are not included under personal expenses. Compare the 433-A and 433-B to income tax returns to verify assets and income or analyze bank deposits.

Secure third party information such as bank deposit records, government agency records, competitors or suppliers to determine the source of funds of the taxpayer. Ensure that third party notice requirements are met (refer to IRM 5.1.17, Third Party Contacts). Use summons authority to secure leads to assets and income (refer to IRM 25.5.1, Summons).

Compare income to expenses. If expenses exceed income, ask the taxpayer probing questions to determine alternate sources of income that may be supplementing his/her income. Look for and consider:

On business accounts, determine if there are "non-cash " expenses such as depreciation or amortization. Also consider a commingling of funds between related entities. Examine prior year returns to detect sporadic income. Review bank deposits for at least 3 months to determine the taxpayer's stated income.

Generally, a taxpayer will be allowed only the expenses they are required to pay. Consideration must be given to any other income into the household and any expenses shared with a non-liable person.

Generally, the assets and income of a non-liable person are excluded in the computation of the taxpayer's ability to pay. One notable exception is community property states. Follow the community property laws in these states to determine what assets and income of the otherwise non-liable spouse are subject to collection of the tax.

Regardless of whether community property laws apply, secure sufficient information concerning the non-liable person to determine the taxpayer's proportionate share of the total household income and expenses. Review the entire household's information and:

Shared expense calculations between spouses are used when the parties live in a separate property state or state law permits the parties to separate their incomes and the non-liable spouse does not agree to have their income considered in the repayment of the liable spouse’s tax debt (IRM 5.15.1.4(2)). If the non-liable spouse does not agree to have their income considered in the repayment amount, determine the income percentages as stated in IRM 5.15.1.4. After determining the percentage of income of the liable spouse, that percentage is multiplied against the National Standards amount for the household, the Local Housing and Utilities standard and against the Local Transportation standard for ownership and operating cost (IRM 5.15.1.4(3)). The National Out-of-Pocket Health Care Standard allowed would be the above calculated percentage multiplied against the Out-of-Pocket Health Care Standards for the household or the Out-of-Pocket Heath Care Standard for one person, whichever is greater. However, in all allowable expenses except the National Standards, the liable spouse can only claim the amount they actually pay (IRM 5.15.1.4(3)(f)). Consideration should also be given to any separate expenses the liable spouse may be solely responsible for paying, such as alimony, child care etc.

When the taxpayer can provide documentation that income is not commingled (as in the case of roommates who share housing) and responsibility for household expenses are divided equitably between co-habitants (as documented by rental agreements, bank statement analysis, etc.), the total allowable expense should not exceed the total allowable housing standard for the taxpayer. In this situation, it would not be necessary to obtain the income information of the non-liable person(s), however sufficient financial information must be secured to verify the total household expenses and prove that the taxpayer is paying his/her proportionate share. The investigating employees should exercise sound judgment in these situations to determine which approach is most appropriate, based on the facts of each case.

If an internal verification is conducted on the non-liable person, this information cannot be provided to the taxpayer. This is not an Unauthorized Access (UNAX) violation if the revenue officer's duties require the inspection or disclosure of this information for tax administration purposes. However, it is a disclosure violation under IRC 6103 if any information is shared with someone other than the non-liable person in question, unless consent to disclose the information is obtained from the non-liable person.

Verify as much of the financial statement as possible through internal sources.

When internal locator services are not available, or a discrepancy is indicated, request that the taxpayer provide reasonable information necessary to support the financial statement.

Consider securing a full credit report as additional verification of the taxpayer's financial situation if warranted by the facts and circumstances. See IRM 5.1.18.5

Regardless of the amount of the liability consider the following:

Request appropriate documentation from the chart below to verify the CIS. Do not make a blanket request for information. Tailor your request to each taxpayer's specific situation. Do not require the taxpayer to provide information that is available from internal sources.

Allowable expenses include those expenses that meet the necessary expense test. The necessary expense test is defined as expenses that are necessary to provide for a taxpayer's and his or her family's health and welfare and/or production of income. The expenses must be reasonable. The total necessary expenses establish the minimum a taxpayer and family needs to live.

There are three types of necessary expenses:

National Standards: These establish standards for Food, Clothing and Other Items and Out-of-Pocket Health Care Expenses.

Local Standards: These establish standards for two necessary expenses: housing and utilities and transportation. Taxpayers will normally be allowed the local standard or the amount actually paid, whichever is less.

National and local expense standards are guidelines. If it is determined a standard amount is inadequate to provide for a specific taxpayer's basic living expenses, allow a deviation. Require the taxpayer to provide reasonable substantiation and document the case file.

If the taxpayer or the Service believes reviewing the last three months of expenses are not reflective of the actual yearly expenditures additional months, up to one year, may be reviewed.

Other - Other expenses may be allowed if they meet the necessary expense test. The amount allowed must be reasonable considering the taxpayer's individual facts and circumstances.

Conditional expenses. These expenses do not meet the necessary expense test. However, they are allowable if the tax liability, including projected accruals, can be fully paid within five years.

Generally, the total number of persons allowed for national standard expenses should be the same as those allowed as exemptions on the taxpayer's current year income tax return. Verify that exemptions claimed on the taxpayer's income tax return meet the dependency requirements of the IRC. There may be reasonable exceptions. Fully document the reasons for any exceptions. For example, foster children or children for whom adoption is pending.

A deviation from the local standard is not allowed merely because it is inconvenient for the taxpayer to dispose of valued assets or reduce excessive necessary expenses.

Revenue officers should consider the length of loan payments. Although it may be appropriate to allow for payments made on a secured debt that meets the necessary expense test, if the debt will be fully repaid in one year only allow those payments for one year.

National Standards: Food, Clothing and Other Items include the following expenses:

Allow taxpayers the total national standard amount for their family size without questioning the amount actually spent.

A taxpayer who claims more than the total allowed by the national standards must provide documentation to substantiate and justify as necessary those expenses that exceed the total national standard amounts.

All deviations from the national standard expenses for food, clothing and other items must be verified, reasonable and documented in the case history.

National Standards: Out of Pocket Health Care Expenses – These include medical services, prescription drugs, and medical supplies (e.g., eyeglasses, contact lenses). Elective procedures such as plastic surgery or elective dental work are generally not allowed.

The out-of-pocket health care standard amount is allowed in addition to the amount taxpayers pay for health insurance.

Taxpayers and their dependents are allowed the standard amount monthly on a per person basis, without questioning the amounts they actually spend. Taxpayer verification of out-of-pocket expenses is not required unless the amount claimed exceeds the standard.

Taxpayers who claim more than the total allowed by the out-of-pocket health care standard, may be allowed more than the standard if they provide documentation to substantiate and justify the additional expenses. This situation may be encountered in situations involving taxpayers with no health insurance.

All deviations from the national standards for out-of-pocket health care expenses must be verified, reasonable and documented in the case history.

Local standards include the following expenses:

Other expenses may be considered if they meet the necessary expense test - they must provide for the health and welfare of the taxpayer and/or his or her family or they must be for the production of income. This is determined based on the facts and circumstances of each case.

If other expenses are determined to be necessary and, therefore allowable, document the reasons for the decision in your history.

The amount allowed for excessive necessary or conditional expenses depends on the taxpayer's ability to full pay the liability plus projected accruals within five years and on the taxpayer's individual facts and circumstances. If the liability plus accruals can be paid within 5 years, it may be appropriate to allow the taxpayer the excessive necessary and conditional expenses. If the taxpayer cannot pay within 5 years, it may be appropriate to allow the taxpayer the excessive necessary and conditional expenses for up to one year in order to modify or eliminate the expense. (See IRM 5.14.1, Installment Agreements)

For purposes of determining the taxpayers' ability to pay, total household income must first be determined. Refer to See IRM 5.15.1.4., Shared Expenses, for a complete explanation of determining proportionate income and expense calculations. If the taxpayer refuses to provide total household income, allocate 50% (or an appropriate percentage based on the number of household individuals) of household expenses to the taxpayer.

Income consists of the following:

Businesses and individuals both have the same type of assets. For example, cash is the same for a corporation or an individual. However, some assets that are unique to businesses can be more complex or difficult to value. Many businesses employ accounting firms to maintain records and books or use over the counter software programs. Because of the complexity of business entities, acquiring and reviewing these records are very important in determining the true value of an asset. The statements you should secure from business entities are described below.

Income Statement. Income Statement or Profit and Loss Statement is a financial statement that shows revenue, expenses and profit during a given accounting period, usually either a quarter or a year. Along with the balance sheet, the income statement is a tool used to assess the health and prospects of a company. The income statement shows revenue and expenses, including operating expenses, depreciation, income taxes and extraordinary items. Using the income statement, a taxpayer or revenue officer can quickly figure cash flow, profit margins and other important indicators of how the business is doing.

Balance Sheet. A business' balance sheet is a snapshot of its financial picture on a given day. A balance sheet shows the financial position of a company by indicating the resources that it owns, the debts that it owes and the amount of the owner's equity in the business. One side of the balance sheet totals up assets, moving from most liquid (cash) to least liquid (plant and equipment or goodwill). The other side of the balance sheet lists liabilities in order of immediacy. Remember that assets must equal liabilities plus shareholder's/owner's equity. The balance sheet, along with the income statement, is an important tool for analyzing the financial health of a company. Using the balance sheet, compare current assets and current liabilities to assess equity; and consider hidden value in assets.

The IRC permits a taxpayer entity to reduce its income by deducting expenses paid to earn that income. Often these expenses help to identify assets to pay the tax liability.

Deductions may not necessarily be allowed as an expense in determining the ability to pay -- only actual cash expenses are used. If the taxpayer submits their own income and expense statement, the non-cash expenses should be removed from the analysis.

Substantiation and verification is required for cash expenses.

In analyzing and verifying the business income and expenses or deductions, real or potential assets may be identified. The following charts provide an explanation of the income or expense item and other considerations for identifying assets or other considerations.

Compensation of Officers. This amount represents compensation paid to corporate officers during the taxable year.

Bad Debt. Bad debts are amounts owed to the corporation but uncollectible.

Taxes and Licenses. This represents deductible taxes and license fees paid on assets by the corporation.

Interest. Interest deduction represents any interest paid or payable on corporate debt.

Depreciation. Depreciation is a method to deduct the purchase price or basis of an asset over its useful life.

Depletion. Depletion is similar to depreciation, but applies to assets such as oil, gas, coal or gemstones. Since the asset is removed from the ground, the depletion allowance is computed to account for this removal from the source.

Pension Plans, Profit Sharing Plans and Employee Benefit Programs. Generally, pension plans, profit-sharing plans and employee benefit programs indicate a retirement account for the employees and corporate officers.

Other deductions. Other deductions represent the cumulative total of all deductions that do not have a line entry on the return.

Net Operating Loss (NOL) Deduction. The net operating loss is not an "out-of-pocket" expense but an artificial amount based upon tax law.

Income represents the return in money from a business, labor or capital investment.

Gross Receipts or Sales.

Dividends.

Interest.

Gross Rents.

Gross Royalties.

Capital Gain Net Income.

Net Gain (or Loss).

Other Income.

As described in the previous sections, analysis of the income and expenses identifies many of the assets the taxpayer may have. Additionally, each section of the Collection Information Statement (CIS) should be reviewed to ensure that all sections are completed and all assets have been identified.

Secure the location (foreign or domestic) for each asset, any debts owed on the assets, the date the debt was acquired and the date the debt will be satisfied.

Proper valuation of the assets is necessary to determine the total collection potential of the taxpayer. The value should be based on the fair market value (FMV).

A field call should be made to locate and personally observe the condition of assets based on the merits and circumstances of the investigation.

Determine the Fair Market Value (FMV). The FMV is the price set between a willing and able buyer and the seller in an arms length transaction with full knowledge of the relevant facts.

Quick Sale Value (QSV) is an estimate of the price a seller could get for the asset in a situation where financial pressures motivate the seller to sell in a short period of time, usually 90 days or less. Generally, QSV is calculated at 80% of fair market value. A higher or lower percentage may be appropriate depending on the type of asset and current market conditions.

When taxpayers own assets jointly with others, allocate equity in the assets equally between the owners, unless the joint owners demonstrate their interest in the property is not equally divided. In this case, allocate the equity based on each owner's contribution to the value of the asset.

Although we may determine not to execute our lien on jointly held assets, that would not prohibit us from requesting the taxpayer to attempt to secure a loan against the asset, at least to the equity we have allocated to the taxpayer.

When determining the reasonable collection potential, an analysis is necessary to determine if certain assets are essential for the production of income. When it is determined that an asset or a portion of an asset is necessary for the production of income, it may be appropriate to adjust the income or expense calculation for that taxpayer to account for the loss of income stream if the asset were either liquidated or used as collateral to secure a loan.

When valuing income-producing assets:

These considerations should be fully documented in the case history. For example:

A critical part of the financial analysis is to determine what degree of control the taxpayer has over assets and income in the possession of others.

When these issues arise, apply the principles in the Legal Reference Guide for Revenue Officers ( IRM 5.17.14) or request an opinion from counsel.

Cash assets include currency on hand and bank account balances, including checking, savings and any other account. Determine the location (foreign or domestic) of the bank accounts.

Determine the taxpayer's interest in bank accounts by ascertaining the manner in which they are held. Apply the principles described in the Legal Reference Guide for Revenue Officers ( IRM 5.17.3).

Verify whether deposits in escrow or trust accounts are actually held for the benefit of others.

Financial securities are considered an asset and their value should be determined.

To determine the value of publicly traded stock, research a daily paper or inquire with a broker for the current market price.

Life insurance as an investment is not considered a necessary expense. However, reasonable premiums for term life policies may be allowed when the policy is for the life of the taxpayer.

When determining the value in a taxpayer's insurance policy consider:

Funds held in a retirement or profit sharing plan are considered an asset and may be reachable by levy. See the Legal Reference Guide for Revenue Officers, IRM 5.17.3.5.24, Pension and Retirement Benefits.

Contributions to voluntary retirement plans are not a necessary expense. Review of the retirement plan document is generally necessary to determine the taxpayer's benefits and options under the plan.

When determining the value of a taxpayer's pension and profit sharing plans consider:

When the taxpayer will liquidate the retirement plan, allow any penalty for early withdrawal and the current year tax consequence. Consider requiring the taxpayer to submit an estimated tax payment as applicable.

The taxpayer's declared value of household goods is usually acceptable unless there are articles of extraordinary value, such as: antiques, artwork, jewelry, or collector's items. Exercise discretion in determining whether the assets warrant personal inspection.

There is a statutory exemption from levy that applies to the taxpayer's furniture and personal effects and an exemption that applies to the value of tools used in a trade or business. These separate exemption amounts are updated on an annual basis. The levy exemption for tools of the trade does not apply to corporate entities, but only to individual business taxpayers.

When determining the value consider the following:

Motor vehicles, aircraft and vessels (boats) are considered assets. Equity in these types of vehicles must be determined and should be considered as possible collateral for loans.

Generally, it is not necessary to personally inspect automobiles used for personal transportation since their value is easily determined by consulting trade association guides. If the values are in dispute, the taxpayer should be instructed to secure an appraisal from a knowledgeable and impartial dealer or the revenue officer may adjust the value based on the condition of the vehicle. Adjustments to value based on condition should be documented in the case file.

Assets such as airplanes and boats may require an appraisal to determine FMV unless the items can be located in a trade association guide. The case file should document how these values were determined.

When these assets are used for business purposes they may be considered income producing assets. See See IRM 5.15.1.18 , Income Producing Assets, for a full discussion of the treatment of income producing assets.

When determining equity in real estate, FMV of the property must be established. FMV is defined as the price a willing buyer will pay for the property based on the property's current condition and use. The following methods may be used to establish FMV:

In determining the interest of the liable party, and the value of the interest, refer to the Legal Reference Guide for Revenue Officers ( IRM 5.17.1.2) and state law for additional guidance. The basis for the valuation should be documented in the case history.

The equity in real estate should be pursued as a means to full pay or reduce the tax liability. The taxpayer should be asked to secure a loan. Refusal to pro-actively seek a loan will be considered refusal to pay and appropriate enforcement actions should be pursued. See IRM 5.10.1 , Seizure and Sale.

Mortgage and real estate loans represent money loaned to pay for real property. This may disclose real property or real estate notes previously unreported.

Determine the status of the loan and who holds the note or mortgage. Determine if the real estate note can be used as collateral for a loan to satisfy the tax liability or be factored or sold to the debtor.

Trade notes and receivables are income or "account receivable " amounts owed to the taxpayer by others. Consider the value of accounts for purposes of potential enforcement.

To determine the value of accounts receivable:

Careful consideration should be given prior to serving a Notice of Levy on an account receivable when it is determined that liquidation of the receivable would be detrimental to the continued operation of an otherwise profitable business.

Secure a complete listing of account receivables:

Inventory is property held for sale by the corporation.

The most common inventories are:

Determine the value of the inventory. This may be used as collateral for a loan or may be seized and sold in the event enforcement action becomes necessary.

To determine the value of business assets:

Tax-exempt securities are investments which pay interest which is not taxable.

However, these securities are assets. Since they are not taxable, they are not always listed on the return. The earnings from these securities should be list on line 8b of the Form 1040.

These securities can include:

These assets represent an account receivable due to the corporation by its shareholders. Sometimes the corporation grants a loan to a shareholder or relative of the shareholder with no intention of repayment.

Determine the following to verify the existence of the loan:

Intangible assets are those without physical form or substance. The most common are:

The existence of an intangible asset can indicate a potential future benefit. While not "physical" , these are valuable assets and thus subject to amortization.

Amortization, like depreciation, is the write-off of an investment expense over a specified period or the economic useful life of the intangible asset. The amount on the return is the unamortized residual balance of the intangible. In other words, it is the amount that has not been written off.

The value of the intangibles can be obtained through the sale of the asset. Examples include:

Taxpayers may substitute the corporate financial statements for the income and expense section of the 433-B. However, if the taxpayer does not submit the income and balance sheet of the corporation, they should be requested in order to review the viability of the corporation and to complete a cash flow analysis if appropriate as discussed in IRM 5.15.1.12., Business Entities.

The taxpayer may be asked to submit a cash flow analysis. These are often completed when taxpayers seek loans or investors and may already be available for the revenue officer's review.

Cash Flow. Cash flow is net income minus preferred dividends plus depreciation (as given in the income statement). Generally speaking, cash flow is the best measure of a company's profits. It is usually calculated by adding depreciation and any other non-cash charges to earnings after taxes. Investors look to cash flow for several reasons:

The analysis of the taxpayer's financial condition provides a basis for making one or more of the following decisions:

Address full compliance and ensure taxpayer is current with all filing and paying requirements, including federal tax deposits and estimated tax payments.

When analyzing and verifying the financial data, be alert to any indications of fraud. If indications of fraud are identified, refer to IRM 25.1, Fraud Handbook or contact the Fraud Referral Specialist (FRS) before further contact with the taxpayer or representative.

Trust Fund Recover Penalty (TFRP). If the delinquency includes trust fund employment taxes, a TFRP investigation must be completed. The finances of any responsible person would be considered in analyzing the potential payment of the account. See IRM 5.7, Trust Fund Compliance.

The Internal Revenue Code does not include specific provisions for liability collection from most state law business organizations. The provisions of state law that shield certain persons or entities from liability are used as guidance for determining the entity liable for taxes incurred in a business.

State law is also the determining factor for defining property and rights to property. Therefore, the attachment of a federal lien to property is highly dependent upon state law.

Classification principles must be used to first determine the identity of the liable party. State law definitions of property are then used to determine what property the federal tax lien attaches to.

Generally, an assessment of tax in the name of a business entity can be generally taken as evidence of liability on the part of the party assessed. However, partners who are not assessed may be liable under state law - e.g., general partners may be liable for partnership liabilities.

Single owners of certain limited liability companies (LLCs), with respect to employment taxes on wages paid prior to January 1, 2009, could file returns in the name of the LLC even though only the owner was liable. This has created problems since assessments where the single owner is liable are indistinguishable from assessments where the LLC is liable.