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

An interview should be conducted in order to determine the appropriate case resolution. Complete income and expense analysis is necessary only if the taxpayer does not full pay, however secure a complete Collection Information Statement upon initial contact.

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, housing and transportation. Reference to these standards will be found throughout this section. Exhibit 5.15.1-2 provide instructions for on-line access to the actual standards for the income levels and locales.

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 fact's and circumstances, it may be appropriate to deviate from the standard amount when failure to do so will cause the taxpayer economic hardship. The taxpayer must provide reasonable substantiation of all expenses claimed that exceed the standard amount. Document the case file accordingly. For example:

Analysis and verification of a Collection Information Statement (CIS) should take place shortly after receipt of the CIS. The ability to pay determination based on this analysis will be communicated to the taxpayer within a reasonable amount of time after receipt of 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 his/her 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 we expect from them rather than how we expect 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 expense items with varying monthly payments over 12 months unless the variation is excessive.

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 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.

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 Necessary Expenses (LEM 5.3.1).

Substantiation of expense amounts could include items like 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 realty 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, 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 the past 3-6 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 not liable person(s).

Generally, the assets and income of a not liable person are considered in the computation of the taxpayer's ability to pay. Their income is considered in the computation of the taxpayer’s ability to pay the debt from disposable income. One notable exception is community property states. Follow the community property laws in these states to determine what assets and income of the otherwise not liable spouse are subject to collection of the tax.

When the taxpayer indicates income is not commingled and responsibility for specific expenses is divided between the cohabitants, allow the expenses assigned to the taxpayer or apply the taxpayer's percentage of income to the total expenses, whichever is less.

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 the taxpayer to provide reasonable information necessary to support their financial statement.

For CNC hardship or Offer in Compromise cases, a full credit report is required on all cases with a total liability (including accrued penalty and interest) greater than $100,000. Unable to contact or unable to locate CNC cases over $50,000 (including accrued penalty and interest) require a full credit report. For all other investigations, consider securing a full credit report as additional verification of the taxpayer's financial situation if warranted by the facts and circumstances.

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 reasonable amounts for five necessary expenses. Four of them come from the Bureau of Labor Statistics (BLS) Consumer Expenditure Survey: food, housekeeping supplies, apparel and services, and personal care products and services. The fifth category, miscellaneous, is a discretionary amount established by the Service. It is $100 for one person and $25 for each additional person in the taxpayer's household.

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

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 expenses test. However, they are allowable if the tax liability, including projected accruals, can be fully paid within five years.

National 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.

Generally, the total number of persons allowed for national standard expenses should be the same as those allowed as dependents on the taxpayer's current year income tax return. Verify exemptions claimed on 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.

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

National standards include the following expenses:

Allow taxpayers the total national standard amount for their income level.

A taxpayer that claims more than the total allowed by the national standards must substantiate and justify each separate expense of the total national standard amounts.

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 necessary or conditional expenses depends on the taxpayer's ability to full pay the liability within five years and on the taxpayer's individual facts and circumstances. If the liability 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, Installment Agreements)

For purposes of determining the taxpayers' ability to pay, total household income must first be determined. Refer to Section 5.1.15.1.4, 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 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 determine actual 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 firm's 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 shareholders 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.