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.

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 secured by an asset.

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, Profit Sharing Plans and Employee Benefit Programs. Generally, pensions, profit-sharing plans and employee benefits 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: gains, profits, salary, and wages.

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 an amount less than FMV but greater than Forced Sale Value (FSV). FSV is defined as no less than 75% of FMV.

Normally, QSV is calculated at 80% of FMV less amounts owed to secured lien holders with priority over the federal tax lien. 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.

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) 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).

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. Then, allow for the estimated costs of the sale to arrive at QSV.

When a taxpayer holds only a negligible or token interest, has made no investment and exercises no control over the corporate affairs, it is permissible to assign the stock no value.

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.

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. The general rule for determining net realizable equity, as discussed in Allowable Expenses, applies when determining equity in these vehicles.

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 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 LRG (IRM 5.17) 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. Refer to applicable sections within Part 5 of the IRM.

Mortgage and real estate loans represent money loaned by the corporation 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:

When it is determined that liquidation of a receivable would be detrimental to the continued operation of an otherwise profitable business, careful consideration should be given to levying the receivable.

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 investment securities that are not taxable.

These securities are assets. Since they are not taxable, they are not always listed on the return. The earnings from these securities are not reflected on the interest or dividend lines of the tax return.

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 note:

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 taxpayer's 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 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 Handbook.

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

In the absence of specific guidance on collection issues from business entity types, rely upon characteristics substantiated in the code of Federal Regulations for determining the party liable for taxes (26 CFR 7101-1).

Since state law is also the determining factor for defining property and rights to property, the attachment of a federal lien to property is highly dependent upon factors outside federal law. The principle of state law definition for property and rights to property is one that has been confirmed repeatedly in decisions of the federal courts.

Determining an effective course of collection action requires the application of classification principles to first determine the identity of the liable party and then to determine if state law definitions of property are sufficient to justify attachment of a federal lien.

Application of these principles is not a significant concern for treatment of most tax assessments. 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.

In recent years the popularity of the state law limited liability company (LLC) and its classification under federal regulations, in certain circumstances, as an entity "disregarded" as separate from its owner has created problems for determining the party liable for tax.

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