NEWS IRS COLLECTION STANDARDS FOR ALLOWABLE EXPENSES

By Thomas H. Zick

The IRS has introduced new procedures for determining a taxpayer's ability to pay tax liabilities. A basic understanding of these new rules is critical for any practitioner who represents a client before the Collection Division of the IRS, since reliance on the old rules could result in some unwelcome surprises for the practitioner and the client.

Background

The determination of "allowable expenses" has always formed the framework for determining the amount of disposable income that a taxpayer has available to pay towards back taxes on a monthly basis. This disposable income amount is used by IRS to fix a set monthly payment amount under a formal installment payment agreement and is also used by IRS to determine future income potential for determining acceptability of an offer in compromise.

Generally, the IRS will require payment from available assets, either voluntarily or through enforcement action. IRS will consider an installment agreement only if immediate collection is not possible.

If it is determined that an installment agreement is the right collection tool, a computation of monthly allowable expenses is required. In the past, this process required an analysis of the taxpayer's actual living expenses and a negotiation by the taxpayer or his or her representative as to what expenditures were necessary and what amounts were reasonable given the taxpayer's income level, family size, etc.

Since the results of the analysis and negotiation process was based on the judgment of the IRS collection personnel, the determination of the bottom line disposable income amount was somewhat subjective. Therefore, significant variations in the treatment of taxpayers' cases among IRS collection employees in different regions, district offices, and even within the same local collection group resulted. These differences raise, among other things, the issue of fairness among similarly situated taxpayers in different geographic locations.

The IRS, with input from practitioner groups, developed national and local standards for various types of necessary living expenses and incorporated these standards in a new set of standardized procedures in an attempt to eliminate many of the subjective differences and alleviate the perceptions of unfairness. These new rules and procedures became effective September 1, 1995.

Procedures

The stated goal of IRS collection personnel is to collect the liability in full. If that is not possible, they will attempt to collect the maximum reasonable amount as quickly as possible. The stated purpose of the new procedures is to establish a consistent framework for evaluating a taxpayer's ability to pay.

The new procedures provide a number of new concepts and definitions. For instance, there are now two types of allowable expenses, "necessary" and "conditional."

Necessary expenses must provide for the taxpayer family's health and welfare or the production of income. The expense must also be reasonable in amount. The total necessary expenses are what the IRS considers the minimum a taxpayer and family need to live on.

Necessary expenses are divided into three categories. These are national standards, local standards, and other.

The national standards determine reasonable amounts for the following five types of expenses: food; housekeeping supplies; apparel and services; personal care products and services; and miscellaneous. The first four types were derived from the Bureau of Labor Statistics (BLS) Consumer Expenditure Survey 1992-93. The fifth type was determined by IRS.

These expenses are stratified by income level and updated annually. The national standards appear in Publication 1854, How to Prepare a Collection Information Statement Form 433-A and Form 433-F.

Conditional expenses do not meet the necessary expense criteria. However, if the tax liability (including projected penalties and interest) can be paid within three years, they are allowable.

The new procedures describe a three-year rule and a one-year rule. The three-year rule provides that excessive necessary and conditional expenses will be allowed if the liability is fully paid within three years. The one-year rule provides that if the tax liability cannot be paid within three years, the IRS will provide up to one year to modify or eliminate excessive necessary and not-allowable conditional expenses.

Reasonable amounts for certain specified expenses will now be provided by national and local standards. IRS collection personnel will still determine the reasonable amount for any other expenses.

Disposable income is defined as gross income less allowable expenses, including deductions required by law to be withheld, or any legally binding child support or alimony payments. Examples of deduction required by law to be withheld include Federal and state taxes, FICA and medicare contributions, and wage garnishment payments. This disposable income figure is the amount that IRS will apply to the tax liability.

All claimed expenses except national standard amounts are subject to substantiation and verification.

IRS collection personnel will want to consider the taxpayer's compliance and tax history before granting an installment agreement. Some of the questions that the taxpayer should be prepared to answer include the following:

Is the taxpayer current in all payments and filings?

Has the taxpayer defaulted on any prior agreements?

What is the source of the liability?

Has the taxpayer increased or decreased expenses since the liabilities were assessed?

The IRS collection person must determine a course of action depending on the responses to questions such as these. For instance, a liability which unexpectedly resulted from a tax examination is viewed much less harshly than a liability resulting from a failure to pay any estimated taxes for a tax year. Or for instance, a taxpayer who moves into less expensive housing will be viewed in more favorable light than the taxpayer who purchases a new luxury automobile after incurring the tax liability.

This attitude is based on an IRS collection principle that provides that IRS Collection personnel should help taxpayers who try to comply and take appropriate enforcement actions when taxpayers resist complying.

After analyzing the taxpayer's financial condition and compliance history, the IRS collection person is faced with a choice of case resolution decisions including--

* requiring payment from available assets;

* initiation of enforcement action;

* filing of a Notice of Federal Tax Lien;

* preparation of an installment agreement;

* explanation of offer-in-compromise provisions;

* reporting the account as currently not collectible.

Before a decision can be made on the last three items, the taxpayer's income and expenses must be analyzed, substantiated, and verified.

Analysis Substantiation and Verification of Income and Expenses

Generally, expenses must be reasonable in amount for the size of the family and the geographic location, as well as any unique individual circumstances.

There is no requirement to substantiate national standard expenses, but any amounts claimed in excess of national standards must be substantiated. The taxpayer may be required to substantiate expenses which are categorized as local standards or as other necessary expenses.

If expenses exceed income, the taxpayer must be prepared to offer an explanation. If no explanation is offered or if the explanation is inadequate, a referral to IRS examination personnel is likely.

The practitioner needs to point out that future expenses such as the birth of a child or the necessary replacement of a car will increase allowable expenses.

Allowable Expenses

Allowable expenses include necessary and conditional expenses. Reasonable necessary expenses are always allowable. Therefore, if there is no disposable income beyond necessary expenses, the collection case would normally be closed as currently uncollectible.

Conditional expenses are allowed if a tax liability, including projected accruals of penalty and interest, can be paid in full in three years through an installment agreement.

Necessary Expenses

There are three categories of necessary expenses:

National Standards

The National Standards appear in IRS Publication 1854. This standard amount from the IRS table does not need to be justified or substantiated. Taxpayers making more than the highest income level shown in the national standards are limited to the highest income level shown in the national standards. However a larger amount may be allowed if substantiated and justified. For example, if a taxpayer claims a larger expenditure for food than allowed, justification would have to be based on special prescribed or required dietary needs.

Larger amounts may be allowed under the three-year rule if each item is substantiated.

Local Standards

National standards are not feasible for some kinds of expenses. Therefore, local standards have been developed for housing, utilities and transportation.

Although the national standard amounts are allowable without substantiation, the local standards for housing, utilities, and transportation act as a cap. The taxpayer is only allowed the local standard or the amount actually paid, whichever is less.

The local standards are provided by county and are derived from census and Bureau of Labor Statistics data. A single dollar amount is provided which includes both housing and utilities.

Housing expense includes‹

* monthly rent or mortgage payment,

* property taxes,

* homeowner's or renter's insurance,

* parking,

* necessary maintenance and repair, and

* homeowner dues and condominium fees.

Utilities include gas, electricity, water, fuel oil, coal, bottled gas, trash and garbage collection, wood and other fuels, septic cleaning, and telephone.

The IRS will require payments equal to excessive or not-allowable housing expenses. The taxpayer should demonstrate the increased cost of transportation to work and school that would result from the taxpayer moving to lower-cost housing as well as the tax consequences that would result from selling a home. (Loss of tax deduction for mortgage interest or taxes and possibility of a capital gain liability and the cost of moving to a new residence.) All of these costs must be taken into account in determining the allowable amount.

The transportation standard consists of nationwide figures for loan or lease payments referred to as ownership costs plus additional amounts for operating costs broken down by census region and metropolitan statistical area.

Operating costs that are derived from Bureau of Labor Statistics data include insurance, registration fees, normal maintenance, fuel, public transportation, parking, and tolls.

Separate caps are provided in the tables for a one-person household and if a second car payment is allowed, a two- or more person household. The ownership costs are based on relatively modest assumptions of a $17,000, five-year loan/lease at 8.5% interest for the first car and a $10,000 five year loan/lease at 8.5% interest for a second car.

The practitioner must be careful when explaining the need for one or more automobiles. IRS collection personnel will evaluate whether public transportation is a viable alternative if car payments will prevent the tax liability from being paid in part or in full. The IRS collection person may argue against a car as a necessary expense item if public transportation does not significantly increase commuting time and does not inconvenience the taxpayer. The taxpayer must be prepared to demonstrate that each car is a necessity and not a personal convenience.

Other Necessary Expenses

Other necessary expenses include taxes, health care, court-ordered payments, involuntary deductions, accounting and legal fees for representing a taxpayer before the IRS, secured or legally perfected debts (minimum payments), and accounting and legal costs that meet the necessary expense test of health and welfare or production of income.

Depending upon individual circumstances, there may be other expenses which may meet the necessary expense test of providing for health and welfare or production of income. Therefore, it is incumbent to carefully examine each of the taxpayer's expenses to determine if any of them may qualify as a necessary expense.

Such expenses include child care; dependent care for the elderly, invalid, or disabled; secured or legally-perfected debts; life insurance; charitable contributions; education disability insurance for a self-employed individual; union dues; professional association dues; accounting & legal; and optional telephone services.

Payments on unsecured debts may also be necessary where for instance a line of credit is needed for business. However, if the tax liability can be paid within 90 days, payments will not be allowed. Payments may also be allowed on debt incurred (but not to relatives) to pay a Federal tax liability.

Conditional Expenses Three-Year Rule

If a taxpayer can demonstrate that he or she can stay current in all tax requirements and that the tax liability including accruals of penalty and interest can be paid within three years, all expenses may be allowed.

Notwithstanding the three-year rule, IRS collection personnel are directed to secure payment agreement amounts based on the taxpayer's maximum ability to pay. Also, excessive necessary and not allowable conditional expenses incurred after the assessment of the tax liability are not covered by the three-year rule. Therefore, assets acquired after assessment of the tax liability may be subject to collection enforcement action if the collection employee feels that a taxpayer has acted to reduce his or her ability to pay.

In unusual circumstances, it may be appropriate to allow conditional expenses even if the liability cannot be paid within three years. However. managerial approval is required.

Where payments on unsecured debts are allowed as conditional expenses, IRS collection personnel will require increased payments in the collection agreement after the dates of final payment. If the liability cannot be paid within three years, taxpayers will be allowed up to one year to modify or eliminate excessive necessary or not allowable conditional expenses under the one-year rule.

The practitioner must negotiate vigorously for the largest amount of allowable expenses in order to make the final installment agreement as palatable as possible. The negative consequence is that if the taxpayer does not agree to the installment agreement on the terms determined by this process, immediate distraint will be considered by the IRS.

There are some practical considerations that should not be overlooked when dealing with conditional expenses. Examples of conditional expenses that may be allowed up to one year include car payments on luxury cars or a child's college tuition payments. The car payments would be allowed up to the earlier of one year or the end of the lease term or car payment schedule. Tuition payments would be allowed for the earlier of one full year or the end of the school term. In many cases, it will be necessary to negotiate for the full year allowable under this rule.

In the case of housing expenses, taxpayers may be paying more than is warranted based on their level of income or what is necessary for similar housing. Before a determination is made that expenses are excessive, the IRS collection person must consider all aspects of what is involved. In many cases, the taxpayer must be prepared to demonstrate that the additional costs of selling a home or breaking a lease are likely to exceed the additional payments IRS can otherwise expect. These additional costs can include sales expenses, including brokers and attorneys fees, capital gain taxes due on the sale of the home, moving expenses etc.

Also to be considered are extraordinary expenses that will be incurred within the time frame of the installment agreement such as the birth of a child, necessary replacement of a major appliance, or a home roof repair. If these types of expenses are anticipated, these needs should be worked into the negotiation as well.

Offer in Compromise

The new standards and procedures also apply for purposes of determining the future income amount for an offer in compromise. Only necessary expenses are allowed for computing future income. No allowance is made for conditional expenses.

It is clear that the success of the IRS's offer-in-compromise program in recent years has been due to the liberalized IRS policy since 1992 and the practical attitude exhibited by most revenue officers in accepting reasonable, negotiated amounts for necessary expenses.

However, with the introduction of standard amounts, there is significantly less wiggle room for negotiation of acceptable offers. In fact, for many upper-income taxpayers with commensurate housing expenses, an acceptable offer amount reflecting future income based on the relatively modest standard amounts allowable for housing and utilities will be much more difficult to negotiate.

Appeal Rights

Formal appeal rights outside of the offer-in-compromise area have been seriously lacking for years. However with the recent announcement by the IRS of new taxpayer rights initiatives effective April 1, 1996, taxpayers will have the right to administratively appeal liens, levies, and seizures proposed by the IRS. This should provide an opportunity for a relatively unbiased review of contemplated enforcement action when agreements are not reached. *

Thomas H. Zick, CPA, is a former Internal Revenue Agent and Appeals Officer. Mr. Zick currently has a tax consulting practice in Port Jefferson, New York.

Editors:
Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

Contributing Editors:
Richard M. Barth, CPA

Robert L.. Goldstein, CPA
Leipziger & Breskin

Joel Rothstein, CPA
Cantor Fitzgerald Securities

AUGUST 1996 / THE CPA JOURNAL