How the IRS conducts financial analysis

Working with the Internal Revenue Service on an installment payment plan for your tax debt may make you feel frustrated. The IRS conducts its own financial analysis to verify and analyze your financial information. During the examination, the IRS evaluates your income and expenses to calculate a figure for disposable income. While the process may seem complicated, there are specific rules and regulations on how the IRS conducts financial analysis.

If you have questions about these financial analytics, speak to the experienced tax attorneys at Damiens Law at (601) 957-9672 to ensure your legal and financial rights remain protected.

IRS financial analysis

The IRS analyzes a taxpayer’s income and expenses to determine disposable income. Disposable income is the gross income minus all allowable expenses. Why would the IRS conduct a financial analysis? In most situations, this action helps to resolve those accounts with a due balance. The IRS often requests that the taxpayer make an immediate payment if the cash on hand equals their total tax liability.

During the analysis, the IRS works to identify key sources of funds, such as liquid assets. According to the Internal Revenue Service, “liquid assets can be pledged as security or readily converted to cash.” The IRS calculates the net realizable equity in assets. With that, the financial analysis determines the property’s fair market value multiplied by the quick sale amount or 80%. That amount is subtracted by the balance of any loans secured with the property. The net realizable equity in assets applies to real estate, personal property, and vehicles. 

Determination of assets

The IRS conducts financial analysis using the asset-equity table (AED). This table will list and document all of the taxpayer’s assets, exemptions, and encumbrances. A revenue agent uses the table to calculate “the equity which is included in the reasonable collection potential (RCP) calculation.” The major categories in the asset-equity table include:

• Assets
• Fair market value
• Quick sale value
• Encumbrances
• Exemptions
• Quick sale reduction percentage
• Net realization equity

Under those categories, the taxpayer will list information regarding various assets. These assets may include:

• Cash
• Bank accounts
• Loan values
• Life insurance
• Offer deposits
• 401K and pensions
• Furniture
• Personal effects
• Vehicles
• Accounts receivable
• Tools
• Real estate
• Equipment and machinery

On the table, the taxpayer will then calculate the current amount and future income value from these items. The IRS allows exceptions based on an asset’s total dollar amount. The net equity cannot be less than zero for the individual’s bank and cash account. Taxpayers may qualify for the six-year rule, which allows these individuals to pay back their federal tax liability within six years. The six-year limitation does not apply to LLCs, partnerships, or corporations. 

Verification of documentation

During the IRS financial analysis process, agents will verify the information by conducting interviews, asking specific questions, and documenting the final results. The IRS will want to know:

• how an individual generates income
• the nature of their business
• the services and products offered by the individual
• all assets in the taxpayer’s name
• their internet presence

The IRS makes every effort to verify any previous collection issues of the individual. In some situations, a re-investigation of a person’s finances is necessary. If the taxpayer fails to pay these taxes, it is a felony. Under the Internal Revenue Code, “any willful attempt to evade taxes” can be punished with a fine of not more than $100,000 or five years in prison.

Applying for an installment repayment agreement can be complex. Consider visiting with a dedicated tax attorney at Damiens Law to explore your options. 

What are the IRS national standards?

While it may seem like a never-ending process, the IRS conducts financial analysis following national standards. These standards serve as guides to help taxpayers resolve any tax liabilities. According to the IRS Collection Financial Standard, five categories make up a taxpayer’s necessary expenses, or Allowable Living Expenses. These standards help the IRS to calculate the individual’s repayment of federal tax liability. These categories include the following:

Food

The IRS allows for calculations of food bought for the home and away from home. The expenditures for food at home include those items purchased at a grocery store or other store. Food away from home can mean meals and snacks at full-service restaurants, fast food establishments, server tips, and delivery fees.

Housekeeping supplies

All those items necessary for carrying on with daily life fall into this category. These expenses include delivery service fees, postage, stationery supplies, lawn and garden supplies, and miscellaneous household products.

Apparel and services

According to the IRS, taxpayers could include footwear, clothing, watches, and jewelry in this category. Additionally, expenses for material patterns to make clothes, repairs, alternations, dry cleaning, and laundry costs fall into this designation.

Personal care products and services

The taxpayer can include hair, shaving, and oral hygiene products. This category also covers bath and cosmetic products, electronic personal care appliances, and other miscellaneous personal care products.

Miscellaneous allowance

The IRS will include bank fees and charges, credit card payments, reading materials, and school supplies in this category.

Taxpayers can calculate these national standards according to their family size. However, if these claimed amounts are more than the standards for a specific category, taxpayers must provide documentation about the necessary expenses.

Does the IRS have local standards?

Along with national standards, these financial standards extend to local areas. The IRS does have guidelines that cover local housing and utility costs. A family’s size, state, and county determine these calculations. Also, these local standards include transportation costs. For example, single taxpayers can claim one vehicle and the operating costs in a specific metropolitan or regional area.

Plus, there is a single allowance for public transportation needs. The IRS bases these allowances on the Bureau of Labor Statistics data for a particular area’s train, bus, ferry, and taxi fares. If the taxpayer has no vehicle, they are allowed these standard transportation costs.

However, if the taxpayer uses both a personal vehicle and public transportation, the IRS may allow both expenses if there is a need for the welfare and health of the family. Additionally, those expenses must contribute to income production.

Special circumstances

These standard amounts established in the national and local guidelines account for basic living expenses. In some situations, the taxpayer has individual circumstances and factors that will allow the IRS to deviate from the standard. If the standard criteria are applied, the taxpayer will suffer economic hardship.

On the other hand, the taxpayer must provide reasonable substantiation to all their expenses exceeding the standard amounts. The substantiation can consist of credible written or verbal communication and documentation from the taxpayer. The IRS will add the substantiation to the individual’s case history. For example, if the taxpayer’s income dropped significantly from the prior year due to a divorce, the supporting substantiation will be documented in the case history.

The IRS often asks to verify these expenses in several ways. The revenue agents will ask for copies of:

• Canceled checks and bank statements
• Credit card vouchers and payment receipts
• Payment coupons
• Lease agreements and receipts
• Contracts
• Court orders
• Taxpayer statements, documentation, or written communications
• Tax statements and returns that document actual expenses
• Documentation of future costs, including the necessary replacement of a vehicle or birth of a child

There are other considerations. For example, if a taxpayer has an unusually large family or has a physical disability, those housing costs might exceed the local standards. To verify those exceeding costs, the taxpayer must provide copies of the rent or mortgage payments, utility bills, and maintenance costs.

An economic hardship occurs when the taxpayer cannot pay any reasonable basic living expenses. The Commissioner sets the reasonable amount for basic living expenses, and these allowances often vary according to the individual’s circumstances. Keep in mind that the maintenance of a luxurious or affluent standard of living will not fall into those basic living standards. If taxpayers disagree about the IRS’ determination of an economic hardship, then they may appeal to the Taxpayer Advocate Service.

Understanding the financial analysis process

When taxpayers apply for an installment payment agreement, the IRS will investigate their expenses and income streams. These financial analyses determine whether the taxpayer can pay back their tax liability at once or with help from an installment plan. With this information, taxpayers will know whether they will get approval for the payment agreement or must pay the total amount immediately.

The national and local standards can change. If a taxpayer wants a better understanding of these standards, the IRS website continues to offer the latest information. Contact an attorney if you have questions about how the IRS conducts financial analysis.

Reach out to a tax attorney to ensure your legal rights remain protected

The IRS conducts financial analysis when you apply for an installment payment agreement. In most cases, the taxpayer does not have enough cash to pay the total amount of their tax liability. With advice from an attorney, you may be able to prepare for these financial analyses.