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First Published in the Los Angeles Lawyer
When Congress enacted the Taxpayer Bill of Rights in 1988, it provided the Internal Revenue Service with the legal authority, but not the obligation, to enter into installment payment agreements with delinquent taxpayers.1 It was IRS practice to calculate the monthly installment payment by subtracting allowable expenses from monthly income. The surplus became the amount of the monthly payment.
The determination of allowable expenses was left within the virtually unfettered discretion of the individual IRS collection employee assigned to the taxpayer's case. An agreement with the IRS as to which expenses were allowable was usually the subject of intense negotiation, and, depending on the IRS employee involved, it was possible in many instances to arrive at an installment agreement which, while not overly generous, would not require a complete change in lifestyle by the taxpayer in order to meet his obligations.
On August 29, 1995, the IRS issued new guidelines ("Guidelines") which completely change how installment agreements are analyzed. The heart of the Guidelines are new standards for various types of expenses. No longer will the taxpayer be able to negotiate what is reasonable, but instead will be forced to live on a largely predetermined budget. Before considering the standards in more detail, it is helpful to examine the rest of the new IRS structure for granting payment agreements.
First, installment agreements will generally be granted only if the taxpayer is unable to pay the tax liability by liquidating assets or by borrowing.2 A taxpayer with equity in his or her home will be expected to borrow against that equity to liquidate the liability in whole or in part. In insisting on immediate payment, the IRS is probably doing the taxpayer a favor, since in virtually all cases it is cheaper to borrow than to enter into an installment agreement with the IRS.
Next, IRS employees are instructed to consider not granting an installment agreement if the taxpayer has violated the terms of a previous agreement.3 Other considerations are the reason for the liability. Was it caused by insufficient withholding or estimated taxes? Or did it come about from an audit? The IRS recognizes that an audit may create a significant liability which is unexpected, and that perhaps forbearance is more appropriate in such cases then when a taxpayer simply does not pay the tax when due.4
Assuming a payment agreement is the appropriate solution, the taxpayer will be expected to apply all of his disposable income to paying the taxes. Determining the amount of disposable income will depend upon whether the liability, together with the projected accruals of additional interest and penalties, can be liquidated within three years.5 If not, then the taxpayer will be allowed only expenses which are necessary and reasonable in amount.6 Expenses are necessary if they are used for the taxpayer's and his family's health and welfare, or the production of income.7
The Service has defined three types of necessary expenses: (1) National Standards; (2) Local Standards; and (3) Other.8 Food, housekeeping supplies, apparel and services, personal care products and services and "miscellaneous" are all categorized as National Standards.9 For each of these categories, the Service has published specific amounts which will be allowed as necessary expenses, depending upon the taxpayer's income and the size of her family. The National Standards make no allowances for where in the country a taxpayer resides.10 A taxpayer in Los Angeles, New York or San Francisco is assumed to have no higher expenses than one living in Little Rock or Boise.
The National Standards are derived from the Bureau of Labor Statistics Consumer Expenditure Survey 1992-3, and are supposed to be updated yearly as the information becomes available.11 Of course, they are already several years out of date. The amounts allowed are set forth by the IRS in Publication 1854 and are reproduced below:
|Total Monthly Income||Number of Persons in Household|
|Less than $830||$315||$509||$553||$714||+120|
|$830 to $1,249||383||517||624||723||+130|
|$1,250 to $1,669||448||569||670||803||+140|
|$1,670 to $2,499||511||651||731||839||+150|
|$2,500 to $3,329||551||707||809||905||+160|
|$3,330 to $4,169||590||840||948||1,053||+170|
|$4,170 to $5,829||665||913||1,019||1,177||+180|
|$5,830 and over||923||1,179||1,329||1,397||+190|
Thus a married couple with one child, having gross annual income of between $50,040 and $69,948, would be entitled to spend only $1,019 for food (both at home and away), clothing, dry cleaning, haircuts, laundry, postage, stationery, lawn and garden supplies, cosmetics, deodorants, electric personal care appliances, paper towels and miscellaneous household supplies.12 A taxpayer is not required to prove that she actually spent any particular amount for expenses specified by the National Standard. She is automatically allowed that amount even in the unlikely event that she spent less.13 Even though a taxpayer spends more than the National Standards, this does not mean the expense is necessary. However, if the taxpayer can justify the amount as being necessary, it can be allowed. For example, if more is spent on food than allowed by the National Standards, it could be allowed if the taxpayer proved that she had medical needs which required a more expensive than normal diet.14
Local Standards cover expenses which the IRS concedes are not amenable to determination on a national level.15 These are housing and transportation.16 A taxpayer will be allowed the lesser of the amount actually spent or the Local Standard amount for these categories. Housing includes utilities such as gas, electric, water and garbage collection, as well as telephone.17 Housing also includes rent, mortgage payments, property taxes, necessary maintenance and repair, homeowner's or renter's insurance, homeowner's dues, and condominium fees.18 Transportation includes car or lease payments, insurance, maintenance, fuel, state and local registration, parking, tolls and public transportation. Transportation costs not required to produce income or ensure health and welfare are not necessary and therefore not allowable.19
The IRS has announced that the maximum total amount of housing expense, including utilities, for taxpayers residing in Los Angeles County will be $1,417, without regard to the size of the taxpayer's family or the neighborhood he lives in.20 A taxpayer with three children living in West Los Angeles will be allowed the same amount as a single individual living in Panorama City. The Census Bureau amounts upon which the IRS originally based its National Standards would have allowed utility expense to vary with income level and the size of the family. Amounts as published by the IRS varied from a high of $269 to a low of $93.21 By extrapolation it appears that the IRS expects that housing costs exclusively of utilities should not exceed between $1,148 and $1,324.22 Based upon current interest rates, a taxpayer could not afford to make payments on a home loan of more than approximately $160,000.23 If the taxpayer has a mortgage acquired several years ago at higher rates, the situation is even worse. Nor is refinancing usually an option, since individuals with substantial unpaid taxes may have poor credit. Even if they do not, due to declining property values refinancing may not be possible. Additionally, if the IRS has already filed its tax lien, no lender will refinance without the IRS agreeing to subordinate its lien to the new loan. While it may be possible to negotiate such an agreement with the IRS, it is another hurdle to overcome.
Nationally, taxpayers will be allowed monthly car "ownership costs" of $350 per month for one car or $550 for two.24 This covers either lease payments or payments on auto loans. The amounts rule out cars with a purchase price of over approximately $13,800 for the first car and $7,900 for the second car.25 Since three and four year leases for cars selling for over twice the former amount are available for payments of about $350, the Guidelines discriminate against car owners. Vehicle operating costs for Los Angeles area taxpayers are limited to $280 per month for one car and $317 for two.26 The IRS' view that the incremental cost of insurance, maintenance and all other expenses associated with a second car are only $37 per month can only be termed incredible.
Expense categories not included under the National or Local Standards may be allowable if they are necessary as previously defined. Usually, the IRS considers the following expenses to be necessary:
|4.||Involuntary payroll deductions;|
|5.||Accounting and legal fees for representing a taxpayer before the IRS;|
|6.||Secured or legally perfected debts (minimum payments); and|
|7.||Accounting and legal fees (other than those for representing a taxpayer before the IRS) which meet the necessary expense test of health and welfare and/or production of income.27|
Other expenses which may be considered necessary include:
|2.||Dependent care: elderly, invalid or disabled;|
|3.||Secured or legally-perfected debts (over the amount of the minimum payment);|
|7.||Disability insurance for a self-employed individual;|
|9.||Professional association dues; and|
|10.||Optional telephone services (call waiting, caller identification, etc.), or long distance calls, if they meet the necessary expense test of health and welfare and/or production of income.28|
Educational expense will not be considered necessary unless it is a condition of employment, or it is for a physically or mentally handicapped dependent, and the taxpayer demonstrates that the education is not provided by the public school system.29 Unsecured debts, such as credit card payments, will generally not be allowed.30 This list is not intended to be exhaustive, and other expenses will be considered if they meet the necessary expense test.31
Clearly the secret to effective negotiation will be convincing the IRS that particular expenses are necessary. This task is not likely to be easy. The Guidelines provide questions and answers to common situations, and they are not encouraging. One question posits a self-employed taxpayer who has no other source of future retirement income other than an IRA. If payments to the IRA are continued, then it will take her five years to pay the liability in full. Under these circumstances the IRS indicates that it will not allow any contributions to the IRA.32
In addition to allowing expenses which are necessary for the health and welfare of the taxpayer and his family, expenses which are necessary for the production of income will be allowed.33 The problem is determining what expenses are truly necessary for the production of income. In some cases there will be little argument. A self-employed landscaping contractor should have no difficulty establishing that the cost of advertising in the yellow pages is necessary for the production of income. More skepticism can be expected in the case of an attorney who claims that he needs substantially more than the National Standard allowance for clothing due to the high cost of maintaining an appropriate wardrobe for court appearances and meetings with clients.
Although the IRS has gone to great lengths to attempt to describe necessary expenses both qualitatively and quantitatively, it has also instructed its employees not to tell taxpayers how to spend their money, but rather to emphasize how much the IRS expects to be paid.34 Thus IRS employees are instructed not to tell a taxpayer that he cannot own a boat or summer cabin, but that he must pay the IRS an amount an equal to the payment on the boat or cabin.35 This nicety will not usually have any practical import. The taxpayer will still have to give up the boat or cabin. Even if the taxpayer were able to reallocate his expenses so that he spent less on an allowed expense and used that amount to pay for the boat, the act of doing so may reduce the amount otherwise allowable.
For example, if a taxpayer spent only $800 per month on rent, and wanted to spend the balance of his housing allowance for boat payments, he could not do so since although a maximum of $1,417 is permitted to be spent on housing, the maximum is not allowable unless actually spent for that purpose.36 If, however, the taxpayer instead cut back on expenses which are included in the National Standards, he could reallocate that amount to boat payments, since the IRS allows these amounts without regard to whether they are actually paid.37
The IRS realizes that in some cases the taxpayer will have fixed expenses which cannot be immediately reduced to conform to the Guidelines. Therefore an installment agreement which allows higher expenses for up to one year may be permitted.38 Thus, a taxpayer might be given a year to move from a house with mortgage payments which exceeds the allowable amount. For the first year the taxpayer would make payments based upon expenses which include his current mortgage. At the end of the year the payments would increase to reflect only the allowable amount of the housing expense.
The IRS also recognizes that eliminating certain expenses may itself create new expenses. The sale of a house may create an additional tax liability. Someone moving from an owned home to a rented home will lose the tax advantages of itemizing interest. Moving costs will also be incurred. IRS personnel are instructed to consider these costs when determining whether housing expenses are excessive.39
Exactly how these instructions will be applied is unclear. For example, a homeowner with total house payments including property taxes of $2,000 per month with a combined federal and state tax bracket of approximately 43% has a net after-tax cost of only $1,140. Since the latter amount is less than the Local Standard, the IRS should allow the $2,000 per month payment even though it exceeds the Local Standard.
A more difficult problem arises if the sale of the house generates a tax liability. If the sale creates an additional tax liability of $30,000, how is this to be taken into account? Is the rule different depending on whether enough cash is generated by the sale to pay the liability, as opposed to the rule if due to previous borrowing on the house only a paper gain is realized? These and other questions will need to be dealt with in negotiations with the IRS.
The Guidelines promulgate a three-year rule which ameliorates some of the harshness of the standards. Under the three-year rule, if a taxpayer can establish that she can afford to pay all of the tax liabilities plus projected interest and penalties40 within three years, then collection personnel have the option of allowing "conditional expenses,"41 even though they would not be considered necessary.42 However, if the taxpayer can pay the total tax in less than three years he will be expected to do so.43 Furthermore, if the taxpayer has incurred "excessive" expenses after the assessment of the tax liability, the three-year rule will not be applicable.44 Thus, if a taxpayer leased a "luxury" car after the tax liability was assessed, then even if he could pay the total due within three years, the IRS would not allow the lease payments in its calculation of allowable expenses.
The Guidelines will make life miserable for many taxpayers. They will have to completely alter their lifestyles to comply. It is likely that taxpayers who had previously shunned bankruptcy as a solution to their problems may have to reconsider that as the only viable alternative. Whether or not the IRS will revisit its stance in response to a waive of bankruptcy filings is unknown. However, under present practices the IRS rarely considers the threat of bankruptcy as a factor in negotiating an installment payment agreement, and the Guidelines make no suggestion that this is a factor to be considered.
1. IRC Section 6159. The IRS had a longstanding policy of granting installment-payment agreements even before it had specific statutory authority to do so.
2. IRM 5323.41(1).
3. IRM 5323.2(1)(b).
4. IRM 5323.2(1)(c).
5. IRM 5323.12(b)(2).
6. IRM 5323.431(4).
7. IRM 5321.431(1).
8. IRM 5323.431(3).
9. IRM 5323.432(1).
10. IRM 5323.432.
11. IRM 5323.432(1)(a).
12. See IRM 5323, Exhibit 5300-46.
13. IRM 5323.432(2).
14. IRM 5323.432(2)(c).
15. IRM 5323.433(1).
17. IRM 5323.433(3).
18. IRM 5323, Exhibit 5300-46.
20. Handout received by the author from the IRS, dated September 1, 1995.
21. IRM 5323, Exhibit 5300-49 (undated draft version).
22. This is not obvious from a cursory reading of the IRS guidelines since the published housing standard does not show a breakdown.
23. This assumes an interest rate of 7.5% and that about $200 per month will be paid for property taxes and homeowner's insurance which the IRS includes as part of the housing standard.
24. Handout received by the author from the IRS, dated September 1, 1995.
25. Based upon a no-down-payment 48-month loan at 10%.
26. Handout received by the author from the IRS, dated September 1, 1995 .
27. IRM 5323.434(1).
28. IRM 5323.434(3).
29. IRM 5323.434(4).
30. IRM 5323.442(2).
31. IRM 5323.434(5).
32. IRM 5323, Exhibit 5300-47.
33. IRM 5323.431(1).
34. IRM 5323.42(3).
35. IRM 5323.42(3).
36. See IRM 5323.433(3)(a).
37. See IRM 5323.432(2).
38. IRM 5323.5(1).
39. IRM 5323.433(3)(a).
40. Through March 31, 1996, the current interest rate is 9%. It is adjusted quarterly. In addition to interest, late payment penalties of between ½ and 1% per month accrue on the unpaid tax balance until they reach a maximum of 25%. IRC Section 6651. This penalty continue to accrue even though an installment agreement has been entered into.
41. Conditional expenses are those expenses which are incurred by a taxpayer that are not necessary. IRM 5323.-12(1)(b).
42. IRM 5323.441(1).
43. IRM 5323.441(2).
44. IRM 5323.441(3).
*Dennis Brager, Esq., is a State Bar Certified Tax Specialist in Los Angeles. A former IRS senior trial attorney, Mr. Brager now devotes his efforts exclusively to helping clients resolve their tax problems with the IRS and California State tax agencies. Services include negotiating Tax Debts, Tax Fraud Representation, Tax Litigation, Tax Audit and Appeals Representation, Tax Preparer Penalty Mitigation, Payroll Tax Audits, and California Sales Tax Problems. He may be reached at 800.380.TAX LITIGATOR.