Although a favorite saying of IRS revenue officers is that “The IRS is not a bank” and takes collection of taxes owed seriously, the IRS is prevented from collecting assets that a person needs to survive and meet their basic living requirements.
The IRS calls these “Allowable Living Expenses” and they are excluded from the calculation that collection agents use to determine a taxpayer’s reasonable collection potential. Keep in mind that regardless of the size of the liability, whether $1,000 or $1,000,000, the IRS will always allow the taxpayer to keep enough cash to pay for their allowable living expenses.
If you are applying for an offer in compromise or other repayment plan with the IRS, they are going to make you justify your living expenses. How do you do that? The first thing you want to do is make sure the expenses you claim are reasonable and consistent with your income. For example, if you work at a low-wage job and live in Beverly Hills, that would be a big red flag to the IRS. Likewise, if you are a hedge fund manager and live in a slum, that is also questionable.
The IRS has very strict guidelines in defining “allowable living expenses,” and there is a very fine line between what is acceptable and what is deemed as unnecessary or extravagant. If you are confused and unsure how to proceed, contact our office. We have years of experience in interpreting IRS rules and can help you make your case.
The Definition of IRS Allowable Living Expenses
So, what does the IRS consider allowable living expenses? The IRS has developed a test called the necessary expense test to determine whether or not it will allow an expense to be included. According to the Internal Revenue Manual (IRM), “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”.
These are further broken down by the IRS into three categories.
- Allowable Living Expenses – based on published IRS National and Local Standards
- Other Necessary Expenses – expenses that meet the necessary expense test, and are normally allowed
- Other Conditional Expenses – expenses, which may not meet the necessary expense test, but may be allowable based on the circumstances of an individual case.
How IRS Allowable Living Expenses Are Classified
First, allowable living expenses have been separated into five basic necessities:
- Food, Clothing, Personal Effects
- Transportation – Ownership
- Transportation – Operating
- Out-of-Pocket Healthcare Costs
Within these five categories, two of them (Food, Healthcare) are governed by set national standards, which are deviations of the statistics compiled by the Bureau of Labor Statistics (BLS) Consumer Expenditure Survey (CES). In these two cases, how much your monthly budget is for food and out-of-pocket healthcare is a fixed number.
The allowable expense in these categories depends principally on how many members are living in the household. In addition, healthcare costs also take into consideration how old the particular member of the household is.
Current IRS national standards can be found here.
It is important to note for collection purposes that these amounts are given to you to maintain your basic standard of living whether you exhaust them in a month or not.
Therefore, if the amount that you actually spend per month is lower than the IRS national standard, you should indicate to the IRS that you wish for them to use the standards when computing your collection potentials.
Many of the nicer collections agents (and there are plenty of them) will go ahead and give it to you automatically.
Remaining IRS Allowable Living Expense Categories
The remaining expense categories (Housing, Transportation – Ownership, Transportation – Operating) are set by IRS local standards, which are based on the part of the country that the taxpayer lives in.
Think about it from the IRS perspective. Taxpayers who live in Tupelo, Mississippi, will likely spend less on their monthly housing than those who live in New York City. Likewise, transportation costs would be higher in Los Angeles than in other parts of the country.
As such, these expenses increase or decrease based on the county that the taxpayer resides in. Unlike national expenses, however, the IRS will examine the taxpayer’s actual amount spent on these categories and take whatever amount is lower between the actual amount spent and the standard.
However, some IRS collections personnel will just take the local standard amount if the taxpayer requests it without requesting verification of the expense. IRS protocol dictates that collections agents verify these amounts though.
Other Expenses the IRS Considers Necessary
Outside of these basic necessary expense categories, the IRS will also factor other “necessary expenses” into their collection equation. Federal income taxes are considered a necessary expense, as are court-ordered payments and the vast majority of secured debts.
Here is a quick list of some of the expenses that the IRS considers reasonable in certain circumstances:
- Accounting and legal fees
- Charitable deductions
- Childcare, especially when both parents work
- Court ordered payments
- Educational expenses (Note: College tuition is generally not considered necessary)
- Involuntary deductions (uniforms for a job, dues, etc.)
- Life insurance
- Secured or legally perfected debts
- Credit cards (for the portion of the debt that was for basic living expenses)
- Some other unsecured debts
- Current year taxes
- Delinquent state and local taxes
- Telephone service
- Student loans
- Repayment loans made for purpose of paying federal taxes
Likewise, expenses that are needed for the production of income such as wages to employees, materials and other business expenses will also likely be considered allowable.
The IRS will rarely challenge expenses listed for a taxpayer’s business unless they appear to be facially unreasonable.
Other Expenses/Items The IRS May Disallow
On the other hand, expenses that exceed the national/local standards are presumed disallowed absent significant necessity shown on the part of the taxpayer. From a practical perspective, if the expense that you want to claim does not appear on the above list, if you are claiming more than the allowable standard, or if you cannot demonstrate that it is necessary to your production of income, then you are going to fight an uphill battle with the IRS to get it approved.
The purpose of having the collection standards in the first place is to provide a uniform and fair system for all collection accounts to be judged equally.
The IRS generally does not deviate from these rules, absent good cause. One general exception to this is if your out-of-pocket medical costs exceed the standard.
I have found in practice that the IRS usually will not fight you too much on the reasonableness of a medical expense, provided the expense is not outrageous and you can document the medical reason for the expense claimed and/or show substantiation of the expense.
In some instances, the taxpayer may be allowed conditional expenses for a period of time while working with collections. These are on a case-by-case basis and up to the discretion of the collections representative that you are working with.
For example, a taxpayer who has a mortgage amount higher than the local standard for housing may be allowed that expense for a period of time (usually provided they are in the process of liquidating that house to satisfy their tax liability or to lower their monthly housing expense).
Unfortunately, as mentioned earlier, college tuition expenses for a dependent are roundly not considered allowable expenses by collections personnel. As such, I am often forced to manage expectations of my IRS collections clients when asked their two most common questions: can I keep my house and can I continue to send my kids to college?
The short answer from the IRS is often “no” (although we practitioners would not be doing our job if we always took that answer).
There is a seemingly difficult line drawn by the IRS when it comes to allowable expenses. Many have criticized the IRS for what appears to be hard and fast rules regarding the expense categories and “allowable expenses” which are not actually reflective of a taxpayer’s financial position.
However, there are no serious proposals on the table to change the collections financial calculations and taxpayers are going to have to do the best they can with the current system.
For many taxpayers, filling out a collection financial information statement can seem like a daunting task.
I hope that the information contained in this article will help alleviate some of the difficulty associated with these financial statements. However, I also would encourage taxpayers to seek help from a qualified tax professional when the going gets tough.
IRS collections can sometimes be difficult to deal with and rarely give taxpayers the benefit of the doubt. It is important to achieve a resolution that will help satisfy any pending tax liabilities, but it is equally important to have a plan that will be manageable for the taxpayer and will not put them into financial hardship. It is the very goal the IRS was trying to achieve with the Allowable Living Expense Standards.
If you are struggling to try to interpret the rules and fill out the necessary forms, give me a call. Brotman Law has helped many, many taxpayers make a case to justify their necessary living expenses to the IRS.
We will help you legitimately maximize your expense allowances so you can maintain a comfortable and reasonable standard of living while you sort out your problems with the IRS. You can bring any of your IRS problems to us and take advantage of our wealth of experience in working our way through complex tax issues.