PART 3 REPRESENTATION, PRACTICE, AND PROCEDURES Section 3: Specific Types of Representation Part 3 Representing a Taxpayer in Audits/Examinations IRS authority to investigate IRS utilizes internally developed programs for selecting tax returns for audit that will most likely to yield substantial amounts of additional taxes. IRS audits about 1% of all tax returns filed by U.S. individuals. Nevertheless, certain taxpayers and types of tax returns have higher audit levels. No single factor controls in selecting audited returns, but those considered in a choice of a return for audit are summarized below. a. Probability of audit increases with higher income taxpayers. b. Nature of a taxpayer's business may raise the potential for audit. The IRS now also uses economic reality audits to target returns for audit. c. When IRS has been successful on past audits, the taxpayer involved may expect future visits. d. If the amounts reported on a taxpayer's return are not in substantial agreement IRS expectations, such lack of correlation may lead to an audit. Also, the IRS monitors certain types of deductions (e.g., large casualty and theft losses, office in home and vacation home deductions). e. Some returns are selected because the IRS is targeting special industries [the Industry Specialization Program (ISP)] or market segments (the Market Segment Specialization Program (MSSP)]. 9. Information obtained from non-return sources (e.g., other government agencies, news items, informants, whistleblowers) may result in an audit. The IRS can pay rewards to persons providing information leading to the detection and punishment of those violating the tax laws. 10. Data underlying the statistical modeling programs used by the IRS chiefly from the National Research Program (NRP), which updates the underlying formulas and gathers audit data from about 13,000 taxpayers every year. In connection with audit procedures, the following mechanical requirements are used. a. The RAR (Revenue Agent's Report) and the 30-day letter. b. Form 870 (Waiver of Restrictions on Assessment and Collection of Deficiency in Tax). c. The 90-day letter (Statutory Notice of Deficiency).
Verification and substantiation of entries on the return It is important that all records are present, available, and separately identifiable at the audit location in advance of the audit. The requested information should be organized in a manner that will allow for quick and easy review. Taxpayers should not wait for the agent to arrive to begin locating or pulling records that have been requested unless mutually agreed between the agent and you or your representative. It is also helpful to have the records labeled or tabbed to coincide with the Information Document Request (IDR) attached to the appointment letter. Having records pulled and organized will help to ensure the audit process is more efficient and may lessen the time an agent will need to spend either at the audit location or in any required follow up appointments. Copying of any documents is not needed unless specifically requested by the agent either prior to or during the audit. IRS authority to fix time and place of investigation Some examinations are handled entirely by mail. Examinations not handled by mail can take place in your home, your place of business, an Internal Revenue office, or the office of your attorney, accountant, or enrolled agent. If the time, place, or method is not convenient for you, the examiner will try to work out something more suitable. However, the IRS makes the final determination of when, where, and how the examination will take place. Throughout the examination, you can act on your own behalf or have someone represent you or accompany you. If you filed a joint return, either you or your spouse, or both, can meet with the IRS. You can have someone represent or accompany you. This person can be any federally authorized practitioner, including an attorney, a certified public accountant, an enrolled agent (a person enrolled to practice before the IRS), an enrolled actuary, or the person who prepared the return and signed it as the preparer. If you want someone to represent you in your absence, you must furnish that person with proper written authorization. You can use Form 2848 or any other properly written authorization. If you want to consult with an attorney, a certified public accountant, an enrolled agent, or any other person permitted to represent a taxpayer during an interview for examining a tax return or collecting tax, you should make arrangements with that person to be available for the interview. In most cases, the
IRS must suspend the interview and reschedule it. The IRS cannot suspend the interview if you are there because of an administrative summons Steps in the process (e.g., initial meeting, submission of IRS requested information) A preliminary review of returns includes matching of the information recorded on the return with corresponding data received from third parties, for example data from a W-2 received from an employer. The IRS also conducts mathematical/clerical error and unallowable items program in which returns are checked for certain errors and tax due is automatically recalculated. Tax returns are selected for review based upon their likely dollar return to the Treasury using a variety of tools including a discriminant function (DIF) formula which rates a return for its audit potential. Based upon the nature of the taxpayer and its income, the IRS uses the following audits. a. Correspondence audits (mail audits). This is the largest number of audits. (1) Often the IRS computer corrects an apparent error in computation and either issues a refund check or requires payment for the revised tax. (2) Some cases the taxpayer typically must provide photocopies or other forms of documentation supporting a claimed deduction or exemption. b. Office audits. Conducted in the IRS office when taxpayer has few items questioned. c. Field audits. Used primarily for returns with business or professional income and is a more complete audit. d. Taxpayers can request that recordings be made of the audit procedures. In addition, tax-payers must be advised that they can have legal counsel present during the procedure.
Innocent spouse Many married taxpayers choose to file a joint tax return because of certain benefits this filing status allows. Both taxpayers are jointly and individually responsible for the tax and any interest or penalty due on the joint return even if they later divorce. This is true even if a divorce decree states that a former spouse will be responsible for any amounts due on previously filed joint returns. One spouse may be held responsible for all the tax due even if all the income was earned by the other spouse. In some cases, a spouse will be relieved of the tax, interest, and penalties on a joint tax return. Three types of relief are available. 1. Innocent spouse relief. 2. Separation of liability. 3. Equitable relief. You are an injured spouse if your share of the overpayment shown on your joint return was, or is expected to be, applied against your spouse's past-due federal debts, state taxes, or child or spousal support payments. If you are an injured spouse, you may be entitled to receive a refund of your share of the overpayment. For more information, get Form 8379, Injured Spouse Claim and Allocation. Interpretation of revenue agent report (RAR) (e.g., 30-day letter) Revenue Agent Reports (RARs) should contain all the information necessary to ensure a clear understanding of the adjustments and demonstrate how the tax liability was computed. Based upon the importance of the RAR, examiners should take all necessary steps to ensure report accuracy. Workpapers are the written records kept by the examiner that provide the principal support for the RAR and document the procedures applied, tests performed, information obtained, and the conclusions reached in the examination. They should include all the information necessary to conduct the examination and support the audit results. A regular agreed report ( Form 4549) may contain up to three tax years. Agreed RARs require the taxpayer s signature and include a statement that the report is subject to the acceptance of the Area Director, Area Manager, Specialty Tax Program Chief, or Director of Field Operations.
Generally, the report forms for unagreed cases are identical to the report forms for agreed cases. Some exceptions include examinations involving non-taxable returns. All unagreed cases require written comment regarding: the Team Manager s involvement in the examination the validity of the issues involved, and a statement that a closing conference was or was not held with the taxpayer. Form 886-A is the written explanation of adjustments in all unagreed cases. If an adjustment involves a detailed computation, a worksheet will be attached. The following format is used when preparing Form 886-A: a) Facts, e.g., the activity or non-activity the organization or plan has engaged in or started b) Law states the applicable code and regulation sections, and Rev. Rulings, Revenue Procedures, etc., that support the position c) Government s Position states why the application of the law to the facts supports the conclusion reached by the specialist d) Taxpayer s Position what authority the taxpayer is relying upon (as opposed to the agent s conclusions). If possible, the taxpayer s position should be secured in writing e) Conclusion comments on the position taken by the taxpayer. After consideration of all items, the proper tax liability or other Service action is to be sustained Basic report forms in unagreed cases are designed to cover three years. Regardless of the number of years examined. The 30-day letter is a computation report of proposed adjustments to your tax return. It outlines your options if you do not agree with the proposed adjustments. If you agree with the adjustment, you sign and return the agreement form. If you do not agree, you can submit a request for appeal to the office/individual that sent you the letter. The letter contains information and lists IRS publications on how to file an appeal/protest. You need to file your protest within 30 days from the date of this letter in order to appeal the proposed adjustments with the Office of Appeals.
Explanations of taxpayer options (e.g., agree or appeal) If a taxpayer is not satisfied with the result reached at the agent level, the next step is to proceed to the Appeals Division of the IRS. Such a request must be accompanied by a written protest, except in the following cases. Proposed tax deficiency does not exceed $10,000 for any of the tax periods involved in the audit. Deficiency resulted from a correspondence or office type audit (i.e., not as a result of a field audit). a. Income tax appeal procedure is illustrated in Figure 17.2 in the text. In terms of the litigation process, the flowchart also reviews some of the material discussed in Chapter 1. b. Appeals Division possesses more flexibility than an agent in settling tax disputes. This added flexibility primarily is attributable to their ability to assess the hazards of litigation, that is, the probabilities of winning or losing in a court proceeding. Failure at the Appeals level may take the parties to litigation. a. Most tax litigation takes place in the Tax Court. b. The Small Cases division of the Tax Court is available if no more than $50,000 in tax is under dispute. Neither party can appeal a Small Cases decision. Special procedures for partnership audits (e.g., unified audit procedures for TEFRA) This section is designed to give students a basic understanding of TEFRA (the Tax Equity and Fiscal Responsibility Act of 1982) and is not intended to be a fully comprehensive work. Certain topics are covered by referencing statutes, regulations, or the Internal Revenue Manual (IRM) rather than by way of narrative text. This section addresses TEFRA only as it applies to TEFRA partnerships and TEFRA related partners. It is important to note that Limited Liability Companies (LLCs) and Real Estate Mortgage Investment Conduits (REMICs) that file a Form 1065, U.S. Return of Partnership Income, and their respective members are also subject to TEFRA administrative and judicial procedures and treated in a manner similar to TEFRA partnerships and their partners. IRC section 6244 extended the TEFRA partnership provisions to S corporations for tax years beginning after 1982. The Small Business Job Protection Act of 1996 repealed the TEFRA administrative and judicial procedures for S corporations for tax years beginning after Dec. 31, 1996.
TEFRA as it applies to S corporations and REMICs will not be covered in this chapter. Non-TEFRA partnership statute considerations and procedures are also not covered in this overview. The procedural differences between TEFRA and non- TEFRA are significant. For non-tefra considerations, examiners should consult IRM 4.31.5 & 6 of the Pass-Through Entity Handbook, and IRM 4.29, Partnership Control System (PCS) Handbook. IRC sections 6221 through 6234 govern audit, administrative, and judicial procedures, as well as certain filing requirements to be used by entities qualifying as TEFRA partnerships. These procedures are commonly referred to as unified proceedings, TEFRA proceedings, and partnership proceedings. These Code sections provide that examination, administrative, and judicial actions are to be conducted at the partnership-level. Final Regulations were issued and are effective for taxable years beginning on or after October 4, 2001 (66 FR 50541, Treas. Reg. sections 301.6221-1 through 301.6233-1). For taxable years beginning before October 4, 2001, the Temporary Treasury Regulations continue to govern (see Treas. Reg. section 301.6221-1(f)). The Final Treasury Regulations are substantially similar to the temporary regulations. IDENTIFYING THE TEFRA PARTNERSHIP It is critical to the examination of a partnership that the examiner recognize whether he or she is dealing with a TEFRA or non-tefra partnership. Failure to properly identify a TEFRA pass-through entity in a timely manner will impact the statute of limitations, proper initiation of the examination, and other administrative considerations at both the entity and partner levels. The identification of a TEFRA entity is essentially governed by IRC section 6231. While this section of the Code addresses conditions under which the partnership return will be exempted from being considered a TEFRA entity; and therefore, exempt from TEFRA procedures, we will focus on what makes a partnership a TEFRA entity. Generally, a partnership with 11 or more partners at any one time during the partnership s tax year is a TEFRA partnership (Treas. Reg. section 301.6231(a)(1)- 1(a)(1) and Temp. Treas. Reg. section 301.6231(a)(1)-1T(a)(1)).
CAUTION: A TEFRA/non-TEFRA determination, often referred to as the small partnership exception test, must be made for each separate tax year being examined. The phrase tax year is meant to encompass not only calendar and fiscal year tax periods, but also short tax periods that result from events such as technical terminations under Treas. Reg. section 1.708-1(b). If an examiner finds one or more short periods when examining a partnership, they should consult with their local TEFRA coordinator. CAUTION: For the TEFRA/non-TEFRA determination, a husband and wife, each having their own partnership interest (i.e. separate Schedules K-1), are considered to be one partner, irrespective of their filing status, for the small partnership exception test. A jointly held interest (one Schedule K-1) also qualifies as one partner for making this determination (see IRC sections 6231(a)(1)(B) and (12), Treas. Reg. 301.6231(a)(1)-1(a)(1), and Temp. Treas. Reg. 301.6231(a)(1)- 1T(a)(1)). CAUTION: An individual who has died during the tax year and their estate, each of whom is represented by a separate Schedule K-1, are considered one partner for the TEFRA/non-TEFRA determination. A partnership containing fewer than 11 partners, commonly referred to as a small partnership, will qualify as a TEFRA partnership if it meets any of the following requisites: It has as a partner any one of the following: Partnership. Limited liability Company (LLC) which files a Form 1065 or is treated as a disregarded entity (see Revenue Ruling 2004-88) for federal tax purposes. Trust (any type, including Grantor Trusts and grantor type trusts, even if the Schedule K-1 contains the SSN of the grantor). Nominee. Nonresident alien individual. S corporation. CAUTION: For tax years ending on or before August 5, 1997, C corporations, as partners, make the entity they were invested in a TEFRA partnership. The Taxpayer Relief Act of 1997 (TRA 97) changed the TEFRA/non-TEFRA criteria to allow C corporations to be partners without automatically making the partnership TEFRA. This change became effective for tax years ending after August 5, 1997.
CAUTION: For TEFRA/non-TEFRA determination purposes only, a C corporation is considered to be any corporate entity that is not an S corporation regardless of whether they are taxable under subchapter C. As an example, a foreign corporation is usually considered a C corporation for this determination. CAUTION: If Schedule K-1 identifies the entity type of the partner to be a corporation, without specifying that the partner is an S corporation, the examining agent should secure an IDRS print to make this determination. Since a partnership may be TEFRA one year and non-tefra the next, the tax year researched for the partner must be the same tax year as the partnership being examined. This is also recommended where the partner is identified as an LLC in order to confirm whether the member has filed a Form 1120 (U.S. Corporation Income Tax Return), Form 1065, or is a disregarded entity for federal tax purposes. Prior to enactment of TRA 97, a partnership of fewer than 11 partners qualified as a TEFRA entity if it failed the same share test, (see Temp. Treas. Reg. section 301.6231(a)(1)T-1(a)(3)). The same share test was repealed by TRA 97 and no longer applies for tax years ending after August 5, 1997. A partnership that does not otherwise qualify for TEFRA treatment can elect to be treated as a TEFRA partnership (see IRC section 6231(a)(1)(B), Treas. Reg. section 301.6231(a)(1)-1(b), and Temp. Treas. Reg. section 301.6231(a)(1)-1T(b)). A small partnership can make this election by filing Form 8893, Election of Partnership Level Tax Treatment, or attaching an election statement to the partnership return for the first tax year for which the election is to be effective. This election must be signed by all partners who were partners during the partnership s tax year. Once this election is made, it may not be revoked without IRS consent (see Form 8894, Request to Revoke Partnership Level Tax Treatment Election). Even when the election is revoked, any prior tax years that were subject to TEFRA procedures remain subject to TEFRA.
CAUTION: For 2004 and subsequent tax years, checking the yes box on question #4 of Schedule B of Form 1065 which asks the question, Did the partnership file Form 8893, Election of Partnership Level Tax Treatment, or an election statement under section 6231(a)(1)(B)(ii) for partnership-level tax treatment, that is in effect for this tax year? does not constitute a TEFRA election. For tax years prior to 2004, checking the yes box on question #4 of Schedule B of Form 1065 which asks the question, Is this partnership subject to the consolidated audit procedures of sections 6221 through 6233? also does not constitute a valid TEFRA election. Nor does the identification of a TMP at the bottom of Schedule B, in and of itself, constitute a proper TEFRA election. CAUTION: In instances where the partnership would not appear to qualify as a TEFRA entity but still designates a TMP on the Form 1065 or responds positively to question #4 on Schedule B, the examiner should inquire as to whether there is a TEFRA election in effect. The examiner should secure the partnership s file copy of the election and determine if the election is valid under Treas. Reg. section 301.6231(a)(1)-1(b)(2). If the election is determined to be invalid, the partnership is not a TEFRA entity. If the election is determined to be valid, attach a copy of the election to the partnership tax return and document this fact in the case file. For tax years ending on or before August 5, 1997, the Service could not rely solely on the information contained on the Form 1065 when making a TEFRA/non-TEFRA determination. For tax years ending after August 5, 1997, information reflected on the Form 1065 can be relied on for determining if the TEFRA procedures apply. Under the new rules, Service personnel must be reasonably assured that the information on the partnership return is correct (IRC section 6231(g)). To meet the reasonable determination standard and as a best practice, additional information should be secured whenever possible when making the TEFRA/non- TEFRA determination for each tax year. This reasonability factor is likely to be a source of litigation; therefore, care should be taken when applying it. If IRC section 6231(g) is used in the examiner s TEFRA/non-TEFRA determination, it should be reviewed by the local TEFRA coordinator and clearly documented in the workpapers. CAUTION: Based on the changing number or type of partners within the partnership, as well as changes in the law, a partnership may qualify as a TEFRA partnership in one tax year, while being treated as a non-tefra partnership in another. All qualifying tests should be applied to each tax year of the partnership. As previously mentioned, this includes short tax periods..