The Nuts And Bolts Of Deficiency Cases: From Examination To The Tax Court

1. IRS Examination

1. How A Return Is Selected

   Matching Programs/DIF Score. Generally, the IRS accepts most taxpayers' returns as filed. However, IRS computer programs routinely locate disparities between amounts reported on a tax return and amounts reported to the IRS via information returns and other sources, such as Forms 1099, W-2, etc. When this occurs, the IRS may contact the taxpayer, generally via mail, to inquire about the disparity and, when appropriate, propose an adjustment. See IRS Pub. 3498; Rev. Proc. 2003-9. DIF Score. Every individual return and some corporate returns are assigned a score by an IRS computer program called the Discriminant Inventory Function System ("DIF"). If a return is selected for audit because of a high DIF score, the potential is high that an examination of the return will result in a change to the taxpayers' income tax liability. See IRS Pub. 556. Referrals, public sources, etc. A return may be selected as a result of information received from other sources on potential non-compliance with the tax laws or inaccurate filing. This information can come from a number of sources, including newspapers, public records, and individuals such as whistleblowers, former employees, etc. See IRS Pub. 556. Examination of related parties or tax return preparers. The IRS may examine the return of a related party such as a partner in a partnership or another partnership in a tiered partnership structure or a related corporation. Additionally, the IRS has aggressively targeted tax return preparers in recent years who meet certain characteristics, such as a high fail rate of Earned Income Tax Credit compliance, a higher than average amount of large refunds, etc. The IRS will sometimes obtain the client lists of these tax return preparers and audit those taxpayers. B. During The Examination

   Examination by mail. Some examinations are conducted entirely by mail. A taxpayer will receive a letter requesting additional information about certain items shown on the return, such as income, expenses, and itemized deductions. IRS Pub. 3498. The IRS letter will generally propose a response date by which information must be submitted. If no information is submitted, or if the information submitted is insufficient, the IRS will generally either request additional information or propose an adjustment. Examination in person. If the examination is conducted in person, the IRS examiner will contact the taxpayer and request documentation to be presented at a meeting. Generally, an IRS Revenue Agent will be assigned to examine a corporation, partnership or high net worth individual and an IRS Compliance Officer will be assigned to examine other individuals or small businesses. Generally, the IRS examiner will request information from the taxpayer in advance of the meeting via an Information Document Request ("IDR"), or Form 4564 (http://www.irs.gov/pub/irs-utl/form4564.pdf ). The IDR will list specific information or documents requested and set a deadline to respond. A typical IDR requests the taxpayer's books and records, copies of tax returns, information returns and other specific information. Depending on the scope of the examination, the IDR will be limited to specific issues that the examiner is auditing. If additional time is needed to respond to the IDR, the taxpayer may request additional time from the Revenue Agent or Compliance Officer. The taxpayer may need to explain why additional time is needed and should not expect that a lengthy extension or multiple extensions will be granted. During the examination, the IRS examiner will review the taxpayer's information, ask questions of the taxpayer and/or her representative and discuss follow-up or proposed adjustments. and set a deadline to respond. A typical IDR requests the taxpayer's books and records, copies of tax returns, information returns and other specific information. Depending on the scope of the examination, the IDR will be limited to specific issues that the examiner is auditing. If additional time is needed to respond to the IDR, the taxpayer may request additional time from the Revenue Agent or Compliance Officer. The taxpayer may need to explain why additional time is needed and should not expect that a lengthy extension or multiple extensions will be granted. During the examination, the IRS examiner will review the taxpayer's information, ask questions of the taxpayer and/or her representative and discuss follow-up or proposed adjustments. Proposed adjustments. An IRS Examiner may issue to the taxpayer a Form 5701, Notice of Proposed Adjustment ("NOPA") (http://www.irs.gov/pub/irs-utl/f5701.pdf). The NOPA will provide the proposed examiner's adjustments and provide an explanation for the proposed adjustments. If the explanation is lengthy, it will be included on a Form 886-A, Explanation of Items (example: http://www.irs.gov/pub/irs-tege/pate_form_886a.pdf ). The taxpayer will be provided an opportunity to respond to the NOPA prior to the issuance of the Revenue Agent's Report. The taxpayer may also request a meeting with the IRS examiner and his/her manager to discuss the proposed adjustments. The IRS examiner generally does not have settlement authority and must resolve issues based on the Examiner's interpretation of the applicable law as it applies to the taxpayer's facts and circumstances. Statute of limitations extension. Any additional deficiency must generally be assessed by the IRS within three years after the return was filed. Internal Revenue Code ("Code") §6501(a). But see Code §6501(e) (six year statute of limitations for substantial omission of gross income). Accordingly, if the applicable statute of limitations is approaching, the IRS examiner may request that the taxpayer extend the statute by executing Form 872, Consent to Extend the Time to Assess Tax (example: http://www.irs.gov/pub/irs-utl/f872ovdi.pdf). If the taxpayer does not execute the statute extension, the IRS examiner may close the audit and issue a Notice of Deficiency based upon the information then available. The matters and periods subject to the statute extension, along with the length of the extension, may be negotiated between the taxpayer and the IRS. See IRS Pub. 1035 (http://www.irs.gov/pub/irs pdf/p1035.pdf ). Other considerations; summons. If the taxpayer does not respond to the IDR or provides insufficient information, the IRS examiner may elect to issue another IDR, issue a summons, or propose adjustments based upon the information available. An IRS summons may also be issued to the taxpayer, officer or employee of the taxpayer, third-party recordkeeper, "or any other person the Secretary may deem proper." Code §7602. The summons may require the recipient to produce records or appear before the IRS examiner for inquiry, or both. If the recipient neglects or refuses to obey the summons, the Department of Justice, on behalf of the IRS, may enforce such summons in a U.S. District Court. If the taxpayer does not comply with the Judge's order to comply with the IRS summons, the Judge can hold the taxpayer in contempt of court. Criminal/Fifth amendment considerations. Depending on the taxpayer or scope of the audit, consideration may want to be given to a taxpayer's risk of criminal prosecution and/or liability for civil fraud penalties. If these are a concern, consideration may want to be given to potential incriminatory statements by the taxpayer and/or preserving Fifth amendment, attorneyclient, and other privileges. Below are some examples of civil and criminal penalties to consider. Civil penalty (examples): See Code §6663 (civil fraud penalty of 75 percent of the portion of the underpayment attributable to fraud); Code §§6700 (Promoting Abusive Tax Shelters, etc.), 6701 (Penalties for Aiding and Abetting Understatement of Tax Liability), 6702 (Frivolous Tax Submissions). Criminal penalty (examples): Code §§7201 (Attempt to Evade or Defeat Tax), 7202 (Willful Failure to Collect or Pay Over Tax), 7203 (Willful...