Anyone who has received a letter whose sender is the Department of the Treasury, Internal Revenue Service understand the anxiety the receipt of such a letter engenders. If that letter informs you that your return has been selected for examination, your anxiety increases markedly. In this post I will try to assuage your anxiety by describing the major forms of examinations and how the examinations type are conducted.
Contrary to popular belief, examinations are not normally random events. That is, returns, with a few exceptions, are not selected randomly. The returns may be part of a project in which returns are selected because the items reported on a return meet certain selection criteria, such as reporting a tax shelter.
Returns may be selected for examination because the return’s Discriminant Function (DIF) score is above a certain level. The DIF score is a score that is computed based upon relationships within the return as well as individual items reported on the return. The computational process is a highly guarded secret and we can only make educated guesses on what may trigger an examination.
After a return is selected for examination, the return is sent to a person who looks at the return for potential issues. The issues determined to have examination potential are termed classified issues in the vernacular of the I.R.S. These issues are relayed with the return to the examiner. Depending on the type of examination, the examiner may or may not examine the classified issues. I have been a classifier. It is a tedious process that may not yield any results as it is based upon no input provided by the taxpayer. The issues identified by a classifier are best guesses, at best.
Correspondence from the I.R.S. that may seem like an examination but may not be are requests to perfect a return. Requests to perfect a return include requests, for example, asking for trust documents to make sure the trust return was prepared properly or asking why Forms 1009-K do not reconcile to a taxpayer’s gross income. The I.R.S. has the authority to request returns be perfected without engaging in a formal examination. That being said, your replies to an I.R.S. requests may lead your return to be referred to the appropriate I.R.S. division for examination.
The most common examinations are CP2000 examinations and correspondence examinations. CP2000 letters are products of the I.R.S.’s automated underreported program. This is a program that compares returns to the amounts reported by third parties. This comparison is designed to detect unreported income from Forms W-2 or 1099, for example. When a discrepancy between a tax return and the items reported by third parties is detected, the taxpayer is sent a letter, the CP2000, proposing an adjustment to the tax return. Taxpayers have then the opportunity to provide substantiation or an explanation that the I.R.S. may or may not accept. If the taxpayer disagrees with the determination of the I.R.S., the taxpayer may appeal the I.R.S’s proposed adjustments.
Correspondence examinations are, as the name implies, a tax examination conducted via mail. Typically, correspondence examinations are limited to one or two items reported on your return. The I.R.S. will ask you to provide substantiation for one or more items reported on your return. For example, the I.R.S. may ask you to substantiate your travel and entertainment expenses. In this case, you should submit copies of your receipts, any logs you may have kept, and a explanation of the expenses you deducted including the business purpose of each expense. Hopefully, the I.R.S. will accept you information and will not propose any changes to your return.
The next type of examination I will discuss is an examination conducted by a taxpayer compliance officer (TCO). This type of examination is conducted at an I.R.S. office by a taxpayer compliance officer. Examinations conducted by TCOs are limited to individual taxpayers. They do not examine other entities such as corporations, partnerships, or trusts. If the examination is determined to be beyond the scope of a TCO, the TCO may refer the examination to the next level for examination.
Taxpayer compliance officer examinations are the lowest level of examinations conducted by actual humans. Taxpayer compliance officers are typically less knowledgable in the tax law and accounting methods than higher levels of I.R.S. examiners. They are verifiers. It has been my experience that dealing with taxpayer compliance officers is difficult because of their limited training and understanding of the intricacies of tax law and accounting principles. They are the “show me the receipt” people.
Taxpayer compliance examinations typically begin with a letter to the taxpayer with an appointment date and time and an information document request that details the issues being examined. The TCO does not usually have a copy of the tax return being examined, consequently some of the descriptions of the issues being examined may seem unfamiliar. The TCO is working from a tax return transcript. This is a summary record of the tax return that was filed. This increases the difficulty of dealing with a TCO as we do not always know what is being examined.
TCO examinations usually target one or two issues that are brought to the fore by an I.R.S.classifier as explained above. Taxpayer compliance officers may increase the scope of their examinations if they determine the return merits a wider breadth of examination. They cannot, however, stray from their mandate to examine only individuals’ tax returns.
The last type of examination I will discuss in this post is the field examination. This is an in depth examination conducted by a revenue agent. The scope of a field examination is limited only by the imagination and skill of the revenue agent. The revenue agent may use the classified issues as a guide, but he or she isn’t bound by the classified issues. The information request of a revenue agent is usually broad, inclusive, and detailed. The information requested by a revenue agent can be, and frequently is, daunting. The information request is a fishing expedition. Care should be taken in responding to these requests.
Field examinations are normally conducted at either the taxpayer’s representative’s office (attorney, CPA, or other representative of the taxpayer) or at the taxpayer’s place of business. We like to conduct the examination at the representative’s office as it is quite disruptive to conduct an examination at the taxpayer’s place of business. While the I.R.S. has a right to control the examination, most revenue agents are accommodating to reasonable requests as to the place of the examination.
Field examinations take much longer than correspondence or TCO examinations. They are much more intrusive and much more detailed. In my career I have conducted examinations that have taken over a year to complete. Granted these were public companies with complex records and complex issues, but this serves notice that these examinations can be lengthy and complicated.
TCOs and revenue agents are under pressure to complete examinations within specific periods of time. This is to reduce cycle time. Cycle time is, in the vernacular of the I.R.S., the time a taxpayer’s examination is open. After 7 months an examination is considered overage; and overage is a no-no, albeit a minor no-no.
TCOs have much more pressure to complete examinations is the shortest time span as is possible, usually in one or two visits. This time pressure may lead to results that are arbitrary and capricious. The TCOs frequently propose adjustments that are not based in fact, but are expedient. This just get the case closed mentality causes harm and unfairness to taxpayers. Beware of this.
It has been my experience that TCOs and even revenue agents are frequently unaware of the limits of their authority. They operate under a ask for everything and it is not a violation if the taxpayer does not complain or if the taxpayer complies. A good and knowledgeable representative is imperative if a taxpayer is to comply only with lawful requests. Those of us who have worked both sides of the examination fence are best equipped to protect our clients.
If the I.R.S. proposes adjustment to which you do not agree, you have, in most cases, the right to an administrative appeal. There are strict rules and regulations regarding the time and method for requesting an appeal. Appeals will be discussed in a subsequent post.