Source: https://procedurallytaxing.com/category/exam/
Timestamp: 2020-07-12 19:08:35
Document Index: 388841028

Matched Legal Cases: ['art 35', 'art 4', '§ 7602', '§ 7602', '§ 7602', '§ 446', '§ 7602']

Unreal and Real Audits: Surgeon Finds No Relief From IRS’s “Byzantine” Exam Procedures
February 14, 2020 by Leslie Book 4 Comments
The recent Tax Court case of Essner v Commissioner highlights a problem when the IRS conducts both a traditional examination of taxpayer’s books and records while simultaneously contacting the taxpayer under its automated underreporter program.
Here is a simplified version of the still somewhat messy Essner facts. In 2013, Essner, a surgeon, inherited an IRA from his mother, who in turn had inherited the IRA from her husband (Essner’s father). In 2014 Essner took a distribution of over $360,000 from the IRA. He researched on his own the tax treatment of the distribution and concluded that the distribution was not gross income because it reflected his father’s original investment in the account. Despite Essner’s belief that the IRA reflected a nontaxable distribution, the financial institution that held the IRA issued an information return both to the IRS and Essner reflecting the distribution as taxable. Essner’s 2014 return, however, did not include the distribution as gross income.
In March and May of 2016, Essner received letters generated from the IRS automated underreporter (AUR) program essentially noting the discrepancy between the income reported on Essner’s return and the income reported by third parties. That discrepancy was attributable to the IRA distribution that Essner did not include as income on his return. In late June of 2016 Essner sent a handwritten letter to the AUR unit saying that he disagreed with the proposed changes. The next letter Essner received from the AUR unit was a January 3, 2017 notice of deficiency reflecting the full amount of the IRA distribution as gross income.
Here is where things get even messier. After Essner sent his letter in response to the AUR notices, but before the IRS sent the notice of deficiency, Essner received a letter from IRS Tax Compliance Officer Joshi saying that the IRS was examining his 2014 federal income tax return. The letter Joshi sent mentioned that IRS was looking into Essner’s business expenses but did not mention the IRA distribution that the AUR unit had flagged.
The opinion states that Joshi was not aware of the AUR contact and continued with his examination, focusing on expenses. On January 10, 2017, a week after IRS sent Essen a notice of deficiency, Joshi sent an examination report and proposed adjustments. A month later, in February, Joshi sent a revised exam report for 2014. Neither the original or revised report included any income from the IRA distribution.
On March 10, 2017 Essner sent a letter to Joshi requesting that Joshi send the report to confirm that the IRA distribution was not taxable. Essner received another report and it too did not include the IRA distribution as gross income.
Recall however that the AUR office generated a notice of deficiency reflecting the IRA distribution as gross income. Essner filed a timely pro se petition, arguing initially that the distribution was not gross income. Unfortunately for Essner, at trial he was unable to secure proof of the alleged nondeductible contributions, as well as any prior distributions or withdrawals of those contributions, so he was unable to carry his burden of proof on the issue.
At trial, he also alleged that the IRS actions amounted to a duplicative examination of the same year and tax. While IRS has broad powers to examine tax returns to ensure that the return reflects a taxpayer’s liability, Section 7605(b) contains a general statutory protection against unnecessary or repeat taxpayer examinations for the same tax year. The idea behind 7605(b) is to limit burdens on taxpayers, including time and expense associated with responding to multiple requests for information.
Essner’s argument was that because the AUR contacts and Joshi’s examination ran concurrently, taken together they violated the duplicate exam restriction of Section 7605(b). In addition, he argued that the correspondence showed that “Joshi’s examination was unnecessary (given that it extended past the date when the AUR program generated the notice of deficiency with respect to 2014) and that it required an unauthorized second inspection of petitioner’s books and records (given that Officer Joshi’s examination ran parallel to and appears to have come to positions at odds with the AUR adjustments that underlie the IRS’ position taken in the notice).”
The IRS argued, as it has in the past, that any contact stemming from AUR is not an examination for purposes of 7605(b) because it derives from a review of third-party records and not the taxpayer’s books and records.
The opinion sympathized with Essner but held that 7605(b) provided no basis for relief on this case:
At the outset, we note that petitioner’s interactions with the IRS–both through the AUR program and his correspondence with Officer Joshi–would be confusing to an ordinary taxpayer. Various offices of the IRS contacted petitioner without coordination, without clarity as to what the other parts were doing, and without providing petitioner a clear explanation as to why the IRS was speaking out of many mouths. A taxpayer ought not to have been subjected to such a byzantine examination. However, we are not empowered to police what ought to have occurred in an examination; we are limited to considering whether section 7605(b), as written, was violated. See Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974). (emphasis added)
The opinion continues and notes that 7605(b) does not address contacts that stem from the IRS’s receipt of information returns:
Under section 7605(b), the AUR program’s matching of third-party-reported payment information against petitioner’s already-filed 2014 tax return is not an examination of petitioner’s records. See Hubner, 245 F.2d at 38-39. Therefore, no second examination of petitioner’s books and records could have occurred, regardless of the concurrent actions of Officer Joshi. Additionally, as we have found above, petitioner failed to properly report income from the 2014 distribution from the retirement account, and he has conceded other adjustments for tax year 2014. Therefore, respondent’s examination of petitioner’s 2014 tax return was not unnecessary. While we understand petitioner’s frustration with the process of this examination, we cannot say that a failure to communicate and coordinate within the IRS–standing alone–violates section 7605(b). We therefore agree with respondent.
The IRS’s failure to coordinate its communications as typified in Essner is likely to generate confusion. It is inconsistent with the right to finality, impinges on a taxpayer’s right to be informed and is in tension with a taxpayer’s right to a fair and just tax system. Carving out from 7605(b) protection “unreal” audits like AUR contacts is an issue that the Taxpayer Advocate Service has repeatedly flagged in its annual reports as a most serious problem. (For some more on the TAS view and IRS disagreement with TAS see the FY 2019 Objectives Report at page 38).
The opinion in Essner rightly reflects concern with the IRS practice. IRS should revisit the limited rights taxpayers are afforded in unreal audits like AUR correspondence (including no right to Appeals review prior to the issuance of a 90-day letter), and should at a minimum strive to ensure that a concurrent examination sweeps in any issues that are raised in AUR correspondence. Subjecting taxpayers to inconsistent and uncoordinated communication is far from best practice and creates burdens that are inconsistent with a taxpayer rights–based tax administration and the concerns that underlie Section 7605(b). Absent IRS policing itself perhaps it is time for a legislative fix that more directly addresses the growing importance of unreal audits and the burdens they impose.
Proposed Regulations Narrow Ability of Private Attorneys to Participate on Behalf of IRS in Exams
April 2, 2018 by Leslie Book 4 Comments
A few years ago we discussed litigation involving Microsoft (see, eg., Keith’s Enforcing the Summons Against Microsoft), which implicated Treasury regulations that allowed private lawyers to participate in exams. While the litigation did not strike down that practice, it was heavily criticized, and Treasury now proposes to scale back the practice significantly.
Last week Treasury has proposed to “significantly narrow the scope of the current regulations by excluding non-government attorneys from receiving summoned books, papers, records, or other data or from participating in the interview of a witness summoned by the IRS to provide testimony under oath, with a limited exception.”
The exception relates to lawyers who have expertise in issues other than federal tax law, such as state, local or other countries’ tax laws, or in other substantive areas, like patent law. The exception does not extent to nonsubstantive specialized knowledge (like litigation skills).
Treasury regulations still permit other outside specialists like economists to “receive and review summoned information and fully participate in the summons interview, including questioning witnesses.” The proposed regs also allow for lawyers who are not acting as lawyers but who are performing services associated with outside permitted specialists to participate.
The proposed regs attempt to restrike the balance between the need for outside assistance to help administer the tax laws with the “perceived risk that the IRS may not be able to maintain full control over the actions of a non-government attorney hired by the IRS when such an attorney, with the limited exception described below, questions witnesses.”
Perhaps the rebalancing of these interests will inspire a fresh look at the private debt collection issue, an area that likewise has raised questions about risks associated with non-government employees performing essential IRS functions.
4/3 Update: Title Changed to clarify we are talking about IRS limitations!
Tax Court Determines IRS Actions Do Not Violate Restrictions on Second Examinations
January 23, 2018 by Keith Fogg 1 Comment
The moral of the story in Planty v. Commissioner, T.C. Memo. 2017-240 is that if you ask the IRS to take another look at your return you cannot successfully claim that this “look” is a second examination of the return subject to the rules and approvals that limit the IRS’s ability to take a second look. In this case, the IRS examined the taxpayers’ return and seemed to have some difficulty coming to the final answer. After some fits and starts, the IRS made a determination and an assessment of $2,755. I could not determine from the description of the case how the IRS obtained permission to make the assessment but it does not seem to be a troublesome aspect of the case for the parties or the court.
After the IRS made the assessment and before paying the additional assessed tax, the taxpayers immediately submitted a Form 1040X claiming a refund of $1,560. The IRS treated the Form 1040X as a request for abatement. After looking at the request, the IRS decided that the taxpayer really owed a corrected tax liability of $64,704. Petitioners concede that the adjustment is correct subject to their argument that the adjustment resulted from an impermissible second examination of the tax year. Additionally, the IRS imposed an accuracy related penalty on this additional tax.
The Court states that “we may deal summarily with petitioners’ claim that they were subjected to an impermissible second examination of their 2010 return.” The Court cites to IRC 7605(b) which sets out the rules on second exams. The Code does not prohibit second exams but does require that the IRS go through a high level approval process. Most of the time the IRS will not do this because it spotlights that the original examiner and exam manager made a large mistake and provides proof of the mistake to their high level manager. Bureaucrats do not like to highlight their mistakes to high level management since doing so has a tendency to suppress future advancement and current bonuses.
In response to the taxpayers’ argument that the IRS engaged in an impermissible second examination, the IRS responded that IRC 7605 has “no bearing upon the Commissioner’s authority to examine tax returns already in his possession.” The Court points out that it would have been very difficult for the IRS to make a determination regarding their claim for refund without pulling the return and looking at it. Since the IRS was looking at the return to satisfy petitioners’ own request, doing so did not run afoul of IRC 7605.
Petitioners’ actions here point to the problem taxpayers have when they want to file an amended return. They think they are due a refund which they would like to receive ASAP; however, making the request for the refund will cause the IRS to scrutinize their return. Here, the quest for a $1,500 refund results in a $64,000 liability, plus a 20% penalty for good measure. Petitioners should have waited to file their request until the statute of limitations on assessment was about to expire. Had they waited, the IRS would still have denied their refund request but would not have hit them with the large assessment. Their impatience proves very costly.
So, the lesson here is not only should you not argue about an impermissible second exam when you have caused the IRS to look at the return but you should not make the request with gobs of time left on the assessment statute of limitations.
Taxpayers here not only brought unnecessary attention on their return costing themselves over $60,000, but they ramped up the liability to the point where the IRS felt obliged to penalize them adding insult to injury regarding their mistake for filing the Form 1040X too early. The Court finds that taxpayers’ return contains an understatement of the tax. It states that based on the proof provided by the IRS, taxpayers’ only hope of averting the penalty is to mount a credible defense based on substantial authority, adequate disclosure, or reasonable cause.
Taxpayers’ understatement resulted from their erroneous claim of almost $150,000 of real estate losses. The Court quoted from the regulations on the standard for substantial authority which requires that “the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” The Court also pointed out that this is an objective and not subjective standard, and that the existence of a legal opinion does not by itself create substantial authority. Here, the IRS disallowed the loss because of the passive activity loss rules. As authority, taxpayers pointed to an opinion from a tax attorney and the failure of the IRS to notice the issue when it first looked at their return.
Unfortunately, at trial taxpayers did not call the tax attorney to testify. So, the Court says it does not have any evidence to know why she gave the advice and whether her opinion had a basis in tax authorities that would allow the taxpayers to meet the substantial authority test. The Court also finds that the failure of the IRS to notice the issue initially does not constitute substantial authority pointing to provisions in the regulations on precisely this point.
The Court points out that adequate disclosure has no effect unless the return position has a reasonable basis and the failure of the tax attorney to testify leaves the Court without an ability to determine if there was a reasonable basis. With respect to reasonable cause, the taxpayers admitted that the tax attorney did not prepare their return and they could not show that the return preparer gave them advice with respect to this item that could cloak them with a reason for taking the erroneous position on their return.
The penalty portion of the opinion follows routine patterns but points to the need to obtain the testimony of any tax professional upon whom the taxpayer relies for the position taken on the return. It is not clear that taxpayers would have won if the professional had testified, but without the testimony a loss on the penalty issue was almost a foregone conclusion costing the taxpayers another $10,000 on top of the over $50,000 liability they picked up by filing the amended return.
IRS Campaign Season Begins
February 9, 2017 by Guest Blogger 1 Comment
Today we welcome first-time guest poster Tom Greenaway. Tom is a principal in KPMG’s Tax Controversy Services practice. He is a former senior attorney in the IRS Office of Chief Counsel’s then-Large and Midsize Business Division. Tom has written on a variety of tax procedure issues and is in the process of updating the chapter on examinations in the 7th edition of Effectively Representing Your Client Before the IRS. We are fortunate to gain his insights as he describes the rollout of IRS changes in its enforcement strategies relating to our nation’s largest taxpayers. Les
Filed Under: Exam, LB&I Tagged With: Tom Greenaway
Using the IRM to Help Taxpayers During Audits Exploring a Taxpayer’s Unreported Income
October 25, 2016 by Guest Blogger 5 Comments
Today we welcome first time guest poster David Breen, the Acting Director of Villanova’s Federal Tax Clinic, former Senior Counsel with the IRS Office of Chief Counsel in Philadelphia and longtime adjunct faculty member in Villanova’s Graduate Tax Program. In addition to his Counsel experience, Dave began his career with Exam. He has taught courses in Villanova’s graduate tax program for years, including Tax Procedure and our innovative trial litigation simulation course. While Keith has been visiting at Harvard, Dave has ably directed our tax clinic. In today’s guest post, he discusses some of the IRS’s own rules relating to examinations that focus on unreported income as well as some of the powers practitioners can but rarely do exercise in the context of those examinations. Les
The country is approaching the half way point of the NFL season and during the Eagles games I’ve watched so far, I can’t help but again notice the tendency of coaches to cover their mouths while talking to one another. This practice, which dates back to at least 2000, prevents opposing teams from employing lip readers to intercept the play the opposition is calling. Stealing plays in a game? By professional lip readers? Really? A bit of overkill, don’t you think? But football is not alone in this type of larceny. Less than one month into this year’s baseball season, the Padres were accused of positioning a spy inside the scoreboard with binoculars to telegraph pitches to San Diego batters.
This got me to thinking about the lengths that professional athletes will go to increase ever so slightly an edge over their opponents. And with that in mind, it made me look to my own profession as a tax attorney for whatever edge, legally, of course, that I could exploit as well. I didn’t have to look far.
When I was an IRS Revenue Agent back in the 1970s, the Internal Revenue Manual was IRS’s playbook, containing well-guarded tips, resources, recommendations, and directions on how to audit taxpayers. As a Senior Counsel in IRS’s Office of Chief Counsel from 1987 to my retirement in 2014, Part 35 of the IRM, also called the CCDM, provided the same practical guidance and advice for IRS attorneys. Today the IRM continues to guide IRS employees in the performance of their duties and thanks to the Freedom of Information Act (FOIA) it can be an invaluable resource for practitioners as well. In my experience, however, I find that many practitioners fail to avail themselves of this resource. In other words, they don’t take advantage of the ability to read IRS’s lips from across the gridiron to see what IRS’s next step will be.
When it comes to an IRS audit, particularly in the SBSE division which includes self-employed Schedule C filers, unreported income is the name of the game. From 2008 – 2010 the average annual tax gap was $458 billion, up from $450 billion in 2006. IRS revenue agents are given discretion in deciding which deductions to scrutinize on a return. Proof for deductions that are LUQ (large, unusual, or questionable) is sure to be requested. Examiners do not, however, have discretion in examining gross income. Unlike deductions, gross income must be examined in all audits. It is one of the relatively few mandatory items examiners must investigate.
This article discusses how a practitioner can utilize the IRM to represent clients more competently during an audit of gross income. I am limiting my comments to IRM Part 4 – Examining Process, but the advantages of being well-versed in IRS’s own procedures applies well beyond this area.
The law is clear on gross income: all income from any source is taxable unless specifically excluded somewhere in the Code. Taxpayers are required to maintain books and records to support items on their returns. If a taxpayer refuses to provide books and records, IRS may issue a summons to the taxpayer and third parties to compel production of documents and to give testimony under oath. Finally, before an examiner may use financial status or economic reality examination techniques to determine the existence of unreported income there must be an indication that there is a likelihood of unreported income.
While the above paragraph would score well on a law school tax final, it provides little insight into how the law is put into action. Let’s put some flesh on the bones by looking at how examiners are taught to audit returns.
To insure that returns are examined within the 3 year statute of limitations, IRM 4.10.2.2.2-1 requires that the examination and disposition of individual income tax returns be completed within 26 months after the due date of the return or the date filed, whichever is later. For example, if an examiner is assigned a timely filed 2015 return, the audit should not be started if it cannot be completed by June 2018 (26 months from April 15, 2016). This includes, however, the time to process the return, select it for examination, ship it to the examination group closest to the taxpayer’s location, assign it to an examiner, and schedule an appointment. To add additional incentive to IRS to examine returns promptly, interest is suspended if the Service fails to notify the taxpayer of a liability within 36 months of the later of the date the return is filed, or the due date for the return without regard to extensions. Like soggy hors d’oeuvres once the main course is served, returns falling short of this timeframe are forgotten about, “surveyed” as excess inventory and replaced by fresher, more current work. The lesson here is that despite the three year statute of limitations on assessment of tax, the likelihood of a return being audited is actually much less than three years after its filing under the 26 month cycle rule.
For those returns that are audited, however, examiners are given specific guidelines for verifying gross income. How does an IRS examiner decide how detailed the gross income investigation must be? To answer, we have to consider one more Code section, IRC § 7602(e), enacted as part of the IRS Structuring and Reform Act of 1998:
(e)Limitation on examination on unreported income
The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.
Prior to the enactment of IRC § 7602(e) examiners could (and often did) investigate gross income by engaging in intrusive inquiries into a taxpayer’s private life and finances. Interviews of business associates, co-workers, lenders, and even neighbors were conducted, sometimes without the taxpayer’s knowledge. Time consuming, intensive, expensive requests for voluminous records were the norm rather than the exception.
IRC § 7602(e) put the brakes on IRS examiners. Before an examiner may conduct an in-depth, intrusive examination – what the statute refers to as financial status or economic reality techniques – the examiner must first have some reason to suspect that a taxpayer has not reported all gross income. So called “indirect methods” are economic reality techniques. How does an IRS agent determine if there is a likelihood of unreported income to gain entrée into a detailed investigation? The answer is in the IRM.
IRM 4.10.4 sets forth a number of mandatory “minimum income probes” examiners must perform. If the minimum income probes indicate a likelihood of unreported income, the examiner must consult with a group manager. They jointly determine whether to conduct a more in-depth examination of income and document their findings in the workpapers. This more in-depth examination may include, but is not limited to a bank deposits and cash expenditures analysis, a source and application of funds analysis, or a net worth analysis – what IRS calls a formal indirect method of proof. ( Note, however, that IRC § 446(b) allows IRS to use any reasonable method. The high water mark of reasonable may have been IRS’s Atlantic City Tip Income Project back in the 1980s when IRS reconstructed cocktail waitress tip income by placing undercover special agents in casinos to watch how much tip income waitresses typically received during a shift and applying those findings to compute tip income for a “normal waitress.”).
All practitioners want to dissuade examiners from conducting time-consuming, costly, detailed indirect methods. Volumes have been written on defending a client when IRS determines under one of these methods that a taxpayer hasn’t reported all income. But remember, the minimum income probes are the gateway to the use of a formal indirect method of proof. For that reason, they should be the first line of defense in representing clients.
What are these “MIPs”? It depends on the type of taxpayer. The minimum income probes for individual business returns, i.e. Schedule C taxpayers, include: preparing a financial status analysis; conducting an interview with the taxpayer or representative; touring the business; evaluating internal controls; reconciling the income per return to the taxpayer’s books and records; testing gross receipts by tying original source documents to the books; preparing an analysis of the taxpayer’s personal and business bank and financial accounts; preparing an analysis of business ratios; and determining if there is Internet use and e-commerce income activity.
I present two ways for the minimum income probes to be used proactively by representatives.
Lay the groundwork during return preparation. Most return preparers send some form of tax organizer to clients which clients complete (or at least are supposed to complete) as part of having their returns filed. I encourage preparers to include questions concerning the minimum income probes in their client surveys. Gathering information on internal controls, bank accounts, business ratios, and e-commerce activity will serve as reminders to clients on what they records they should be keeping and also identify potential weak areas in the client’s operations. Weaknesses that can be corrected or anticipated in the event of an audit.
Challenge the examiner’s conclusions regarding the use of an indirect method. If early in the audit, say after the initial meeting and taxpayer interview, an examiner issues a detailed, voluminous information document request (IDR) clearly focused on income or personal living expenses, that is a clear indication that the examiner is “ramping up” the examination of gross income. Representatives should not simply shrug and hope for the best. I encourage representatives to ask the examiner in writing, if the examination has extended into IRC § 7602(e) territory. If the examiner answers affirmatively, or doesn’t answer at all, the representative should take the offensive and request a meeting with the group manager, request the examiner’s workpapers detailing the minimum income probe analysis and the discussion with the group manager green-lighting the indirect method, file a FOIA request for the workpapers, or all of the above. A taxpayer should be given an opportunity to respond to an examiner’s determination that the minimum income probes reflect unreported income. If the agent’s analysis is flawed, it is better for IRS and your client to not waste time on needless issues. To date, however, I have yet to find a representative who has taken any of these pre-emptive steps. My suspicions were confirmed when my opinion search of 7602(e) on the Tax Court’s website produced a single case which dealt only with the effective date of the statute.
In summary, as a representative you should adhere to the old adage, “Forewarned is forearmed” and study the IRM as if it were the Cowboys playbook and you were the coach of the New York Giants.
Filed Under: Exam Tagged With: David Breen