ROBERT E. MCKENZIE, ESQ.ARNSTEIN & LEHR

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By Robert E. Mckenzie

ALSO VISIT IRS AUDIT PROCEDURES & WHO GETS AUDITED BY THE IRS ?

Overall Rates

1.120 As the overall audit rates for different income classes are shifting, the proportion of individualtaxpayers who faced any kind of audit--either the more rigorous district audits or the semi-automatedCompliance Center audits--dropped to its lowest rate in modern history, just under one percent(0.49%) in 2001 and rose slightly to .57% in 2002.

Reduced Audit Levels

1.130 Two developments have contributed to the dramatic shift in audit targets from the relatively richto the relatively poor. One has been a Congressional mandate that the IRS reduce non-compliancein the Earned Income Credit program, a special tax benefit for low-income Americans. A secondfactor has been the substantial decline in the size of the IRS. After a buildup during the Reaganyears, a series of cut-backs agreed to by the Bush and Clinton administrations and by Congressmeans that in 2001 the full-time IRS staff was 31% smaller than it was in 1988. (By contrast, the FBIis today larger than at any time in its history.) With substantially fewer employees, the face-to-faceArea audits essential for the examination of larger and more complex tax returns have plummeted.This is true for both individuals and corporations. In fiscal year 2001, the chances for an Area auditfell to 0.16% per individual return filed -- less than 1 out of ever 600 returns. Only three years ago,the Area rate was more twice the 2001 rate.

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Face to Face vs. Compliance Center Audits

1.140 Individual taxpayers can face two kinds of IRS audit -- the Area "face-to-face" audit or thesemi-automated Compliance Center audit. While Area audits have long been a major focus of publicconcern, Compliance Center audits have become a significant component of the IRS's enforcementarsenal. The result of Compliance Center audits on individual taxpayers is far from negligible. In2002, for example, the average additional taxes and penalties for simpler returns reporting $25,000 orless was $3,134 even though the time spent by the IRS Compliance Center staff averaged just onehour per ""audit.""

Examination Rates

1.150 There is a substantial variance in audit rates depending upon where you live. In 2000 SouthernCalifornia District had the highest audit rate. Ohio District had the lowest audit rate.

IRS Compliance Center Notices IssuedFor Math Errors and Under-ReportingAdjustments From ComputerizedDocument Matching

FiscalYear

ReturnsFiled*

Math ErrorReturns Percent

Under-Reporting Percent

Returns

1981 93,052,000 na

1,200,000 1.3

1982 94,013,000 na

2,900,000 3.1

1983 95,419,000 na

2,900,000 3.0

1984 95,541,300 na

3,900,000 4.1

1985 96,496,900 na

3,600,000 3.7

1986 99,529,000 na

3,200,000 3.2

1987 101,750,800 na

2,242,000 2.2

1988 103,251,000 na

3,800,000 3.7

1989 107,029,000 na

3,650,000 3.4

1990 109,868,400 na

2,950,000 2.7

1991 112,304,900 na

4,840,000 4.3

1992 113,829,200 4,985,000 4.38 3,771,509 3.3

1993 114,718,900 4,088,000 3.56 2,723,830 2.4

1994 113,754,400 4,059,000 3.57 2,645,075 2.3

1995 114,683,400 6,102,000 5.32 2,711,086 2.4

1996 116,059,700 4,751,000 4.1 1,930,326 1.7

1997 118,362,600 *5,984,000 5.1 931,354 0.8

1998 120,342,400 5,669,000 4.7 1,726,098 1.4

1999 121,829,470 6,552,000 5.4 1,770,695 1.5

2000 124,887,140 5,751,000 4.6 1,353,545 1.1

Corporations

1.160 Corporations also are being treated more gently, with a 2002 Area audit rate of only .97%. This was lessthan half of1998 (2.04%) audits. The decline was especially noticeable among the largest corporations withassets of $250 million or more. In 1992, over half (55%) of these giants were audited. In 2002, the audit rate haddropped to only one in three (34.37%).

Examination

1.170 The Examination Division administers an audit program involving the selection and examination of alltypes of federal tax returns to determine correct liabilities due from taxpayers. Examinations are conductedeither through interviews or correspondence. Many audits are conducted via correspondence from ComplianceCenter Tax Examiners. Each Area Office has Tax Auditors (TA) and Revenue Agents (RA) assigned to conductaudits. The TA’s are not accountants and are only required to have two semesters of accounting to qualify forthe job. Revenue Agents in field audit are required to have at least 30 semester hours of accounting. Therespective Compliance Officers and/or Revenue Agents are assigned to groups of 10 to 12 persons managed by aGroup Manager. The Group Manager reports to a Branch Chief who will be in charge of four to five groups in anarea. That Branch Chief reports directly to the Chief of the Examination Division.

Tax Exempt and Government Entities

1.180 The IRS has a special function in charge of auditing employee plans and exempt organizations. Agentsassigned to Tax Exempt and Government Entities specialize in determining issues with respect to pension plansand employee benefit plans. This division also has specialists in examining exempt organizations such aschurches, municipalities and charities.

Criminal Investigation

1.190 Each Internal Revenue Area has special agents whose duty is to seek prosecution of persons who havecriminally violated tax laws. As part of its compliance efforts, the Internal Revenue Service recognizes that thethreat of criminal prosecution causes many people to voluntarily comply with the tax laws. If the InternalRevenue Service believes a matter indicates criminal intent it will be assigned to a special agent who willconduct a thorough investigation to determine if prosecution is appropriate. It takes a very unlucky person to beprosecuted for a tax crime. The IRS only prosecuted 1942 people in fiscal year 2002. Of that number 585 werepart of special programs to prosecute narcotics offenders.

Types of Examinations

1.200 The IRS utilizes several different examination techniques to determine the accuracy of tax returns. At theCompliance Center, computers are utilized to verify the computations shown on each return. If it is determinedthat the computations are incorrect on a return, a notice is issued to the taxpayer adjusting the amount of taxesdue on the return. The Compliance Centers also conduct correspondence audits on issues by initiating letters totaxpayers requiring verification of deductions and/or exemptions shown on a return. Office audits of simpler1040 returns are conducted in local Area Offices. Field examinations are conducted by Revenue Agents of morecomplex 1040 returns and other types of tax returns.

Compliance Center Audits

1.210 Compliance Centers conduct most correspondence audits. Some of these audits are generated as a result ofinformation return matches. When the Compliance Center receives 1099s and W-2's, it matches them with areturn. If there is an indication that not all income has been reported, a letter known as a CP-2000 will be issuedto the taxpayer. This letter requests that the taxpayer explain why particular income items were not reported onhis return. The taxpayer may request that the matter be transferred to a local Area Office for consideration.Compliance Centers also conduct audits of other items which can be easily explained via mail. In 2002, over70% of the audits of individual tax returns were made by the Compliance Centers. In 1994, the Internal RevenueService conducted 405,475 Compliance Center Audits and in 2003it more that number was 544,848 of auditstotaling 743,881.

Mathematical Errors

1.220 Each return received by a Compliance Center is checked for mathematical errors. If there is an apparentmathematical error, the Compliance Center computer will issue a notice to the taxpayer that the amount due onthe respective return has been corrected because of the error. That computer generated notice will note thereasons why the change has been made on the return. A notice is not a deficiency notice where it is based solelyupon a mathematical or clerical error appearing on the return. The taxpayer has 60 days after the notice to file arequest for abatement for the assessment. Upon receipt of the request, the IRS is supposed to abate theassessment. Any reassessment must be made using the normal deficiency notice procedure. The IRS may notinitiate collection procedures during the 60-day period [IRC Sec. 6213].

Omitted Schedules

1.230 The Compliance Center checks returns to be sure all appropriate schedules are attached to the return.

When schedules are not attached, the taxpayer receives a letter requesting that the appropriate schedule be filed.If the appropriate schedule is not provided, the Compliance Center will adjust the taxes due on the return.

Document Matches

1.240 Many IRS correspondence audits are the result of document matches. Most large providers of 1099s andW-2s are required to file via magnetic media. This magnetic media is fed directly into the Internal RevenueService computers. The remaining paper 1099s and W-2s are manually encoded into the IRS computers by itsclerical personnel. Once the information from 1099s and W-2s is encoded into the IRS computers, the IRS isable to conduct a matching of the information documents with income tax returns. If such matches indicatecertain 1099s and/or W-2s have been omitted from a taxpayer’s return, a CP-2000 notice is issued to thetaxpayer requesting an explanation of the omission. If the taxpayer fails to fully respond to the notice, the IRSwill issue an adjustment notice.

Correspondence Audits

1.250 The Compliance Center computers are programmed to select those returns with high DIF scores whichreflect issues that could be easily resolved by mail. The computers select those returns which are appropriate forcorrespondence audits and each respective return is reviewed by either a Tax examiner or clerk. [IRM 4(13)10].The returns are DIF screened and quality reviewed using technically proficient examination personnel who areexperienced in DIF screening operations. Returns which have apparent examination issues other than thoseappropriate for correspondence audit are referred to the local Area Office. Some examples of the kinds of itemswhich can be verified by correspondence are itemized deductions, such as interest, taxes, contributions, medicalexpenses, and simple miscellaneous deductions such as union dues and small tools [IRM 4143.2(1)(a)]. Issuesother than itemized deductions may be examined if they are single matters which would not be appropriate foroffice audit or field examination.

Correspondence Audit Procedures

1.260 When a return has been selected for a correspondence audit, the IRS has developed a series of computergenerated notices with respect to various issues on a tax return. Once a reviewer has determined an issue forexamination, he will cause the computer to generate the appropriate notice for that issue. The IRS notice willgrant the taxpayer 30 das to respond to the notice. The Taxpayer may request that the audit be transferred to hislocal Area Office [IRM 4 (13)13.1].

Taxpayer Reply

1.270 When a taxpayer responds to a correspondence examination notice, his response is processed by a firstread section at the Compliance Center which attempts to determine the nature of his response. If his replyrequires a response by the Internal Revenue Service, the matter is referred to the Adjustments andCorrespondence Branch for preparation of a reply. The Internal Revenue Manual provides that taxpayer repliesshould be processed within 30 days, but practitioners have found that in many instances the processing time farexceeds 30 days [IRM 4(13)13.41]. If the section determines that the reply from the taxpayer has an adequateexplanation of items questioned, it is forwarded to a Tax Examiner for review. If the explanation is satisfactory,the return will be accepted without change. If the explanation is not satisfactory, the Service will issue a Noticeof Deficiency advising the taxpayer of the proposed tax change. If the taxpayer requests an interview to discuss

the matter or it is determined that an interview is necessary to resolve issues, the case is transferred to the AreaOffice in which the taxpayer resides [IRM 4259].

Undeliverable Correspondence

1.280 When correspondence sent to a taxpayers is returned undeliverable, the IRS will search its systems in aneffort to determine a new address. The IRS also may initiate requests to employers and the Post Office todetermine a forwarding address. If a new address is not obtained after pursuing steps to determine it, the Servicewill issue the next appropriate letter, either a 30- or a 90-day letter to the taxpayer at his last known address[IRM 4(13)13.5].

1.290 If the taxpayer does not agree or does not respond within 30 days of issuance of the initial letter, the IRSwill issue a 30-day letter. If the taxpayer requests an interview or an appeals conference in response to the30-day letter, the matter is transferred to the appropriate Area Office for necessary action. Compliance Centerpersonnel are instructed to attempt to avoid transferring matters to the Area Office [IRM 4(13)14.1(3)] If thetaxpayer does not respond to the 30-day letter, the IRS normally will issue a notice of deficiency (90-day letter).If the taxpayer does not respond to the 90-day letter by initiating a suit before the Tax Court within 90 days, theService will assess the proposed deficiency.

Quality of Service Examiners

1.300 The authors have found that Compliance Center examiners are not well trained by the IRS. On manyoccasions, clients have properly responded to IRS computerized notices only to have deficiencies improperlyassessed against them. If such an erroneous deficiency should occur, the taxpayer will receive a balance duenotice from the Internal Revenue Compliance Center. In that event, the practitioner should immediatelyapproach local Area Collection personnel and request that the audit be reopened. Collection personnel haveauthority to reopen an audit if it is determined that the matter was not properly handled by the ComplianceCenter. This procedure is called an audit reconsideration. If collection personnel refuse to reopen an audit,contact the Taxpayer Advocate.

Office Audits

1.310 Most office audits are of income tax returns which indicate under $100,000 in total positive income. Mostinvolve deductions taken on Schedule A and Schedule E. Of the 111,695 conducted by office audit in 2002, only33,000 involved Schedule C taxpayers. The vast majority of audits conducted for taxpayers having total positiveincome of less than $100,000 are conducted by Compliance Officers. Office audits are conducted in a verysummary fashion. Because of the poor training of Compliance Officers and the large volume of cases, results canvary greatly from one audit to another. Tax Auditors (TA) normally only audit one year at a time. They may,however, request that prior or subsequent years be opened for audit if they find an issue which they believe tohave been incorrectly reported on other years. Audits of small businesses are normally conducted by a specialgroup within the office audit section.

Initiation of Office Audits

1.320 The office audit commences with a notice to the taxpayer requesting his appearance at an IRS office on acertain date. The letter will list a series of documents which the taxpayer must bring to the audit. When the letterarrives for an office audit, you may request that a proposed audit date be changed to a date more convenient foryour schedule.

Initial Interview

1.330 The IRS considers the initial interview to be the most important part of the examination process [IRM MT4231-72-230]. The taxpayer has the right to have a representative at the interview and the Service may notrequire a taxpayer to accompany an authorized representative to an examination interview in the absence of anadministrative summons [IRC Sec. 7521(c)]. IRS personnel, however, normally request the taxpayer’s voluntarypresence at the interview with the representative. Only in rare instances should the taxpayer accompany therepresentative to an interview. During the initial interview, the Tax Examiner will seek information to develop afinancial history and standard of living for the taxpayer. He will also seek information concerning the nature ofemployment, exempt income, and look for the potential for moonlighting income. The responses to the questionsduring an interview could result in an expansion of the issues under consideration during the audit.

Pro Forma Audit Aids

1.340 The Service has developed pro forma audit aids for use by Tax Auditors on the following frequentlyexamined items:

(1) Miscellaneous deductions;

(2) Taxes;

(3) Interest expenses;

(4) Medical expenses;

(5) Casualty losses;

(6) Moving expenses;

(7) Contributions;

(8) Rental income and expenses.

Compliance Officers must use the pro forma forms when examining any of the above issues. The aids aredesigned to promote uniformity in examination technique and as a checklist for documentation.

Scope of Audit

1.350 The scope of an office audit is generally much more limited than a field examination. Examiners aregenerally expected to only audit issues raised by the classification section of the IRS. There is much less

emphasis on determining unreported income during an office audit than during a field examination. However, theTax Auditor may expand the examination when significant issues become apparent as a result of informationsecured during examination. In most cases, the Auditor must secure Group Manager approval prior to openingnew issues during the audit.

Discretion of Auditor

1.360 Tax Auditors are given great discretion as to the standard of proof required to support questioned items.For example, one Auditor might accept only cancelled checks as support for an expense, whereas another mightliterally accept an oral statement to support an expense. You can best represent you client by properly organizingall of his/her records which support the deductions and expenses under audit by the IRS. Compliance Officersare given a very limited amount of time to complete their examination. The more thorough and well organizedyour client’s records, the better the chance that you can prevent or reduce deficiencies. Because there is a greatdegree of discretion granted to an Auditor, you should attempt to develop a rapport with him at the outset. Thegreater the rapport between the practitioner and the Office Auditor, the greater the chance of a no-change audit.In 1993, 14% of office audits resulted in no change.

Office Audit Issues

1.370 Travel and entertainment expenses are always a favorite target of the IRS during audits. The OfficeAuditor will look at the travel expenses to be sure that they were necessary to the taxpayer’s occupation.Convention expenses and out-of town travel are particularly subject to review. With respect to entertainmentexpenses, the IRS will review the record system, if any, of the taxpayer. The ideal would b a quality diary systemfor each respective entertainment expense. If these records are not available, then some supportingdocumentation must be supplied in order to preserve your client’s deduction for travel and entertainmentexpenses. Receipts, affidavits, charge account records, and other supporting documents may preserve thededuction.

Automobile Expenses

1.380 Automobile expense are an issue in many audits. The Office Auditor will look at the records maintained bythe client to assure that they meet the standard of adequacy. He will also try to contest the amount of personaluse of the automobile by the taxpayer. Compliance Officers are not prone to believe that automobiles are usedexclusively for business. Usually the advocate will be required to convince the Office Auditor with supportingdocuments and oral explanations.

Contributions

1.390 Contribution deductions have always been a favorite target of the office audit. Compliance Officers willseek to determine if payments were made to qualified organizations. They will also look at the nature of thetaxpayer’s documentation. Obviously, canceled checks are the best supporting documentation during suchaudits, but are not always available. Acknowledgments from the donee organization are also appropriate. TheIRS has recently placed greater emphasis upon determining if the taxpayer receives something of value as aresult of the contribution. For example, the taxpayer may have paid $100 to attend a charity dinner. The value ofthe dinner itself would have to be excluded from the deduction for charitable expenses.

Casualty and Theft Losses

1.400 The IRS has always been prone to disallow casualty and theft losses. Compliance Officers continually hearstories regarding the alleged flood or fire which caused substantial losses. The taxpayer will be required to submitpolice and/or fire reports to support the claimed deduction. The taxpayer also must establish the value of the lostitems. Even when confronted with such evidence, the IRS tends to place limited value upon the taxpayer’s assets[IRM MT 4231-46 575].

Educational Expenses

1.410 Educational expenses are an area of great scrutiny by the IRS The Service will seek to determine ifexpenses were primarily incurred for the purposes of maintaining or improving skills or meeting expressrequirements or retention of status. When auditing educational expenses involving overseas travel, the Auditorwill review registration receipts and the transcript of students from the overseas educational institution. TheAuditor will consider the amount of time devoted to educational pursuit in relation to total time spent overseas[IRM MT 4231-6 576].

Interest Expenses

1.420 When auditing interest expenses, the Service will verify the amount claimed and determine if thededuction was taken in the proper year. The Service will also seek to determine whether the payments are forinterest or for some other item such as discounts. Special scrutiny will be given to loans from related individualsto determine if in fact there is a valid debt. Compliance Officers will request the supporting documentsconcerning the loan including the loan contract and other loan documents [IRM MT 4231-66-573].

Other Issues

1.430 Compliance Officers may scrutinize earned income credits, child care credits, and credits for the elderly.Personal business expenses are also high profile audit items.

Field Audits

1.440 Revenue Agents are accountants and have at least 30 credit units of accounting. They are much bettertrained than Compliance Officers. Field Agents are responsible for auditing high income non-business andbusiness 1040 returns. Field Agents also conduct almost all of the audits of corporate tax returns. Normally, aRevenue Agent will audit more than one year at a time. For example, if 1999 is being audited, 2000 and 2001may also be brought into the audit. On business audits, a field audit puts particular emphasis on determiningwhether all income was properly reported on the tax return. The Revenue Agent will review deposits to checkingand savings accounts for the years at issue. He will also look at the disbursements form those accounts. RevenueAgents put more emphasis on the quality of records and methods of accounting than Tax Auditors. They willconsider all of the deposits to a bank account as income unless the taxpayer is able to show that the funds camefrom bank transfers, loan proceeds, repayment of notes receivable, gifts and/or insurance proceeds. RevenueAgents tend to shift the burden for establishing these matters to the taxpayer. They also will raise specificaccounting issues to be resolved during the audit. For example, you might be required to establish when assetswere placed in service for the purposes of determining whether depreciation will be allowed in a particular year

for those assets. He may also question the quality of the records utilized within the taxpayer’s bookkeepingsystem. It is not unusual for an Agent to reconcile those records in an effort to find discrepancies and flaws inthe system.

Unreported Income

1.450 In business audits, the primary focus is to find unreported income. Two methods are used to findunreported income: (a) cash reconciliation, and (b) net worth method. The cash reconciliation method requiresall bank statements and savings deposit passbooks be analyzed for income and expenses. The Revenue Agentwill analyze all deposits and compare those deposits to gross income reported on the tax return. He will thendiscount for non-taxable sources of income and transfer of funds between various accounts. A second method ofdetermining under-reporting of income is the net worth method. This method requires analysis of the changes inthe net worth of the taxpayer and a comparison of changes in income reported on the tax return. For example, ifthe value of the taxpayer’s cash in the bank had increased by $20,000, the amount of stock he owned increasedby $10,000, and he had acquired a $10,000 car in a particular year for cash or cash equivalent, that taxpayerbetter have reported at least $40,000 in income or have some explanation as to the alternative sources of thosefunds.

Financial Status Examinations

1.460 During fiscal year 1995 the IRS trained all of its agents on techniques known as Financial Status Audits(also known as Economic Realty Audits). These audits emphasize looking at the taxpayer’s lifestyle. Agentswere given extensive instructions on securing financial data prior to beginning the actual examination. As amatter of standard practice, the Internal Revenue Service now checks motor vehicle information, real estatedatabases and credit databases to secure more information regarding the taxpayer before an audit even begins. Italso looks at Bureau of Labor Statistics for the taxpayer’s zip code to determine normal living expenses and percapita income. Armed with this information, the Internal Revenue Service then begins his Financial Status Audit.All agents have been trained in the use of T account methods for determination of unreported income. Using theT account method, the agent will attempt to reconstruct the taxpayer’s total expenditures in relations to knownsources of income. To the extent that the taxpayer’s expenditures exceed known sources of income the InternalRevenue Service will assume that the taxpayer under reported income.

IRS Must Prove Statistically Computed Income

1.470 When the IRS uses statistical information from unrelated taxpayers solely to reconstruct an individualtaxpayer’s income (such as found in life-style or financial status audits), the burden of proof is also on the IRSwith respect to the income items reconstructed (Act §3001(b), Code §7491(b)).

Use of Financial Status Audits Limited

1.480 The Bill prohibits the IRS from using financial status or economic reality examination techniques todetermine the existence of unreported income unless there is a "reasonable indication" that there is a likelihoodof unreported income (Act §3412; Code §7602; effective on July 22, 1998).

Location of Audit

1.490 Generally, a Field Agent conducts an examination of the taxpayer’s place of business. The authorsrecommend that the taxpayer request that the audit be conducted at the practitioner’s office. By conducting theaudit at the practitioner’s office the Agent will not gain the extraneous information which becomes available tohim via observing the day-to-day operations of the client’s business. It might be somewhat inconvenient tocontinually have your client deliver records to your office during the course of an audit, but this method ispreferable to the IRS gaining an advantage by being present at the taxpayer’s place of business.

Agent’s Interview

1.500 The best way to represent your client at the audit interview is to give the impression that you know whatyou are doing and that you are fully organized. IRS Agents tend to be the harshest on persons who aredisorganized. When you appear at the audit, have your client’s records organized in a logical fashion and be ableto support those deductions that are at issue. If adequate records do not exist, have the alternative documentswhich support the respective deductions and expenses. If there are unusual issues with respect to the case, beprepared to discuss them in depth. It would be best to research complex issues in tax reporters prior to appearingat the audit if you anticipate a particular issue will be raised by the Agent. Don’t volunteer information! It neverhurts to be chatty with the Revenue Agent but remember, if you discuss an issue which hadn’t come to theAgent’s mind, it may become an issue. You should maintain a professional demeanor during the discussions withRevenue Agents. Personalities play an important role during an audit. If the Agent doesn’t like you, you can betyour client will receive harsh treatment. Given the power that Agents have, you must approach them in a politemanner. Even is he is extremely officious, try to maintain a professional, polite manner. Shouting and power playnegotiations are ineffective in dealing with IRS Agents. If the Agent is totally unreasonable, be aware that youhave several levels of appeal prior to the assessment becoming final.

Use of Computers by Agents

1.510 Agents are now assigned portable personal computers which they bring to audits. The IRS extensivelyutilizes its portable computers during an examination. The Agent has programs available to him for reconcilingbank statements and disbursements. Once an Agent has determined a tax deficiency, he may enter thosedeficiencies into the computer and it will compute all applicable taxes, interest and penalties.

Audit Plans

1.520 Prior to initiating a field examination, Revenue Agents are required to prepare a plan of examination. Theplan sets forth the issues which the Agent expects to audit and a time budget for conducting the audit. The IRSrequires this plan in an effort to promote an efficient audit process. The Agent will discuss the plan with hismanager and adjustments with respect to time allocations and emphasis of the audit will be made during theconference. For the practitioner, it is important to realize that the Agent has a time budget for each audit. If theaudit becomes much more complex than originally expected, some Agents may let issues fall by the wayside. Onthe other hand, if the Agent is able to develop a matter rapidly with respect to some issues and still has timeremaining in his budget, he may pursue new issues during the audit.

Closely Held Businesses

1.530 When an Agent is examining a closely held corporation, he will normally also review the individual taxreturns of the corporate shareholders. The individual returns might be surveyed subsequent to that review, but inmany instances the Agent decides to open audit issues with respect to the individual returns. On many occasions,alleged unreported income of a corporation is then double taxed. The Agent will allege under-reporting by the

corporation and then attribute a dividend to the shareholders. Such an allocation results in the income beingtaxed at both the corporate level and the individual level. Audits of other shareholders of closely heldcorporations may also be opened as a result of an examination of one of its shareholders. In such an event, othershareholders may suffer an audit because of misstatements by one officer.

Audit Coordination Between Officers and Corporation

1.540 If the returns for respective officers and the corporation are assigned to different Agents, the IRS hasdeveloped procedures for coordination of the examination. Agents apprize each other of the progress of therespective audits and/or open new issues when they arise on one of the respective returns. During the course ofthe examination, Agents may also determine payments to family members which may not be for servicesrendered. For example, a corporation may show the owner’s son on the payroll as an employee when, in fact,that son has not performed any services. In such an event, the son’s return might then become the subject of anexamination. Some clients might also utilize bank accounts of friends and relatives to conceal unreportedincome. Such schemes may lead to a criminal investigation.

Large Case Audits

1.550 The IRS has developed a program to audit the largest corporations conducting business in the UnitedStates. That program is known as the Coordinated Examination Program. Teams of the most experiencedexaminers and specialists of the IRS conduct examinations of the 1,650 largest and most complex domestic andforeign controlled corporations

Audit Team

1.560 A large case examination is conducted by a team of specialists which is assigned to a particular company.Each team is managed by a large case manager. Each of the respective specialists will be assigned various issuesto review within the corporation. At one time, the IRS would assign Agents to one corporation for years andyears, but the Service now has a policy of periodically rotating Agents so that personal relationships are lesslikely to develop between corporate staff and the Agents.

Audit Plan

1.570 As with small audits, the audit team will develop an audit plan. Normally, this plan will also be shared withthe tax department of the corporation and its representative.

Industry Specialization Program

1.580 The IRS has developed a program for identifying industry groups requiring centralized coordinationexpertise. Industries are designated for this program based upon the complexity and significance of tax issues.This information is obtained through an industry study which is coordinated nationally. Currently, there are 27designated industries in the program. Once an industry is designated for a specialized program, a team of expertsfrom examination and chief counsel functions is established, and they become the focal point for providing legaland audit direction to front line examining agents.

Market Segment Specialization Program

1.590 In 1993, the Internal Revenue Service began developing a program called the Market SegmentSpecialization Program (MSSP). The IRS decided that it was in its best interests to create specialists in variousindustries to conduct exams. In the past, agents would be assigned 15 or 20 cases in various industries. Such anapproach was not very effective because an agent was required to become familiar with the accounting methodsand procedures of each new industry. The Market Segment Specialization Program is designed to createguidelines for audits in many industries.

Audit Guidelines

1.600 As part of the MSSP, the Internal Revenue Service has issued audit guidelines for each identifiedindustries. The guidelines are, in effect, a manual of procedures for examination of each respective industry.Among the first guidelines to be issued, were those for examination of attorneys. The practitioner might besurprised to find that those guidelines suggest that if an attorney pays costs on behalf of a client, it should not beexpensed but shown as a loan to client.

Market Segment Specialization

1.610 Industries which the IRS had issued audit guides for as of December 2003 are as follows:

Air Charters Released May 1993

Alaska Commercial Fishing: Part I - Catcher Vessels Released July 1995

Alaska Commercial Fishing: Part II –

Processors and Brokers Released July 1995

AMT for Individuals Released Dec 1999

Architects Released Jan 1995

Artists and Art Galleries Released April 1997

Attorneys Revised June 1994

Auto Body and Repair Industry Released August 1995

Auto Industry Released Sept 2000

Aviation Tax Released Feb 1999

Bail Bond Industry Released July 1997

Bars and Restaurants Released Feb 1995

Beauty and Barber Shops Released July 1995

Bed & Breakfasts Released May 1993

Business Consultants Released April 2001

Carpentry and Framing Released Feb 1999

Car Wash Industry Released August 1998

Cattle Industry Released May 1996

Child Care Providers Released May 2000

Coal Excise Tax Released Feb 1998

Commercial Banking Industry Released July 2001

Commercial Printing Industry Released April 1997

Computers, Electronics and High Technology Released March 1998

Construction Industry Released July 1998

Drywallers Released August 1998

Entertainment - Important 1040 Issues Released April 1995

Entertainment - Music Industry Released March 1994

Farm Hobby Loss Released April 2001

Farming - Specific Income Issues and Farm Cooperative Released July 1997

Foreign Athletes & Entertainers Released Oct 1994

Furniture Manufacturing Released July 1997

Garden Supplies Industry Released Feb 2000

Garment Contractors Released June 1997

Garment Manufacturers Released April 1997

Gasoline Retailer Industry Released July 1995

Grain Farmers Released July 1995

Hardwood Timber Industry Released Feb 1998

Independent Used Car Dealers Released April 1996

Laundromat Industry Released June 2000

Lawsuit Awards & Settlements Released Jan 2001

Livestock Released May 2000

Low-Income Housing Credit Released August 1999

Manufacturing Industry Released May 1998

Masonry and Concrete Industries Released August 1998

Ministers Released May 1995

Mobile Food Vendors Released April 1995

Mortuaries Released May 1993

Net Operating Losses for Individuals Released Feb 1999

Oil & Gas Industry Released May 1996

Passive Activity Losses Released Feb 1996

Placer Mining Industry Released July 1999

Pizza Restaurants Released Sept 1995

The Port Project Released August 1995

Reforestation Industry Released August 1995

Rehabilitation Tax Credit Released Dec 1994

Retail Gift Shops Released Oct 2001

Retail Liquor Industry Released July 1997

RTC Debt Cancellation on Returns Released March 1995

Scrap Metal Industry Released Feb 1999

Shareholder Loan Released April 2001

Sports Franchises Released August 1999

Taxicabs Released May 1993

Tobacco Industry Released March 1996

Tour Bus Industry Released June 1997

Trucking Industry Released Sept 1995

Veterinary Medicine Released Feb 1999

Wine Industry Released April 1995

Market Segment Understandings

1.620 The IRS has also entered Market Segment Understandings (MSUs) with certain industries as to thetreatment of worker compensation and other issues. The following are the current MSUs:

Cosmetology & Barber Industry TRAC Released December 2000

Farm Labor Released December 1994

Food & Beverage Industry TRAC Released December 2000

Food & Beverage Industry TRDA Released December 2000

Gaming Industry Released January 2000

Generic TRAC Released December 2000

Generic TRDA Released December 2000

Hairstyling Industry Released January 2000

Limousine Industry Released March1997

Moving Industry Released December 1998

Television Industry Released May 1994

MSSP Approach

1.630 When conducting audits in the future, the IRS will rely more and more on the MSSPguidelines. The new practice has led to audits being done more efficiently and with fewer errors.

Potential Benefits to IRS of MSSP

1.640 The IRS sees a number of potential benefits from the MSSP:

Information learned from examining a specific market segment will be systematically fed intodatabases and analyzed to determine levels and trends of compliance for the entire segmentrather than individual taxpayers.

1.

Market segment specialization will increase auditors’ knowledge of taxpayer businesses.Taxpayers will become more confident in the ability of the IRS to administer the tax laws.

2.

As Examiners become specialists, their professional development will be aided.3.

Sharing of expertise should assure more competent and consistent treatment of issues.4.

Release of the audit technique guides will tell taxpayers what the IRS wants, which will lead tobetter kept records and easier identification issues.

5.

The IRS envisions that the MSSP will be cross-functional. For example, input from Appeals,Collection, Area Counsel, etc., will more likely ensure that examinations are consistently andefficiently conducted and resolved. This is also consistent with the premise of the IRSreorganization--to cluster the agency along functional lines, such as overall compliance ratherthan Collection and Examination in separate components.

6.

Exam Reengineering

1.650 The Small Business/Self Employed (SB/SE) division of the Internal Revenue Service initiatedits Examination Reengineering effort to improve the quality and consistency of income taxexaminations. SB/SE interviewed a wide range of individuals both internally and externally to find andidentify best practices and potential areas of improvement in its examinations. Among the individualsthe reengineering teams interviewed were previously audited taxpayers, tax practitioners, federal andstate government agencies, financial institutions, examination employees, and many others involvedin the tax community. SB/SE tested the redesigned examination process in both rural and urbanareas to ensure the new process is equally effective and consistent throughout the country. Thereengineered process was adjusted according to the feedback from taxpayers, practitioners andemployees involved in the examinations during the test period.

Features of the New Process

1.660 Some of the features of the reengineered field examination process are:

- ?Clearly communicated expectations of both the taxpayer and field agentthrough mandatory discussions between the revenue agent and taxpayerregarding the specific examination issues, required documentation, and amutually agreed upon date to complete the examination.

- ?At the beginning of each examination, field agents and their managers willmeet to discuss the agent’s approach to the examination, the plan to close theexamination, and the mutual commitment date arrived at with the taxpayer.

- ?Field agents will use standardized templates for every examination issue togather the information necessary to resolve issues. Agents will use astandardized guide when deciding if additional issues need to be added to the

examination. The agent will explain to the taxpayer if any additional issues areincluded in the examination.

Some of the features of the reengineered office examination process are:

- ?Clearly communicated expectations of both the taxpayer and the examinerprior to the initial appointment. Office examiners will provide the taxpayer withfocused document requests that specifically identify the information needed.

- ?Improved flexibility in the scheduling process will enable examiners andtaxpayers to reduce the time it takes to complete an examination.

- ?Office examiners will use standardized templates for every examinationissue to gather the information necessary to resolve issues. Examiners will usea standardized guide when deciding if additional issues need to be added tothe examination. The examiner will explain to the taxpayer if any additionalissues are included in the examination.

Training Has Begun

1.670 With the final adjustments made, SB/SE will train all of its income tax field agents and officeexaminers during the 2004 fiscal year. Field agent training began in December 2003 and training forthe office examiners began in January 2004. The redesigned examination process will benefittaxpayers and practitioners because the audits will be better focused on relevant issues, expectationsbetween the examiner and taxpayer will be clearly communicated, and the time it takes to completethe examination may be reduced.

Why Is the IRS Undertaking This Process Now?

1.680 It's imperative that the IRS make continual improvements while seeking efficient and effectivenew ways to achieve its mission of service to each taxpayer through a quality work environment.These goals can be met only by making specific changes to examination work processes anddeveloping approaches that are specifically tailored for the agency's customer base and employeeneeds. Moreover, the Exam Reengineering Project isn't just about change; it's about making along-lasting, positive impact on the entire SB/SE organization. Commissioner Kehoe said, "We’regoing to give our employees the means to work smarter and more efficiently, and when we’re done,we will not only meet but exceed the expectations of our employees and our customers."

1.690 The IRS leadership believes that all stakeholders--including employees--have the opportunityto contribute to the Exam Reengineering effort by providing input into process improvements as theyevolve. Commissioner Kehoe said, "Improving our business processes is a team effort, and bysharing your knowledge and experience, the Exam Reengineering Project will be a success.Incremental change isn't enough to bring us closer to our goal of providing the best service to ourcustomers. Together, we can rebuild the Exam Reengineering process, and when we’re done, we willall reap the benefits of working better and smarter for years to come."

Other Sources

1.700 Other sources of workload are Collection referrals, Criminal Investigation referrals, EP/EOreferrals, Information Reports and Return Preparers. Detailed information is located in theCompliance Initiative Projects Handbook.

Midwest Automated Compliance System -- MACS

1.710 MACS is an automated compliance tool that provides the capability to profile a population,identify market segments, and identify issues during screening. MACS contains Return TransactionFile data and certain Master File information for three years for all taxpayers who filed within a districtor service/customer service center area (IMF, 1120, 1120S, 1065 and 1041 only). MACS has stringentoperating restrictions to ensure the securing of the data and that taxpayer privacy is notcompromised. MACS may be used for information on specific taxpayers even if only a partial name oraddress is known. This includes a return facsimile in either a one year or three year comparativeformat and a Cash-T analysis. This information may be used for case building or return selectiondecisions. A MACS facsimile may be used in lieu of the original tax return. MACS may be used toidentify potential noncompliance within a market segment, and to select a sample of returns to testthe level of noncompliance.[IRM 4.1 4.21]

Return Preparer Enforcement Program

1.720 The IRS Criminal Investigation Return Preparer Program (RPP) was implemented in 1996, andestablished procedures to foster compliance by identifying, investigating and prosecuting abusivereturn preparers. The program was developed to enhance compliance in the return-preparercommunity by engaging in enforcement actions and/or asserting appropriate civil penalties againstunscrupulous or incompetent return preparers. This is a significant problem for both the IRS and ourtaxpayers. Abusive return preparers frequently prepare bad returns for large numbers of taxpayerswho, at best, are stuck with paying additional taxes and interest and at worse, depending onculpability, are subject to penalties and maybe even criminal prosecution.

FedState Initiative Procedures

1.730 FedState initiatives are developed and shared using a common format (template) that isavailable from Regional FedState Program Managers, the National Office FedState Relations, andthe FedState web page. Using the template to guide initiative development enables a business caseproposal to be developed for projects that should be replicated nationwide. Completing the template

will also provide much of the information needed to prepare a Compliance Initiative Proposal (CIP)where applicable. The FedState template is used for all new FedState initiatives unless an exceptionapplies or regional approval for non-use of the template is obtained.

IRS Sets New Audit Priorities

1.740 The Internal Revenue Service is realigning its audit resources to focus on key areas ofnon-compliance with the tax laws. The strategy represents a new direction for the agency'scompliance effort.

1.750 Following months of research and planning, the new approach will focus on high-risk areas ofnon-compliance. The IRS effort will generally focus first on promoters and then on participants inthese various schemes. The initiative will feature new and enhanced efforts on several priority areas,including:

Offshore credit card users.High-risk, high-income taxpayers.Abusive schemes and promoter investigations.High-income non-filers.Unreported income.The National Research Program.

Increased Resources For Audits – Also Known As Examinations -- Will Be Devoted To These ProjectsIn Fiscal Year 2003, Which Will Be A Year Of Transition And Training As New Audit Cases Move IntoThe IRS System.

1.760 The IRS Small Business/Self-Employed Division will handle the new effort in these key areasaffecting individuals and businesses. Compliance efforts will continue in other parts of the agency,such as the tax shelter initiative in the Large and Mid-Sized Business Division. This initiative reflectspart of a broader, agency-wide plan at the IRS. This strategy places a top priority on pursuingpromoters of abusive schemes, shelters and trusts and then identifying participants in these efforts toevade taxes. To address these problems, the IRS has revamped its compliance programs to refocuson problem areas. The IRS will use a full scope of tools and techniques ranging from summonsenforcement, injunctions and criminal investigation of promoters to civil audits of participants.

Strategy

1.770 The strategy reflects the new way of doing business at the IRS. Several of these efforts -- suchas the National Research Program and the credit card initiative -- reflect innovative approaches totackle long-standing tax problems. The new audit initiative will include similar emphasis for theagency's collection area. And new levels of cooperation and coordination are underway on initiativesthat involve both civil actions and criminal investigation. These illustrate how the new IRS business

model positions the agency to respond to high-risk tax areas. For the six new areas, the agency willdirect more examination resources to address these issues. However, the IRS will maintain apresence in other audit areas to maintain core tax administration responsibilities. Additional examresources will help meet this requirement.

Key areas for the new initiative include:

Offshore Credit Card Project

1.780 It is not illegal to have an offshore credit card. However, there is a reasonable basis forbelieving that some people are using offshore credit cards to evade paying U.S. taxes. Credit cardsprovide easy access to offshore funds and accounts in tax haven countries that allow income to behidden. U.S. citizens must pay tax on their worldwide income.

The IRS has taken several major steps to combat tax-avoidance schemes involving credit cardsissued by offshore banks. According to public records:

On October 30, 2000, a federal judge in Miami issued an order authorizing the IRS to serveJohn Doe summonses on American Express and MasterCard. These summonses weredesigned to obtain limited information for 1998 and 1999 revealing U.S. participants in offshorearrangements who hold credit cards issued by banks from Antigua and Barbuda, the Bahamas,and the Cayman Islands.

1.

On March 27, 2002, a federal judge in San Francisco issued an order authorizing the IRS toserve a John Doe summons on VISA International seeking records on transactions for1999-2001 using cards issued by banks in over 30 tax haven countries.

2.

On August 21, 2002, a federal judge in Miami issued an order authorizing the IRS to serve aJohn Doe summons on MasterCard for records on transactions for 1999-2001 using credit cardsissued by banks in over 30 tax haven countries.

3.

On August 29, 2002, the IRS asked seven courts across the nation (Atlanta, Chicago, Dallas,San Francisco, Seattle, Newark, Alexandria, Va.) for permission to serve John Doe summonseson over 40 businesses to assist in the identification of credit card owners.

4.

Mastercard

1.790 The first summons alone yielded data from MasterCard on 237,000 cards issued through 28banks in three countries. The majority of the cards appear to have been issued to U.S. customers. If

the MasterCard information is representative of the industry, there could be 1 million to 2 million U.S.citizens with debit/credit issued by offshore banks. This compares with only 170,000 Reports ofForeign Bank & Financial Accounts being filed in 2000 and only 117,000 individual 1040 filersindicating they had offshore bank accounts (tax year 1999).

Number of Taxpayers

1.800 Credit cards do not equate to taxpayers. The IRS must utilize an extensive process to identifythe taxpayer associated with each card. Spending patterns, unusual expenses, proximity of spendingand repetitive expenses are all considered in the process. Once taxpayers are identified from cards,case building begins. The IRS already has developed hundreds of cases for civil audits or potentialcriminal investigations. The IRS is increasing resources in Fiscal Years 2003-2004 devoted to workingthese cases.

High-Risk, High-Income Taxpayers

1.810 High-income returns are often more complex and, generally, upper income taxpayers haveresources to engage in pass-through entities such as partnerships, trusts and corporations. Evenutilizing IRS’s various matching programs, income and deductions from such activities are moredifficult to verify.

K-1 Matching

1.820 While the IRS has begun to match K-1 forms from pass-through entities, the technique doesnot provide any verification of income reported by the entity itself. Verifying the income on thesereturns requires an examination. Starting in fiscal year 2003, the IRS will be utilizing a combination offilters to identify high-risk, high-income returns. The returns selected for examination will be thosemost likely to have unreported income or structured transactions.

Structured Transaction

1.830 A structured transaction is one with limited economic benefit and whose primary purpose is toreduce or eliminate a tax liability. Structured transactions are generally done through one or morepass-through returns, such as Forms 1065 or 1120-S. The pass-through returns create paper lossesthat flow back to individual income tax returns offsetting income from other sources.

Abusive Schemes And Promoter Investigations

1.840 IRS efforts to combat abusive schemes and scams (including the Offshore Credit Card Project)will significantly increase from FY2002 to FY2003. Schemes and scams on the rise include:

Schemes, reducing a person’s tax liability by claiming inflated expenses, false deductions,1.

unallowable credits or excessive exemptions.

Frivolous return arguments, telling taxpayers compliance is voluntary or the U.S. Constitutiondoes not provide for tax collection.

2.

Promotion of slavery reparation claims, scams that claim compensation for people who haveancestors who were slaves.

3.

Abusive shelters and trusts, investments established for the purpose of hiding income fromtaxation.

4.

Employment tax schemes, employee leasing, paying in cash and filing false payroll tax returns.5.

Abusive Scheme Groups are being established in each Area and the use of Fraud Specialists willincrease. To identify and address promoter activity, a Promoter Lead Development Center has beencreated. The Center systematically monitors the Internet to identify promoters of abusive activitiesand develops cases for injunctive investigations.

High-Income Non-Filers

1.850 The IRS efforts to address non-filers in FY 2003 will focus on the most egregious and high-risksegments of the population.

The non-filer strategy will be pursued on many fronts:

Re-engineered processes and work streams to improve efficiency and productivity.1.

Identification and expedited assignment of the most egregious non-filers.2.

Expanded and centralized automated enforcement.3.

Outreach and education efforts.4.

Unreported Income

1.860 Unreported income represents the largest component of the tax gap. IRS has developed a newtool for identifying returns with a high probability of unreported income. The new tool is known asUnreported Income Discriminant Index Formula (UI DIF). All individual returns have traditionally beenassigned a DIF score rating the probability of inaccurate information on the return. The new UI DIFscore rates the probability of income being omitted from the return. The IRS has customarily usedindirect examination methods to identify unreported income but until now has had no systemicmethod for selecting the returns at highest risk for unreported income. UI DIF gives the IRS the abilityto systemically identify returns at high risk for unreported income and beginning this fall all returnswill receive a UI DIF score in addition to the traditional DIF score.

National Research Program

1.870 National Research Program (NRP) examinations, which begin this fall, will measure reportingcompliance and identify compliance issues. NRP will enable the IRS to improve the examinationselection process. NRP is very different from its predecessor, the Taxpayer Compliance MeasurementProgram (TCMP). NRP no longer relies heavily on time-intensive, "line-by-line" audits for establishinga baseline measure of reporting compliance.

The IRS has not conducted updated research on the distribution of errors on returns for more than13 years, a period when the economy and the tax law have changed dramatically. Without theinformation that will be gathered through NRP, the IRS will have less ability to direct examinationsand other compliance activities with accuracy and precision. With updated information, the NRP effortwill prevent thousands of "no change" audits each year.

Small Sample

1.880 The NRP effort will review a small, statistically valid sample of individual returns for tax year2001, less than 47,000 returns out of 132 million individual returns filed. The new NRP process willhave four main categories:

No IRS contact. About 8,000 returns will be checked relying solely on information alreadyavailable to IRS.

1.

Correspondence. These will be less intrusive correspondence exchanges with taxpayers –rather than the old standard of sit-down audits. About 9,000 returns will be included in thisprocess.

2.

Less intrusive audits. Instead of the old "line-by-line" examination approach, the IRS will gathermore information beforehand from agency records and focus only on selected parts ofapproximately 30,000 returns.

3.

Calibration audits. These will consist of about 2,000 examinations that will check each line ofthe return. But, in a major change from earlier programs, taxpayers will not be required toprovide line-by-line substantiation.

4.

Abusive Trusts

1.890 It is estimated that $4.8 trillion in wealth will be inherited or transferred from one generation tothe next by 2015, with much of it transferred through a variety of trusts. Filings of trust returns (Form1041) are now the third most frequently filed income tax return behind individual and corporatereturns. Although the vast majority of these transfers are legal, there is widespread potential forfraud. In the last few years, the Internal Revenue Service has detected a proliferation of abusive trusttax evasion schemes. These promotions are targeted towards wealthy individuals, small businessowners, and professionals such as doctors and lawyers.

Promotion

1.900 Abusive trust arrangements typically are promoted by the promise of such benefits as:

Reduction or elimination of income subject to tax.Deductions for personal expenses paid by the trust.Depreciation deductions of an owner's personal expenses paid by the trust.Depreciation deductions of an owner's personal residence and furnishings.A stepped-up basis for property transferred to the trust.The reduction or elimination of self-employment taxes.The reduction or elimination of gift and estate taxes.

Hidden Ownership

1.910 Abusive trust arrangements often use trusts to hide the true ownership of assets and income orto disguise the substance of transactions. Although these schemes give the appearance ofseparating responsibility and control from the benefits of ownership, as would be the case withlegitimate trusts, the taxpayer in fact controls them.

More Than One Trust

1.920 These arrangements frequently involve more than one trust, each holding different assets ofthe taxpayer (the taxpayer's business, equipment, home, automobile, etc.), as well as interests inother trusts. The trusts are vertically layered, with each trust distributing income to the next layer.Funds may flow from one trust to another trust by way of rental agreements, fees for services,purchase and sale agreements, and distributions. The goal is to use inflated or nonexistentdeductions to reduce taxable income to nominal amounts.

Two Basic Schemes

1.930 Although the individual abusive promotions vary, two basic schemes have been identified:

The domestic package, andThe foreign package.

These schemes are often promoted by a network of promoters and sub-promoters who have charged$5,000 to $70,000 for their packages. This fee enables taxpayers to have trust documents prepared,to utilize foreign and domestic trustees as offered by promoters, and to use foreign bank accountsand corporations. In some instances, tax return preparer services are also made available.

Abusive Home-Based Business Schemes

1.940 Abusive home-based business tax schemes have gained popularity over the last few years fora variety of reasons, including:

Taxpayers being inappropriately advised they can deduct all or a portion of their personalassets and living expenses.

1.

Unscrupulous promoters and tax practitioners selling "tax relief" and "audit assistance"packages.

2.

The desire of individuals to reduce the amount of taxes they pay.3.

Aggressive marketing of multi-level pyramid schemes.4.

Non-deductible Personal Expenses

1.950 Many taxpayers accurately report their income and expenses, while enjoying the benefits that ahome-based business can offer. However, there are individuals who have received advice that theycan operate any type of unprofitable "business" out of their home and claim personal expenses.Non-deductible personal living expenses cannot be transformed into deductible expenses regardlessof how convincing the information in marketing materials may seem.

Applicable Internal Revenue Code sections include, but are not limited to:

§127 Educational Assistance Programs

§162 Trade or Business Expenses

§183 Activities Not Engaged in for Profit

§195 Start-Up Examination

§212 Expenses for the Production of Income

§262 Personal, Living, and Family Expenses

§274 Disallowance of Certain Entertainment, etc., Expenses

§280A Disallowance of Certain Expenses in Connection with Business Use of Home,etc

Examples

1.960 The following are a few examples of items that are generally not deductible as businessexpenses:

Deducting the cost and operation of a personal residence. Placing a calendar, desk, filecabinet, telephone, or some other business-related item in each room does not increase theamount that can be deducted. Individuals may attempt to deduct a portion of the total housepayment, which is not allowable. (Even in cases of appropriate home-business deductions,depreciation recapture rules are applicable when assets are later sold.)

1.

Paying children a salary (e.g. answering telephones, washing cars, etc.).2.

Deducting education expenses for children without regard for Internal Revenue Code §127.3.

Deducting excessive car and truck expenses when the asset has been used for both businessand personal use.

4.

Deducting personal furniture, home entertainment equipment, children’s toys, etc.5.

Deducting travel, meals, and entertainment under the guise that everyone is a potential client.6.

Any investment scheme or promotion that claims to allow a person to deduct normal personalexpenses should be considered highly suspect. A business must truly exist prior to claimingexpenses.

Tax Protestor Arguments

1.970 Since shortly after the federal income tax was enacted in 1913, some individuals and groupshave encouraged others not to comply with the law. There have been unsuccessful challenges aboutthe applicability of tax laws using a variety of arguments. There have been assertions that the 16thAmendment was not properly ratified, the tax law was unconstitutional, the tax law did not apply tocertain types of income, the tax law only applied to certain individuals, and the tax law violated one ormore constitutional rights.

Courts Reject

1.980 Despite the courts having consistently rejected these arguments, their promoters continue toexpound them, even incurring penalties for bringing frivolous cases into court or for filing frivolous taxreturns. They often present their arguments in a pseudo-legal format, luring unsuspecting peopleinto participating in their schemes to evade taxes.

Americans with Disabilities Act Schemes

1.990 Title I of the Americans with Disabilities Act of 1990 (ADA) prohibits private employers with 15 ormore employees from discriminating against a qualified individual with a disability. To implement thisprohibition, the ADA also requires that employers provide reasonable accommodations to the knownphysical or mental limitations of a qualified individual with a disability, unless to do so would imposean undue hardship on the operation of an employer's business. In order to comply with thisrequirement (and other requirements imposed by the ADA, e.g. those of Title III), an employer mayhave to make significant outlays.

More Dollars for IRS

1.1000 The Bush administration has proposed adding more IRS resources for compliance.Specifically, the budget request would add an additional $109.8 million and 1,599 staff members toenhance compliance. Most of the extra resources will he allocated to five areas.

First, nearly half of the extra money would go to the IRS Small Business/Self-Employed (SB/SE) Division, which would apply the extra resources to beef upmany of its existing compliance programs and "leverage new workloadselection systems and case building from on-going reengineering efforts." Therationale is in a new IRS acronym: ABLE (achieving balanced levels ofenforcement). ABLE would provide $55.5 million and 887 additional staffmembers in 2004. Areas receiving additional attention include organized taxresistance, abusive trusts and shelters (including offshore credit cards),special purpose entities, and employment tax schemes. The abusive trustsand shelters and special purpose entities effort would primarily affecthigh-income individuals who use structured transactions and flow-throughentities (for example, partnerships) to conceal tax liability and avoid payment oftaxes. The IRS estimates that abusive tax schemes cost the government up to$40 billion annually in lost tax revenue. With the ABLE funds, the IRS expectsto close 20,999 examinations on flow-through returns in fiscal 2004. This is a110 percent increase over expected fiscal 2003 levels, according to the IRS.Also, the IRS expects to close 78,244 individual examinations on returns withincome in excess of $100,000. This represents a 33 percent increase — ormore than 19,600 more return closures — over expected fiscal 2003 levels.

Second, the White House budget proposes for the IRS Wage and InvestmentOperating Division (W&I) an extra $3.6 million and 67 extra staff members toreduce the existing nonfiler inventory. The IRS has a nonfiler inventory of 6.8million taxpayers, of which 1.6 million will be selected for potential contact infiscal 2004. The IRS also intends to focus on a questionable Form W-4program as a first step in establishing higher levels of voluntary compliancewith the filing requirements. One way for taxpayers to avoid filing is by inflatingthe number of dependents for withholding purposes on the Form W-4.Although the number of questionable Forms W4 reviewed in recent years hasdecreased, the IRS believes that reviewing additional W4s will improve filingand payment compliance across the W&I population. W&I would also devotemore staff to the automated substitute for return (ASFR) program, whichallows the IRS to create a return for a potential nonfiler so collection action ona possible tax debt can begin. With increased ASFR efforts, the IRS hopes toreduce the inventory of non-filers. Specifically, the IRS hopes ASFR will resultin approximately 82,000 closures, $74 million net assessments, and $14.5million collected. The effort could create $60 million in extra accountsreceivable.

Third, W&I expects to reduce the size of the accounts receivable by devoting$4.5 million and 100 more staff members to this effort. According to the IRS, itestimates that this will allow for the closure of 16,000 more cases in 2004 thatshould result in an additional $22 million in revenue.

Fourth, W&I would devote an extra $2.2 million and 51 staff members toautomated underreporter (AUR) cases. The IRS contends that it can work only30 percent of the five million cases currently in inventory. The extra staff would

allow the IRS to work an additional 116,000 cases in 2004, which could resultin roughly $98 million in additional assessments.

Fifth, LMSB would apportion an extra $22.4 million and 258 staff members toincrease examinations of large flow through entities and abusive corporatetransactions. The Service has designated abusive tax shelters as one of thehighest priorities. With existing staff allocations, this means that 949 staffmembers will be working in the tax shelter area. In the short-term, this group’sproductivity is likely to decrease because experienced auditors will probablyspend their time training newly hired staff rather than focusing onexaminations.

K-1 Matching

1.1010 In 2002 the IRS attempted to begin a K-1 matching program. The program had serious flawsand the was withdrawn after loud protests from the practitioner community. Once again in 2003 theService will attempt a K-1 matching program. With changes in place, the matching program willbegin issuing notices to some taxpayers later this year requesting more information about their 2001tax return. For the enhanced matching program, the IRS will use additional filters during screening tosubstantially reduce the number of notices issued. The IRS expects the changes recommended byexternal stakeholders and implemented by the agency will reduce taxpayer burden and increase theoverall effectiveness of the matching program.

Copyright 2005

07/16/2009