ROBERT E. MCKENZIE, ESQ.

ARNSTEIN & LEHR

120 SOUTH RIVERSIDE PLAZA, SUITE 1200
CHICAGO, IL 60606
312-876-6927
312-876-7318 fax

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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 individual
taxpayers who faced any kind of audit--either the more rigorous district audits or the semi-automated
Compliance 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 rich
to the relatively poor. One has been a Congressional mandate that the IRS reduce non-compliance
in the Earned Income Credit program, a special tax benefit for low-income Americans. A second
factor has been the substantial decline in the size of the IRS. After a buildup during the Reagan
years, a series of cut-backs agreed to by the Bush and Clinton administrations and by Congress
means that in 2001 the full-time IRS staff was 31% smaller than it was in 1988. (By contrast, the FBI
is today larger than at any time in its history.) With substantially fewer employees, the face-to-face
Area 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 audit
fell 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.
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 the
semi-automated Compliance Center audit. While Area audits have long been a major focus of public
concern, Compliance Center audits have become a significant component of the IRS's enforcement
arsenal. The result of Compliance Center audits on individual taxpayers is far from negligible. In
2002, for example, the average additional taxes and penalties for simpler returns reporting $25,000 or
less was $3,134 even though the time spent by the IRS Compliance Center staff averaged just one
hour per ""audit.""

Examination Rates

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

IRS Compliance Center Notices Issued

For Math Errors and Under-Reporting
Adjustments From Computerized
Document Matching

Fiscal Returns Math Error Under-Reporting Percent

Year Filed* Returns 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 less
than half of1998 (2.04%) audits. The decline was especially noticeable among the largest corporations with
assets of $250 million or more. In 1992, over half (55%) of these giants were audited. In 2002, the audit rate had
dropped to only one in three (34.37%).

Examination

1.170 The Examination Division administers an audit program involving the selection and examination of all
types of federal tax returns to determine correct liabilities due from taxpayers. Examinations are conducted
either through interviews or correspondence. Many audits are conducted via correspondence from Compliance
Center Tax Examiners. Each Area Office has Tax Auditors (TA) and Revenue Agents (RA) assigned to conduct
audits. The TA’s are not accountants and are only required to have two semesters of accounting to qualify for
the job. Revenue Agents in field audit are required to have at least 30 semester hours of accounting. The
respective Compliance Officers and/or Revenue Agents are assigned to groups of 10 to 12 persons managed by a
Group Manager. The Group Manager reports to a Branch Chief who will be in charge of four to five groups in an
area. 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. Agents
assigned to Tax Exempt and Government Entities specialize in determining issues with respect to pension plans
and employee benefit plans. This division also has specialists in examining exempt organizations such as
churches, municipalities and charities.
Criminal Investigation

1.190 Each Internal Revenue Area has special agents whose duty is to seek prosecution of persons who have
criminally violated tax laws. As part of its compliance efforts, the Internal Revenue Service recognizes that the
threat of criminal prosecution causes many people to voluntarily comply with the tax laws. If the Internal
Revenue Service believes a matter indicates criminal intent it will be assigned to a special agent who will
conduct a thorough investigation to determine if prosecution is appropriate. It takes a very unlucky person to be
prosecuted for a tax crime. The IRS only prosecuted 1942 people in fiscal year 2002. Of that number 585 were
part 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 the
Compliance Center, computers are utilized to verify the computations shown on each return. If it is determined
that the computations are incorrect on a return, a notice is issued to the taxpayer adjusting the amount of taxes
due on the return. The Compliance Centers also conduct correspondence audits on issues by initiating letters to
taxpayers requiring verification of deductions and/or exemptions shown on a return. Office audits of simpler
1040 returns are conducted in local Area Offices. Field examinations are conducted by Revenue Agents of more
complex 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 of
information return matches. When the Compliance Center receives 1099s and W-2's, it matches them with a
return. If there is an indication that not all income has been reported, a letter known as a CP-2000 will be issued
to the taxpayer. This letter requests that the taxpayer explain why particular income items were not reported on
his 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, over
70% of the audits of individual tax returns were made by the Compliance Centers. In 1994, the Internal Revenue
Service conducted 405,475 Compliance Center Audits and in 2003it more that number was 544,848 of audits
totaling 743,881.

Mathematical Errors

1.220 Each return received by a Compliance Center is checked for mathematical errors. If there is an apparent
mathematical error, the Compliance Center computer will issue a notice to the taxpayer that the amount due on
the respective return has been corrected because of the error. That computer generated notice will note the
reasons why the change has been made on the return. A notice is not a deficiency notice where it is based solely
upon a mathematical or clerical error appearing on the return. The taxpayer has 60 days after the notice to file a
request for abatement for the assessment. Upon receipt of the request, the IRS is supposed to abate the
assessment. Any reassessment must be made using the normal deficiency notice procedure. The IRS may not
initiate 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 and
W-2s are required to file via magnetic media. This magnetic media is fed directly into the Internal Revenue
Service computers. The remaining paper 1099s and W-2s are manually encoded into the IRS computers by its
clerical personnel. Once the information from 1099s and W-2s is encoded into the IRS computers, the IRS is
able to conduct a matching of the information documents with income tax returns. If such matches indicate
certain 1099s and/or W-2s have been omitted from a taxpayer’s return, a CP-2000 notice is issued to the
taxpayer requesting an explanation of the omission. If the taxpayer fails to fully respond to the notice, the IRS
will issue an adjustment notice.

Correspondence Audits

1.250 The Compliance Center computers are programmed to select those returns with high DIF scores which
reflect issues that could be easily resolved by mail. The computers select those returns which are appropriate for
correspondence 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 are
experienced in DIF screening operations. Returns which have apparent examination issues other than those
appropriate for correspondence audit are referred to the local Area Office. Some examples of the kinds of items
which can be verified by correspondence are itemized deductions, such as interest, taxes, contributions, medical
expenses, and simple miscellaneous deductions such as union dues and small tools [IRM 4143.2(1)(a)]. Issues
other than itemized deductions may be examined if they are single matters which would not be appropriate for
office 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 computer
generated notices with respect to various issues on a tax return. Once a reviewer has determined an issue for
examination, he will cause the computer to generate the appropriate notice for that issue. The IRS notice will
grant the taxpayer 30 das to respond to the notice. The Taxpayer may request that the audit be transferred to his
local 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 first
read section at the Compliance Center which attempts to determine the nature of his response. If his reply
requires a response by the Internal Revenue Service, the matter is referred to the Adjustments and
Correspondence Branch for preparation of a reply. The Internal Revenue Manual provides that taxpayer replies
should be processed within 30 days, but practitioners have found that in many instances the processing time far
exceeds 30 days [IRM 4(13)13.41]. If the section determines that the reply from the taxpayer has an adequate
explanation 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 Notice
of 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 Area
Office 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 an
effort to determine a new address. The IRS also may initiate requests to employers and the Post Office to
determine a forwarding address. If a new address is not obtained after pursuing steps to determine it, the Service
will 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 IRS
will issue a 30-day letter. If the taxpayer requests an interview or an appeals conference in response to the
30-day letter, the matter is transferred to the appropriate Area Office for necessary action. Compliance Center
personnel are instructed to attempt to avoid transferring matters to the Area Office [IRM 4(13)14.1(3)] If the
taxpayer 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, the
Service 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 many
occasions, clients have properly responded to IRS computerized notices only to have deficiencies improperly
assessed against them. If such an erroneous deficiency should occur, the taxpayer will receive a balance due
notice from the Internal Revenue Compliance Center. In that event, the practitioner should immediately
approach local Area Collection personnel and request that the audit be reopened. Collection personnel have
authority to reopen an audit if it is determined that the matter was not properly handled by the Compliance
Center. 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. Most
involve deductions taken on Schedule A and Schedule E. Of the 111,695 conducted by office audit in 2002, only
33,000 involved Schedule C taxpayers. The vast majority of audits conducted for taxpayers having total positive
income of less than $100,000 are conducted by Compliance Officers. Office audits are conducted in a very
summary fashion. Because of the poor training of Compliance Officers and the large volume of cases, results can
vary 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 to
have been incorrectly reported on other years. Audits of small businesses are normally conducted by a special
group 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 a
certain date. The letter will list a series of documents which the taxpayer must bring to the audit. When the letter
arrives for an office audit, you may request that a proposed audit date be changed to a date more convenient for
your schedule.

Initial Interview

1.330 The IRS considers the initial interview to be the most important part of the examination process [IRM MT
4231-72-230]. The taxpayer has the right to have a representative at the interview and the Service may not
require a taxpayer to accompany an authorized representative to an examination interview in the absence of an
administrative summons [IRC Sec. 7521(c)]. IRS personnel, however, normally request the taxpayer’s voluntary
presence at the interview with the representative. Only in rare instances should the taxpayer accompany the
representative to an interview. During the initial interview, the Tax Examiner will seek information to develop a
financial history and standard of living for the taxpayer. He will also seek information concerning the nature of
employment, exempt income, and look for the potential for moonlighting income. The responses to the questions
during 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 frequently
examined 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 are
designed 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 are
generally 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, the
Tax Auditor may expand the examination when significant issues become apparent as a result of information
secured during examination. In most cases, the Auditor must secure Group Manager approval prior to opening
new 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 might
literally accept an oral statement to support an expense. You can best represent you client by properly organizing
all of his/her records which support the deductions and expenses under audit by the IRS. Compliance Officers
are given a very limited amount of time to complete their examination. The more thorough and well organized
your client’s records, the better the chance that you can prevent or reduce deficiencies. Because there is a great
degree of discretion granted to an Auditor, you should attempt to develop a rapport with him at the outset. The
greater 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 Office
Auditor 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 entertainment
expenses, the IRS will review the record system, if any, of the taxpayer. The ideal would b a quality diary system
for each respective entertainment expense. If these records are not available, then some supporting
documentation must be supplied in order to preserve your client’s deduction for travel and entertainment
expenses. Receipts, affidavits, charge account records, and other supporting documents may preserve the
deduction.

Automobile Expenses

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

Contributions

1.390 Contribution deductions have always been a favorite target of the office audit. Compliance Officers will
seek to determine if payments were made to qualified organizations. They will also look at the nature of the
taxpayer’s documentation. Obviously, canceled checks are the best supporting documentation during such
audits, but are not always available. Acknowledgments from the donee organization are also appropriate. The
IRS has recently placed greater emphasis upon determining if the taxpayer receives something of value as a
result of the contribution. For example, the taxpayer may have paid $100 to attend a charity dinner. The value of
the 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 hear
stories regarding the alleged flood or fire which caused substantial losses. The taxpayer will be required to submit
police and/or fire reports to support the claimed deduction. The taxpayer also must establish the value of the lost
items. 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 if
expenses were primarily incurred for the purposes of maintaining or improving skills or meeting express
requirements or retention of status. When auditing educational expenses involving overseas travel, the Auditor
will review registration receipts and the transcript of students from the overseas educational institution. The
Auditor 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 the
deduction was taken in the proper year. The Service will also seek to determine whether the payments are for
interest or for some other item such as discounts. Special scrutiny will be given to loans from related individuals
to determine if in fact there is a valid debt. Compliance Officers will request the supporting documents
concerning 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 better
trained than Compliance Officers. Field Agents are responsible for auditing high income non-business and
business 1040 returns. Field Agents also conduct almost all of the audits of corporate tax returns. Normally, a
Revenue Agent will audit more than one year at a time. For example, if 1999 is being audited, 2000 and 2001
may also be brought into the audit. On business audits, a field audit puts particular emphasis on determining
whether all income was properly reported on the tax return. The Revenue Agent will review deposits to checking
and savings accounts for the years at issue. He will also look at the disbursements form those accounts. Revenue
Agents put more emphasis on the quality of records and methods of accounting than Tax Auditors. They will
consider all of the deposits to a bank account as income unless the taxpayer is able to show that the funds came
from bank transfers, loan proceeds, repayment of notes receivable, gifts and/or insurance proceeds. Revenue
Agents tend to shift the burden for establishing these matters to the taxpayer. They also will raise specific
accounting issues to be resolved during the audit. For example, you might be required to establish when assets
were 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 bookkeeping
system. It is not unusual for an Agent to reconcile those records in an effort to find discrepancies and flaws in
the system.

Unreported Income

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

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. Agents
were given extensive instructions on securing financial data prior to beginning the actual examination. As a
matter of standard practice, the Internal Revenue Service now checks motor vehicle information, real estate
databases and credit databases to secure more information regarding the taxpayer before an audit even begins. It
also looks at Bureau of Labor Statistics for the taxpayer’s zip code to determine normal living expenses and per
capita 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 the
T account method, the agent will attempt to reconstruct the taxpayer’s total expenditures in relations to known
sources of income. To the extent that the taxpayer’s expenditures exceed known sources of income the Internal
Revenue 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 individual
taxpayer’s income (such as found in life-style or financial status audits), the burden of proof is also on the IRS
with 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 to
determine the existence of unreported income unless there is a "reasonable indication" that there is a likelihood
of 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 authors
recommend that the taxpayer request that the audit be conducted at the practitioner’s office. By conducting the
audit at the practitioner’s office the Agent will not gain the extraneous information which becomes available to
him via observing the day-to-day operations of the client’s business. It might be somewhat inconvenient to
continually have your client deliver records to your office during the course of an audit, but this method is
preferable 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 what
you are doing and that you are fully organized. IRS Agents tend to be the harshest on persons who are
disorganized. When you appear at the audit, have your client’s records organized in a logical fashion and be able
to support those deductions that are at issue. If adequate records do not exist, have the alternative documents
which support the respective deductions and expenses. If there are unusual issues with respect to the case, be
prepared to discuss them in depth. It would be best to research complex issues in tax reporters prior to appearing
at the audit if you anticipate a particular issue will be raised by the Agent. Don’t volunteer information! It never
hurts to be chatty with the Revenue Agent but remember, if you discuss an issue which hadn’t come to the
Agent’s mind, it may become an issue. You should maintain a professional demeanor during the discussions with
Revenue Agents. Personalities play an important role during an audit. If the Agent doesn’t like you, you can bet
your client will receive harsh treatment. Given the power that Agents have, you must approach them in a polite
manner. Even is he is extremely officious, try to maintain a professional, polite manner. Shouting and power play
negotiations are ineffective in dealing with IRS Agents. If the Agent is totally unreasonable, be aware that you
have 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 extensively
utilizes its portable computers during an examination. The Agent has programs available to him for reconciling
bank statements and disbursements. Once an Agent has determined a tax deficiency, he may enter those
deficiencies 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. The
plan sets forth the issues which the Agent expects to audit and a time budget for conducting the audit. The IRS
requires this plan in an effort to promote an efficient audit process. The Agent will discuss the plan with his
manager and adjustments with respect to time allocations and emphasis of the audit will be made during the
conference. For the practitioner, it is important to realize that the Agent has a time budget for each audit. If the
audit becomes much more complex than originally expected, some Agents may let issues fall by the wayside. On
the other hand, if the Agent is able to develop a matter rapidly with respect to some issues and still has time
remaining 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 tax
returns of the corporate shareholders. The individual returns might be surveyed subsequent to that review, but in
many 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 being
taxed at both the corporate level and the individual level. Audits of other shareholders of closely held
corporations may also be opened as a result of an examination of one of its shareholders. In such an event, other
shareholders 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 has
developed procedures for coordination of the examination. Agents apprize each other of the progress of the
respective audits and/or open new issues when they arise on one of the respective returns. During the course of
the examination, Agents may also determine payments to family members which may not be for services
rendered. 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 an
examination. Some clients might also utilize bank accounts of friends and relatives to conceal unreported
income. 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 United
States. That program is known as the Coordinated Examination Program. Teams of the most experienced
examiners and specialists of the IRS conduct examinations of the 1,650 largest and most complex domestic and
foreign 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 issues
to review within the corporation. At one time, the IRS would assign Agents to one corporation for years and
years, but the Service now has a policy of periodically rotating Agents so that personal relationships are less
likely 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 with
the 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 coordination
expertise. 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 27
designated industries in the program. Once an industry is designated for a specialized program, a team of experts
from examination and chief counsel functions is established, and they become the focal point for providing legal
and 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 Segment
Specialization Program (MSSP). The IRS decided that it was in its best interests to create specialists in various
industries to conduct exams. In the past, agents would be assigned 15 or 20 cases in various industries. Such an
approach was not very effective because an agent was required to become familiar with the accounting methods
and procedures of each new industry. The Market Segment Specialization Program is designed to create
guidelines for audits in many industries.

Audit Guidelines

1.600 As part of the MSSP, the Internal Revenue Service has issued audit guidelines for each identified
industries. 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 be
surprised to find that those guidelines suggest that if an attorney pays costs on behalf of a client, it should not be
expensed 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 the
treatment 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 MSSP
guidelines. 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:

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

2. 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.

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

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

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

6. 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 and
efficiently conducted and resolved. This is also consistent with the premise of the IRS
reorganization--to cluster the agency along functional lines, such as overall compliance rather
than Collection and Examination in separate components.

Exam Reengineering

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

through mandatory discussions between the revenue agent and taxpayer
regarding the specific examination issues, required documentation, and a
mutually agreed upon date to complete the examination.

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

- ?Field agents will use standardized templates for every examination issue to
gather the information necessary to resolve issues. Agents will use a
standardized guide when deciding if additional issues need to be added to the
 examination. The agent will explain to the taxpayer if any additional issues are
included in the examination.

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

- ?Clearly communicated expectations of both the taxpayer and the examiner

prior to the initial appointment. Office examiners will provide the taxpayer with
focused document requests that specifically identify the information needed.

- ?Improved flexibility in the scheduling process will enable examiners and

taxpayers to reduce the time it takes to complete an examination.

- ?Office examiners will use standardized templates for every examination

issue to gather the information necessary to resolve issues. Examiners will use
a standardized guide when deciding if additional issues need to be added to
the examination. The examiner will explain to the taxpayer if any additional
issues 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 office
examiners during the 2004 fiscal year. Field agent training began in December 2003 and training for
the office examiners began in January 2004. The redesigned examination process will benefit
taxpayers and practitioners because the audits will be better focused on relevant issues, expectations
between the examiner and taxpayer will be clearly communicated, and the time it takes to complete
the 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 effective
new 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 and
developing approaches that are specifically tailored for the agency's customer base and employee
needs. Moreover, the Exam Reengineering Project isn't just about change; it's about making a
long-lasting, positive impact on the entire SB/SE organization. Commissioner Kehoe said, "We’re
going 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 opportunity
to contribute to the Exam Reengineering effort by providing input into process improvements as they
evolve. Commissioner Kehoe said, "Improving our business processes is a team effort, and by
sharing 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 our
customers. Together, we can rebuild the Exam Reengineering process, and when we’re done, we will
all 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/EO
referrals, Information Reports and Return Preparers. Detailed information is located in the
Compliance 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 Transaction
File data and certain Master File information for three years for all taxpayers who filed within a district
or service/customer service center area (IMF, 1120, 1120S, 1065 and 1041 only). MACS has stringent
operating restrictions to ensure the securing of the data and that taxpayer privacy is not
compromised. MACS may be used for information on specific taxpayers even if only a partial name or
address is known. This includes a return facsimile in either a one year or three year comparative
format and a Cash-T analysis. This information may be used for case building or return selection
decisions. A MACS facsimile may be used in lieu of the original tax return. MACS may be used to
identify potential noncompliance within a market segment, and to select a sample of returns to test
the 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, and
established procedures to foster compliance by identifying, investigating and prosecuting abusive
return preparers. The program was developed to enhance compliance in the return-preparer
community by engaging in enforcement actions and/or asserting appropriate civil penalties against
unscrupulous or incompetent return preparers. This is a significant problem for both the IRS and our
taxpayers. Abusive return preparers frequently prepare bad returns for large numbers of taxpayers
who, at best, are stuck with paying additional taxes and interest and at worse, depending on
culpability, 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 is
available from Regional FedState Program Managers, the National Office FedState Relations, and
the FedState web page. Using the template to guide initiative development enables a business case
proposal 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 exception
applies 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 of
non-compliance with the tax laws. The strategy represents a new direction for the agency's
compliance effort.

1.750 Following months of research and planning, the new approach will focus on high-risk areas of
non-compliance. The IRS effort will generally focus first on promoters and then on participants in
these 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 Projects
In Fiscal Year 2003, Which Will Be A Year Of Transition And Training As New Audit Cases Move Into
The IRS System.

1.760 The IRS Small Business/Self-Employed Division will handle the new effort in these key areas
affecting 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 reflects
part of a broader, agency-wide plan at the IRS. This strategy places a top priority on pursuing
promoters of abusive schemes, shelters and trusts and then identifying participants in these efforts to
evade taxes. To address these problems, the IRS has revamped its compliance programs to refocus
on problem areas. The IRS will use a full scope of tools and techniques ranging from summons
enforcement, 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 -- such
as the National Research Program and the credit card initiative -- reflect innovative approaches to
tackle long-standing tax problems. The new audit initiative will include similar emphasis for the
agency's collection area. And new levels of cooperation and coordination are underway on initiatives
that 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 will
direct more examination resources to address these issues. However, the IRS will maintain a
presence in other audit areas to maintain core tax administration responsibilities. Additional exam
resources 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 for
believing that some people are using offshore credit cards to evade paying U.S. taxes. Credit cards
provide easy access to offshore funds and accounts in tax haven countries that allow income to be
hidden. U.S. citizens must pay tax on their worldwide income.

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

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

2. On March 27, 2002, a federal judge in San Francisco issued an order authorizing the IRS to
serve a John Doe summons on VISA International seeking records on transactions for
1999-2001 using cards issued by banks in over 30 tax haven countries.

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

4. 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 summonses
on over 40 businesses to assist in the identification of credit card owners.

Mastercard

1.790 The first summons alone yielded data from MasterCard on 237,000 cards issued through 28
banks 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 of
Foreign Bank & Financial Accounts being filed in 2000 and only 117,000 individual 1040 filers
indicating 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 identify
the taxpayer associated with each card. Spending patterns, unusual expenses, proximity of spending
and 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 potential
criminal investigations. The IRS is increasing resources in Fiscal Years 2003-2004 devoted to working
these cases.

High-Risk, High-Income Taxpayers

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

K-1 Matching

1.820 While the IRS has begun to match K-1 forms from pass-through entities, the technique does
not provide any verification of income reported by the entity itself. Verifying the income on these
returns requires an examination. Starting in fiscal year 2003, the IRS will be utilizing a combination of
filters to identify high-risk, high-income returns. The returns selected for examination will be those
most 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 to
reduce or eliminate a tax liability. Structured transactions are generally done through one or more
pass-through returns, such as Forms 1065 or 1120-S. The pass-through returns create paper losses
that 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:

1. Schemes, reducing a person’s tax liability by claiming inflated expenses, false deductions,
 unallowable credits or excessive exemptions.

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

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

4. Abusive shelters and trusts, investments established for the purpose of hiding income from
taxation.

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

Abusive Scheme Groups are being established in each Area and the use of Fraud Specialists will
increase. To identify and address promoter activity, a Promoter Lead Development Center has been
created. The Center systematically monitors the Internet to identify promoters of abusive activities
and 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-risk
segments of the population.

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

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

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

3. Expanded and centralized automated enforcement.

4. Outreach and education efforts.

Unreported Income

1.860 Unreported income represents the largest component of the tax gap. IRS has developed a new
tool for identifying returns with a high probability of unreported income. The new tool is known as
Unreported Income Discriminant Index Formula (UI DIF). All individual returns have traditionally been
assigned a DIF score rating the probability of inaccurate information on the return. The new UI DIF
score rates the probability of income being omitted from the return. The IRS has customarily used
indirect examination methods to identify unreported income but until now has had no systemic
method for selecting the returns at highest risk for unreported income. UI DIF gives the IRS the ability
to systemically identify returns at high risk for unreported income and beginning this fall all returns
will 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 reporting
compliance and identify compliance issues. NRP will enable the IRS to improve the examination
selection process. NRP is very different from its predecessor, the Taxpayer Compliance Measurement
Program (TCMP). NRP no longer relies heavily on time-intensive, "line-by-line" audits for establishing
a baseline measure of reporting compliance.

The IRS has not conducted updated research on the distribution of errors on returns for more than
13 years, a period when the economy and the tax law have changed dramatically. Without the
information that will be gathered through NRP, the IRS will have less ability to direct examinations
and other compliance activities with accuracy and precision. With updated information, the NRP effort
will 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 year
2001, less than 47,000 returns out of 132 million individual returns filed. The new NRP process will
have four main categories:

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

2. 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 this
process.

3. Less intrusive audits. Instead of the old "line-by-line" examination approach, the IRS will gather
more information beforehand from agency records and focus only on selected parts of
approximately 30,000 returns.
 4. Calibration audits. These will consist of about 2,000 examinations that will check each line of
the return. But, in a major change from earlier programs, taxpayers will not be required to
provide line-by-line substantiation.

Abusive Trusts

1.890 It is estimated that $4.8 trillion in wealth will be inherited or transferred from one generation to
the next by 2015, with much of it transferred through a variety of trusts. Filings of trust returns (Form
1041) are now the third most frequently filed income tax return behind individual and corporate
returns. Although the vast majority of these transfers are legal, there is widespread potential for
fraud. In the last few years, the Internal Revenue Service has detected a proliferation of abusive trust
tax evasion schemes. These promotions are targeted towards wealthy individuals, small business
owners, 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 or
to disguise the substance of transactions. Although these schemes give the appearance of
separating responsibility and control from the benefits of ownership, as would be the case with
legitimate 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 of
the taxpayer (the taxpayer's business, equipment, home, automobile, etc.), as well as interests in
other 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 nonexistent
deductions 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, and

The 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 accounts
and 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 for
a variety of reasons, including:

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

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

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

4. Aggressive marketing of multi-level pyramid schemes.

Non-deductible Personal Expenses

1.950 Many taxpayers accurately report their income and expenses, while enjoying the benefits that a
home-based business can offer. However, there are individuals who have received advice that they
can 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 regardless
of 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 business
expenses:

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

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

3. Deducting education expenses for children without regard for Internal Revenue Code §127.

4. Deducting excessive car and truck expenses when the asset has been used for both business
and personal use.
 5. Deducting personal furniture, home entertainment equipment, children’s toys, etc.

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

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

Tax Protestor Arguments

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

Courts Reject

1.980 Despite the courts having consistently rejected these arguments, their promoters continue to
expound them, even incurring penalties for bringing frivolous cases into court or for filing frivolous tax
returns. They often present their arguments in a pseudo-legal format, luring unsuspecting people
into 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 or
more employees from discriminating against a qualified individual with a disability. To implement this
prohibition, the ADA also requires that employers provide reasonable accommodations to the known
physical or mental limitations of a qualified individual with a disability, unless to do so would impose
an undue hardship on the operation of an employer's business. In order to comply with this
requirement (and other requirements imposed by the ADA, e.g. those of Title III), an employer may
have 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 to
enhance 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 up
many of its existing compliance programs and "leverage new workload
selection systems and case building from on-going reengineering efforts." The
rationale is in a new IRS acronym: ABLE (achieving balanced levels of
enforcement). ABLE would provide $55.5 million and 887 additional staff
members in 2004. Areas receiving additional attention include organized tax
resistance, abusive trusts and shelters (including offshore credit cards),
special purpose entities, and employment tax schemes. The abusive trusts
and shelters and special purpose entities effort would primarily affect
high-income individuals who use structured transactions and flow-through
entities (for example, partnerships) to conceal tax liability and avoid payment of
taxes. 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 expects
to close 20,999 examinations on flow-through returns in fiscal 2004. This is a
110 percent increase over expected fiscal 2003 levels, according to the IRS.
Also, the IRS expects to close 78,244 individual examinations on returns with
income in excess of $100,000. This represents a 33 percent increase — or
more than 19,600 more return closures — over expected fiscal 2003 levels.

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

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, it
estimates that this will allow for the closure of 16,000 more cases in 2004 that
should result in an additional $22 million in revenue.

Fourth, W&I would devote an extra $2.2 million and 51 staff members to
automated underreporter (AUR) cases. The IRS contends that it can work only
30 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 result
in roughly $98 million in additional assessments.

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

K-1 Matching

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

Copyright 2005

07/16/2009