4.1.5  Classification and Case Building

Manual Transmittal

August 24, 2012

Purpose

(1) This transmits revised IRM 4.1.5, Planning and Special Programs, Classification and Case Building.

Material Changes

(1) The following changes were made:

Reference Description
All Minor editorial changes have been made throughout this IRM. Also, website addresses, form references, and IRM references were reviewed and updated as necessary.
IRM 4.1.5.1.1 Changed title from "Classification at the Campus" to "Classification." Added information on online classification. Paragraphs 7 and 8 were moved from IRM 4.1.5.1.3. Changed "National Office Examination Classification Guidelines" to "National Office TCO Classification Guidelines" .
IRM 4.1.5.1.2 Updated where Discriminant Function (DIF) scores can be found.
IRM 4.1.5.1.3 Added "at the Campus" to the title. Updated and moved the Complexity of Returns Table to paragraph 8 of IRM 4.1.5.1.1.
IRM 4.1.5.1.5 Added a paragraph on national and centralized classification reviews.
IRM 4.1.5.1.5.1 Added issues should be limited to no more than 3 in paragraph 7
IRM 4.1.5.1.5.2 Added online classification. Incorporated IG SBSE-04-0112-004, Quality Reviews for Classification of DIF Returns,
IRM 4.1.5.1.6 Added Campus to the title. Deleted section on MACS Classification.
IRM 4.1.5.1.7 Added new section for electronic classification.
IRM 4.1.5.1.9.2 Clarified instructions for completion of Form 6754, Examination Classification Checksheet.
IRM 4.1.5.1.9.4 Updated activity codes.
IRM 4.1.5.1.11.1.6 Added reminder on high housing cost areas.
IRM 4.1.5.1.11.1.12 Added paragraph 6.
IRM 4.1.5.1.11.1.13 Added question for farmers.
IRM 4.1.5.1.13.2 Inserted a new section "Potentially Productive Issues on a Corporate Return."
IRM 4.1.5.1.18 Added link to Excise Tax IRM.
IRM 4.1.5.1.19 Added link to Employment Tax IRM.
IRM 4.1.5.1.20.1 Added where collectibility indicators can be found on CDE returns.
IRM 4.1.5.2 Clarified case building information.
IRM 4.1.5.2.2 Added other reasons to compare IDRS.
IRM 4.1.5.2.5 Updated information on when to use red case folders and added additional folder colors.
Exhibit 4.1.5-1 Updated Form 5546, Examination Charge Out.

Effect on Other Documents

IRM 4.1.5, dated 10/24/2006 is superseded. Interim Guidance memoranda, IG-SBSE-04-0112-004, Quality Reviews for Classification of DIF Returns, is incorporated into IRM 4.1.5.1.5.2, Review of Performance.

Audience

Planning and Special Programs (PSP)

Effective Date

(08-24-2012)

Karen Schiller
Director, Examination Planning & Delivery
Small Business/Self-Employed

4.1.5.1  (08-24-2012)
Overview

  1. This chapter deals with classification of returns and case building for classification.

  2. Classification is the process of determining whether a return should be selected for examination, what issues should be examined, and how the examination should be conducted.

  3. Case building is the process of assembling available taxpayer specific research to identify possible compliance issues.

4.1.5.1.1  (08-24-2012)
Classification

  1. Classification should be conducted by an experienced examiner who has received appropriate tax law training. Examiners with specialized expertise may be used to classify business returns. Martinsburg Computing Center (MCC) DIF (Discriminant Function) ordered returns should be classified at the Campus. Classification using online systems (such as CDE and Mod E-file) will be done at remote locations via approved procedures. See IRM 4.103.2CDE Procedures.

  2. Tax returns are to be selected and classified for examination by employees who will not be the examiner of the return.

  3. DIF returns are scored and selected for examination by computer and delivered for screening by examiners.

  4. Non-DIF returns will be manually classified to select returns that contain significant issues likely to result in tax changes or that require examination to achieve voluntary compliance by an identifiable group of taxpayers.

  5. All returns will be identified for assignment to a revenue agent (RA) or a tax compliance officer (TCO). The designation as RA or TCO will be based upon the complexity of the issues involved and the degree of accounting and auditing skills required to conduct a quality examination.

  6. Returns should be classified by examiners possessing experience commensurate with the type of return and activity code they are classifying.

  7. Individual returns selected for examination by revenue agents should contain issues requiring accounting skills of a revenue agent. Individual returns not requiring the accounting skills of a revenue agent may be selected for examination by revenue agents if tax compliance officers (TCOs) (including traveling TCOs) are not available in the geographic location of the taxpayer or if the returns are needed for training.

  8. Classifiers will determine whether individual returns will be examined by a RA or TCO. Guidelines are provided below to determine the type and scope of examinations for individual returns.

  9. The following table can be used as a guideline for judging the complexity of the returns. These guidelines should be considered only as recommendations. The designation of selected cases as "Office" or "Field" is ultimately a judgment call to be made by the classifier.

    ISSUE OFFICE OFFICE TCO GS-11 FIELD
    All 1120, 1120S 1120F, 1041, 1065, or other BMF returns     X
    Forms 1120 that meet the following criteria:
    • Form 1120

    • Assets < $250K

    • No balance sheet issues

    • No priority issues

    • No Acquisitions, mergers, reorganization

    • No Recapitalizations, liquidations

    • No Stock redemptions

    • No IRC 351 Stock transfers

    • No Final Returns

    Issues to be considered:
    • Bad Debt Deduction

    • Other Deductions – potential personal expenses

    • Form 4797 – potential related party losses

      X  
    Returns with Schedule C/F Gross Receipts and/or Cost of Goods Sold >$200,000 and < $750,000 if the return has multiple Schedule C/Fs (when gross receipts are a classified issue) and the source of the return is DIF or High Income Non-filer (HINF)   X X
    Returns with Schedule C/F Gross Receipts and/or Cost of Goods Sold <$200,000 if the return has multiple Schedule C/Fs (when gross receipts are a classified issue) X    
    Significant business activity at a place other than the taxpayer’s residence, especially if there are employees     X
    Schedule C/F returns with unusual accounting methods, complex issues and/or need for a significant amount of accounting/auditing skills     X
    Returns with substantial and/or questionable losses from S-Corps or Partnerships (TCO Grade 11 if other return criteria is met)     X
    Returns with significant income or losses from related entities     X
    Returns with simple Schedule C, E, or F, but substantial expenses/losses from interest or depreciation and little or no income in the following activities:
    • Equipment Leasing

    • Real Estate

    • Research and Development

    • Coal/Minerals

    • Farming/Cattle

        X
    Issues requiring on-site inspection of records or assets (e.g., substantial casualty losses, embezzlement losses, etc.)     X
    Individuals receiving wages from closely held C corporations and claiming employee business expenses/Schedule C expenses   X X
    Activity codes should be selected to closely fit the audit plan. Gross receipts as a classified issued is < $200K X    
    Activity codes should be selected to closely fit the audit plan. Gross receipts as a classified issue is between $200K and $750K   X  
    Schedule C/F with only non-gross receipts issues classified and total gross receipts are < $500K X    
    Charitable Deductions that include Artwork as part or all of the Schedule A deduction     X

  10. For effective use of our resources, the classifier must decide which returns are most in need of examination, and through examination, will promote the highest degree of voluntary compliance.

  11. Classifiers should:

    1. Be alert to items that would result in potential over-assessments as well as items that would result in potential deficiencies.

    2. Bring to the attention of the manager any return where the classifier’s relationship with the taxpayer may create a potential conflict of interest.

    3. Bring to the attention of the manager any return where the type, industry, or potential issue is unfamiliar to the classifier.

    4. Be alert to fraudulent refund schemes.

    5. Be alert to potential preparer project returns.

  12. National Office TCO Classification Guidelines provide guidance to enable greater classification consistency nationwide and to select returns for examination with issues that are material in scope. The classification guidelines can be found at: http://mysbse.web.irs.gov/exam/tip/classification/default.aspx

  13. All returns received for classification will be reviewed for international issues. Refer to IRM 4.1.9, International Features. If international issues are present, the return should be referred to an international examiner. See IRM 4.60.5–1, Memorandum of Understanding Between LMSB and SB/SE, and IRM 4.60.5–2, Memorandum of Understanding between LB&I and SB/SE (cont.).

  14. The following reference material should be available for classifiers, along with this IRM:

    1. Document 6209, IRS Processing Codes and Information

    2. Document 6036, Examination Division Reporting System Codes Booklet

    3. Uniform Issues Code List (http://core.publish.no.irs.gov/pubs/pdf/72558k98.pdf)

    4. Area Classification Instructions

    5. National Office Examination Classification Guidelines

4.1.5.1.2  (08-24-2012)
Discriminant Function (DIF) System

  1. Many returns, both IMF and BMF, that are examined each year are above the DIF cutoff score. Therefore, a significant portion of the classifiers’ work will be to screen DIF returns.

  2. For each examination class, different items on the return are scored. The score for an individual item is based on National Research Program (NRP) correlation analyses. The total DIF score for a return is the sum of the scores of the individual items. The higher the DIF score, the greater the audit potential. DIF returns with the highest scores are made available to Examination for manual screening. However, scores for returns of different examination classes are not comparable. DIF scores are shown on Form 5546, Examination Return Charge-Out Sheet, page 1 of the AMDISA, or on the Taxpayer Information Sheet on a Compliance Data Environment (CDE) facsimile Print.

4.1.5.1.3  (08-24-2012)
Sorting of Classified Returns at the Campus

  1. It is important for the Area Planning and Special Programs (PSP) staff to have frequent discussions with the Centralized Files and Scheduling (CF and S) management to keep abreast of the return orders and issues dealing with the Area's inventory.

  2. Prior to the classification detail, CF and S will sort the returns for the Area to be classified by the oldest returns in Status 06 first.

  3. PSP must classify the oldest returns in Status 06 first in order to minimize the amount of inventory CF and S holds in storage at the Campus awaiting classification.

  4. During the course of classification, returns should be sorted as follows:

    1. Selected returns for field examination.

    2. Selected returns for office examination.

    3. Returns accepted as filed. Returns not selected for examination will be appropriately stamped.

    4. Returns that are unusual in nature, such as returns where the examination return charge-out documents are missing or do not match the return or returns where the examination return charge-out contains special messages such as "Information Report Available" (if not in the case file).

    5. Returns to be transferred.

    6. Special program returns - ATTI (Abusive Transactions and Technical Issues), International Issues, etc.

    7. Other returns as provided by Area instructions.

4.1.5.1.4  (10-24-2006)
Area Classification Instructions

  1. Each Area should prepare Area specific classification instructions covering the following topics:

    1. Local issues

    2. Questionable practitioners

    3. Criteria for determining whether individual returns should be examined by tax compliance officers or revenue agents

    4. Training return guidelines

4.1.5.1.5  (08-24-2012)
Review of Classification

  1. PSP Territory Manager has primary responsibility for assuring the quality of returns selected for examination whether classification is done at the Campus or electronically. This is accomplished by assuring all classifiers have received appropriate training on tax law and Area classification instructions. During each classification detail the PSP Territory Manager or designee, should review a representative sample of selected and accepted returns for each classifier and provide appropriate feedback to the classifier and PSP Classification Section Chief. See IRM 4.1.5.1.5.2, Review of Performance.

  2. For national or centralized classification details, the Headquarters representative is responsible for assuring the quality of returns selected for examination. Form 5126, Classification Quality Review Record, may be used to provide feedback. During each classification detail the Headquarters representative should review a representative sample of selected and accepted returns for each classifier and provide appropriate feedback.

4.1.5.1.5.1  (08-24-2012)
Standards for Classification

  1. DIF returns are selected for screening by computer. Each selected DIF return will be screened by an experienced examiner to eliminate those returns not worthy of examination.

  2. All returns will be manually classified by experienced examiners to select returns that contain significant issues.

  3. Classifiers must use their skills, technical expertise, local knowledge, and experience to identify hidden, as well as obvious, issues. The classifier will determine whether the return should be examined, and if so, whether by a tax compliance officer, or revenue agent. Those returns not selected for examination will be accepted as filed.

  4. Regardless of the type or class of return, the classifier should first review the return in its entirety. This action is important in that it:

    1. Quickly gives a complete overview of the total return to allow consideration of the various income, expense, and credit items on the return.

    2. Enables the classifier to evaluate each item as to its significance.

    3. Provides an opportunity to quickly eliminate from consideration items or areas of the return with low examination potential.

  5. Where feasible, returns should be classified by revenue agents with subject matter expertise.

    Example:

    Revenue agents in flow thru group classifying partnership and sub S returns.

  6. All returns will be identified for assignment to a revenue agent or tax compliance officer based on the complexity of the issues involved and the degree of accounting and auditing skills required to conduct a quality examination.

  7. During the classification process, the scope of the examination will be determined for all office examination returns. The number of issues should be limited to no more than three or four.

  8. Financial status must be considered on all returns. SB/SE taxpayers are responsible for two thirds of the tax gap and two thirds of that amount is attributable to unreported income. The classifier must consider this if it appears the taxpayer has insufficient income for the lifestyle indicated on the return. Consider family size and personal living expenses in relationship to the income stated on the return.

  9. Under RRA ’98, the likelihood of unreported income must be established before an indirect method can be used.

4.1.5.1.5.1.1  (10-24-2006)
Materiality-Significance of the Issue

  1. Classifiers should compare the potential benefits to be derived from examining a return to the resources required to perform the examination. Although you may identify some potentially good issues on the return, if they would not yield a significant adjustment, the return should be accepted as filed.

  2. There are several factors that must be considered when determining whether an item is significant:

    1. Comparative size of the item: A questionable expense item of $6,000 with total expenses of $30,000 would be significant; however, if total expenses are $300,000, ordinarily the item would not be significant.

    2. Inherent character of the item: Although the amount of an item may be insignificant, the nature of the item may be significant; e.g., airplane expenses claimed on a plumber’s Schedule C.

    3. Evidence of intent to mislead: This may include missing, misleading, or incomplete schedules, or incorrectly showing an item on the return.

    4. Beneficial effect of the manner in which an item is reported: Expenses claimed on a business schedule rather than claimed as an itemized deduction may be significant.

    5. Relationship to other item(s) on a return: Business expenses without corresponding income. Similarly, the lack of dividends reported when Schedule D shows sales of stocks.

    6. Permanency of the potential adjustment (a permanent adjustment is more material than one that will reverse itself in subsequent years.)

    7. Timing adjustments (the longer the deferral/acceleration period, the more material the item.)

4.1.5.1.5.1.2  (08-24-2012)
Fraud Potential Consideration During Classification

  1. Classifiers should be alert if it appears there are indications of fraud on the returns being classified:

    1. Refund schemes and abusive transactions.

    2. Typed or handwritten W–2 Forms showing a large business corporation or government agency could indicate a potential fraudulent refund scheme. Large corporations or government agencies normally would use computer generated W–2 Forms.

    3. Three-year comparison of return could show significant changes.

    4. Altered Forms W-2 and 1099 could indicate a potential fraudulent refund scheme.

  2. See IRM 25.1.2, Recognizing and Developing Fraud, for a list of fraud indicators.

4.1.5.1.5.2  (08-24-2012)
Review of Performance

  1. A manager (see paragraph 4 below) or Headquarter's representative will conduct reviews of each classifier. Reviews should be performed for each detail to which an examiner is assigned and on a regular basis for permanent classifiers. A 10% sample of the classifier's returns is the recommended number of returns to be reviewed, and can be expanded or contracted as needed. The sample should include a balanced review of the return types being classified. (A reason to contract the sample: all returns have the same issue.) Through these reviews the manager or Headquarter's representative will ascertain if:

    1. Returns are selected for examination or accepted as filed by classification in accordance with established procedures.

    2. Accepted returns have little or no examination potential or if examined would probably result in no change cases.

    3. Classification check sheets are properly completed and should not be limited to single issues for tax compliance officer returns because of the high no-change rate associated with single issue examinations.

    4. Returns are properly selected for office versus field examination.

    5. The potential tax change is sufficient to warrant selection, especially on returns with a negative taxable income.

    6. Classifiers are maintaining a high level of technical proficiency, exercising good judgment in accepting and selecting returns, and effectively utilizing their time.

    7. Classifiers need additional training for screening DIF returns or manual classification of other returns.

  2. Classification reviews will be documented and discussed with the classifier prior to the end of the detail. Form 5126, Classification Quality Review Record, is provided for this purpose and will be retained for two years by the PSP Territory Manager or Headquarter's Analyst. A copy of Form 5126 will be forwarded to the classifiers’ group manager.

  3. A concurrent documented review of returns "selected for examination by classification" and returns "accepted as filed by classification" will be used during the review of the classifier to determine if there is:

    1. A need for changes in instructions to classifiers.

    2. Reasons for variations in select rates among different classes of returns.

  4. For area classification details if the reviewing manager is other than the PSP Territory Manager or Chief, Classification Section, the PSP Territory Manager will be responsible for orientation of the manager regarding classification objectives, instructions to classifiers, quality review procedures, and the documentation to be maintained. The PSP Territory Manager will retain overall responsibility for the quality of the returns selected which includes the work performed by other managers. In order to ensure the desired quality of selections, the PSP Territory Manager must maintain open communication with the Chief, Classification Section.

  5. For Headquarters centralized classification details, the Headquarters Analyst responsible for the classification detail will be responsible for the classification objectives, instructions to classifiers, quality review procedures, and the documentation to be maintained.

  6. These procedures are applicable to examiners who classify returns in the Area office and at the Campus.

    Note:

    Quality review of classification should take place regardless of whether classification is done at the Campus, the Area office, or online.

4.1.5.1.6  (08-24-2012)
Campus Classification Details

  1. The PSP Territory Manager will consult with the Classification Department Manager or the Compliance Operations Manager to determine the volume of returns for classification and the average number of returns classified per staff day. In addition, the PSP staff will determine the number of classifiers needed taking into consideration:

    • Availability and experience level of classifiers

    • Availability of reviewers

    • Effectiveness of classifiers on extended details

    • Impact of shifting examiners from front-line duties to classification

    • Space available for classification

    • Travel costs, including weekends in travel status

4.1.5.1.7  (08-24-2012)
Electronic Classification

  1. The following guidelines apply when returns are classified using an electronic source (e.g. Mod E-File or CDE):

    1. In order to classify returns, access to the Employee User Portal and an Online 5081 must be approved before screening returns.

    2. When determining whether a return should be selected for audit, the classifier should consider the return as a whole, not just the criteria which caused it to be identified.

    3. When practical, the classifier should review the three-year comparison to identify trends on the return and to determine if issues are present on multiple years.

    4. Additional data, if available, should be considered in the electronic classification process.

    5. Check sheets, whether manual or electronic, are to be completed for each classified electronic return.

    6. A facsimile of the return should be used in place of an original return, and the taxpayer may be requested to provide a copy of the return at the beginning of the examination.

    7. Review of electronic classified returns should follow the guidelines in IRM 4.1.5.1.5, Review of Classification.

4.1.5.1.8  (08-24-2012)
Form 5546, Examination Return Charge-Out Sheet or Taxpayer Information Sheet

  1. Before classifying a return, Form 5546, Examination Return Charge-Out Sheet, or the Taxpayer Information Sheet on a CDE facsimile return should be reviewed for information if available.

  2. The following items on Form 5546 (see Exhibit 4.1.5-1) or the CDE Taxpayer Information Sheet (also known as Taxpayer Identifying Information page) relevant to the classifier are:

    1. Year, Form Number, Form Type, TPI Examination Class, and DIF Score are self-explanatory.

    2. Special Messages e.g., Modernized E-File return, employee return, collectibility indicators.

    3. Previous Examination Results — This item will show the results of the two most recent returns closed by Examination, including disposal code and amount of tax change. This information, along with information from the No-Change Issue Codes (only found on the Form 5546), can affect the classifier’s decision to select or accept the return under consideration.

    4. No-Change Issue Codes — These codes identify issues which resulted in no-change to the taxable income for any year reflected under the Previous Year Examination Results. The No-Change Issue Codes should be checked to determine the issue(s) previously no-changed. If the last examination of the taxpayer occurred in one of the two preceding tax years and the examination resulted in no-change (Disposal Code 01 or 02), the return will be selected for examination only if issues, other than those previously no-changed, are present on the return. The examination return charge-out sheet will also reflect issues previously examined and no-changed, even though the examination resulted in change or change/no-change. The IMF no change codes can be found at http://mysbse.web.irs.gov/exam/tip/CloseaCase/Examined/general/12187.aspx or the Uniform Issue Code list can be found at http://core.publish.no.irs.gov/pubs/pdf/72558k98.pdf.

    5. Collectibility Indicators — See IRM 4.1.5.1.20, Returns With Collectibility Indicators.

  3. The following exhibits can be found in IRM 4.4.1, AIMS Processing:

    • Activity (Abstract) Codes

    • DIF Reason Codes

    • Disposal Codes

    • Employee Group Code Charts

    • Form Number, Master File and Non-Master File Tax Codes Valid on AIMS

    • Push Codes

    • Reference Guide

    • Source Codes

    • Sort Codes

    • Special Messages on Form 5546, Examination Return Charge Out

    • Status Codes

    • Taxpayer Identification Number

4.1.5.1.9  (08-24-2012)
Classification Checksheets

  1. The following checksheets have been developed to assist examiners in performing their duties. A classification checksheet should be prepared for each return classified.

    Type of Return Form
    1040 Individual Form 6754, Examination Classification Checksheet
    1041 Fiduciary Form 6255, Fiduciary Classification Checksheet
    1065 Partnerships Form 6250, Partnership Classification Checksheet
    1120 Corporate DIF or Non-DIF Form 6241, Non-DIF Corporate Classification Checksheet
    1120S Corporation Form 6256, S Corporation Classification Checksheet
    Strategy or Non-DIF (All Returns) Form 10264, Revenue Agent - Classification Checksheet

  2. Classifiers must provide their Standard Employee Identifier (SEID) on each checksheet to ensure the person who classified the return is not the examiner of the return.

  3. The checksheet will be included with the return or facsimile.

  4. Classifiers should provide comments to assist the examiner regarding the items questioned. This information should be provided in the Remarks section.

4.1.5.1.9.1  (08-24-2012)
Instructions for Preparation of Form 6754, Examination Classification Checksheet

  1. It is important to note the Form 6754, Examination Classification Checksheet (checksheet), is designed for both non-business and business issues and allows for write-in issues (issue numbers 33–35).

  2. Since the taxpayer will be requested to bring in certain records to the initial appointment based on the items that are classified, it is important the classification of each return be accurately completed.

  3. Classifiers are to use a red pen on the manual checksheet. All blocks should be marked with an "X" and not check marked, to reduce the possibility of marking through more than one box.

4.1.5.1.9.2  (08-24-2012)
Special Instructions (All Returns) for Form 6754

  1. Form 6754, Examination Classification Checksheet, is composed of three sections:

    • Non-business issues, other taxes and tax credits (left side)

    • Schedule C, E, or F issues (right side)

    • Write-in issues (bottom)

  2. Classifiers will complete the following blocks for each selected return:

    1. Block A — Taxpayer Name and SSN — If available, affix an "Examination" label with POD, Check Digit (2 Alpha Characters), DIF Score, DLN.

    2. Block B — Type of Examination — Returns will be identified as either Correspondence, Pre-contact Analysis or Field Examination. All office examination returns will be identified as pre-contact per Examination Re-engineering.

    3. Block C — Special Inventory — One of the items may be marked, if they apply. The items are listed in the table below:

      BOX # TITLE USE
      Box 5 Extended Time Slot For returns with issues requiring additional interview time. The major determination for this level is judgment. Once the return is classified, decide if the examination can be completed in two hours. (This will assist the manager when assigning cases.) These are generally returns with Gross Receipts classified or more complex issues.
      Box 6,7, or 8 Trainee Level Generally training returns are not classified during details, however, if it is warranted PSP will provide the guidelines to determine the appropriate training level.
      Box 9 GS-11 TCO/Local Option This option will be used to designate Grade 11 work. By checking this box for GS-11 work, the Area will be able to order GS-11 returns using the command CSORD.

    4. Block D — Priority Number 4 is the only number currently in use. It is used for an IRMF Blue Tab case. Issue Number 08 (Income W–2/1099) and/or 09 (Other Income) should also be marked. This designation is used when the Information Returns Master File/Information Returns Program (IRMF/IRP) issue requires an interview to resolve the IRMF/IRP discrepancy and meets specified criteria.

    5. Block E, F and G — These blocks are not completed by the Area classifiers.

  3. Block H — Issue Numbers generally appear in the same order on the tax return, Form 1040, U.S. Individual Income Tax Return. Below is additional information for completing issue numbers:

    1. Number 10, IRMF — Blue Tab Criteria, is to be used when there is an IRMF issue that meets specified criteria.

    2. Numbers 50 through 82 are for business issues. There are three columns available for each issue. Use Column C–01 if the issue appears on Schedule C, Column E–02 if the issue appears on Schedule E, and Column F–03 if the issue appears on Schedule F. You may use same issue for more than one schedule.

    3. Numbers 33–35 are to be used for issues that do not fit any of the preprinted categories on the checksheet. Forty five spaces are available to write in the issue. If the Centralized Files and Scheduling (CF and S) appointment letter program or a similar program is used, the computer will print on the appointment letter exactly what is shown on the checksheet, so care should be taken to avoid abbreviations. Also, the write-in should not duplicate or overlap other items identified on the checksheet. Whenever possible, the language used on the tax return should be used for the write-in. The use of general phrases should be avoided.

  4. The Remarks section should be used for any comments, explanations, or observations the classifier would like to provide to the examiner. The information is not transmitted to the taxpayer so this section should not be used to classify an issue. Do not enter any information that would be inappropriate for disclosure to the taxpayer.

    1. This may include comments about the Schedule C, E, or F.

    2. Examples are: "Income does not appear to support standard of living" , "Schedule C appears to be invalid" , "Possible personal expenses being deducted" , "questionable preparer" .

  5. Block I — Classifier's Standard Employee Identifier (SEID), initials, or classification stamp number.

  6. Block J — Enter the date.

  7. Block K — Classification Reviewer's SEID will be shown on all classified returns that are reviewed.

  8. Block L — Date Reviewed.

4.1.5.1.9.3  (08-24-2012)
Special Instructions—Non-Business Returns

  1. In non-business TPI codes it is possible to have business schedules where the Schedule C or F is not the primary source of income.

  2. By checking "specific" issues, the taxpayer’s appointment letter will contain only the information requested to examine that particular item, e.g., other dependents, interest expense, automobile expenses, stock sales, etc. The result is we will not burden the taxpayer with bringing records to the examination that are not being questioned or to substantiate items which may not have even been claimed on the return.

  3. Phrases such as "other expenses" should not be used since this will cause the taxpayer to bring in substantiation for all such expenses. Rather, a specific phrase should be used such as "software expenses under the other expense category." This will also assist the tax compliance officer examining the return.

  4. For Office Examination returns, you should select only those issues that warrant examination. Limit the number of issues to the "vital few" , only 3 or 4.

    1. Do not select more issues than appear questionable; the examiner may expand the scope, if necessary, beyond the initial classification.

    2. If more than 4 issues appear questionable, approval from the classification manager is required prior to the final classification of the return.

    3. The manager will provide their Standard Employee Identifier (SEID) in Block K of Form 6754, Examination Classification Checksheet.

4.1.5.1.9.4  (08-24-2012)
Special Instructions — Business Returns

  1. Business returns are designated by the following Total Positive Income (TPI) activity codes, based on the total gross receipts (TGR) contained on the return: Schedule C, Activity Codes 274, 275, 276, 277 and 280; Schedule F, Activity Code 278 and 280.

  2. If all books and records are needed, or if gross receipts is a classified item, Issue Number 50, Gross Receipts Schedule C or F Issues, should be marked with an "X."

  3. The classification of gross receipts should not be automatic. Gross receipts should not be classified on those returns where the potential for unreported income is not substantial.

  4. If you classify gross receipts, remember to classify cost of goods sold if there is a deduction on the return. Gross receipts do not need to be classified if cost of goods sold is an issue, unless it is warranted.

  5. The classification of gross receipts for Grade 9 TCO should primarily focus on Schedule C where the primary income of the taxpayer(s) is not generated from the Schedule C or, Schedule Cs where there would be few transactions resulting in a small number of documents to verify the gross receipts. These should generally be able to be obtained from third parties. For example, the receipt of Form 1099-MISC, Miscellaneous Income, by truckers or insurance sales.

  6. The classification of gross receipts for more complex businesses with gross receipts between $200,000 and $750,000 should generally be assigned to Grade 11 TCOs.

  7. Make sure you are aware of the taxable income on the return. Judgment must be used to determine if a net operating loss (NOL) carry back or carry forward should be examined. There are instances where the current year NOL as well as the NOL carry forward is not accurate and therefore should be selected as an issue. If the loss cannot be substantiated, it can be disallowed.

4.1.5.1.10  (08-24-2012)
Information Returns Program

  1. The information returns master file (IRMF) transcript is a listing of the information returns processed for the taxpayer. The IRMF transcript summary is a summation by various payment groups of the information returns printed on the IRMF transcript.

  2. IRM 2.3.35, IDRS Terminal Responses, Command Code IRPTR, contains the format of the IRMF transcript with an explanation of the items shown on the transcript.

  3. IRMF transcripts are generated on Campus DIF IMF returns ordered after Cycle 19.

4.1.5.1.10.1  (08-24-2012)
Classifying Returns With IRMF Transcripts by Tax Compliance Officers and Revenue Agents

  1. As part of the regular classification of a DIF scored individual return, the classifier will review the IRMF transcript to identify discrepancies between the return and the IRMF transcript.

  2. The tax effect of carrybacks and carryforwards of losses and/or credits should be considered when applying the criteria in IRM 4.19.11.1.3.1, Non-Business Issue Conducive to Correspondence Examination.

  3. If the return meets the criteria of repetitive examination procedures according to IRM 4.10.2.4.2, Repetitive Audit, and there is a discrepancy as outlined above, the return will be selected for examination of the IRMF issue only.

4.1.5.1.10.2  (08-24-2012)
IMF CTR Screening/Matching

  1. The IRMF transcripts also contain currency transaction report (CTR) data. IRM 2.3.35, IDRS Terminal Responses, Command Code IRPTR, gives an explanation of the CTR data contained on the IRMF transcript.

  2. The information contained on the IRMF transcript relating to CTRs should assist the classifier in making decisions on the need to recommend the use of special auditing techniques, or to question source of income not subject to withholding tax.

  3. The CTR screening/matching program does not replace the normal IRMF screening procedures.

4.1.5.1.10.3  (10-24-2006)
BMF CTR Screening/Matching

  1. BMF CTR transcripts will be generated for Forms 1041, 1065, and 1120 if there is CTR activity.

  2. IRM 2.3.35IDRS Terminal Responses, Command Code IRPTR, contains the format of the transcript and an explanation for the items contained on it.

  3. Revenue agents will classify the BMF CTR transcripts and related returns.

4.1.5.1.11  (08-24-2012)
Identifying Issues on Individual Returns

  1. Returns containing office examination type issues will be selected and assigned to tax compliance officers without regard to distributive type of income or loss shown on the return from partnerships (Form 1065), small business corporations (Form 1120S), and fiduciaries (Form 1041). Examination by tax compliance officers may include a comparison of the individual taxpayer’s retained copy of a K–1 with the amount of the distributive income or loss shown on the 1040. If the information provided on the tax return indicates the partnership EIN was "applied for" or is left blank, the K–1 should be inspected, but only if there are other issues on the individual return that warrant examination. If the K–1 should be inspected, the distributor’s name and year of the K–1 to be submitted should be listed on the classification checksheet.

  2. The goal of the classification guidelines is to achieve greater efficiency in the way we classify and conduct examinations. Please be specific in the selection of issues. Do not select "all" expenses or "other" expenses – BE SPECIFIC.

  3. Questionable business schedules will be identified during the classification process. As noted in IRM 4.1.5.1.9.3 above, we have designed a process requiring managerial concurrence to allow for selection of "all expenses" on these returns when this is appropriate.

  4. When a Schedule C, E, or F does not appear to be a legitimate business (bogus) or you have a questionable preparer known to inflate expenses, understate income, or include fictitious schedules; classify the appropriate income or appropriate expenses and notate in the "Remarks" section either "Is this a legitimate business?" or "QP." Managerial or reviewer concurrence must be obtained. The manager/reviewer will provide their SEID and date in Blocks K and L of Form 6754, Examination Classification Checksheet.

  5. When a Schedule C, E, or F does not appear to be a business engaged in for profit (hobby loss), the examination should focus on whether this is an income producing business. Gross receipts and all expenses should generally not be classified.

  6. If a potential questionable preparer is identified, these returns should be given to the Manager assigned to the detail to share with the rest of the classifiers and to contact the Area Return Preparer Coordinator. The Area Return Preparer Coordinator will make a decision concerning any further consideration of potential program action against the preparer.

4.1.5.1.11.1  (08-24-2012)
Non-Business Individual Returns

  1. Once you determine the return will not be accepted as filed, it must be decided if the examination should be conducted by a revenue agent or a tax compliance officer. In making this determination, the classifier must give consideration to the type(s) of issue(s) identified for examination.

  2. Below are examples of items which generally cause the return to be identified for field examination:

    1. Issues which require on-site inspection of the taxpayer’s books, records, or assets.

    2. Complex Schedule D transactions.

    3. Returns with unusually complex rental income and expenses.

    4. Tax shelter returns.

    5. Donations of real property which would involve an engineering specialist.

    6. Alimony, if it appears there is a property settlement involving business property (e.g., accounts receivable, inventory).

  3. Tax Compliance Officer Interview Examinations: Individual returns identified for office interview examinations should contain issues which lend themselves to an analytical approach and require individual judgment in addition to direct verification of records.

    1. A classification checksheet will be attached to each return identified for an examination.

    2. Regardless of the issue, the return will be identified for office interview method if, in the judgment of the classifier, an office interview is needed to ensure the taxpayer’s rights under the law.

    3. Certain types of issues lend themselves to interview examination. Examples: Dependency exemptions; income from tips, pensions, annuities, rents, fellowships, scholarships, royalties, and income not subject to withholding; deductions for business related expenses; deductions for bad debts; determinations of basis of property; deductions for education expenses; capital gain versus ordinary income determinations; complex miscellaneous itemized deductions such as casualty and theft; losses where determinations of fair market value are required; and deductions for employees business expenses such as travel and entertainment.

    4. Other factors may indicate an interview is necessary. For example, if the taxpayer’s occupation requires only a limited formal education, or the appearance of the return (writing, grammar, neatness, etc.) indicates the taxpayer may not be able to effectively communicate by letter, a face to face interview should be held.

    5. If the taxpayer’s income is low in relation to financial responsibilities as suggested from a review of the return (number of dependents, interest expense, etc.), a face to face interview is necessary.

    6. Business returns may be identified for office interviews.

4.1.5.1.11.1.1  (10-24-2006)
Issue Identification

  1. Discussed below are suggested guidelines to assist in the identification of significant issues on individual non-business returns. In identifying issues on the classification checksheet, the classifier should be as specific as possible.

4.1.5.1.11.1.2  (10-24-2006)
Itemized Deductions

  1. Important! Look first at overall potential based on the amount by which the itemized deductions exceed the standard deduction.

  2. Verify itemized deductions are not claimed elsewhere on the return when the standard deduction has been elected (e.g., personal real estate taxes and mortgage interest deducted on rental schedule).

4.1.5.1.11.1.3  (10-24-2006)
Exemptions

  1. Exemptions claimed by the non-custodial parent have proven to have high potential for adjustment.

  2. When married persons file separately, both taxpayers may not have made the same election for standard, or itemized deductions. If dependent children are claimed, the other spouse may also be claiming them.

4.1.5.1.11.1.4  (10-24-2006)
Medical Expenses

  1. High medical expenses for large families, deceased taxpayers, or older taxpayers are usually not productive.

4.1.5.1.11.1.5  (08-24-2012)
Taxes

  1. Consider changes in address when reviewing real estate taxes (e.g., Form W–2, Form 1040, Form 2119).

4.1.5.1.11.1.6  (08-24-2012)
Interest Expense

  1. Productive issues could come from payments to individuals and closing costs on real estate transactions.

  2. Home mortgage interest varies by locality. Special attention should be paid to those areas where housing costs are high (over $1,000,000.)

4.1.5.1.11.1.7  (10-24-2006)
Contributions

  1. Check to see if contributions exceed 50 percent of adjusted gross income (AGI).

  2. Check large donations made to questionable miscellaneous charities.

  3. Check for payments which may represent tuition.

  4. Check for large dollar non-cash contributions.

4.1.5.1.11.1.8  (10-24-2006)
Casualty or Theft Loss

  1. Watch for business assets, valuation methods, and statutory limitations.

4.1.5.1.11.1.9  (10-24-2006)
Miscellaneous Deductions

  1. Scrutinize large, unusual, or questionable items.

4.1.5.1.11.1.10  (10-24-2006)
Capital Transactions

  1. Gains on sales of rental and other depreciable property, where the taxpayer has been using an accelerated method of depreciation should be questioned since the taxpayer may have to report ordinary income.

  2. Loss on the sale of rental property, recently converted from a personal residence, is usually productive.

  3. Current year installment sales and exchanges of property should be carefully scrutinized as taxpayers frequently make errors in computing the recognized gain.

  4. Check to see if the gain on a sale is large enough to require the alternative minimum tax computation.

4.1.5.1.11.1.11  (10-24-2006)
Pension and/or Annuity

  1. Check whether the taxpayer received a premature distribution from a pension/profit sharing plan.

  2. Check whether distribution qualifies as a lump sum distribution.

4.1.5.1.11.1.12  (08-24-2012)
Rental Properties

  1. Consider fair rental value.

  2. If the rental property is located at the same address as the taxpayer’s residence, consider whether the allocation is proper between the rental portion and the portion used personally by the taxpayer.

  3. Repairs may be capital improvements.

  4. Consider whether the cost of land is included in the basis.

  5. The rental of vacation/resort homes should be scrutinized.

  6. Consider passive activity rules if rental losses are greater than $25,000.

4.1.5.1.11.1.13  (08-24-2012)
Unreported Income

  1. Is the income sufficient to support the exemptions claimed?

  2. Installment sale of property but no interest has been reported.

  3. If a taxpayer lists his/her occupation as waiter, cab driver, porter, beautician, etc., tip income is a productive issue.

  4. Are there substantial interest expenses with no apparent source of funds to repay the loans?

  5. Does the taxpayer claim business expenses for an activity that shows no income on the return (e.g., beautician supplies, but no Form 1099 or Form W-2, Wage and Tax Statement, for that occupation)?

  6. Has the farmer received any farming subsidies, grants, or land leases (tenant farmer)?


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