4.10.4  Examination of Income

Manual Transmittal

August 09, 2011

Purpose

(1) This transmits revised IRM 4.10.4, Examination of Returns, Examination of Income.

Background

This manual guidance is for the examination of income tax returns. It includes guidance for conducting the minimum income probes, in-depth examinations of income, and using formal indirect methods to determine income.

Material Changes

(1) Minor editorial changes have been made throughout this IRM. Website addresses, legal references, and IRM references were reviewed and updated as necessary. Significant changes to this IRM are reflected in the table below:

Reference Description
Background section Modified the Background section by clarifying that this IRM is for the examination of income tax returns.
IRM 4.10.4.2.1 (2) Modified paragraph 2 to delete "including those with" and added "which have."
IRM 4.10.4.2.2 (2) Added paragraph 2 to clarify office audit procedures.
IRM 4.10.4.3.1 (2) Revised language and clarified that the requirement is with respect to a preliminary T instead of a T-Account.
IRM 4.10.4.3.1 (3) Deleted last sentence of paragraph 3.
IRM 4.10.4.3.1 (5) Modified paragraph 5 regarding when to examine the prior and subsequent year return.
IRM 4.10.4.3.2 (1) Added paragraph 1 and renumbered the remaining section to provided guidance on IRP reconciliation.
IRM 4.10.4.3.2 (2) Added additional text to paragraph 2 to clarify process for office audit. Changed the last sentence of paragraph 2 to read, "If the analysis does not indicate a material imbalance, the conclusions should be documented in the examination workpapers." Deleted items a and b.
IRM 4.10.4.3.2 (3) Changed table to text and edited for clarity.
IRM 4.10.4.3.2 (5) Added paragraph 5 to provide direction when the taxpayer does not appear to have sufficient funds for even the most minimal personal expenses.
IRM 4.10.4.3.3.1 (1) Modified to remove reference to bank account analysis and internal controls.
IRM 4.10.4.3.3.1 (6) Modified Item C because bartering should not be shown as a source on the T-Account.
IRM 4.10.4.3.3.2 (4) Modified language for clarity.
IRM 4.10.4.3.3.5 (2) Deleted paragraph 2 because IRP reconciliation is not related to reconciliation of books to return.
IRM 4.10.4.3.3.8 (4) Clarified what information is available via Bizstat.
IRM 4.10.4.3.4.5 (1) Modified language for clarity.
IRM 4.10.4.3.4.7 (2) Deleted paragraph 2 because payors are not required and generally do not issue Forms 1099 for payments to incorporated businesses.
IRM 4.10.4.3.4.7 (3) Modified to change the word "test" to "reconcile" and deleted the sentence, "If it is determined that internal controls are weak, examiner should consider testing the bank records."
IRM 4.10.4.3.6.5 (2) Changed Form 4700 to Form 4318 OA.
IRM 4.10.4.6.1.2 Clarified language regarding when an examination of personal living expenses goes beyond the minimum income probes.

Effect on Other Documents

This section supersedes the previous section, IRM 4.10.4, Examination of Income, dated May 27, 2011.

Audience

Small Business Self-Employed (SB/SE) Examination Field Operations Employees

Effective Date

(08-09-2011)

Duane M. Gillen
Director, Examination Policy SE:S:E:EP
Small Business/Self-Employed Division

4.10.4.1  (08-09-2011)
Overview

  1. The purpose of this section is to provide guidance for the examination of income. It includes the minimum income probe requirements for all types of returns, in-depth examination techniques, and formal indirect methods. See IRM 4.10.4.3.5, Minimum Income Probes: Delinquently Filed Returns and Nonfiled Returns, for instructions regarding income probes for nonfilers and delinquently filed returns.

  2. An examination of income is conducted to determine whether taxable income has been accurately reported on the tax return. The steps taken in an examination are dependent on the facts and circumstances, and therefore, the audit strategy for completing the examination of income must remain dynamic. Consideration should be given to tax return information, responses to interview questions, the taxpayer’s books and records, and other financial information when completing an examination of income. As new information becomes available, the audit plan should be adjusted accordingly; examiners should use their judgment when determining the depth of the examination of income.

  3. It is advisable to include a statement on the initial information document request (IDR) indicating that the examiner may request additional records as the examination progresses. This will help prevent any potential misunderstanding about the scope and depth of the examination of income.

  4. Examinations of income for all business tax returns should incorporate industry-based audit techniques. The Audit Technique Guides are available in alphabetical order at http://www.irs.gov/businesses/small/article/0,,id=108149,00.html .

4.10.4.1.1  (05-27-2011)
Scope of Section

  1. This IRM applies to all examinations except correspondence examinations conducted by the Campus.

  2. Occasionally an examiner will conduct the majority of an examination by correspondence nonetheless the minimum income probes apply.

  3. Compliance Initiative Project cases are subject to the general rules for the examination of income.

4.10.4.2  (05-27-2011)
Definitions

  1. The following definitions are provided to clarify terms used within this IRM section. An understanding of these definitions is helpful to complete the examination of income.

4.10.4.2.1  (08-09-2011)
"Nonbusiness" Returns

  1. Individual tax returns with no attached business schedule(s); i.e., no Schedule C, Profit or Loss from Business (Sole Proprietorship) or Schedule F, Profit or Loss from Farming.

  2. For office audit, individual returns which have attached business Schedule(s) C and/or Schedule(s) F, for which gross business receipts is NOT a classified issue.

4.10.4.2.2  (08-09-2011)
"Business" Returns

  1. All types of returns other than nonbusiness returns described in IRM 4.10.4.2.1 above.

  2. For office audit, individual returns which have attached business Schedule(s) C and/or Schedule(s) F, for which gross business receipts is a classified issue.

  3. An individual business return is an individual return that also includes a business activity, such as a Schedule C sole proprietorship, reflects financial activities of both living person(s) and/or an entity. For purposes of auditing an individual business return, the financial activities of the business entity and the individuals are audited simultaneously as one taxpayer.

  4. Corporations and other business returns are considered separate legal entities from the owners of the business; i.e., the business entity and its owner file separate tax returns. However, since the business entity is controlled by the owners, it is subject to manipulation and the diverting of income or camouflaging of financial transactions. For purposes of auditing a business return, the audit will be expanded to include the tax returns of the related owner only if specific criteria are met. See IRM 4.10.4.3.4.3. All of the steps for the minimum income probes of a business entity should include an evaluation of potential for diverting income or camouflaging transactions with related owners of the business.

4.10.4.2.3  (05-27-2011)
Gross Receipts or Gross Income

  1. The term "gross receipts" or "gross income" means the taxpayer's total or gross taxable receipts during the year from all sources. Gross receipts is not reduced by returned sales, allowances, cost of goods sold, basis, or expenses. Gross receipts includes, but is not limited to the following:

    1. Gross sales of a trade or business;

    2. Gross fees and commissions;

    3. Gross wages, salaries, tips, and gratuities;

    4. Gross dividends, interest, rents, royalties, pensions, and annuities;

    5. Gross income from estates, trusts, and partnerships;

    6. Gross proceeds from the sale of assets; and

    7. Gross farm income.

4.10.4.2.4  (05-27-2011)
Gross Business Receipts

  1. The term "gross business receipts" means the gross receipts derived from a trade, business, farm, or profession. The distinction between "gross receipts" and "gross business receipts" is important when examining nonbusiness returns or business returns which also include nonbusiness income.

4.10.4.2.5  (05-27-2011)
Cash-on-Hand

  1. Generally, cash-on-hand is currency (not balances in bank accounts) associated with routine business practices and/or the need to complete cash transactions with customers.

4.10.4.2.6  (05-27-2011)
Accumulated Funds

  1. Accumulated funds is currency accumulated by the taxpayer, but not associated with routine business practices and/or transactions with customers. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit.

4.10.4.2.7  (08-09-2011)
Specific Item Method

  1. The specific item method involves the use of direct evidence to determine the tax liability based on omitted income, overstated expenses, or both. For example, funds from known sources are tracked to deposits made to a taxpayer's bank account rather than analyzing bank deposits to identify unreported income from likely sources.

  2. Direct evidence is evidence from which only one logical conclusion can be reached. Direct documentary evidence is generally regarded as having the greatest value; and, when possible, examiners should ask to see the original documents when there is reason to believe they exist. Documentary evidence should not be relied upon to the exclusion of facts established through oral testimony or other techniques, such as a tour of the business site.

  3. The specific item method is appropriate when the taxpayer maintains books and records, adjustments are due to technical issues (such as timing or character of funds), or the potential sources of unreported income are limited (such as an insurance agent who underwrites for several companies).

  4. The specific item method is not useful if the taxpayer's gross receipts are generated from numerous sources or in small amounts, such as a grocery store.

  5. See IRM 4.10.7.3, Evaluating Evidence, for complete discussion.

4.10.4.2.8  (08-09-2011)
Indirect Method

  1. The indirect method involves the use of circumstantial evidence to determine the tax liability based on omitted income, overstated expenses, or both. Circumstantial evidence is evidence from which more than one logical conclusion can be reached. To support adjustments for additional taxable income, both the credibility of the evidence and the reasonableness of the conclusion must be evaluated before the determination of tax liability is made.

  2. Analytical reviews and testing of the taxpayer's books and records, as required by the minimum income probes, may result in the identification of additional taxable income based on circumstantial evidence from which an inference can be made. The financial status analysis and bank account analysis are not prohibited by IRC 7602(e), Limitation on the Use of Financial Status Audit Techniques, simply because an adjustment to taxable income supported by indirect (circumstantial) evidence may be the result.

    Example:

    The minimum income probes for an individual business return include a bank account analysis. There is an identifiable potential source of additional taxable income. The records used for the analysis are the bank account statements, which are prepared by a third party, and are credible evidence. The characterization of excess funds as additional taxable income is reasonable because deposits of nontaxable funds are identified and eliminated. See IRM 4.10.4.3.3.7, Bank Account Analysis (Individual Business Returns).

  3. See IRM 4.10.7.3, Evaluating Evidence, for complete discussion.

4.10.4.2.9  (08-09-2011)
Formal Indirect Method

  1. The formal indirect methods are audit techniques used to determine the tax liability based on the amount of unreported income.

    1. IRM 4.10.4.6.3, Source and Application of Funds Method

    2. IRM 4.10.4.6.4, Bank Deposit and Cash Expenditures Method

    3. IRM 4.10.4.6.5, Markup Method

    4. IRM 4.10.4.6.6, Unit and Volume Method

    5. IRM 4.10.4.6.7, Net Worth Method

  2. The formal indirect methods are also known as financial status audit techniques. See IRM 4.10.4.6.1 for additional discussion. They are distinguishable from other audit techniques by the following characteristics:

    1. Reliance on indirect evidence of income,

    2. In-depth analysis of actual costs that requires the extensive collection of detailed information, and

    3. Subject to IRC 7602(e), which states, "the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income."

  3. Formal indirect methods are appropriate when:

    1. The taxpayer's books and records are missing, incomplete, or irregularities are identified; or

    2. The financial status analysis indicates a material imbalance of cash flows after consideration of other adjustments identified during the examination.

    See IRM 4.10.4.6.2 and IRM 4.10.4.3.3.1.

4.10.4.3  (08-09-2011)
Minimum Requirements For Examination of Income

  1. All examiners will consider gross income during the examination of all income tax returns.

  2. Minimum income probes will be completed regardless of the type of return filed by the taxpayer. The minimum income probes are designed as a set of analytical tests intended to determine whether the taxpayer accurately reported income. If the taxpayer is underreporting income, the probes should result in the identification of at least a portion of the understatement.

    1. The minimum income probes vary depending upon the type of return (nonbusiness or business) and the method of the examination (office audit or field examination).

    2. The minimum income probes are not subject to IRC 7602(e) governing the use of financial status audit techniques.

    3. Internet use and e-commerce activities will be audited as part of the minimum income probes for all business returns. See IRM 4.10.4.3.7 for detailed discussion.

    4. All minimum income probes will be completed regardless of whether or not the taxpayer maintains a double-entry set of books.

  3. Minimum income probes must be addressed in no show/no response cases. See IRM 4.10.4.3.6.

  4. Large, unusual, or questionable (LUQ) income items will be considered, in addition to the completion of the minimum income probes.

    1. IRM 4.10.2.3.1, Large Unusual Questionable Items Defined, advises an LUQ item can be based on comparative size of the item, the absolute size of the item, inherent character of the item, evidence of intent to mislead, beneficial effect of manner in which the item was reported, relationship to other items, possible whipsaw effect on other taxpayers, automatic adjustments, and missing items.

      Example:

      An income whipsaw is when income is reported on a joint state return and the examiner cannot determine the appropriate income to reflect on the federal return for each spouse. The examiner should not automatically report the total income on both spouses returns. The examiner should first check the state tax return for information that would provide a basis for allocating the income reported. Second, the examiner should cross-reference the information on the state return with any other information that may be available, such as information returns (Forms W-2, 1099, etc.). If the examiner has sufficient information to determine the amount of income per spouse, the examiner can prepare a report. If the examiner does not have sufficient information to allocate income based on the steps taken above, the examiner should try to contact each spouse and attempt to obtain information on how much income should be reported for them prior to issuing a report. If the taxpayer(s) are non-responsive or uncooperative, the examiner can then treat this as a whipsaw issue and place the full income on each taxpayer’s return. The latter will be done only when the steps outlined above provide insufficient information on how to allocate income. For community property states, the examiners should refer to IRM 25.18.2, Income Reporting Considerations of Community Property. For whipsaw see IRM 4.10.13.5, Adjustments Between Correlative Taxpayers, (aka whipsaw issues).

    2. An LUQ may be identified during the pre-contact analysis or as information is gathered during the course of an examination.

    3. An LUQ may be based on direct evidence and, in this instance, is not subject to IRC 7602(e) governing the use of financial status audit techniques.

      Example:

      When the federal / state matching program indicates a taxpayer has reported significantly less income on the federal return, the examiner can use the income reported on the state tax return to produce a federal tax examination report. It has been held that positions taken in a tax return signed by a taxpayer may be treated as admissions. See Waring v. Commissioner, 412 F.2d 800, 801 (3rd Cir. 1969); Lare v. Commissioner, 62 T.C. 739, 750 (1974); Kaltreider v. Commissioner, 28 T.C. 121, 125 -126(1957). As stated in Crigler v. Commissioner, T.C.M . 2003-93, a taxpayer "cannot ...disavow ... returns without cogent proof that they are incorrect." Evidence obtained through the taxpayer’s own admission on a state income tax return signed under penalties of perjury is as reliable as evidence from third parties, and perhaps more so if the taxpayer is unable to successfully refute the information contained in the state return. If the taxpayer establishes during the course of the examination that the state information is incorrect, the examiner will adjust their report accordingly.

  5. When the amount of a net operating loss deduction (NOLD) is material, it constitutes a LUQ item that should be addressed as part of the examination of income. See IRM 4.10.2.3.1, Large Unusual Questionable Items (LUQs) Defined, for complete LUQ discussion. See Exhibit 4.10.4-6, Auditing Net Operating Loss Deductions (NOLD), for additional audit guidance. Additional factors specific to the NOLDs, which should be considered, include:

    1. Whether the NOLD was generated from the same business that gave rise to an adjustment for unreported income in the current year under examination.

    2. Materiality of the current year adjustment to income,

    3. Likelihood of erroneous reporting in prior years,

    4. Materiality of the NOLD, and

    5. Prior audit activity.

4.10.4.3.1  (08-09-2011)
Exception to the Minimum Requirements

  1. Minimum income probes will be conducted during every examination unless the examination is a "limited scope" examination as defined by IRM 4.10.2.6.1.1, Limiting the Scope of an Examination.

  2. Before limiting the scope of an audit of an individual business return, a preliminary financial status analysis based on the tax return and available data will be prepared as outlined in IRM 4.10.4.3.3.1. If the analysis indicates a material imbalance, then further development is required and the minimum income probes must be completed.

    Example:

    A claim will be examined for a highly technical issue requiring factual development. The preliminary financial status analysis indicated the taxpayer had sufficient funds for the expenditures identified on the return. The scope of the audit can be limited to the technical issue.

    Example:

    A taxpayer filed a Form 1040X, Amended Individual U.S. Income Tax Return, reflecting a significant increase in Schedule C expenses. The statute was open for the claim issue only. The taxpayer verified all the additional expenses during the audit. However, when the additional expenses were included in the preliminary financial status analysis, there was a material imbalance. The scope of the audit should not be limited; the material imbalance should be resolved.

  3. Before limiting the scope of an audit of a related return, examiners should

    • Determine whether or not the related return warrants examination from a classification perspective; i.e., trace transactions between the related entities

    • Complete a preliminary financial status analysis for individual returns based on the related return as filed and internal sources of information (Exhibit 4.10.4-2, and

    • Review the return for other potential issues. See IRM 4.10.5.4, Related Returns.

    ,

  4. When the minimum income probes have been completed for the primary return and no income issues are identified, minimum income probes are not required for a prior or subsequent year return. However, examiners must review the prior and subsequent year returns to ensure there are no LUQ or income issues. Examiners must document the conclusions reached.

  5. The examination workpapers should state that the scope of the audit was limited and cite the reasons.

4.10.4.3.2  (08-09-2011)
Minimum Income Probes: "Nonbusiness" Returns

  1. IRP Reconciliation - Prepare an Information Return Processing (IRP) analysis of the taxpayer's IRP information to ensure all business and/or investment activities reflected on the IRP document(s) are properly accounted for on the tax return.

  2. Interview - The taxpayer should be interviewed. From the taxpayer's perspective, an interview with an examiner may be overwhelming. Interviews should be professional and not overbearing. Question the taxpayer concerning possible sources of income, other than those reported, and accumulated funds. This would include potential bartering activities questions.

  3. Financial Status Analysis - A financial status analysis will be completed for office audit nonbusiness returns which include a Schedule C or Schedule F, but for which the gross receipts is not a classified issue. See IRM 4.10.4.2.1 (2). At a minimum, the analysis should be based on information disclosed on the tax return as filed, information included as part of the case building, and information available through internal sources. See IRM 4.10.4.3.3.1. The T-Account provides a quick and easy format for documenting whether there is an indication of a potential understatement of taxable income; i.e., a material imbalance as defined in IRM 4.10.4.4. Enter sources of cash funds on the left side of the T-Account and expenditures of cash funds on the right side. Total sources are compared with total expenditures. If the analysis does not indicate a material imbalance, the conclusions should be documented in the examination workpapers.

  4. If the preliminary financial status analysis indicates a material imbalance:

    1. Use subsequent interviews and information gathered during the audit to update the analysis and resolve the imbalance. The analysis should be updated as audit adjustments are identified. When completed, the analysis should indicate that either income is sufficient to support the taxpayer’s financial activities or there is a significant imbalance indicating the potential for unreported income.

    2. Expand the minimum income probes to include an analysis of the taxpayer’s bank accounts. The purpose of the analysis is to identify deposits that may be taxable income and identify sources of taxable income not otherwise disclosed by the taxpayer. See IRM 4.10.4.3.3.7 for general guidelines.

  5. Financial Status Analysis - A financial status analysis will be completed for nonbusiness returns, if it appears the taxpayer does not have sufficient funds for even the most minimal personal living expenses including those reflected on Schedule A (or the standard deduction) plus the exemption deduction. The T-Account provides a quick and easy format for documenting whether there is an indication of a potential understatement of taxable income.

    1. The imbalance must be specifically addressed during the audit; i.e., use interviews and information gathered during the audit to update the analysis and resolve the imbalance. The analysis should be updated as audit adjustments or sources of funds are identified. When completed, the analysis should indicate that either income is sufficient to support the taxpayer’s financial activities or there is a significant imbalance indicating the potential for unreported income.

    2. Enter sources of cash funds on the left side of the T-Account and expenditures of cash funds on the right side.

    3. The results of a financial status analysis and the conclusions should be documented in the examination workpapers.

    4. See IRM 4.10.4.3.3.1 for complete discussion.

4.10.4.3.2.1  (05-27-2011)
Nonbusiness Returns Examination of Bank Information

  1. With regards to IRC 7602(e), which addresses the use of financial status audit techniques, examiners should not routinely ask for bank statements, cancelled checks or deposit slips to complete the examination of income on nonbusiness returns. Requests for documentation supporting specific issues can be made and may include cancelled checks.

  2. There may be situations in which there is a reasonable indication of unreported income in the pre-contact stage of the examination; i.e., a grossly imbalanced financial status analysis or Forms 1099 for business income not included on the tax return. In such situations, the initial information document request (IDR) may include a request for personal banking records, including bank statements, cancelled checks, and deposit slips.

4.10.4.3.2.2  (05-27-2011)
Deviation on Nonbusiness Minimum Income Probes

  1. Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

  2. When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

    Caution:

    This section cannot be used to deviate or otherwise limit the minimum income probes due to workload or other factors not related to the taxpayer.

4.10.4.3.3  (08-09-2011)
Minimum Income Probes: Individual "Business" Returns

  1. Financial Status Analysis - Prepare a financial status analysis to estimate whether reported income is sufficient to support the taxpayer's financial activities. See IRM 4.10.4.3.3.1.

  2. Interview - Conduct an interview with the taxpayer (or representative) to gain an understanding of the taxpayer's financial history, identify sources of nontaxable funds, and establish the amount of currency the taxpayer has on hand. Consider possible bartering income as part of the minimum income probes. See IRM 4.10.4.3.3.2.

  3. Tour of Business - Tour the business site and review of the Internet website to gain familiarity with the taxpayer's operations and internal controls, and identify potential sources of unreported income. However, a tour of the physical business site is not required for office audit cases but may be conducted if appropriate and with manager approval. See IRM 4.10.4.3.3.3.

  4. Internal Control - Evaluate internal controls to determine the reliability of the books and records (including electronic books and records), identify high risk issues, and determine the depth of the examination of income. See IRM 4.10.4.3.3.4.

  5. Reconciliation of Income - Reconcile the income reported on the tax return to the taxpayer's books and records. An analysis of the IRP information in the file should also be completed to ensure all business and/or investment activities reflected on the IRP document are properly accounted for on the tax return. See IRM 4.10.4.3.3.5.

  6. Testing Gross Receipts - Test the gross receipts by tying the original source documents to the books. See IRM 4.10.4.3.3.6.

  7. Bank Analysis - Prepare an analysis of the taxpayer's personal and business bank and financial accounts (including investment accounts) to evaluate the accuracy of gross receipts reported on the tax return. See IRM 4.10.4.3.3.7.

  8. Business Ratios - Prepare an analysis of business ratios to evaluate the reasonableness of the taxpayer's business operations and identify issues needing a more thorough examination. See IRM 4.10.4.3.3.8.

  9. E-Commerce and/or Internet Use - Determine if there is Internet use and e-commerce income activity. See IRM 4.10.4.3.7.1.

4.10.4.3.3.1  (08-09-2011)
Financial Status Analysis (Individual Business Returns)

  1. Prepare a financial status analysis of the taxpayer's cash flow to estimate whether there are sufficient funds to cover the taxpayer's expenses. The financial status analysis includes both business and personal financial activities. The analysis serves two purposes:

    1. Determining the depth of the examination of income, and

    2. Establishing that there is a reasonable likelihood of unreported income that justifies the use of a formal indirect method.

  2. The intent of the analysis is to determine whether there is a significant risk of a material misstatement of taxable income. Materiality is the significance or importance of an item in determining the correct tax liability and requires the examiner’s judgment regarding the return as a whole and the separate items that comprise the return. Among the factors which must be considered when determining whether the imbalance is material are:

    1. Absolute amount of the imbalance;

    2. Results of multi-year analyses;

    3. Ratios and industry standards (it is recommended that the ratio analysis include three tax years, to the extent information is available, to provide a comprehensive financial picture and allow for trend analysis);

    4. Relationship between the size of the imbalance and the tax liability.

  3. The financial status analysis should include consideration of all sources and expenditures of funds identified on the tax returns, information included as part of the case building, and sources of information such as asset locator people locator contract, Currency and Banking Retrieval System (CBRS), Information Document Retrieval System (IDRS), Corporate Files on Line (CFOL), and/or Compliance Data Environment (CDE). See Exhibit 4.10.4-2 for internal sources of information. Reasonable estimates for other expenses known to exist, but for which the exact costs are not known should be included in the analysis. Personal living expenses (PLE) must be estimated using Bureau of Labor Statistics (BLS) information or comparable statistics from a reliable source, except where the actual amount of the expense is disclosed on the tax return.

    Example:

    Total PLE based on BLS data is $25,000, of which $4,000 represents home mortgage interest. The taxpayer included $8,000 as home mortgage interest on Schedule A. The BLS data should be revised to account for the actual mortgage interest expense. Total PLE = $25,000 - $4,000 + $8,000 = $29,000.

  4. The analysis should also be updated during the examination as additional information becomes available; i.e., nontaxable sources of funds or disallowed expenses. Refer to Exhibit 4.10.4-4, Example of Financial Status Analysis for Individual Business Return.

  5. The T-Account provides a quick and easy format for documenting and determining whether there is an indication of a potential understatement of taxable income. Enter sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures.

  6. Steps for completing a financial status analysis:

    1. Prepare the financial status analysis (using the T-Account format) based upon the tax return data and information in the case file; e.g., records of monetary transactions (CBRS). Use BLS or comparable statistics from another reliable source to estimate the taxpayer's personal living expenses. If the analysis indicates a material imbalance, the excess expenditures are considered to be a potential understatement of taxable income which requires further development during the audit.

    2. An analysis of IRP information in the file should be completed to evaluate if there are any additional sources of income. Income not included on the tax return should be included in the T-Account.

    3. Use subsequent interviews and information gathering during the examination to update the financial status analysis and resolve any imbalance. For example, when the profit margins are consistently low, but the taxpayer is able to continuously service substantial debt (mortgage), the examiner should make further inquiries.

    4. The analysis should be updated as audit adjustments are identified. The adjustment may be the result of unreported gross receipts, overstated expenses, or from a combination of these items.

    5. When completed, the financial status analysis should indicate that either income is sufficient to support the taxpayer's expenditures or there is a significant imbalance indicating the potential for unreported income.

  7. The completion of a financial status analysis does not trigger the provisions of IRC 7602(e), which states, "The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income." A financial status analysis is an analytical tool used to identify and estimate the materiality of cash flow imbalances. Financial Status Audit Techniques are the formal indirect methods used to make the actual determination of tax liability and are subject to the limitations of IRC 7602(e). See IRM 4.10.4.6.

  8. Income or losses reported on Schedule E, Supplemental Income and Loss, may not represent an actual flow of funds.

    1. If the taxpayer is reporting income or loss from a partnership, S corporation, estate, or trust, review, for example, Form 1120-S Schedule K-1, Shareholder's Share of Income, Deductions, Credits, Etc., to identify actual capital contributions, withdrawals or distributions.

    2. If the taxpayer is reporting income or a loss from a Real Estate Mortgage Investment Conduit (REMIC), review Schedule Q, Form 1066, U.S. Real Estate Mortgage Investment Conduit (REMIC) Income Tax Return.

  9. Common errors in a financial status analysis include failure to include loan payments as an application of funds, treating the cost of goods sold as an application of funds rather than current period costs (i.e., purchases, labor costs, materials and supplies, and other costs associated with inventory), and accepting unreasonably low estimates of personal living expenses.

  10. An examiner may consider observing a taxpayer's residence when completing a financial status analysis. However, observing a taxpayer's home should not be intrusive and generally should not include talking with the taxpayer's neighbors. Inspections of the inside of a taxpayer's home should be limited due to privacy issues and the intrusive nature. Note: the purpose of inspecting the interior of a taxpayer's home includes determining the validity of a deduction for an office or business located in the residence.

    Example:

    An examiner believes, based on the address on the tax return, that the taxpayer's home is located in a recently developed subdivision where the homes are selling for more the $300,000. The preliminary financial status analysis indicates that the taxpayer could not support the purchase or maintenance of such a home based on the reported income. The examiner drives by the home and discovers that the taxpayer lives in a modest 40-year-old home across the street from the new subdivision.

  11. The financial status analysis, as originally prepared based upon the tax return data and information in the case file and subsequently modified, will be made part of the examination workpapers. The analysis should indicate the information considered and the conclusions reached.

  12. If the financial status analysis indicates that the taxpayer's sources of funds are not sufficient to support the taxpayer's expenditures; the use of a formal indirect method can be justified.

4.10.4.3.3.2  (08-09-2011)
Initial Interview (Individual Business Return)

  1. The examiner should conduct the initial interview with the taxpayer to gain an understanding of the taxpayer’s overall financial picture, the business history and operations, and an overview of the taxpayer’s recordkeeping practices. Interviews should be professional and not overbearing.

  2. IRC 7521(c) states that an examiner cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer's voluntary presence can be requested through the representative as a means to expedite the examination process. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.

  3. Question the taxpayer/representative concerning possible nontaxable sources of funds, gifts, loans, known errors/omissions on the return, and unreported sources of income. These questions should be addressed at the initial interview early in the examination. The information will be needed to reconcile the financial status analysis, analyze the bank accounts, and reconcile the income reported on the tax return to the books and records. Also, the information will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.

    1. If loan proceeds are identified, verify the source and amount of the nontaxable funds.

    2. If the loan is from a financial institution, consider whether the loan amount is consistent with the taxpayer's financial picture as represented on the tax return. Evaluate for consistency with other evidence; i.e., cash flows, anticipated gross receipts, etc. If inconsistencies are identified, request the loan application and attachments. Review the financial statements submitted with the application; look for information such as the disclosure of sources of income not included on the tax return or the disclosure of more profit than reported on the return. Consider when evaluating the credibility of the taxpayer's oral testimony and accuracy of the taxpayer's books and records.

    3. If the loan or gifts are from family members or other individuals, verification may be difficult. The examiner should inquire as to why the amount provided was cash, when the amount was given, how it was given (one payment or multiple), and any provisions for repayment. Discrepancies should be resolved with the taxpayer's assistance. Nontaxable sources of funds can be eliminated by showing that the provider of the funds was incapable of generating the amounts stated by the taxpayer; i.e., the absence of any documentation reflecting the source of the funds and/or the absence of sources of funds available to the provider.

    4. Refer to IRM 4.10.7.3, Evaluating Evidence, for additional guidance.

  4. If the IRP analysis reveals that there are additional known sources of income not included on the tax return, the examiner should question the taxpayer as to where they may have already reported this information.

  5. Question the taxpayer concerning bartering income. Bartering is the trading of one product or service for another. Usually there is no exchange of cash. Bartering may take place on an informal one-on-one basis between individuals and businesses, or it can take place on a third party basis through a modern barter exchange company.

  6. Obtain the beginning and ending balances for cash-on-hand from the taxpayer or representative for the year(s) under examination. See IRM 4.10.4.6.8.3 for complete discussion and Exhibit 4.10.4-1 for interview questions. Generally, cash-on-hand is currency associated with normal business practices and the need to complete cash transactions with customers. If additional years are examined, be sure to determine and document the beginning and ending cash-on-hand for those years. This information will be needed to complete the reconciliation of income as reported on the tax return to the taxpayer's books and records and will be critical should it later become necessary to use a formal indirect method to make the actual determination of tax liability.

  7. Determine the beginning and ending balances of accumulated funds for the year(s) under examination. Generally, accumulated funds is currency not associated with normal business practices. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit. See IRM 4.10.4.6.8 for complete discussion and Exhibit 4.10.4-1 for interview questions.

  8. The examiner should ask the taxpayer for assistance to resolve a financial status analysis indicating a material imbalance.

    Example:

    The examiner completes a pre-contact analysis of an individual taxpayer's return with a Schedule C. Based upon an analysis of the taxpayer's cash flows on the face of the return, the examiner believes the reported income is insufficient to support the taxpayer's expenses. The examiner may ask the taxpayer how the expenditures were paid, based on the income reported on the return.

  9. The examiner should ask the taxpayer to explain the accounting system, including:

    1. The normal flow of each type of transaction from its initiation to its inclusion in the financial statements, and

    2. The flow of funds into and out of the business.

  10. The examiner should question the taxpayer regarding business policies and practices for:

    1. Product pricing and determining profit margins,

    2. Accounting for cost of goods sold, and

    3. Accounting for spillage, breakage, and theft losses.

  11. The examiner should determine the extent of the taxpayer's use of the Internet for e-commerce purposes. See Exhibit 4.10.4-7 for a list of interview questions.

  12. IRC 7521 (b)(2), Recording by IRS Officer or Employee, requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly observed and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.

  13. Examiners should use the appropriate Lead Sheet 125 in RGS to document the interview.

  14. Refer to IRM 4.10.7.3.2, Oral Testimony, for complete discussion and documentation requirements.

4.10.4.3.3.3  (05-27-2011)
Tour of Business Sites (Individual Business Return)

  1. Conduct a tour of the physical business site controlled by the taxpayer. Generally, the physical business site will be the principal location and any other locations acquired during the period under examination should be visited. The purpose of a tour is to:

    1. Gain familiarity with the taxpayer’s business operation and internal controls,

    2. Identify potential sources of unreported income, and

    3. Confirm the existence of assets.

  2. A tour of the physical business site is not required for office audit cases. However, if appropriate (and with manager's approval), a tour of the business site may be conducted.

  3. The results of a tour and any observations and/or comments should be documented in the examination workpapers.

  4. See IRM 4.10.3.3, Tours of Business Sites, for complete discussion.

  5. Review the business websites controlled by the taxpayer. See IRM 4.10.4.3.7.2.

4.10.4.3.3.4  (08-09-2011)
Evaluation of Internal Controls (Individual Business Return)

  1. Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. The evaluation will help examiners set the scope and depth of the examination of income and determine the appropriate audit techniques.

  2. Examiners should:

    1. Document the business operation

    2. Document the accounting system

    3. Document assets

    4. Document the flow of transactions

    5. Document procedures established for safeguarding business operations

  3. The evaluation should not be limited to a consideration of the segregation of duties. See IRM 4.10.3.4, Evaluating the Taxpayer’s Internal Controls, for a complete discussion. Examiners should:

    1. Determine the reliability of the books and records, regardless of the sophistication of the recordkeeping method. Refer to IRM 4.10.4.3.7.5 if the taxpayer maintains electronic books and records.

    2. Gain an understanding of the taxpayer's business operations; i.e., how income is generated and recorded.

    3. Determine how business assets are safeguarded; i.e., what steps the taxpayer takes to ensure that the business operates as intended and avoid misstatements of financial information.

  4. While there is no exhaustive definition of weak internal accounting controls which will impact the scope and depth of the examination of income, examples include:

    1. Books and records that cannot be reconciled to the tax return

    2. Transactions that are not properly authorized

    3. Recorded transactions are not valid

    4. Existing transactions are not recorded

    5. Transactions are improperly valued

    6. Transactions are improperly classified

    7. Transaction are recorded at the improper time

    8. Transactions are incorrectly summarized

    9. Transactions all made by the same person or related parties

    10. Significant commingling of business and personal funds

  5. Weak internal controls alone do not necessarily establish a reasonable likelihood of unreported income under IRC 7602(e) that justifies the use of a formal indirect method to make the actual determination of tax liability. Examiners must also demonstrate that there are irregularities in the taxpayer's books and records. See IRM 4.10.4.3.3.5.

    Example:

    The fact that a taxpayer does not maintain separate business and personal bank accounts does not, per se, warrant the use of a formal indirect method to make the actual determination of tax liability. The examiner must first:
    (1) Determine the reliability of the books and records,
    (2) Reconcile the books and records to the return, and
    (3) Identify the sources of funds to properly account for taxable income. The examiner can use a formal indirect method to determine the tax liability if there is a reasonable indication that there is a likelihood of unreported income.

  6. The workpapers will document the conclusions reached by the analysis of internal controls and their impact on the scope and depth of the examination.

4.10.4.3.3.5  (08-09-2011)
Reconciliation of Income per Books and Records to Income Reported on Tax Return (Individual Business Returns)

  1. Reconcile the income reported on the tax return to the taxpayer’s books and records. Ask the taxpayer how income was computed and duplicate the taxpayer's steps. Refer to IRM 4.10.3.5.6, Step 6: Reconciling the Taxpayer's Books and Records to the Tax Return, for complete discussion.

  2. Analyze the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation of the internal controls to determine if transactions were properly recorded.

    1. Determine whether information provided by the taxpayer in the interview(s) is reflected in the book and records.

    2. Confirm that income from all assets observed during the tour of the business is included in income.

    3. Based on the evaluation of internal controls, identify weaknesses which could be overridden or compromised, allowing for the diversion of income. Test the weaknesses to determine whether income actually was diverted.

  3. Test whether income from e-commerce activities has been accounted for in the books and records and reported on the tax return. See IRM 4.10.4.3.7.

  4. If the income per the books and records cannot be reconciled with the income reported on the tax return, the examiner should ask the taxpayer to provide an explanation for the difference; i.e., how the accounts per books were accumulated for the tax return.

  5. Irregularities in a taxpayer's books and records, or inconsistencies in reporting transactions may be an indication of unreported income justifying the use of a formal indirect method to determine the actual understatement of taxable income.

    Example:

    A taxpayer's books and records are reconciled to the income tax return. No discrepancy is noted when reconciling income to the bank statements and sales journals, or verifying purchases by inspecting cancelled checks and invoices. The examiner also attempted to tie purchases to specific jobs and the income received from those jobs. For a few purchases, there was no corresponding job or income reported.

  6. The lack of books and records or the underlying source documents will justify expansion of an income probe beyond the minimum income probes.

    Example:

    The taxpayer owns and operates a cash-intensive food service business. The taxpayer's books and records tie to the tax return. As part of the audit, the examiner should test gross receipts by tying the original source documents (cash register receipts and/or invoices) to the books. However, the taxpayer does not have the original documents.

  7. The fact that a taxpayer's books and records were not prepared contemporaneously to the business activity does not, per se, permit the examiner to use a formal indirect method to make the actual determination of tax liability. The test of whether a formal indirect method can be used is whether there is a reasonable indication that there is a likelihood of unreported income.

    Example:

    A taxpayer advises the examiner during an audit that the books were prepared after the end of the tax year based on bank statements and cancelled checks.

4.10.4.3.3.6  (08-09-2011)
Testing Gross Receipts (Individual Business Returns)

  1. Test gross business receipts to verify that all the gross receipts are accounted for. For additional techniques, see IRM 4.10.3.9, Testing Gross Receipts or Sales.

    1. Trace original entries in the books back to the original sales document (e.g., sales slips, cash register receipts, or job contracts, etc.).

    2. Trace original sales documents to the corresponding entries in the books.

    3. If original sales documents are numbered or otherwise sequenced, identify and account for missing sales documents.

    4. Determine the method and adequacy of the accounting for merchandise withdrawn for personal use.

    5. Scan sales agreements, contracts and other related documents to identify unreported bonuses, awards, kickbacks, etc.

    6. Determine that all accounts receivables are included in income for accrual basis taxpayers.

4.10.4.3.3.7  (08-09-2011)
Bank Account Analysis (Individual Business Returns)

  1. Perform an analysis of the taxpayer's business and personal bank accounts (including investment accounts); i.e., statements, deposit slips, and canceled checks, etc. The examiner should use judgment to determine the depth of the analysis and use of automation. The Service is not prohibited from asking for these records, as well as wire transfers, on the initial information document request (IDR) or at any time during the examination for an individual business return. See IRM 4.10.4.3.

  2. This analysis is used to:

    1. Identify deposits which may be taxable income,

    2. Determine whether business expenses may have been paid from other sources (such as cash-on-hand or accumulated funds) or are overstated,

    3. Estimate the risk of commingled personal and business bank accounts, and

    4. Determine whether cash is deposited.

  3. The steps of the bank account analysis are:

    1. Analyze the deposits. Look for unusual deposits (size or source), frequency of deposits. Also check for deposits of cash, specific deposits that do not follow the taxpayer's normal routine or pattern, nontaxable deposits such as loans and transfers, commingling of personal and business activities, and cash-backs when a deposit is made.

    2. Total the deposits and reconcile deposits of nontaxable funds and transfers between accounts. Particular attention should be paid to transfers in, out, and between accounts as previously unknown accounts may be identified. Checks deposited by the taxpayer but later returned by the bank (e.g., the maker of the check did not have sufficient funds in the account to pay the check) should be categorized as a nontaxable transactions. As a reminder, the nontaxable funds, transfers-in, and returned deposits need to be subtracted from total deposits to get "Taxable Deposits."

      Note:

      This step is a duplication of the reconciliation of income reported on the tax return to the taxpayer's books and records if the taxpayer reported income based on bank deposits.

    3. Determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance.

    4. To the extent possible, conduct a review of cancelled checks to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the dollar amount. If cancelled checks are unavailable, trace transactions from the bank statement to the check register and original document. Significant commingling of accounts warrants a more in-depth analysis.

    5. Subtract the nondeductible expenditures from the total disbursements. The remainder should approximate the deductible business expenses on the tax return (other than non-cash expenses such as accruals and depreciation).

      Note:

      It may be easier to identify the business expenditures in some cases, which can then be subtracted from the total disbursements; the remainder will be personal expenses paid by check.

  4. Compare the total deposits with the reported Gross Income. Include all accounts, whether designated as personal or business.

  5. If the analysis results in the identification of excess deposits over the reported gross income, the excess represents potential unreported income.

    1. If specific transactions or deposits can be identified as the source of the understatement, a specific item adjustment to income supported by direct evidence should be made.

    2. If the specific transactions or deposits creating the understatement are not identified, an adjustment to taxable income may be made based on the circumstantial evidence. Technically, this is an adjustment due to the use of an indirect method. However, IRC 7602(e) governing the use of financial status audit techniques, is not triggered because the adjustment stems from an analysis of the taxpayer's books and records and does not require the extensive collection of detailed information. IRM 4.10.4.2.8, Indirect Method.

  6. If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds.

  7. If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records may be unreliable. IRM 4.10.4.3.3.4.

  8. A potentially material misstatement of taxable income identified through a bank account analysis establishes a reasonable likelihood of additional unreported taxable income justifying the use of a formal indirect method to make the actual determination of tax liability.

4.10.4.3.3.8  (08-09-2011)
Business Ratio Analyses (Individual Business Returns)

  1. The initial reconciliation of income per the books and records to the tax return provides the examiner with an understanding of how the taxpayer determined gross receipts. The books and records can also be used to evaluate the accuracy and reasonableness of the reported amount of income through the use of ratios.

  2. A horizontal analysis should be prepared, with documented conclusions, and be included in the case file for all business returns. A vertical analysis may not be appropriate for every case.

  3. Horizontal analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single return alone. The tax return under audit should be compared to the prior and subsequent year returns.

    1. Examiners should consider absolute numeric entries, changes in key ratios, and any other changes indicative of a change in financial activities. The analysis should be based on expenses that vary with changes in production or volume of sales.

    2. The analysis should include all schedules that report financial activity, including Schedules C, D, E, and F.

    3. The analysis can be documented by notes on the CDE prints, or a prepared schedule.

    4. This analysis should be completed in conjunction with the Required Filing Checks under IRM 4.10.5.3, Prior and Subsequent Year Returns.

    5. Significant variations (5% or more) suggest changes in business or reporting practices that need to be discussed with the taxpayer.

      Example:

      In many industries, cost of goods sold bears a direct relationship to sales. An analysis of the prior and current year business ratios indicates consistency between years. The analysis for the current and subsequent year indicates a change in business practices that should be explained by the taxpayer.

      Horizontal Analysis for Prior and Current Year

      Description Prior Year Current Year Change % Change
      Sales $90 $100 $10 11%
      COGS $27 $30 $3 11%
      Fixed Costs $30 $30 0 0
      Net Income $33 $40 $7 45%

      Horizontal Analysis for Current Year and Subsequent Year

      Description Current Year Next Year Change % Change
      Sales $100 $130 $30 30%
      COGS $30 $42 $12 40%
      Fixed Costs $30 $30 0 0
      Net Income $40 $58 $18 25%

  4. Vertical Analysis - This analysis identifies differences between the taxpayer's business and the industry standards for a given year and is an indicator of the reasonableness of gross receipts and net profit reported on the tax return. Ask the taxpayer what the gross profit should be and test the gross profit percentage by tracing specific transactions from the purchase of a product for resale to the sale of the item. Industry standards can be found at http://www.bizstats.com. IRM 4.10.4.3.3.8 for complete discussion and examples.

    Note:

    Bizstat industry standards data is available for one year. It is generally available for the third year from the current calendar year. (i.e., for calendar year 2011, data is available for 2008).

    1. Expenses are expressed as a percentage of gross receipts.

    2. Potential underreporting of income which equals 10% or more of the reported income should be resolved with the taxpayer's assistance. Discrepancies can be caused by errors in reporting gross receipts, inventory, or purchases. See IRM 4.10.3.9.1, Gross Profit Ratio Test, paragraphs 12, 13, and 14 for lists of possible errors.

    3. A comparison against industry norms alone, which indicates a discrepancy, is not justification for using a formal indirect method to make the actual determination of tax liability unless the taxpayer is uncooperative or nonresponsive.

    Example:

    An analysis of the taxpayer's business activity can be based on the following ratio.

    Cost of Sales
    Gross Receipts from Sales

    The following schedule represents the gross receipts and expenses reported by a taxpayer. Assume that there are no inventories.

    Gross Receipts   $330,000
    Material $150,000  
    Labor $120,000  
    Subcontractors $30,000  
    Cost of Goods Sold   $300,000
    Gross Profit   $30,000

    The taxpayer's cost of goods sold to sales ratio is $300,000/$330,000 = 91%. The industry standard, however, is 75%. To estimate the potential underreporting of income, use the industry standard and the taxpayer's reported costs: $300,000 / Gross Receipts = 75%.
    Based on the industry standards, the gross receipts should be about $400,000. The potential underreporting of income is $400,000 - $330,000 = $70,000.

  5. Examiners are not limited to the ratio demonstrated above. Any ratio or standard available for the taxpayer's industry can be used for the analysis. See IRM 4.10.3.9.1, Gross Profit Ratio Test.

    Example:

    The taxpayer is the sole proprietor of a bar. The examiner reviews the taxpayer's books and records, and tests the gross receipts as a percentage of purchases. The taxpayer states that the markup percentage is approximately 150%, which the examiner knows is consistent with industry practices. However, the examiner determines that the actual markup percentage is 100%. Based on the taxpayer's oral testimony and the industry practice, it appears that the taxpayer may not be reporting all of the gross receipts.

    Example:

    The taxpayer sells pianos. The examiner selected a sample of four actual purchases and subsequent sales by the taxpayer; the average markup for the four piano sales was 51.7%. Overall, for the business as reported on Schedule C, the markup is 27%. Based on the comparison, it appears that the taxpayer may not be reporting all of the gross receipts.

4.10.4.3.3.9  (05-27-2011)
E-Commerce

  1. More information on e-commerce income issues can be found in IRM 4.10.4.3.7.1.

4.10.4.3.3.10  (05-27-2011)
Deviation on Individual Business Returns Minimum Income Probes

  1. Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

  2. When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

    Caution:

    This section cannot be used to deviate or otherwise limit the minimum income probes due to workload or other factors not related to the taxpayer.

4.10.4.3.4  (05-27-2011)
Minimum Income Probes: Corporations and Other "Business" Returns

  1. Balance Sheet - Prepare a Balance Sheet Analysis. See IRM 4.10.4.3.4.1.

  2. Reconciliation - Reconcile Schedules M-1, M-2, and M-3. See IRM 4.10.4.3.4.2.

  3. Shareholder and Partners - Evaluate the tax returns of significant shareholders or partners. See IRM 4.10.4.3.4.3.

  4. Interview - Interview the taxpayer. See IRM 4.10.4.3.4.4.

  5. Tour of Business - Perform a tour of the business site. See IRM 4.10.4.3.4.5.

  6. Internal Controls - Evaluate the internal controls. See IRM 4.10.4.3.4.6.

  7. Gross Receipts - Test gross receipts or sales. See IRM 4.10.4.3.4.7.

  8. Ratio Analysis - Prepare a business ratio analysis. See IRM 4.10.4.3.4.8.

  9. E-Commerce and/or Internet Use - Determine if there are Internet use and E Commerce income activity. See IRM 4.10.4.3.3.9.

4.10.4.3.4.1  (08-09-2011)
Balance Sheet Analysis (Corporations and Other "Business" Returns)

  1. Prepare an analysis of the balance sheet and tax return information. The purpose of the analysis is to assist in the identification of issues to be examined.

  2. Significant changes to any accounts should be noted and resolved during the examination.

    1. Analyze significant balance sheet accounts which show substantial increases or decreases that may indicate the misclassification of income and accounts.

    2. Entries that reduce taxable income, such as a deferral or postponed recognition of income should be examined. A deferred income account (typically included in the liability section of the balance sheet), may indicate income from services performed or merchandise shipped and received by the customer. A deferral of income is not proper in these cases. Additional examples include "loans to shareholders," suspense accounts, and reserve accounts.

    3. Cash accounts should always be analyzed to identify unusual transactions; i.e., transactions that are not part of the day-to-day operations, and transactions involving shareholders, partners, or employees. Review all adjusting entries. Compare year-end bank reconciliation to the books for all cash accounts. Review the cash receipts journal for any items that are not credits to income or accounts receivable. Look for entries from sources other than cash receipts or disbursements which may indicate unauthorized withdrawals or expenditures, the acquisition or disposition on an asset, omitted income, or undisclosed bank accounts.

    4. Notes and accounts receivable should be identified (beginning and ending balances); tie the general ledger to the subsidiary ledger. Credit balances may indicate additional income or unrecorded sales. Old receivables, where no legal or collection action has taken place, should also be reviewed. The receivable may have been paid directly to a shareholder, partner or employee and left on the books.

    5. Review inventory sheets and identify how the inventory value was determined (Cost or Market, LIFO or FIFO). Ending inventory can be manipulated to control new profit. Look for write-downs, review items valued at $0, and trace values back to purchase invoices.

    6. Loans to shareholders should be analyzed to ensure entries to this account are not distributions of earnings, dividend income, or another form of taxable income reportable by the shareholder. If no interest is paid, consider imputing interest at the current rate. If no repayments have been made, consider whether the debt has been forgiven.

    7. Buildings and other depreciable assets should be reviewed to verify additions and deletions. How was a purchase financed? Could the asset be for personal use? If assets are removed from the balance sheet, how did the disposition occur? Was the disposition accounted for? Assets may remain on the balance sheet, even if disposed of.

    8. Accounts payable should be identified (beginning and ending balances); tie the trial balance to the general ledger; check for adjusting entries, netting of related accounts receivable, or reclassifications that may be unreported income or understatement of sales. Review taxpayer's policies for making payments; deviations should be reviewed. The majority of accounts payable should be inventory purchases; when the value of the account payable is similar to or greater than inventory, there may be a misstatement of ending Inventory.

    9. Analyze the loans from shareholder account (beginning and ending balances), which may be consolidated with other accounts. Consider the possibility that diverted corporate income was lent back to the corporation. Make sure the transactions reflects a bona fide loan and loan repayments; there should be a loan instrument with terms and stated interest rate. Does the shareholder have the means to loan the money to the entity? If not, what was the source of funds? Consider whether the loan is a capital contribution and if the interest paid to the shareholder is really a dividend. Loans from financial institutions to the taxpayer, where the shareholder cosigned or guaranteed the debt, are not loans from shareholders; these loans should be included in Notes Payable.

    10. The retained earnings account should be analyzed, including all adjustments and adjusting entries. Make sure the reasons for the adjustments are understood. Entries that are debited or credited to retained earnings have no affect on the profit and loss statement for the current year. Also review Schedules M-1 and M-2 and make sure items such as meals and entertainment, book versus tax depreciation, penalties, etc. are accounted for and that no item with potential tax impact is incorrectly included in retained earnings rather than addressed on the tax return.

    11. IRM 4.10.3.8.4, Step 3: In-Depth Analysis, includes guidance for specific balance sheet accounts.

    12. Review the corporate minutes to evaluate potential for accumulated earning tax under IRC 531. Corporations must have a business reason for accumulating earnings in excess of $250,000; otherwise, earnings should be distributed to shareholders as dividends. Review the dividend history to determine when (if ever) dividends were issued. If the business is consistently profitable and no dividends have been distributed to the shareholder, the shareholder's compensation may be unreasonably high.

  3. Use CFOL information or secure copies of subsequent and prior year returns from the taxpayer to complete the comparative analysis when the examination is initiated.

  4. Tie balance sheet accounts, such as cash, to their respective source documents (cash receipt/disbursement journals and bank reconciliations).

  5. Tie balance sheet accounts such as accounts receivable and accounts payable to the receivable/payable subsidiary ledger ending balance.

  6. Compare the adjusted trial balance to the balance sheet to ensure they match. Account grouping sheets should be requested for this analysis. This is an essential step in the examination of a double-entry set of books.

  7. Review the adjusting journal entries from the unadjusted trial balance to the adjusted trial balance for misclassifications, unusual debits to income accounts or possible manipulations of reported income. The adjusted trial balance should be tied to the general ledger to ensure there are no missing adjusting journal entries.

  8. The general ledger should be scanned for large, unusual or questionable items in the journal entries or adjusting journal entries, such as debit entries to income accounts or credit entries to asset accounts (i.e., accounts receivable that do not flow from the cash receipts journal).

  9. See IRM 4.10.3.8, Balance Sheet Analysis: Introduction, for additional instructions.

4.10.4.3.4.2  (08-09-2011)
Schedules M-1, M-2, and M-3 (Corporations and Other "Business" Returns)

  1. Perform a reconciliation of Schedule M–1, Reconciliation of Income/Loss Per Books with Income Per Return, or equivalent schedule.

    1. The entries on Schedule M-1 are not part of the taxpayer's double-entry account system. Normal accounting controls do not exist; and, therefore, errors can be frequent. Look for items that are deducted from the books and then again (erroneously) on the Schedule M-1; transpositions of numbers; an expense on the books but not on the tax return.

    2. The taxpayer may disguise its Schedule M-1 adjustments by combining or netting items which normally are reported as separate line items.

    3. Omitted Schedule M-1 items can be found by analyzing balance sheet accounts (especially liabilities), which are not affected by Schedule M-1 adjustments on the tax return.

    4. See IRM 4.10.3.6.1, Schedule M-1, for a complete discussion and example.

  2. Perform a reconciliation of Schedule M–2, Analysis of Unappropriated Retained Earnings per Books, or equivalent schedule. The disposition of, or changes to, retained earnings can indicate whether monies have been distributed to a shareholder and where those funds originated. Refer to IRM 4.10.3.6.2, Schedule M-2, for complete discussion.

  3. Perform a reconciliation of Schedule M-3.

    1. Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, is used by corporations filing Form 1120 whose total assets on Schedule L, Line 15, column (d) equal $10 million or more for taxable years ending on or after December 31, 2004. For tax years ending on or after December 31, 2006, the filing requirement is expanded to include taxpayers with total assets of $10 million or more and who file Form 1120S, 1120L, or 1120PC.

    2. Part I primarily reconciles financial statement worldwide net income (loss) for the corporation (or consolidated financial statement group, if applicable) to net income (loss) per the income statement of the corporation for U.S. taxable income purposes. Parts II and III reconcile financial statement net income (loss) for the U.S. corporation (or consolidated tax group, if applicable) to taxable income reported on Form 1120. Part II generally reflects income, gain and loss items. Part III generally reflects expense and deduction items.

    3. A partnership will be required to file M-3, Net Income (Loss) Reconciliation for Certain Partnerships, if it has $10 million or more in assets at the end of the year, $35 million or more in total receipts, or is 50% or more owned by a taxpayer.

    4. Refer to LB&I's Schedule M-3 Technical Guidance website for more detail on analyzing Schedule M-3.

4.10.4.3.4.3  (08-09-2011)
Required Filing Checks (Corporations and Other "Business" Returns)

  1. Corporate and stockholder returns, as well as partnership and the associated partner returns, are considered related because the returns are for entities over which the taxpayer (stockholder or partner) has control and which can be manipulated to divert funds or camouflage transactions. Evaluate copies of the tax returns of significant shareholders or partners (greater than 20% direct or indirect ownership) for:

    1. Examination potential (including issues unrelated to the corporate or partnership return),

    2. The proper treatment of related transactions with the corporation or partnership, including losses from related parties, and

    3. The likelihood of diverted funds.

  2. See Exhibit 4.10.4-8, Tax Treatment of Diverted Income, if funds diverted from a corporation to a stockholder are identified.

  3. Completion of the Required Filing Checks is not a violation of IRC 7602(e). See IRM 4.10.5, Required Filing Checks.

  4. Copies of related shareholder/partner returns should be obtained using CFOL or CDE first. If the CFOL and CDE information is insufficient, the return should be requested from either the campus or the taxpayer for inspection. See IRM 4.10.5.2.2, CFOL/IDRS and CDE.

  5. For cases in which entities related through a flow-through relationship are suspected, but cannot be otherwise identified, examiners should request research using the yK1 Link Analysis Tool. This tool provides a graphic representation of flow-through relationships created by partnerships, trusts, and S corporations. The tool uses Schedule K-1 data to depict ownership relationships and income/loss flows between payers and payees.

    1. SBSE examiners can request research using Form 13680, Small Business/Self Employed yK1 Link Analysis Research Request.

    2. For additional information or to request yK1 research, go to http://k1.soi.irs.gov/.

  6. Examiners should determine if the income from the related business entity was included on the shareholder/partner's individual return. If the income was reported and there are no other issues, the return should not be opened for examination. If the income from the related business entity was not reported on the return, the examiner should open the shareholder/partner's individual return for audit. For example, the business did not issue Form W-2, Wage and Tax Statement, to corporate officers. See IRM 4.10.5.4, Related Returns, for additional discussion.

  7. Independent of the potential underreported income from the business entity, the return should be opened for audit if the examiner notes that a financial status analysis based solely on the return indicates insufficient funds to support the identified expenses, or a large, unusual, or questionable item is identified.

  8. Examiners should determine whether the related return warrants examination from a classification perspective; i.e., trace the transactions between the individual and related business entity, complete a financial status analysis based on the return as filed and internal sources of information (Exhibit 4.10.4-2), and review the return for other potential issues.

  9. Should the related individual return be opened for audit, it is subject to the minimum income probes and examiners are expected to determine whether the taxpayer has reported the correct amount of taxable income. The depth of the examination of income and the techniques used are dependent on the facts and circumstances of the case.

    Example:

    A closely held corporation was examined. The 100% shareholder's personal expenses were deducted as a business expense on the corporate return. The shareholder's personal return was examined to make the adjustment for the unreported dividend. A reasonable likelihood of unreported income on the shareholder's return exists because the shareholder has manipulated the corporate entity and camouflaged nondeductible personal expenses as deductible business expenses. The examiner should go beyond the minimum income probes for this related shareholder, since there is a reasonable likelihood of unreported income on the individual return.

4.10.4.3.4.4  (08-09-2011)
Initial Interview (Corporations and Other "Business" Returns)

  1. The initial interview should be held with the partnership's general partner, managing member if an LLC, Tax Matters Partner (TMP) if a TEFRA entity, or the corporate officer most familiar with the day-to-day operations of the business. From the taxpayer's perspective, an interview with an Internal Revenue examiner may be overwhelming. Therefore, initial interviews should be professional and not overbearing.

  2. Bartering income should be considered.

  3. IRC 7521(c) states that examiners cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence can be requested through the representative. Should an examiner find that a representative has unreasonably delayed or hindered an examination, an examiner can bypass the representative and deal directly with the taxpayer. See Exhibit 4.10.4-5, Bypassing Powers of Attorney.

  4. Question the TMP, corporate officer, or representative concerning possible loans, gifts, or other nontaxable funds, known errors/omissions on the return, unreported sources of income and ask for any information necessary to resolve issues identified during the pre-audit analysis. If loan proceeds are identified, request the loan application documents to validate that financial reporting is consistent with the tax return. Discrepancies should be resolved with the taxpayer's assistance.

  5. Question the TMP, corporate officer, or representative about cash-on-hand and accumulated funds. See IRM 4.10.4.3.3.2, IRM 4.10.4.6.8.3, and see Exhibit 4.10.4-1 for additional discussion.

  6. Question the TMP, corporate officer, or representative about e-commerce activities. See Exhibit 4.10.4-7 for additional discussion.

  7. Question the TMP, corporate officer or representative about internal controls, including the segregation of duties, which can be verified during the audit. The flow of money should be established to determine any potential control weaknesses which could result in diversion of funds.

  8. Refer to IRM 4.10.3, Examination Techniques, and IRM 4.10.4.3.3.2 for additional interview questions. Although these questions are intended for individual business returns, they are equally applicable to other business entities.

  9. IRC 7521(b)(2) requires examiners to suspend interviews when taxpayers state that they wish to consult with a representative or otherwise seek advice. The taxpayer’s right of consultation will be strictly honored and interviews will be suspended and rescheduled accordingly. This provision does not apply to interviews initiated by administrative summons and will not be used to repeatedly delay or hinder the examination process.

4.10.4.3.4.5  (08-09-2011)
Tour of Business Sites (Corporations and Other "Business" Returns)

  1. Conduct a tour of the physical business site controlled by the taxpayer. Generally, the physical business site will be the principal location and any other locations acquired during the period under examination should be visited, (see IRM 4.10.4.3.3.3). The purpose of a tour is to:

    1. Gain familiarity with the taxpayer’s business operation and internal controls,

    2. Identify potential sources of unreported income, and

    3. Confirm the existence of assets.

  2. A tour of the physical business site is not required for office audit cases. However, if appropriate (and with manager's approval), a tour of the business site may be conducted.

  3. The results of a tour and any observations should be documented in the examination workpapers.

  4. Conduct a tour of the business websites controlled by the taxpayer. See IRM 4.10.4.3.7.2.

4.10.4.3.4.6  (05-27-2011)
Evaluate Internal Controls (Corporations and Other "Business" Returns)

  1. Internal controls are the taxpayer's policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information. Evaluate the internal controls to gain an understanding of the taxpayer’s business operations and control features. See IRM 4.10.3.4, Evaluating the Taxpayer's Internal Controls. If the taxpayer maintains electronic books and records, refer to IRM 4.10.4.3.7.5.

  2. While there is no exhaustive definition of weak internal accounting controls, which will impact the scope of the examination of income, examples include:

    1. Books and records that cannot be reconciled to the tax return

    2. Transactions that are not properly authorized

    3. Recorded transactions are not valid

    4. Existing transactions are not recorded

    5. Transactions are improperly valued

    6. Transactions are improperly classified

    7. Transaction are recorded at the improper time

    8. Transactions are incorrectly summarized

    9. Transactions all made by the same person or related parties

    10. Recording and handling of assets by the same person or related parties

    11. Income is diverted from the corporation or other business entity to a stockholder or other related entity

  3. If it is determined that the internal controls are weak, identify when and how income could be diverted.

    1. Cash receipts could be skimmed if the sole shareholder makes all the deposits.

    2. A large number of over-aged receivables or bad debts, where no debt collection agency is involved, may indicate that payments on account are being diverted by a shareholder.

    3. Secondary sources of income (such as video arcade games or vending machines) that are not accounted for in the books and records are indicative of unreported income.

  4. Example: A taxpayer's business consists of small home repairs and construction projects. The taxpayer files a corporate tax return and is the 100% shareholder. The books and records tie to the corporation's income tax return and the invoices tie into the gross receipts shown on the return. The corporate return reflects a net profit of $5,000. The corporation did not pay the taxpayer a salary, but the taxpayer's spouse earned $30,000 in wages from an unrelated business (as reported on the shareholder's Form 1040 tax return). Although the cash flow analysis suggests sufficient funds to support the corporation's expenses, most of the gross receipts are cash and the internal controls are weak because the shareholder's spouse maintains the books.

    1. The corporate and shareholder income tax returns are considered related because the returns are for entities over which the shareholder has control and which can be manipulated to divert funds or camouflage transactions. Therefore, the examination of the corporation cannot be completed without also examining the shareholder's individual return.

    2. Once an audit of the related individual return is initiated, the examiner should request the personal bank records (statements, cancelled checks and deposit slips) for both spouses to determine if any corporate funds were diverted.

    3. If, after reviewing these records, the examiner believes there is a reasonable indication that there is a likelihood of unreported income, a formal indirect method may be used to make the actual determination of tax liability.

  5. The workpapers will document:

    1. The conclusions reached by the analysis of internal controls,

    2. The impact on the scope of the examination, and

    3. The impact on the depth of the examination of income.

4.10.4.3.4.7  (08-09-2011)
Test Gross Business Receipts or Sales (Corporations and Other "Business" Returns)

  1. Analyze the information obtained in the initial interview, observed during the tour of the business site, and from the evaluation of the internal controls to gain a complete understanding of the taxpayer’s business operations and control features.

  2. Reconcile the bank records. The depth of bank record inspection will depend on the reliability of internal controls and the judgment of the examiner. See IRM 4.10.4.3.4.6, Evaluate Internal Controls, for complete discussion. In addition, consider the results of the analysis of the primary shareholders’ or partners’ individual returns. The initial IDR may include a request for the business bank records, including the statements, deposit slips and cancelled checks. See IRM 4.10.3.7, Bank Record Reconciliations.

  3. See IRM 4.10.3.9, Testing Gross Receipts or Sales, for a complete discussion and listing of audit techniques.

  4. See IRM 4.10.4.3.7.4, Identifying Gross Business Receipts from E-commerce Activities.

4.10.4.3.4.8  (08-09-2011)
Business Ratio Analyses (Corporations and Other "Business" Returns)

  1. The taxpayer's books and records can be used to evaluate the accuracy and reasonableness of the reported income through the use of ratios. A horizontal analysis, with documented conclusions, should be included in the case file for all business returns. A vertical analysis may not be appropriate for every case.

  2. Horizontal Analysis - This analysis identifies changes over time and may result in the identification of LUQ items not readily identified from a review of a single tax return. The tax return under audit should be compared to the prior and subsequent year returns. See IRM 4.10.4.3.3.8 for complete discussion and examples.

  3. Vertical Analysis - This analysis identifies differences between the taxpayer's business and industry standards for a given year and is an indicator of the reasonableness of gross business receipts and net profit reported on the tax return. A vertical analysis may not be appropriate for every case. Industry standards can be found at http://www.bizstats.com. See IRM 4.10.4.3.3.8 for complete discussion and examples.

    Note:

    Bizstat industry standards data is available for one year. It is generally available for the third year from the current calendar year. (i.e., for calendar year 2011, data is available for 2008).

4.10.4.3.4.9  (05-27-2011)
E-Commerce

  1. Refer to IRM 4.10.4.3.7.1 for additional information on e-commerce income issues.

4.10.4.3.4.10  (05-27-2011)
Deviation on Corporations and Other Business Returns Minimum Income Probes

  1. Examiners may find that one or more of the minimum income probes cannot be performed in a particular case or that no value is added by performing a specific minimum income probe. The decision to deviate from one or more of the minimum income probe requirements must be based on the specific facts of the case as they relate to the taxpayer.

  2. When the examiner determines a deviation from a minimum income probe is warranted, the reason(s) must be documented in the appropriate minimum income probe workpapers. The factors considered and rationale for deviating must be specifically documented. The documentation must clearly support the decision.

    Caution:

    This section cannot be used to deviate or otherwise limit the minimum income probes due to workload or other factors not related to the taxpayer.

4.10.4.3.5  (08-09-2011)
Minimum Income Probes: Delinquently Filed Returns and Nonfiled Returns

  1. Delinquent returns filed at a campus or with an examiner are subject to the same minimum requirements for the examination of income as timely filed returns.

  2. If a financial status analysis (or another analysis) based on a return secured from a nonfiler as part of an examination indicates that there is a likelihood of unreported income, then an in-depth examination of income should be conducted and a formal indirect method is used to make the actual determination of tax liability if warranted.

  3. Refer to IRM 4.12.1, Nonfiled Returns, for more information.

  4. Substitutes for return(s) filed on behalf of a nonfiler under IRC 6020(b) will require a reconstruction and examination of income.

    1. Secure and review available internal information to use in the determination of the scope of examination of income. See (Exhibit 4.10.4-2). If income is identified through the Information Returns Program (IRP), it may be necessary to contact third parties to verify income items reported on a Form 1099 or Form W-2 if the taxpayer disputes the income items reported. The IRC 7602(c) requirement to provide the taxpayer with notice of third party contacts applies.

      Note:

      Refer to IRC 6201 and IRM 4.10.4.3.6.1 below for when third party contact for verification is legally required, and IRM 4.10.7.6.1.2, Relationship with IRC section 6201(d) for steps that should be taken if the taxpayer disputes IRP income.

    2. Business expenses should be determined using the taxpayer's books and records. In the event the taxpayer cannot substantiate business expenses, the Service has no legal requirement to estimate expenses. Estimates may be used if the taxpayer can provide a reasonable basis. For example, the taxpayer can substantiate business expenses in another year and establishes that the nature of the business was the same as for the year under audit.

    3. If the sale of securities (stock, bond, etc.) is an issue, the Service has no legal requirement to obtain basis information from third party sources, despite the fact that the proceeds of such sales are included in income.

    4. Use Bureau of Labor Statistics (BLS) information (or comparable statistics from a reliable source) to estimate personal living expenses. See IRM 4.10.4.3.3.1 and IRM 4.10.4.6.1.3.1.

    5. Use industry ratios (available at http://www.bizstats.com) to evaluate the reasonableness of the nonfiler’s records of gross income.

      Note:

      Bizstat industry standards data is available for one year. It is generally available for the third year from the current calendar year. (i.e., for calendar year 2011, data is available for 2008).

    6. Only the standard deduction should be allowed as the use of itemized deductions is an election by the taxpayer. However, IRP or other information about deductible personal living expenses should be included in the financial status analysis.

  5. Examiners should attempt to use the nonfiler’s books and records to prepare a preliminary schedule of gross income. Based upon the evaluation of the nonfiler’s schedule of gross income, available internal information, and statistical information, the examiner must determine the subsequent audit scope using the following criteria:

    IF THEN
    The nonfiler’s schedule of gross income prepared from his/her books and records is consistent with all financial activities of the nonfiler and available internal information. The substitute for return may be prepared using the nonfiler’s record of gross income. The results and conclusions reached should be documented in the examination workpapers.
    The nonfiler’s schedule of gross income prepared from his/her books and records is inconsistent with the financial activities of the nonfiler and/or available information. A more in-depth examination of income is warranted. See IRM 4.10.4.5 below for suggested elements of an in-depth examination income for an individual nonfiler. Note: Collectibility consideration should be given to each situation in which the examination scope may be expanded.

4.10.4.3.6  (05-27-2011)
Minimum Income Probes: No Show and/or No Response Cases

  1. All examinations, including no show/no response cases, must address the minimum income probes required by this IRM, including a T-Account.

  2. A no show occurs when a "deliverable" address exists, but the taxpayer does not respond to the correspondence or does not "show" for any scheduled appointment. Follow-up attempts must be made to contact the taxpayer to encourage him/her to schedule and keep an appointment or to solicit an agreement.

    • If all attempts to get the taxpayer to respond are unsuccessful (or the taxpayer raises a frivolous dispute) and minimum income probes have been completed, a report may be issued if income is not an issue.

    • If income is an issue, the examiner must conduct research and resolve the income issue before preparing the report.

    Note:

    When a report is prepared, generally, only classified issues will be disallowed. If certain issues were declassified at the group level due to time constraints, these items should be disallowed as well. All the necessary related or automatic adjustments will be made. Consideration will be given to picking up prior and subsequent years.

  3. No response occurs when a taxpayer fails to respond to the initial contact letter or telephone call. The field and office examiner must determine why the taxpayer is not responding:

    • The examiner will follow the procedures in IRM 4.10.2.7.3.1, Field Examination Initial Contact, paragraphs 3 and 4.

    • If the initial appointment letter has been returned undeliverable, the examiner will follow the steps in IRM 4.10.2.7.2, Locating the Taxpayer, to secure a current address or telephone number. If unsuccessful, the mandatory steps in IRM 4.10.2.7.2.2, Unlocatable Taxpayers - Mandatory Steps to Locate, must be taken and documented on Form 1900-B, Unlocatable Taxpayer Check Sheet.

    • If the steps above do not result in a current address for the taxpayer, ensure the minimum income probes listed below have been conducted, and income is not an issue. The examiner and group manager must consider whether an audit report is appropriate when the taxpayer cannot be located using the criteria in IRM 4.10.2.7.2.7, Case Closing Procedures if the Taxpayer Cannot Be Located.

    • If a decision is made to issue a report, disallow all classified issues only, consider prior and subsequent years, and mail it to the taxpayer’s last known address as reflected on IDRS. See IRM 4.10.2.7.2.1, Undeliverable Initial Contact Letters.

      Note:

      Cases where the taxpayer fails to respond to the initial contact letter or telephone call are not classifiable as no-contact, therefore they may not be surveyed. See IRM 4.10.2.10.1, Confirmation of the Initial Appointment. If an assessment is not appropriate, the case should be closed using Non-examined Disposal Code 42, Return Filed - Unable to locate. Form 1900, Income Tax Survey After Assignment, should be completed. The examiner should also document steps taken to locate the taxpayer on Form 1900-B, Proceeds From Broker and Barter Exchange Transactions, in the workpapers.

4.10.4.3.6.1  (05-27-2011)
Minimum Income Probes Used by Examiners

  1. Income probes for no show/no response cases may also include specific items or indirect methods to determine whether the taxpayer accurately reported income.

4.10.4.3.6.2  (08-09-2011)
Specific Item Probes Using Information Returns Program (IRP) Cases

  1. When using the specific item method for adjustments based on unreported Information Return Program (IRP) income, if the taxpayer fails to respond or raise a "reasonable dispute" regarding the correctness of the IRP data, then the burden of proof remains with the taxpayer and does not shift to the government. In unreported income cases based on IRP information, there is no legal requirement pursuant to IRC 6201(d) to contact third parties to verify income items unless the taxpayer reasonably disputes the income and has fully cooperated with the Service.

  2. In no show/no response cases where the taxpayer has not responded or raised a frivolous dispute (wages are not income, etc.), there is no legal requirement for further verification with third parties and an income adjustment in the amount reflected on the IRP document is appropriate. Verification with third parties is required when IRP information is relied upon to support the civil fraud penalty (IRC 6663) or where the taxpayer disputes the IRP income information.

  3. Verification with third parties should also be made in no show/no response cases where there is an inconsistency noted in the file that would cause the examiner to question the validity of the IRP information.

    Example:

    Verification of income should be attempted if there is some obvious inconsistency in the IRP information (such as Forms 1099 or W-2) that appears to be out of line in dollar amount from previous years, or there is some aspect of the Forms 1099 or W-2 that is unusual on its face (such as Forms 1099 or W-2 income that is completely inconsistent with the known profession or occupation of the taxpayer).

  4. In cases involving large dollar income items (e.g., Form 1099-MISC amounts greater than $100,000), examiners, in consultation with their manager, should use their professional judgment in deciding whether it makes good business sense (given the circumstances) to verify IRP information. This discussion should be documented in the workpapers.

4.10.4.3.6.3  (05-27-2011)
Indirect Methods in Which the Preliminary T-Account Has a Material Imbalance:

  1. If an indirect method is used, the use of statistical data must be tailored to the individual taxpayer.

  2. If an indirect method reveals an understatement of income in excess of $10,000 and the case is a no show, the examiner will take the following steps:

    1. Examiners must use all available administrative tools, including summons enforcement, to gather necessary information before statistical data is used.

    2. If a T-Account is used, do not reduce the expense side for disallowed expenses. Assume (even though disallowed) that the taxpayer spent the money.

    3. Refer to IRM 4.10.4.6.1.3, Use of Bureau of Labor Statistics Data or Other Statistical Information to Reconstruct Taxable Income, to determine when income may be reconstructed using Bureau of Labor Statistics (BLS) data or comparable statistics from a reliable source. The analysis is completed using the tables for annual expenses, not income, because determining the expenses represents a better reflection of the actual costs to maintain a household.

    4. The examiner and manager must determine if an income adjustment will be pursued based on the information contained in the indirect method, and if so, document it in the case file.

    5. Prior and subsequent year’s returns should be considered for similar imbalances.

    6. For TCO cases, discuss with the manager whether the case warrants transfer to the field. This would include any cases that are beyond the scope of an office audit for reasons such as the complexity of the issues or complexity of additional related businesses such as flow-through entities. See IRM 4.11.29, Transfer of Returns Open for Examination.

4.10.4.3.6.4  (05-27-2011)
Estimated Business Expenses

  1. In no show/no response cases the Service has no legal requirement to estimate expenses, including cost of goods sold. If the examiner has actual taxpayer information regarding expenses, then taxpayer specific information (not industry averages) should be used to determine expenses.

  2. If the sale of securities is an issue and in cases where the taxpayer has not substantiated stock basis, the Service has no legal requirement to obtain basis information from third party sources, despite the fact that the proceeds of stock sales are included in income.

4.10.4.3.6.5  (08-09-2011)
Penalties Application

  1. Penalties, such as negligence, will not be asserted solely due to the taxpayer’s failure to appear for an audit or respond to an inquiry or notice. However, the facts and circumstances from the return and the case file may warrant assertion of the accuracy-related penalty attributable to negligence.

  2. See IRM 20.1.5.7.1, Negligence, and IRM 20.1.5.8.2, Substantial Understatement, paragraph 5. The examiner should document actions and decisions using Form 9984, Examining Officer's Activity Record.

4.10.4.3.7  (08-09-2011)
Minimum Income Probes: E-Commerce Income

  1. Electronic commerce (e-commerce) includes a wide range of business activities transacted over computer networks and the Internet. This section outlines audit techniques for addressing e-commerce during the minimum income probes. Additional assistance is available at http://www.irs.gov/businesses/small/industries/article/0,,id=208385,00.html E-Business & E-Commerce Tax Center.

4.10.4.3.7.1  (08-09-2011)
Identifying E-Commerce Businesses

  1. Determining whether a taxpayer uses the Internet can be done during any phase of the examination. However, if it can be identified, the website should be reviewed during the pre-contact stage.

  2. Examination issues for e-businesses are published on MySB/SE Issues and Procedures Module. Select Electronic Business from the drop down menu for "Filter by Program Area." Internet activity provides techniques on finding websites, analyzing and saving websites, the tax treatment of domain names, and finding the owner of a website using "whois" tools. Online Sales provides sample document requests and interview questions with explanations. Interview questions should be tailored to the taxpayer and appropriate follow up questions asked. Items to consider:

    1. Research the business name. The business name maybe included in an Internet domain name; i.e., "mycompany.com."

    2. Research the taxpayer's name, business name, or phone number using a search engine such as Google®, Bing®, or Yahoo® to determine whether the taxpayer has web page listings. Be alert for multiple listings.

    3. Look for deductions on the return that are common to e-commerce businesses, such as depreciation for networking equipment or high telecommunications expenditures, or payments to a Internet Service Provider (ISP) or an Application Service Provider (ASP).

    4. Review business cards for website reference. Generally, business cards will include a website address, if one is available.

    5. Review advertisement in the Yellow Pages which may include an Internet address.

  3. In every case, examiners should search for an Internet presence using a search engine such as Google. Examiners should also ask the taxpayer about Internet use. Effective web searching provides tips on using the advanced search features of popular search engines to narrow results. Internet use and e-commerce activities provide examples of appropriate open ended questions.

4.10.4.3.7.2  (05-27-2011)
Reviewing Websites

  1. If a website is discovered, viewing it can provide insight into the taxpayer's activities. Reviewing a taxpayer's website is a complement to touring the physical business site; e.g., to gather information helpful to understanding the business activities.

  2. To see how the website looked in the year under audit, search the Internet Archive at http://www.archive.org. The search feature is call the "Wayback Machine." The Examiner will be provided with a historical copy of all available archived copies of the website.

  3. Use http://www.linkpopularity.com to identify websites with hyperlinks that are linked to the taxpayer's website. Linkpopularity.com is a metasearch website that uses the reverse link feature to find websites that have hyperlinks pointing to a website.

  4. Evidence of an unreported e-business activity can be found by reconciling credit card payments, as a taxpayer may consolidate all credit card or payment vouchers when submitting them to the e-payment provider.

  5. When reviewing a website, consider the following questions:

    1. What purpose does the website serve? Some websites are used as advertisement or for information sharing with no elements of e-commerce.

    2. Is there a unique term that the taxpayer uses to advertise the site? If so, an Internet search may identify additional websites or business operations.

    3. Does the website provide information about the business? Often, there will be an "About Us" page with information about officers, owners and key employees.

    4. Does it provide information on how to contact the business?

    5. Does the business gather information about its customers on the website? Would a customer need a password to sign in?

    6. Are goods and/or services sold on the website?

    7. Can purchases be processed through the website?

    8. What methods of payments are accepted?

    9. Does the website include links to other websites controlled by the taxpayer? Links, banners, and pop-up windows may provide information about additional income from advertisements, reciprocal links to generate traffic, marketing partners, and related websites.

    10. Does the website disclose information about business partners? For example, a wholesaler in the furniture industry may furnish a list of retailers selling their product.

    11. Is the website available in multiple languages? If so, this would indicate global markets.

  6. Further inquiry will be needed to determine how the website is supported; i.e., whether the website is hosted by a third party or maintained on the taxpayer's own web servers, the location of the web servers, what equipment or computers are used, who has access to the servers, what records are maintained, and when the website was placed in service.

  7. To document the case file, save the website or make hard copies of the website pages. Documenting the website content before the taxpayer limits access may be important to the development of, or providing evidence for, an unreported income issue.

4.10.4.3.7.3  (05-27-2011)
Interviewing the Taxpayer Regarding E-Commerce Activities

  1. The taxpayer should be interviewed regarding Internet use for e-commerce activities. For individual business returns, the taxpayer should be asked about both personal and business use. Payments made over the Internet need to be considered as part of the minimum income probes.

  2. Exhibit 4.10.4-7 is a list of interview questions specific to Internet and website use.

4.10.4.3.7.4  (05-27-2011)
Identifying Gross Business Receipts from E-Commerce Activities

  1. This section provides an overview of common sources of taxable income generated by e-commerce activities and associated audit techniques.

4.10.4.3.7.4.1  (08-09-2011)
Payments for Goods and Services

  1. Generally, a business will list the types of payments accepted on the website. Review the taxpayer's web pages for payment systems and providers such as PayPal®, Visa®, MasterCard®, American Express®, Diners Club®, and real time Check Debit.

  2. Trace these income sources through the books and records to the tax return.

  3. Reconcile a sample of entries in the sales ledger for specific providers.

  4. Look for providers that are not reflected in sales and verify that receipts from all payment providers are included in sales.

    1. The taxpayer will commonly have one or more merchant accounts with a credit card processor. A "merchant account" allows a business to accept credit cards, debit cards, gift cards and other forms of electronic payment. This is also known as payment processing or credit card processing.

    2. The taxpayer may also use payment intermediaries such as PayPal.

  5. Evidence of unreported e-business activity can be found by reconciling daily receipts from credit cards and receipts from other electronic funds transfers to bank deposits. Such transactions are usually batched daily by both the taxpayer and the payment processor.

4.10.4.3.7.4.2  (05-27-2011)
Advertising Banners and Pop-Up Ads

  1. Taxpayers may receive advertising income for banner and pop-up advertisements appearing on their website. The taxpayer is being paid for advertising on another e-commerce business's products or services similar to a brick and mortar business putting up a billboard on its property and charging advertising fees.

  2. Ask the taxpayer how this income is accounted for in the books and records.

  3. Advertising fees may be based on the number of times the banner or pop-up ad is accessed. The site may include a counter indicating the number of visitors to the site, from which the amount of traffic on the website can be estimated. Similarly, the number of times the banner or pop-up ad is accessed can be estimated. Based on the ratio and the fee charged per access, advertising income can be estimated.

  4. Other methods for determining the advertising fee include:

    1. Pay-per-view is based on the activity of the website,

    2. A fixed monthly fee, or

    3. A commission based on sales resulting from the banner.

  5. Taxpayers may be part of an "ad network," which is a group of websites joined together by an intermediary who sells advertising to aggregated groups of websites. This is an efficient method for advertising buyers and advertisers to reach broad audiences. Advertising income is usually collected from the intermediary.

  6. "Ad affiliate" networks allow advertisers to trade banners. This is similar to bartering networks in which banner advertising is exchanged without any monetary compensation.

4.10.4.3.7.4.3  (05-27-2011)
Internet Auctions and Bartering

  1. Overstocked items and aging inventory can be liquidated by selling it on Internet auction sites or exchanging it through a bartering transactions. This may be identified by unusual fluctuations in inventory.

  2. Internet auctions and bartering can be used for on-going business activities or for disposing of assets.

4.10.4.3.7.4.4  (05-27-2011)
Online Sales

  1. Online retailers usually ship their product and shipping receipts are another record of a sale that can be reconciled with both cost of goods sold and reported gross receipts.

4.10.4.3.7.4.5  (05-27-2011)
Tip Jars

  1. A website may include a "tip jar" where cash tips may be deposited through various Internet payment forms. Blogging websites have tip jars so visitors can show their appreciation, or help pay for the cost of the website.

4.10.4.3.7.4.6  (05-27-2011)
Customer Information

  1. Websites commonly gather information about the business's customers and sale of customer information can be a significant source of income. Ask the taxpayer if customer information is sold or shared, and review any formal marketing agreements.

4.10.4.3.7.5  (08-09-2011)
Evaluating Electronic Books and Records

  1. The Uniform Electronic Transaction Act (UETA) defines electronic records as a record created, generated, sent, communicated, received, or stored by electronic means. The UETA is suggested legislation that the National Conference of Commissioners on Uniform State Laws, in 1999, drafted and recommended be adopted by all states. More information about the UETA can be found at http://www.nccusl.org.

  2. Rev. Rul. 71-20, 1971 -1 C.B. 392, establishes that all machine-sensible data media used for recording, consolidating, and summarizing accounting transactions and records within a taxpayer's Automatic Data processing (ADP) system are records within the meaning of IRC 6001 and Treas. Reg. 1.6001-1, and are required to be retained so long as the contents may become material in the administration of any internal revenue law.

  3. Rev. Proc. 98-25, 1998-1 C.B. 689, specifies the basic requirements that the Service considers essential when a taxpayer maintains records within an ADP.

  4. Rev. Proc. 98-25 provides an exemption for small business taxpayers with assets of less than $10 million at the end of its taxable year in complying with the record retention requirements of Rev. Rul. 71-20 and Rev. Proc. 98-25. For purposes of meeting that exemption, a controlled group of corporations (as defined in IRC 1563) is considered to be one corporation and all assets of all members of the group are aggregated. Also, a small business taxpayer will not meet the exemption provided in Rev. Proc. 98-25 if any of the following three conditions exist:

    1. All or part of the information required by IRC 6001 is not in the taxpayer's hardcopy books and records, but is available in machine-sensible records;

    2. Machine -sensible records were used for computations that cannot be reasonably verified or recomputed without using a computer (e.g., Last In, First-Out (LIFO) inventories); or

    3. The taxpayer is notified by the Service that machine-sensible records must be retained to meet the requirements of IRC 6001.

  5. An "ADP System" consists of an accounting and/or financial system (and subsystems) that processes all or part of a taxpayer's transactions, records, or data by other than manual methods. It includes, but is not limited to, a mainframe computer, stand-alone or networked microcomputer system, Data Base Management System (DBMS), and a system that uses or incorporates Electronic Data Interchange (EDI) technology or an electronic storage system. Key requirements include:

    1. Machine-sensible records (data in an electronic format intended for use by a computer) must be retained as long as the contents may become material to the administration of the internal revenue laws. The taxpayer may enter a record retention limitation agreement with the Service to provide for the establishment and maintenance of records as agreed upon by the Service and the taxpayer.

    2. Machine-sensible records must provide sufficient information to support and verify entries made on the taxpayer's return and to determine the correct tax liability; i.e., the machine-sensible records must reconcile with the taxpayer's books and the taxpayer's return, and provide an audit trail to transaction-level details in the books of original entry.

    3. Machine-sensible records must contain sufficient transaction-level detail so that the information and the source documents underlying the machine-sensible records can be identified.

    4. All machine-sensible records required to be maintained must be made available to the Service upon request and must be capable of being retrieved, manipulated, printed on paper, and produced as output on electronic media.

    5. A taxpayer is not required to create any machine-sensible record other than that created either in the ordinary course of business or to establish tax return entries.

    6. A taxpayer that used EDI technology must retain machine-sensible records that alone, or in combination with any other records, contain all the information required of hardcopy books and records. The required detail may by captured at any level within the accounting system. However, the taxpayer must establish audit trails between the retained records and books, and between the retained records and the tax return.

    7. Taxpayers continue to be responsible for retaining hardcopy records that are created or received in the ordinary course of business. Alternatively, such records can be retained in microfiche/microfilm format (see Rev. Proc. 81-46, 1981-2 C.B. 621) or in an electronic storage system (see Rev. Proc. 97-22, 1997-1 C.B. 652).

    8. The taxpayer must provide the Service (at the time of examination) with the resources (e.g., appropriate hardware and software, terminal access, computer time, personnel, etc.) necessary to process machine-sensible books and records.

    9. The taxpayer must maintain and provide (upon request) documentation of the processes that create, modify, and maintain its records. The documentation must support and verify entries made on the taxpayer's return and determine the correct tax liability, and evidence the authenticity and integrity of the taxpayer's records. Documentation includes records of internal controls that reflect: (1) the functions being performed as they relate to the flow of data through the system; (2) the internal controls used to ensure accurate and reliable processing; (3) the internal controls used to prevent the unauthorized addition, alteration, or deletion of retained records; and (4) the charts of accounts and detailed account descriptions.

  6. Understanding the reliability of electronic books and records is critical to evaluating internal controls, reconciling the books and records to the tax return, and obtaining records. The following attributes of electronic records need to be considered when evaluating the reliability of electronic books and records:

    1. Software may include features to create a second set of books and records, or allow for manipulation of sales by reducing and/or deleting of sales transactions entirely.

    2. Third party software programs, commonly referred to as "zapper" programs, can be used to selectively delete electronically recorded sales records. Methods or practices of deleting electronic sales records, usually cash sales are referred to as "zapping."

    3. Electronic records are, in general, considered less reliable than their paper counterparts due to the ease with which they can be manipulated.

  7. Rev. Proc. 97-22, 1997-1 C.B. 652, provides guidance to taxpayers that maintain books and records by using an electronic storage system that either images their hardcopy (paper) books and records or transfers their computerized books and records to an electronic storage media, such as an optical disk, which allows books and records to be viewed or reproduced without the use of the original program. Key requirements include

    1. Reasonable controls to ensure the integrity, accuracy, and reliability of the electronic storage system;

    2. Reasonable controls to prevent and detect the unauthorized creation of, addition to, alteration of, deletion of, or deterioration of electronically stored books and records;

    3. An inspection and quality assurance program evidenced by regular evaluations of the electronic storage system including periodic checks of electronically stored books and records;

    4. A retrieval system that includes an indexing system;

    5. The ability to reproduce legible and readable hard copies of electronically stored books and records or when displayed on a video display terminal;

    6. The information in an electronic storage system must provide support for the taxpayer's books and records; and

    7. The taxpayer must maintain and make available to the Service upon request, a complete description of the electronic storage system, including all procedures relating to its use and the indexing system, and provide the Service with the resources (e.g., appropriate hardware and software) necessary to locate, retrieve, read, and reproduce (including hard copies) of any electronically stored books and records.

  8. A taxpayer is not in compliance with the recordkeeping requirements under IRC 6001 (and associated regulations) if the taxpayer's electronic storage system fails to meet the requirements of Rev. Proc. 97-22, and a Notice of Inadequate Records pursuant to Treas. Reg. 1.6001-1(d) should be issued. See IRM 4.10.8.16, Inadequate Records Notices: Overview, for complete discussion of Notices of Inadequate Records.


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