4.1.5 Case Building, Classification, Storage and Delivery

Manual Transmittal

October 20, 2017

Purpose

(1) This transmits a revision of IRM 4.1.5, Classification and Case Building and renames it to Case Building, Classification, Storage and Delivery.

Material Changes

(1) The PSP IRMs 4.1.1 through 4.1.7 have been re-configured into 3 IRMs, IRM 4.1.1, Planning, Monitoring and Coordination, IRM 4.1.2, Workload Identification and Survey Procedures, and 4.1.5, Case Building, Classification, Storage and Delivery to better reflect the flow of work through PSP and to combine all information about a specific source of workload in the same subsection.

(2) This IRM combines IRM 4.1.5, Classification and Case Building, (revision date August 24, 2012), IRM 4.1.6, Storage of Selected Returns, (revision date February 11, 2014), and IRM 4.1.7, Assignment of Selected Returns, (revision date June 17, 2014).

(3) The following changes were made:

Reference Change Details
  Reviewed the IRM for editorial changes in accordance with the new Document 13275, IRS Style Guide.
  Clarified the language throughout, and reviewed and updated all references and website addresses.
IRM 4.1.5.1 Added Authority, Responsibilities, Program Reports, Acronyms, Terms, and Related Sources into new section titled Program Scope and Objectives.
IRM 4.1.5.2 Incorporated Old IRM 4.1.5.2, Case Building Overview, and revised.
IRM 4.1.5.2.1 Incorporated Old IRM 4.1.5.2.1, Case Building Benefits.
IRM 4.1.5.2.2 Incorporated Old IRM 4.1.5.2.2, IDRS Integrated Data Retrieval System.
IRM 4.1.5.2.3 Incorporated Old IRM 4.1.5.2.3, CBRS (Currency and Banking Retrieval System), updated and renamed to Financial Crimes Enforcement Network(FinCEN).
IRM 4.1.5.2.4 Incorporated Old IRM 4.1.5.2.4, Taxpayer Locator Services and updated.
IRM 4.1.5.2.5 Incorporated Old IRM 4.1.5.2.5, Use of Colored Filed Folders, and updated.
IRM 4.1.5.3 Moved from Old IRM 4.1.5.1, Overview, and updated.
IRM 4.1.5.3.1 Moved from Old IRM 4.1.5.1.1, Classification, and revised.
IRM 4.1.5.3.2 Added Classification Background.
IRM 4.1.5.3.2.1 Moved from Old IRM 4.1.5.1.4, Area Classification Instructions and updated.
IRM 4.1.5.3.2.2 Moved from Old IRM 4.1.5.1.3, Sorting of Classified Returns at the Campus, and revised.
IRM 4.1.5.3.2.3 Moved from Old IRM 4.1.5.1.7, Electronic Classification, and updated.
IRM 4.1.5.3.2.4 Moved from Old IRM 4.1.5.1.12, Employee Returns, and updated.
IRM 4.1.5.3.2.5 Incorporated IG SB/SE-04-MM17-0050, Interim Guidance on Return Selection and Documentation, to ensure consistency among PSP employees when documenting classification decisions.
IRM 4.1.5.3.2.6 Moved from Old IRM 4.1.5.1.1(9–14), Classification, Old IRM 4.1.5.1.9.4 (5–6), Special Instructions - Business Returns, Old IRM 4.1.5.1.11.1, Non-Business Individual Returns, and Old IRM 4.1.5.1.11.2, Business Individual Returns, revised and added additional criteria for determining whether the return is classified for an RA or a TCO.
IRM 4.1.5.3.2.7 Moved from Old IRM 4.1.5.1.8, Form 5546, Examination Return Charge-out or Taxpayer Information Sheet, and updated.
IRM 4.1.5.3.2.8 Moved from Old IRM 4.1.5.1.9, Classification Checksheets, and updated.
IRM 4.1.5.3.2.8.1 Moved from Old IRM 4.1.5.1.9.1, Instructions for Preparation of Form 6754, Examination Classification Checksheet.
IRM 4.1.5.3.2.8.2 Moved from Old IRM 4.1.5.1.9.2, Special Instructions (All Returns) for Form 6754, and paragraphs 2, 3, and 4 of Old IRM 4.1.5.1.9.4, Special Instructions – Business Returns and revised.
IRM 4.1.5.3.2.9 Moved from Old IRM 4.1.5.1.10, Information Returns Program, and revised.
IRM 4.1.5.3.2.9.1 Moved from Old IRM 4.1.5.1.10.1, Classifying Returns with IRMF Transcripts by Tax Compliance Officers and Revenue Agents, and updated.
IRM 4.1.5.3.2.9.2 Moved from Old IRM 4.1.5.1.10.2, IMF CTR Screening/Matching, and Old IRM 4.1.5.1.10.3, BMF CTR Screening/Matching, and updated.
IRM 4.1.5.3.2.10 Moved from Old IRM 4.1.5.1.20, Returns with Collectibility Indicators.
IRM 4.1.5.3.2.10.1 Moved from Old IRM 4.1.5.1.20.1, Classification Procedures – Collectibility Indicators, and revised.
IRM 4.1.5.3.3 Moved from Old IRM 4.1.5.1.5, Review of Classification.
IRM 4.1.5.3.3.1 Moved from Old IRM 4.1.5.1.5.1, Standards for Classification, and revised.
IRM 4.1.5.3.3.1.1 Moved from Old IRM 4.1.5.1.5.1.1, Materiality - Significance of the Issue, and updated.
IRM 4.1.5.3.3.1.2 Moved from Old IRM 4.1.5.1.5.1.2, Fraud Potential Consideration During Classification.
IRM 4.1.5.3.3.2 Moved from Old IRM 4.1.5.1.5.2, Review of Performance, and updated. Added content from interim guidance memorandum SB/SE-04-0817-0050, Return Selection and Documentation, dated August 31, 2017 on documenting how workload is identified and selected to ensure consistency among PSP employees.
IRM 4.1.5.3.4 Moved from Old IRM 4.1.5.1.11, Identifying Issues on Individual Returns, and revised.
IRM 4.1.5.3.4.1 Moved from Old IRM 4.1.5.1.11.1.1, Issue Identification, and revised.
IRM 4.1.5.3.4.1.1 Moved from Old IRM 4.1.5.1.11.1.13, Unreported Income, and revised.
IRM 4.1.5.3.4.1.2 Moved from Old IRM 4.1.5.1.11.1.3, Exemptions, and revised.
IRM 4.1.5.3.4.1.3 Moved from Old IRM 4.1.5.1.11.1.10, Capital Transactions.
IRM 4.1.5.3.4.1.4 Moved from Old IRM 4.1.5.1.11.1.11, Pension and/or Annuity.
IRM 4.1.5.3.4.1.5 Moved from Old IRM 4.1.5.1.11.1.12, Rental Properties.
IRM 4.1.5.3.4.1.6 Moved from Old IRM 4.1.5.1.11.1.14, Copy of Schedule K-1, and updated.
IRM 4.1.5.3.4.1.7 Moved from Old IRM 4.1.5.1.11.1.15, Moving Expenses, and revised.
IRM 4.1.5.3.4.1.8 Moved from Old IRM 4.1.5.1.11.1.2, Itemized Deductions.
IRM 4.1.5.3.4.1.8.1 Moved from Old IRM, 4.1.5.1.11.1.4, Medical Expenses.
IRM 4.1.5.3.4.1.8.2 Moved from Old IRM 4.1.5.1.11.1.5, Taxes.
IRM 4.1.5.3.4.1.8.3 Moved from Old IRM 4.1.5.1.11.1.6, Interest Expenses.
IRM 4.1.5.3.4.1.8.4 Moved from Old IRM 4.1.5.1.11.1.7, Contributions.
IRM 4.1.5.3.4.1.8.5 Moved from Old IRM 4.1.5.1.11.1.8, Casualty or Theft Loss, and revised.
IRM 4.1.5.3.4.1.8.6 Moved from Old IRM 4.1.5.1.11.1.9, Miscellaneous Deductions, and revised.
IRM 4.1.5.3.4.1.8.7 Moved from Old IRM 4.1.5.1.11.1.16, Employee Business Expenses.
IRM 4.1.5.3.4.1.9 Moved from Old IRM 4.1.5.1.11.1.17, Alternative Minimum Tax.
IRM 4.1.5.3.4.1.10 Added section on Credits.
IRM 4.1.5.3.4.1.11 Added section on Other Taxes.
IRM 4.1.5.3.4.2 Added section on Potentially Productive Issues on an Individual Business Return.
IRM 4.1.5.3.4.2.1 Moved from Old IRM 4.1.5.1.11.2.1, Net Profit, and revised.
IRM 4.1.5.3.4.2.1.1 Added Section 183, Activities Not Engaged in For Profit.
IRM 4.1.5.3.4.2.2 Moved from Old IRM 4.1.5.1.11.2.2, Cost of Goods Sold.
IRM 4.1.5.3.4.2.3 Moved from Old IRM 4.1.5.1.11.2.3, Bad Debt Deduction.
IRM 4.1.5.3.4.2.4 Moved from Old IRM 4.1.5.1.11.2.4, Depreciation.
IRM 4.1.5.3.4.2.5 Moved from Old IRM 4.1.5.1.11.2.5, Sale of Assets.
IRM 4.1.5.3.4.2.6 Moved from Old IRM 4.1.5.1.11.2.6, Farm Returns.
IRM 4.1.5.3.4.2.7 Moved from Old IRM 4.1.5.1.9.4 (7), Special Instructions - Business Returns.
IRM 4.1.5.3.4.2.8 Moved from Old IRM 4.1.5.1.11.2.7, Self-Employment Tax.
IRM 4.1.5.3.5 Moved from Old IRM 4.1.5.1.13.1, Corporate Classification - General, and revised.
IRM 4.1.5.3.5.1 Moved from Old IRM 4.1.5.1.13.2, Potentially Productive Issues, on a Corporate Return.
IRM 4.1.5.3.5.2 Moved from Old IRM 4.1.5.1.13.3, Profit and Loss Method, and updated.
IRM 4.1.5.3.5.3 Moved from Old IRM 4.1.5.1.13.4, Balance Sheet Method, and updated.
IRM 4.1.5.3.6 Added Form 1120S Classification - General.
IRM 4.1.5.3.6.1 Moved from Old IRM 4.1.5.1.14, For 1120S Special Compliance Problems, and updated.
IRM 4.1.5.3.7 Moved from Old IRM 4.1.5.1.15, Partnership Issues.
IRM 4.1.5.3.7.1 Moved from Old IRM 4.1.5.1.15.1, Partnership Selection Features, and Old IRM 4.1.5.1.15.2, Partnership Distributions, and revised.
IRM 4.1.5.3.8 Moved from Old IRM 4.1.5.1.19, Employment Tax Issues, and revised.
IRM 4.1.5.3.9 Moved from Old IRM 4.1.5.1.18, Excise Tax Issues.
IRM 4.1.5.3.10 Moved from Old IRM 4.1.5.1.17, Fiduciary Returns, and updated.
IRM 4.1.5.4 Moved from Old IRM 4.1.6.1, Overview, and updated.
IRM 4.1.5.4.1 Moved from Old IRM 4.1.6.12.2, AIMS Update Process for Centralized Storage, and revised.
IRM 4.1.5.4.2 Moved from Old IRM 4.1.6.2, Storage at the Campus, and revised.
IRM 4.1.5.4.2.1 Added Research SSIVL.
IRM 4.1.5.4.2.2 Moved from Old IRM 4.1.6.6.1, Surveys from CSDB, and updated.
IRM 4.1.5.4.3 Added Stored in PSP or CDE.
IRM 4.1.5.4.4 Moved from Old IRM 4.1.6.10, Special Requests for Returns Assigned to CF&S.
IRM 4.1.5.4.5 Moved from Old IRM 4.1.6.8, Employee Returns, and revised.
IRM 4.1.5.4.5.1 Added Employee Returns Selected via MCC (Campus).
IRM 4.1.5.4.5.2 Added Employee Returns Selected via CDE.
IRM 4.1.5.4.6 Moved from Old IRM 4.1.6.11, Coordination with Centralized Files and Scheduling, and revised.
IRM 4.1.5.4.7 Moved from Old IRM 4.1.6.12.4, Miscellaneous Items for Centralized Storage, and revised.
IRM 4.1.5.5 Moved from Old IRM 4.1.7.1, Overview, and revised.
IRM 4.1.5.5.1 Moved from Old IRM 4.1.7.2, Assignment of Returns from Central Storage and Centralized Files and Scheduling, and updated.
IRM 4.1.5.5.2 Moved from Old IRM 4.1.7.3, Control and Management of Tax Return and Return Information, and updated.
Old IRM 4.1.5.1.13 Deleted Identifying Issues on Corporation Returns as grading is not done by the classifier.

Effect on Other Documents

IRM 4.1.5, Classification and Case Building, dated 08-24-2012 is superseded. IRM 4.1.6, Storage of Selected Returns, (revision date February 11, 2014), and IRM 4.1.7, Assignment of Selected Returns, (revision date June 17, 2014) are obsolete. Interim Guidance Memorandum SB/SE-04-0817-0050, Return Selection and Documentation, dated August 31, 2017 has been incorporated.

Audience

Planning and Special Programs (PSP) in SB/SE Examination - Field

Effective Date

(10-20-2017)

Elmer Smith
Acting Director, Exam Case Selection
Small Business/Self-Employed

Program Scope and Objectives

  1. Purpose. This IRM Section provides information for case building, classification, storage, and delivery of workload. Guidelines and procedures described below are to ensure uniform case building, classification, review, and delivery of returns.

  2. Audience. These procedures apply to SB/SE Field Exam employees who are responsible for return identification, selection, and delivery in Planning and Special Programs (PSP).

  3. Policy Owner. Exam Case Selection (ECS) is under Headquarters Examination.

  4. Program Owner. Exam Case Selection is the office responsible for the selection of cases and delivery of inventory.

  5. Contact Information. To recommend changes or make any other suggestions to this IRM section contact the senior program analyst in Field Case Selection (FCS) responsible for the PSP IRM Update. Seehttp://mysbse.web.irs.gov/examination/examorg/hq/ecs/fieldexamretsel/10461.aspx for list of analysts in FCS.

Background

  1. PSP is responsible for identifying, selecting, and delivering returns to SB/SE Field Exam. Those returns can come from a variety of sources. This section addresses case building, classification, and delivery of the returns.

Authority

  1. IRM 1.1.16.3.5.3, Exam Case Selection.

  2. IRM 1.2.10.37, Policy Statement 1-236, Fairness and Integrity in Enforcement Selection.

  3. IRM 1.2.13.1.7, Policy Statement 4-9, Highest Integrity Expected.

  4. IRM 1.2.13.1.10, Policy Statement 4-21, Selection of Returns for Examination.

Responsibilities

  1. Director, Exam Case Selection (ECS) is the executive responsible for providing policy guidance on the selection of cases and delivery of inventory for SB/SE Examination.

  2. Program Manager, Field Case Selection is the program manager responsible for providing policy guidance on the selection of cases and delivery of inventory for SB/SE Field Exam.

  3. The PSP Territory Manager is the territory manager responsible for the selection of cases and delivery of inventory within an SB/SE Exam Area.

Program Reports

  1. The following are systems or reports that may be used to monitor the classification, storage, and delivery of inventory.

    • A-CIS

    • Compliance Date Environment (CDE) Inventory Report

    • CDE select rates (CDE Select Rate Report)

    • Delivery of returns for classification (Tables 1040–2, 1041–2, 1065–2, 1120–2, 1120–3)

    • Select rates for area classification at the campus

    • Status 06 report of CDE inventory

    • Unstarted (Status 10 and below) returns by status code, Tables 36 and 37, SSIVL, or ERCS Tableau.

    • Volume and timing of return orders (Classification/Order Plan)

Acronyms

  1. This is a list of acronyms and their definitions.

    Acronym Definition
    AAC AIMS Assignee Code
    A-CIS AIMS Centralized Information System
    AIMS Audit Information Management System
    AKA Also Known As
    AMDISA Displays up to six screens of information about the taxpayer's account for a specific tax period. Refer to IRM 2.8.3-7, Command Code AMDISA.
    AMT Alternative Minimum Tax
    BMF Business Master File
    BRTVU BRTVU summary screens display associated returns/schedules/forms submitted by a specific filer. Refer to IRM 2.3.57-1, Command Code BRTVU
    CCP Centralized Case Processing
    CDE Compliance Data Environment
    CF&S Centralized Files and Scheduling
    CIP Compliance Initiative Project
    COLLSTCD26 Collection Status Code 26
    CORR Correspondence
    CSDB Centralized Scheduling Database
    CTR Currency Transaction Report
    CURNOTCOLL Currently Not Collectible
    DBA Doing Business As
    D&B Dun & Bradstreet
    DIF Discriminant Index Function
    DLN Document Locator Number
    EGC Examination Group Code
    ENMOD Displays name, address, and other entity information. Refer to IRM 2.3.15-1, ENMOD Request.
    ERCS Examination Returns Control System
    EUP Employee User Portal
    FBAR Foreign Bank and Financial Accounts
    FinCEN Financial Crimes Enforcement Network
    HINF High Income Nonfiler
    IDRS Integrated Data Retrieval System
    INOLES Displays specific data for the account addressed. Refer to IRM 2.3.47-1, Command Code INOLE Input Screen
    IRP Information Reporting Program
    IRPTR Requests on-line payee transcripts of income reported on various document types. Refer to IRM 2.3.35, Command Code IRPTR, for more information.
    LIFO Last In First Out
    MCC Martinsburg Computing Center
    MeF Modernized E-File
    NBTPI Non-Business Total Positive Income
    NRP National Research Program
    POD Post of Duty
    PSP Planning and Special Programs
    QP Questionable Preparer
    RA Revenue Agent
    SARP State Audit Report Program
    RTVUE Requests the transcribed line-by-line tax return information, which posted to the IMF. See IRM 2.3.52.1, Command Code (CC) RTVUE
    SB/SE Small Business Self-Employed
    SEID Standard Employee Identifier
    SSIVL Statistical Sample Inventory Validation Listing
    TAS Taxpayer Advocate Service
    TCO Tax Compliance Officer
    TEFRA Tax Equity and Fiscal Responsibility Act of 1982
    TGR Taxable Gross Receipts
    TIGTA Treasury Inspector General for Tax Administration
    TIN Taxpayer Identification Number
    TM Territory Manager
    TP Taxpayer
    TPI Total Positive Income
    TRDBV Retrieves a summary of the available tax information on Tax Return Data Base (TRDB). Refer to IRM 2.3.73.1, Command Code (CC) TRDBV.
    TXMOD Requests a display of tax information for a specific IMF or BMF module. Refer to IRM 2.3.11.3, Command Code TXMOD or more information.
    UCC Uniform Commercial Code
    W&I Wage and Investment

Terms

  1. See IRM 4.1.1.1.6, Terms for a listing of common terms used in PSP.

Related Sources

  1. IRM 4.1.1, Planning, Monitoring, and Coordination.

  2. IRM 4.1.2, Workload Identification and Survey Procedures.

Case Building Overview

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

  2. Various studies have been conducted throughout the years to determine the value of having certain information available during the pre-audit analysis of a tax return versus gathering the information during the audit process. These studies have concluded the resources expended gathering this information for the pre-audit (classification) phase are more than offset by the savings incurred in pursuing non-productive issues/returns.

  3. The studies weighed the value of information available during the pre-audit stage and determined certain items should be made part of the case file for classification purposes. These items are:

    1. Charge out document, Form 5546, Examination Return Charge-Out Sheet, or Taxpayer Information Sheet from Compliance Data Environment (CDE) facsimile.

    2. Original return (only in special circumstances such as potential fraud.)

    3. Three year CDE facsimile print.

    4. Integrated Data Retrieval System (IDRS) prints of various command codes.

    5. Financial Crimes Enforcement Network (FinCEN) information: i.e. Cash Transaction Report (CTR), Foreign Bank Account (FBAR), Form 8300, Cash Payments over $10,000, etc.

    6. Taxpayer locator data compiled from various public information agencies.

    7. yK1 Link Analysis Tool, in some cases, may also be provided. This tool is useful if there are related entities or tiered ownership issues. See http://k1.soi.irs.gov/ for more information.

    8. Cover sheets and/or whitepapers as needed or warranted.

  4. Additionally, there may be other related entities that may materially impact the taxpayer’s tax liability. For instance, the sole source of the taxpayer’s income may be a partnership that is reflected as an entry on a schedule. This income may be offset with other non-related items. This makes it difficult to properly determine the taxpayer’s correct liability without considering the items attributable to that taxpayer from the partnership. When this situation is identified, the information from the related entity should be gathered and associated with the taxpayer’s file.

Case Building Benefits

  1. Case building tools help determine whether a return should be selected for audit, what issues should be audited, and how the audit should be conducted.

  2. Case building data provides taxpayer specific research to identify possible compliance issues.

  3. Case building data in conjunction with the return (original, CDE facsimile or Modernized E-File (MeF) print) provides a broader working knowledge of the taxpayer's financial activities to make an informed decision to accept or examine specific items on the return.

  4. Case building data can corroborate items on the return so they don't have to be raised with the taxpayer.

IDRS (Integrated Data Retrieval System)

  1. IDRS is an internal database accessed by various command codes, each of which provides specific information.

  2. IDRS can provide:

    1. Current name, address, and filing status

    2. Income sources and amounts

    3. Audit activity

    4. Filing requirements

    5. Bankruptcy indicators

    6. Filing status and number of dependents

    7. Prior names and addresses

    8. Filing and payment transactions

    9. Cross reference to other taxpayer identification numbers (TINS)

    10. Prior adjustment to the tax liability that could impact the exam issue

  3. The IDRS information should be compared against the return information to determine if there are discrepancies, amended returns, or activity after the return was filed.

  4. An IDRS Command Code Job Aid can be found at http://serp.enterprise.irs.gov/databases/irm-sup.dr/job_aid.dr/command-code.dr/idrs_command_codes_job_aid.htm

Financial Crimes Enforcement Network (FinCEN)

  1. FinCEN provides an on-line database containing reports of cash transactions in excess of $10,000. Cash transactions include deposits, withdrawals, check cashing, wire transfers, sales and redemption of money orders, travelers’ checks or stored value, casino activity, payments for certain services and information on foreign bank accounts. In addition, FinCEN reports cash and/or other monetary instruments in excess of $10,000 used as payment for certain goods.

  2. FinCEN provides the following forms:

    1. FinCen Report 112, Currency Transaction Report, for cash transactions in excess of $10,000, filed by financial institutions and non-bank financial institutions.

    2. FinCen/IRS Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, filed by businesses when cash and/or monetary instruments of $10,000 or more are received for goods or services.

    3. FinCEN Report 114, Report Of Foreign Bank And Financial Accounts filed by an individual, if the aggregate value of foreign accounts exceeds $10,000.

  3. FinCEN data can be used to generate leads for potential unreported income, money laundering transactions and other tax avoidance schemes.

  4. Consider FinCEN activity in relation to the overall financial status of the taxpayer. FinCEN "hits" along with Information Returns Processing (IRP) documents, CDE 3 year facsimiles, and taxpayer locator data will provide a better picture of the taxpayer’s financial situation. Compare the contents of these case building tools with the return.

Taxpayer Locator Services

  1. Taxpayer locator services provides information on an individual or business, and is designed as a general combination report with data from multiple sources to provide a snapshot of the subject's identity.

  2. At least one consumer reporting agency is scanned and the information found is utilized to search over 2 billion public records and generate a single report that may include:

    • Complete name, Also Known As (AKA), Doing Business As (DBA)

    • Current and previous addresses

    • Social security number

    • Driver license number

    • Phone numbers

    • Date of birth

    • Aliases

    • Bankruptcies, liens, and judgments

    • Corporate ownership

    • UCC (Uniform Commercial Code) filings

    • Real property ownership

    • Professional licenses

    • Aircraft and watercraft ownership

    • Pilot licenses

    • E-mail addresses

    • Internet domains

    • Recreational vehicles

    • Hunting and fishing licenses

    • Concealed weapons permit

    • Financial information for businesses

  3. This information is useful in determining the taxpayer’s lifestyle or business history and aids in determining net worth.

  4. Examples of public search data that could indicate audit potential include:

    • Deed transfer information could reflect sales not reported on tax return.

    • Corporate affiliations where there are no indications of corporate earnings on the return.

    • Property ownership not reflected on the return as either personal residence or rental property.

    • Professional licenses could demonstrate income earning potential not reflected on the tax return.

    • Vehicle searches ownership data (type of vehicle, purchase price, owner name and address) could reflect high cost asset acquisition in excess of earnings reported on the tax return.

    • Address history data contains up to five addresses for the taxpayer in the most recent to least recent order. This data could aid in the financial status analysis when determining high and low cost living areas.

    • Boat and plane registration could reflect ownership of high cost assets in excess of earning potential reflected on the tax return.

Use of Colored File Folders

  1. Field Exam needs to achieve consistency nationwide by using colored file folders on cases to develop national standards for processing. This subsection provides guidance to establish a uniform list of colored file folders exam will use to identify specific types of cases. The use of colored folders also helps Centralized Case Processing (CCP) when closing cases.

  2. For case building purposes, whether performed by area PSPs or at the campus, the following file folder color guidelines will be used:

    1. Red – Case with a statute date expiring within 210 days or Prompt Determination.

    2. Yellow – Headquarter approved usage only. Purpose of use will change periodically as interim guidance is issued.

    3. Orange – IRS Employee audit.

    4. Purple – NRP.

    5. Light Blue – Claims (This includes innocent spouse; injured spouse; and any other type of claim). The type of claim should be notated on Form 3198, Special Handling Notice for Examination Case Processing.

  3. The list above is not all-inclusive. From time to time there will be various projects that will require the use of a particular colored folder, exclusive of the colors listed above.

  4. If a case falls into more than one of the above listed categories, place the colored folders in the order listed above with the highest importance as the outermost folder.

  5. If the case is delivered electronically, worked electronically, and closed electronically, color folders are not required.

Classification

  1. This subsection deals with classification of returns.

  2. Classification is the process of determining whether a return should be selected for audit, the initial issues to be audited, and who should conduct the audit.

Classification Overview

  1. Classification should be conducted by an experienced examiner who has received appropriate tax law training. Examiners with specialized expertise may be used to classify business returns. Classification using online systems (such as CDE and Modernized E-file (MeF)) can be done at remote locations via approved procedures. See IRM 4.103.2, CDE Procedures.

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

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

  4. DIF returns are scored using algorithms/models designed to score returns and deliver in descending DIF score order for classification by examiners.

  5. Non-DIF returns will be classified to select returns that contain significant issues likely to result in tax changes or that require audit to achieve voluntary compliance.

  6. All returns will be identified for assignment to an RA, TCO, or a TCO Grade 11 (TCO-11). The designation as RA, TCO, or TCO-11 will be based upon the complexity of the issues involved and the degree of accounting and auditing skills required to conduct a quality audit. See IRM 1.4.40.4.6.5.2.1, Part 1 - Chart of Case Grading Factors, for additional information.

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

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

Classification Background

  1. The primary objective in selecting returns for audit is to promote the highest degree of voluntary compliance on the part of taxpayers while making the most efficient use of finite examination staffing and other resources. Employees must exercise their professional judgment, not personal opinions, when making return selection decisions. The subsections below discuss the instructions for performing return classification.

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

    1. Local issues

    2. Questionable practitioners

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

  2. Classification will usually only involve local travel. Electronically filed returns can be classified remotely. Paper filed returns, on exceptions or as needed, can be mailed to the appropriate PSP office.

  3. Ideally all status code 06 and 07 inventory will be classified in one classification detail. If not possible, then prior to each classification detail PSP will sort the area returns (using the Statistical Sample Inventory Validation Listing (SSIVL)) to be classified by:

    1. Activity codes needed for the exam plan

    2. Return post year

    3. Descending DIF score order

    The reason for this sort is to ensure the highest DIF scores are classified for each activity code for each return posted year.

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

    1. Selected returns for RA.

    2. Selected returns for TCO versus TCO-11.

    3. Returns accepted as filed. Paper returns not selected for audit will be appropriately stamped. See IRM 4.1.5.3.2.5, Classification Documentation, for reason codes.

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

    5. Returns to be transferred.

    6. Special program returns - International issues, etc.

    7. Other returns as provided by area instructions.

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

    1. When classifying returns, classifiers are required to have access to the Employee User Portal (EUP) and an Online 5081 must be approved before classifying returns. Access to the following applications is also required: CDE and MeF (both IMF and BMF.)

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

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

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

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

    6. For returns that are not MeF, a three-year CDE facsimile of the return should be used in place of an original return, and the taxpayer may be requested to provide a copy of the return at the beginning of the audit.

    7. Review of electronic classified returns should follow the guidelines in IRM 4.1.5.3.3, Review of Classification.

Employee Returns
  1. Please refer to IRM 4.1.1.6.7, Employee Audits, for classification, selection, and procedures related to employee audits. As a general rule when classifying returns, an employee is not treated differently than any other taxpayer.

Classification Documentation
  1. All return classification decisions (selected or accepted as filed) must be documented. Returns that are selected for audit must have a classification check sheet (or equivalent) documenting the reason the return was selected. Returns that are not selected (accepted as filed) must also be documented. The following standard reason codes should be used to document why the return was accepted as filed:

    Letter Description
    A. No LUQ (Large, Unusual or Questionable items)
    B. No change in prior year (repetitive audit on the same issues)
    C. Beyond cycle (statute too short)
    D. Resource issues (not applicable to classification - do not use.)
    E. Other
    F. Collectibility
    G. Combat zone
    H. Timing Issue
    I. De minimus Tax

    Exception:

    If a program has different "accepted as filed" reason codes (i.e. State Audit Report Program (SARP)) then those codes should be used instead of the codes above.

Revenue Agent versus Tax Compliance Officer
  1. Determination of RA or TCO exam — One of the key contributions to the success or failure of our exam program is the selection of the proper function to conduct the exam. If we are to meet the exam plan, it is essential we input returns most adaptable for office interviews to TCOs and those requiring the skills of a revenue agent to RAs. This decision is very important because the planned time of an audit of a business return for TCOs is substantially less than the planned time for RAs. However, substantial issues should not be excluded to convert what would be a RA assignment, to a TCO assignment. The issues discussed below are meant only as a guide. In addition to considering these items, heavy reliance must be placed on judgment and experience. Once determined the return will be selected for audit, it must be decided if the audit should be conducted by a RA, a TCO, or a TCO-11. In making this determination, the classifier must give consideration to the type(s) of issue(s) identified for exam.

  2. Below are examples of classified items which generally cause the return to be identified for a RA:

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

    2. Gains or losses on Schedule D from flow through entities.

    3. Returns with unusually complex Schedule E activities.

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

    5. Voluminous records.

    6. Complex accounting method.

    7. Extensive time frame required to complete the audit.

    8. Inventories are substantial and material.

    9. Termination of business before the end of the taxable year.

    10. Unusual issues that appear to be complex and time consuming to develop.

      Example:

      Nontaxable transfers; complex oil or mineral explorations; sale of IRC 1231 assets; unstated interest (IRC 483).

  3. TCO exams: Individual returns identified for TCO exams should contain issues which lend themselves to an analytical approach and require individual judgment in addition to direct verification of records.

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

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

    3. Certain types of issues lend themselves to TCO audits. Examples: dependency exemptions; income from tips, pensions, annuities, rents, fellowships, scholarships, royalties, and income not subject to withholding; deductions for business related expenses; deductions for bad debts; determinations of basis of property; deductions for education expenses; capital gain versus ordinary income determinations; complex miscellaneous itemized deductions such as casualty and theft; losses where determinations of fair market value are required; Schedule E basis and passive activity issues for flow-through losses; and deductions for employee business expenses such as travel and entertainment.

    4. Business returns may be identified for TCO as long as a visitation is generally not required.

      Note:

      Certain businesses would normally not be adaptable to TCOs, such as contractors, manufacturers, auto dealers, and funeral parlors.

    5. The size of a business is also an indicator of what may be involved when an actual audit is made of the books and records of any particular taxpayer.

  4. The following table can be used as a guideline for judging the complexity of the returns. These guidelines should be considered only as recommendations. The designation of selected cases as RA,TCO, or TCO-11 is ultimately a judgment call to be made by the classifier.

    ISSUE TCO TCO-11 RA
    All 1120 (except those meeting the criteria listed below), 1120S, 1120F, 1041, 1065, or other BMF returns     X
    Form 1120s that meet the following criteria:
    • Assets < $250K

    • No balance sheet issues

    • No priority issues

    • No acquisitions, mergers, reorganization

    • No recapitalizations, liquidations

    • No stock redemptions

    • No IRC 351 stock transfers

    • No final returns

    Issues to be considered on Form 1120:
    • Bad debt deduction

    • Other deductions – potential personal expenses

    • Form 4797 – potential related party losses

      X  
    Form 1040 that meet the following classification criteria as follows:
    Returns with Schedule C/F gross receipts and/or cost of goods sold are:
         
    • between $200K and $750K if the return has multiple Schedule C/Fs (when gross receipts are a classified issue) and the source of the return is DIF or High Income Non-filer (HINF)

      X X
    • <$200K if the return has multiple Schedule C/Fs (when gross receipts are a classified issue)

    X    
    Schedule C/F returns with unusual accounting methods, complex issues and/or need for a significant amount of accounting/auditing skills     X
    Returns with substantial and/or questionable losses from S-Corps or Partnerships (TCO - if basis issue or a partner level issue / TCO Grade 11 if other criteria is met - see clarification above in paragraph 2 and 3 for TCO versus RA.)     X
    Returns with significant income or losses from related entities     X
    Issues requiring on-site inspection of records or assets (e.g., substantial casualty losses, embezzlement losses, etc. )     X
    Individuals receiving wages from closely held C corporations and claiming employee business expenses/Schedule C expenses   X X
    Gross receipts as a classified issued is < $200K X    
    Schedule C/F with only non-gross receipts issues classified and total gross receipts are < $500K. X    
    Charitable deductions that include an appraisal as part or all of the Schedule A deduction     X
  5. Individual returns not requiring the accounting skills of a revenue agent may be selected for audit for revenue agents if tax compliance officers (TCOs) (including traveling TCOs) are not available in the geographic location of the taxpayer or if the returns are needed for training. Any case meeting the criteria for a TCO or TCO-11 grade in a location without TCO or TCO-11 staffing should be graded RA or considered for a TCO circuit ride. This grading practice will equalize the potential for examination across all similar taxpayers regardless of where they reside.

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

  7. Classifiers should:

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

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

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

    4. Be alert to fraudulent refund schemes.

    5. Be alert to potential preparer project returns.

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

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

    1. Document 6209, IRS Processing Codes and Information

    2. Document 6036, Examination Division Reporting Codes Booklet

    3. Uniform Issues Code List (http://ccintranet.prod.irscounsel.treas.gov/Common/UIL/Documents/Uniform Issue List Book.pdf)

    4. Area Classification Instructions

    5. SB/SE RA and TCO Examination Classification Guidelines

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

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

    1. Year, form number, form type, activity code, and DIF score are self-explanatory.

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

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

    4. IMF No-change issue codes — These codes identify issues which resulted in no-change to the taxable income for any year reflected under the previous year audit results. The No-change issue codes should be checked to determine the issue(s) previously no-changed. If the last audit of the taxpayer occurred in one of the two preceding tax years and the audit resulted in no-change (disposal code 01 or 02), the return will be selected for audit only if issues, other than those previously no-changed, are present on the return. The examination return charge-out sheet will also reflect issues previously examined and no-changed, even though the audit resulted in change or change/no-change. The IMF no-change codes can be found at http://mysbse.web.irs.gov/exam/tip/CloseaCase/Examined/general/12187.aspx and the Uniform Issue Code list can be found at http://ccintranet.prod.irscounsel.treas.gov/Common/UIL/Documents/Uniform Issue List Book.pdf.

    5. Collectibility Indicators — See IRM 4.1.5.3.2.10, Returns With Collectibility Indicators.

  3. The following can be found in IRM 4.4.1-1, Reference Guide, for other codes referenced on the Form 5346 or CDE Taxpayer Information Sheet.

    • Activity (Abstract) Codes

    • DIF Reason Codes

    • Disposal Codes

    • Employee Group Code Charts

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

    • Push Codes

    • Reference Guide

    • Source Codes

    • Sort Codes

    • Special Messages on Form 5546, Examination Return Charge Out

    • Status Codes

    • Taxpayer Identification Number

Classification Checksheets
  1. The following checksheets have been developed to assist examiners in performing their duties. A classification checksheet should be completed for each return classified outside of CDE classification.

    Type of Return Form
    1040 Individual Form 6754, Examination Classification Checksheet
    Form 1065, 1120, 1120S, and 1041 (BMF returns) Form 10264, Revenue Agent - Classification Checksheet
  2. Classifiers must provide their Standard Employee Identifier (SEID) on each checksheet to ensure the person who classified the return is not the examiner of the return.

  3. The checksheet will be included with the return.

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

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

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

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

Special Instructions (All Returns) for Form 6754
  1. Form 6754, Examination Classification Checksheet, is composed of three sections:

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

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

    • Write-in issues (bottom)

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

    Block Description Instructions
    A Taxpayer Name and SSN If available, affix an "Examination" label with POD, Check Digit (2 Alpha Characters), DIF Score, DLN.
    B Type of Examination Returns will be identified as either Pre-contact Analysis (TCO) or Field Examination (RA). For area classification "Correspondence" is not applicable and should not be checked.
    C Special Inventory If the return is classified as a GS-11 TCO return then check Box 9
    D, E, F, G Priority, POD, Reserved, ADP Hash Total These blocks are not completed by the area classifiers.
  3. See IRM 4.1.5.3.2.6 (4), for the table to determine the grade level of the return (TCO, TCO GS-11, or RA.)

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

    1. Number 10, IRMF — Blue Tab Criteria is obsolete.

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

    3. Numbers 33–35 are to be used for issues that do not fit any of the preprinted categories on the checksheet. The write-in should not duplicate or overlap other items identified on the checksheet. Whenever possible, the language used on the tax return should be used for the write-in. The use of general phrases should be avoided.

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

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

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

  5. For all returns, select only those issues that warrant audit. Limit the number of issues to the "vital few" , only 3 or 4.

  6. The remarks section should be used for any comments, explanations, or observations the classifier would like to provide to the examiner. Do not enter any information that would be inappropriate for disclosure to the taxpayer.

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

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

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

  8. Block J — Enter the date.

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

  10. Block L — Date reviewed.

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

  2. IRM 2.3.35, Command Code IRPTR, contains the format of the IRP transcript with an explanation of the items shown on the transcript.

Classifying Returns With IRP Transcripts
  1. As part of the regular classification of a DIF scored individual return, the classifier will review the IRP transcript to identify discrepancies between the return and the IRP transcript.

  2. The tax effect of carrybacks and carryforwards of losses and/or credits should be considered when applying the criteria in IRM 4.19.11.1.3, Procedures for Screening Individual Returns.

  3. If the return meets the criteria of repetitive audit procedures according to IRM 4.10.2.13, Repetitive Audits, and there is a discrepancy as outlined above, the return will be selected for audit of the IRP issue only.

CTR Screening/Matching
  1. The IRP transcripts also contain currency transaction report (CTR) data. IRM 2.3.35-56, Payee online Transcript Document Display Screen: Form FinCEN CTR 112 (DOC CODE 89), gives an explanation of the CTR data contained on the IRP transcript.

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

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

Returns with Collectibility Indicators
  1. The purpose of the Internal Revenue Service is to collect the proper amount of tax revenues at the least cost to the public, and in a manner that warrants the highest degree of public confidence in our integrity, efficiency and fairness.

  2. Cases audited by exam impact other functions (e.g, collection, appeals, counsel, etc.) throughout the Service.

  3. Assessments made by exam often result in an increase in the inventory of cases in collection. A significant number of these assessments result in uncollectible accounts.

  4. In the continuing effort to reduce the collection inventory and currently not collectible (CNC) accounts, the Service must strive for quality assessments and promote an increased emphasis on early collections. Taxpayers should be educated as to the benefits of paying a proposed tax deficiency in full or informed as to the availability of other arrangements (e.g., installment payments).

  5. A CNC account is a taxpayer account determined to be uncollectible for one or more of the following reasons:

    • Hardship

    • Insolvency/defunct corporation

    • Bankruptcy

    • Decedents (having no assets)

    • Unable to locate taxpayer

    • Unable to contact taxpayer

    • In business (hardship)

    • Other (de minimus/statute expired while in active status)

  6. The goal of the CNC initiative is to constrain the growth of accounts receivable and uncollectible accounts and to promote a more effective organizational operation by maximizing time and resources devoted to productive efforts.

  7. See IRM 4.20.2.2, General Collectibility Considerations, for more guidance.

Classification Procedures — Collectibility Indicators
  1. PSP Territory Managers must ensure classification checksheets are documented to reflect an overriding compliance justification for conducting an audit on a taxpayer with low collection potential.

  2. Collectibility indicators appear on Form 5546, Examination Return Charge-Out Sheet, CDE Taxpayer (TP) Information Sheet, or on an AMDISA print. Definitions and locations of each indicator are as follows:

    Form 5546 CDE TP Info Sheet Definition
    BANKRUPTCY B Taxpayer is currently in bankruptcy or bankruptcy discharge in a prior period.
    CURNOTCOLL N Prior period was closed as Currently Not Collectible. See Document 6209, IRS Processing Codes and Information, for a complete list and explanation of Taxpayer Delinquent Account (TDA) closing codes, or http://serp.enterprise.irs.gov/databases/irm.dr/current/6209.dr/6209ch11.8.5.htm
    COLLSTCD26 C Open Collection status (e.g. assigned to revenue officer, Automated Collection, or is in Collection queue).
    OIC O Offer-in-Compromise Pending (TC480 on an IMFOLT or TXMOD.)
    Document Location of Indicators:
    Form 5546 Line 18, left side of page. Display: BANKRUPTCY, CURNOTCOLL, COLLSTCD26, or OIC
    AMDISA Print Line 22 of Page 1. Display: BANKRUPTCY, CURNOTCOLL, or COLLSTCD26, or OIC
    CDE Taxpayer Information Sheet Line 2, Collectibility Indicator. Display: B, N, C, or O
  3. The following actions should be taken if a collectibility indicator is reflected on the examination return charge-out document, an AMDISA, or the CDE Taxpayer Information Sheet. These procedures apply to classification of any type of inventory (except National Research Project (NRP) inventory):

    1. Returns will be classified and either accepted as filed or selected for audit based upon the potential for tax change. On returns selected for exam, the classifier must document the consideration of the collectibility indicator in the remarks section of the classification check sheet. A statement such as "Collectibility Indicator considered in selecting this return for audit." should be included on the checksheet. If there is a TC780 on the IMFOLT or TXMOD, DO NOT SELECT FOR AUDIT.

    2. The collection indicators are systemic flags to alert the examiner and classifier to consider collection potential. In some instances, the indicator may not be based on current information (for example, bankruptcy discharge 7 years prior). The classifier or coordinator may need to obtain additional IDRS research to make a selection decision.

      Example:

      A TXMOD would show a TC780 indicating an accepted offer-in-compromise. An account with a TC780 should not be selected for audit.

Review of Classification

  1. The PSP Territory Manager (or designee) has primary responsibility for assuring the quality of returns selected for audit whether classification is done at the campus or electronically. This is accomplished by assuring all classifiers have received appropriate training on tax law and area classification instructions. During each classification detail the PSP Territory Manager (or designee), should review a representative sample of selected and accepted returns for each classifier and provide appropriate feedback to the classifier and PSP Classification Section Chief. See IRM 4.1.5.3.3.2, Review of Performance.

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

Standards for Classification
  1. DIF returns are identified for classification by an algorithm/model designed to score returns. Each identified DIF return will be classified by an experienced examiner to eliminate those returns not worthy of exam.

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

  3. Classifiers must use their skills, technical expertise, local knowledge, and experience to identify hidden, as well as obvious, issues. The classifier will determine whether the return should be examined, and if so, whether by an RA, TCO, or TCO-11. Returns not selected for audit will be accepted as filed.

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

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

    2. Enables the classifier to evaluate the significance of each item on the return.

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

  5. Where appropriate, returns should be classified by examiners with subject matter expertise.

    Example:

    Revenue agents in a flow thru group may classify partnership and S Corp returns.

  6. All returns will be identified for assignment to a RA, TCO, or TCO-11 based on the complexity of the issues involved and the degree of accounting and auditing skills required to conduct a quality exam.

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

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

  9. Classifiers may use all available data during classification to help identify the most non-compliant taxpayer:

    • MeF

    • IDRS

    • Internet

    • yK1

    • Accurint or Dun & Bradstreet data

Materiality-Significance of the Issue
  1. Classifiers should compare the potential benefits to be derived from examining a return to the resources required to perform the exam. Although some potentially good issues may be identified on the return, if they would not yield a significant adjustment, the return should be accepted as filed.

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

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

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

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

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

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

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

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

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

    1. Refund schemes and abusive transactions.

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

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

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

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

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

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

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

    3. Classification checksheets are properly completed and should not be limited to single issues for TCO returns.

    4. Returns are properly selected for RA, TCO, or TCO-11 exams.

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

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

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

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

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

    1. A need for changes in instructions to classifiers.

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

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

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

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

    Note:

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

  7. As part of the Program Review process, the Planning and Special Program (PSP) Territory Manager (or designee) ensures reviews completed by the PSP Section Chief adhere to the examination case selection policy

Identifying Issues on Individual Returns

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

  2. Questionable business schedules will be identified during the classification process. As noted in IRM 4.1.5.3.4.2, Potentially Productive Issues on an Individual Business Return, we have designed a process requiring managerial concurrence to allow for selection of "all expenses" on these returns when this is appropriate.

  3. When a Schedule C, E, or F does not appear to be a legitimate business or has a questionable preparer (QP) known to inflate expenses, understate income, or include fictitious schedules; classify the appropriate income or appropriate expenses and notate in the "Remarks" section either "Is this a legitimate business?" or "QP."

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

  5. If a potential questionable preparer is identified, these returns should be given to the manager assigned to the detail to share with the rest of the classifiers and complete Form 14719, SB/SE Return Preparer Referral, and e-mail to the applicable address on the form. The area Return Preparer Coordinator will make a decision concerning any further consideration of potential program action against the preparer.

Potentially Productive Issues on an Individual Return
  1. The following are potentially productive issues on individual returns.

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

  2. Is there an Installment sale of property but no interest has been reported?

  3. Is the taxpayer’s occupation listed as waiter, cab driver, porter, beautician, etc.? If so, tip income is a productive issue.

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

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

  6. Does the taxpayer have Form 1099-K, Payment Card and Third Party Network Transactions, issued that is more than the reported amount?

    1. Reminder:

      With the advent of the Form 1099-K, taxpayers are likely to report payment card amounts in their gross receipts but may not include all of the cash and checks. Certain businesses are cash intensive. Depending on the type of business, there may be substantial cash receipts in addition to the reportable payment card transactions.

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

  8. Is there a potential of inflated income in order to claim credits. i.e. EITC?

Filing Status/Exemptions
  1. Exemptions claimed by the non-custodial parent have proven to have high potential for adjustment. Consider Head of Household requirements.

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

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

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

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

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

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

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

Rental Properties
  1. Consider fair rental value.

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

  3. Repairs may be capital improvements.

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

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

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

Schedule K–1
  1. Returns containing TCO type issues will be selected for office exam without regard to distributive type income from Forms 1065, 1120S and 1041. However, if the Schedule K–1 requires inspection, the entity’s name and year of Schedule K–1 should be listed on the classification checksheet.

  2. Items of self-employment income shown on Schedule K–1 should be matched to Schedule SE to ensure the amounts are properly included in the self-employment tax computation.

  3. Limitations for basis, at-risk, and passive activities should be considered.

Moving Expenses
  1. Review Form W-2 for address and other compensation. Also, consider sale of residence.

  2. Did the taxpayer move more than 50 miles? Sources to identify the previous address include: INOLES, ENMOD, MeF, RTVUE, IRP, or locator service (lexis Nexus or Accurint).

  3. Moving expenses should not be classified if the taxpayer has reported income from reimbursement from his employer. The reimbursement will be identified on the Form W-2 and included in income from wages and salaries.

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

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

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

Taxes
  1. Consider changes in address when reviewing real estate taxes (e.g., Form W–2, Form 1040, Form 8949, Sales and Other Dispositions of Capital Assets).

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

  2. Home mortgage interest varies by locality. Special attention should be paid to those areas where housing costs are high (over $1,000,000.) Taxpayers are only allowed to deduct mortgage interest on qualifying loans up to $1,000,000.

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

  2. Check large donations if they appear questionable. Organization’s charitable status can be checked at https://apps.irs.gov/app/eos/

  3. Check for payments which may represent tuition.

  4. Check for large dollar non-cash contributions.

Casualty or Theft Loss
  1. Watch for business assets, valuation methods, and statutory limitations.

  2. Erroneous claims may be identified when there is a declaration of disaster for the area.

Miscellaneous Deductions
  1. Scrutinize large, unusual, or questionable items.

  2. Gambling losses must include gambling income under "Other Income" on page 1 of Form 1040, U.S. Individual Income Tax Return.

Employee Business Expenses
  1. Amounts should be reasonable when compared to the taxpayer’s occupation and income level.

  2. Avoid auto expenses as an issue where the standard mileage computation is used and the mileage shown does not appear excessive.

  3. Transportation expenses for construction workers, carpenters, etc., who appear to have several different employers at different locations, have not proven to be productive. However, be alert for expenses claimed for travel to a remote job site(s).

  4. Expenses for clubs, yachts, airplanes, etc., must meet the facilities definition of IRC 274 and therefore, are usually productive issues.

Alternative Minimum Tax (AMT)
  1. If AMT is paid, the materiality of the adjustment should be considered since an increase to the regular tax would cause a decrease to the AMT.

Credits
  1. Below is a chart of potential issues for each credit.

    Credits What to look for
    Child and Dependent Care Expenses
    • Look out for duplicate dependents and the age of the dependents >age 12.

    • TP must claim the dependent to claim the credit (some exceptions for divorced, etc.)

    • Adjustments to the credit when employer provides payments or benefits and that can be found on the W-2.

    Education Credits
    • Not eligible for the credit if MFS return or if the TP is claimed as a dependent on another return or non-resident alien.

    • The credit phases out over certain income levels.

    • Students under age 24 have some additional criteria. requirements for a refundable part of the AOTC credit.

    • Only one education credit per student per tax return per year limitation applies.

    • A form 1098-T should be on IRP from the institution on qualified expenses but the credit can be higher than this form.

    Foreign Tax Credit (FTC)
    • Mandatory referral to the Specialist Referral System when FTC=>$25,000.

    • Can be carried back or forward.

    • Foreign corporations, nonresident alien individuals, and bona fide residents of certain U.S. possessions that are not engaged in a U.S. trade or business are not subject to tax on non-U.S. source income. Accordingly, they are not entitled to the FTC.

    • The following are examples of payments not creditable as taxes:

      • Penalties, interest, fines, and custom duties,

      • Compulsory loans, and

      • Amounts reasonably certain to be refunded, credited, rebated, abated, or forgiven.

    Low Income Housing
    • If the return was not selected by the LIHC Compliance Unit, they can research the filed Form 8823, Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition for additional info needed before audit.

    • This is a very complex area of the law and it is best to reach out to a specialist prior to starting the audit.

    • There are recapture rules if the building is sold when determining basis.

    Premium Tax Credit (PTC)
    • PTC is based on income and family size. There is a chart on income and family size limitations.

    • The TP cannot have health care coverage under Medicare, Medicaid, TRICARE or CHIP, so look for age of TP and if military or retired military.

    • Usually not eligible for the credit if MFS return or if the TP is claimed as a dependent on another return.

    Residential Energy Credits
    • Non-refundable.

    • Credit is only for property owned and put in service after 2005 and before 2017.

    • If a subsidy was provided by any public utility for the purchase or installation of an energy conservation product, the credit must be reduced by the subsidy.

    Small Employer Health Insurance (Form 8941)
    • After 2014, only two consecutive years of credit can be claimed.

    • The credit is phased out for employers with >10 full time employees and average annual wages of $25,000 or less.

    • No credit allowed >25 employees and annual wages >$50,000.

    • Starting in 2014, the employer must go through the SHOP marketplace for the insurance and the form has a checkbox.

    • Flow-through shareholders/partners will get a credit via the K-1.

Other Taxes
  1. 10% penalty on early withdrawal

  2. Health care individual responsibility

Potentially Productive Issues on an Individual Business Return
  1. The following are potentially productive issues on Schedule C’s or F’s.

Net Profit
  1. Is the taxpayer engaged in the type of business or profession normally considered more profitable than reflected on the return?

  2. Do the address, real estate taxes, and/or mortgage interest indicate a higher standard of living than justified by the reported income?

  3. Does the return reveal large amounts of interest and dividend income not commensurate with current sources of income?

Section 183, Activities Not Engaged in For Profit
  1. Does the taxpayer have losses in three of the last five years or two out of seven for breeders? If so, it may indicate a hobby.

  2. There are certain types of businesses that lend themselves to hobbies:

    • Rental properties have many rules and material participation is one that is hard to overcome if the TP is just an investor and not a real-estate professional.

    • Hobby type activities such as, collecting antiques, cars, etc.

    • Personal products for personal use.

  3. IRC section 183 generally limits the deductibility of losses up to income if an activity (business or rental) is not engaged in for profit. IRC 183 is a permanent disallowance provision.

  4. Cannot combine two or more activities to determine profitability. Each activity must be evaluated on its’ own.

  5. Taxpayers who have significant income from other sources may try to reduce their taxable income by reporting losses from activities that may or may not be engaged in for profit.

Cost of Goods Sold
  1. Check for the possibility of withdrawal of items for personal use.

  2. Is the ending inventory inclusive of all costs, direct and indirect?

Bad Debt Deduction
  1. Is it a cash business?

  2. Is it disproportionate for the indicated value of sales?

Depreciation
  1. Does the schedule contain an adequate description of the asset?

  2. Are personal assets being depreciated?

  3. Consider sales of property simultaneously with depreciation issues.

Sale of Assets
  1. Is there a sale of business assets during the year without depreciation recapture?

  2. Is the gain large enough to require the alternative minimum tax computation?

Farm Returns
  1. In the analysis of a Schedule F, the examiner should keep in mind the unique features of a farm return. The farmer may be engaged in a specialized area of dairy cattle, beef cattle, grain, swine, vegetables, poultry, or a multiple of these items. The operation may vary from that of a few acres to several thousand acres. The operator of the farm may rent all the land farmed or may own all or a portion of it. Consider whether the farm is an actual business operation or a hobby.

  2. Consider whether payments from farmers’ cooperatives are reported.

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

Self-Employment Tax
  1. All returns should be screened for self-employment tax issues, including returns with Schedule SE attached. Look for income such as director’s fees, janitorial services, miscellaneous income, partnership income, etc., which may be subject to self-employment tax.

  2. Some items of income earned by independent contractors may be reported as wages or other income. Where the income appears to be personal service income, it must be considered for self-employment tax purposes.

Corporate Classification—General

  1. Corporate returns are identified by three categories; DIF, non-DIF, and automatics. Returns which do not meet automatic criteria, are scored under the DIF system. Returns which meet automatic criteria, regardless of size, are not computer scored. Automatic criteria are contained in IRM 3.11.16.9.1, Audit Codes.

  2. Screening procedures for DIF scored 1120 returns are essentially the same as for other DIF returns.

  3. The corporate DIF system includes returns in Activity Codes 203 through 217. All other corporate returns are Non-DIF.

  4. Classification of the corporation return must include the balance sheet and Schedule M items. Substantial change in accounts receivable, reserve for bad debts, loans to or from stockholders, accounts payable, treasury stock, capital stock, or retained earnings would indicate an audit of these items may be warranted. In addition, such potential issues such as "Thin Corporation," IRC 531, substantial changes in accruals, and decreases in assets which are not accounted for on Schedule D of the return may be identified from an inspection of the balance sheet.

  5. All Schedule M items should be scrutinized to determine the difference between income shown on the books and taxable income shown on the tax return.

  6. The following general items must also be considered during classification:

    1. Overall composition of the return. Is the return complete, containing all necessary information and schedules? Who prepared the return?

    2. Data reported on the return compared to the norms and standards of the business or industry of the taxpayer.

    3. Location of the business. This could have a bearing on the volume of business.

    4. Prior Audit results as indicated on Form 5546, Examination Return Charge-Out Sheet.

    5. The existence of controlled groups, interests in foreign corporations, deductions for facilities, or convention expenses.

  7. Significant issues identified on manually classified Form 1120 returns will be reflected on Form 10264, Revenue Agent - Classification Checksheet.

Potentially Productive Issues on a Corporate Return
  1. Experience has shown the following characteristics result in potentially productive issues:

    • New corporation that incorporated an ongoing business and reflects goodwill, other boot, or accelerated depreciation.

    • International features: a copy of a National Office approved technical ruling attached, but all conditions set forth in the ruling have not been met.

    • Liquidation under IRC 331, IRC 332, IRC 333, IRC 337 (generally trigger recapture under the provisions of IRC 47, IRC 1245, and IRC 1250).

    • A consolidated return, especially one that does not contain schedules showing each member’s respective share of income, expense, assets, liabilities, and capital.

    • A short period return.

    • Credits and/or losses carried forward when information on the return indicates the item(s) should have been carried back.

    • A member of a controlled group, claiming the full amount of the surtax exemption, etc., and not including a properly executed election.

    • Last-in, first-out (LIFO) inventory method being used for the first time.

    • Manufacturing concern not using the full-absorption accounting method to value inventory.

    • Substantial passive income which may indicate a personal holding company.

    • A low asset return reflecting a net operating loss.

    • Returns with minimum tax issues.

    • Foreign tax credit claimed on the return.

Profit and Loss Method
  1. After considering the general guidelines and potentially productive issues above, the examiner should begin a more detailed review of the return utilizing both the profit and loss, and balance sheet approaches. Some of the items to be considered under the profit and loss approach are.

    1. Large or unusual changes in inventories, or no inventory reflected for non-service type business.

    2. Sales of assets without a Form 4797, Schedule D or Supplemental Schedule of Gains and Losses, attached.

    3. No amount claimed as amortization on a newly formed corporation.

    4. Amounts claimed as other deductions without supporting schedules attached.

    5. Questionable bad debt, either under the specific write-off or reserve method.

    6. Expenses that may be high or unusual for the type of business.

Balance Sheet Method
  1. A balance sheet approach, paying particular attention to substantial changes between opening and closing balances, can disclose a number of potential issues:

    1. Cash: Large ending balance — possible IRC 531 issue; and/or negative balance—improper accruals.

    2. Trade Notes and Accounts Receivable: Change in accounting method; premature write-offs; excessive deduction for bad debts; and/or interest income unreported.

    3. Inventories: Change in method of valuation; change in nature of business; and/or possible write-down.

    4. Investments: Interest income and dividend income understated or omitted; expense(s) of tax-free income deducted; unreported sales; erroneous basis; installment election; stockholder loans buried; and/or related party issues.

    5. Other current assets — deferred expenses.

    6. Loans to stockholders — dividend issue.

    7. Building and other depreciable assets: Unreported sales; investment credit recapture; and/or incorrect basis.

    8. Intangible assets: Goodwill has been written-off; sale of license or patent; and/or IRC 351.

    9. Loans from stockholders: Thin corporation; and/or interest deduction versus dividend.

    10. Other liabilities: Improper accruals; deferred income accounts; and/or reserve for contingencies.

    11. Capital accounts: Unreported sale; stock issued for services; and/or thin corporation.

    12. Paid-in surplus: Diversion of earned income; and or IRC 351.

    13. Retained earnings — IRC 351.

    14. Treasury Stock: Potential dividend to stockholders and/or bargain purchase by a stockholder.

    15. Schedules M–1 and M–2: All items should be reviewed for proper tax treatment.

Form 1120S Classification - General

  1. Form 1120S returns are identified by three categories; DIF, non-DIF, and automatics. Returns which do not meet automatic criteria, are scored under the DIF system. Returns which meet automatic criteria, regardless of size, are not computer scored. Automatic criteria are contained in IRM 3.11.217.12.1, Audit Codes.

  2. Screening procedures for DIF scored 1120S returns are essentially the same as for other DIF returns.

  3. Significant issues identified on 1120S returns will be reflected on Form 10264, Revenue Agent - Classification Checksheet.

Potentially Productive Issues on a S Corporation Return and Shareholder Returns
  1. Allocation of loss and deduction items claimed in excess of basis.

  2. Diversion of income by the shareholder or payment of shareholder expenses by the corporation.

  3. Repayment of shareholder’s loans by the corporation where basis has been reduce by loss and deduction items.

  4. Distributions and/or dividend payments made to shareholders in lieu of wages to avoid employment taxes. Rev. Rul. 74–44, 1974-1 C.B. 287, Small Business Corporation Dividends Paid Instead of Salaries.

Form 1065 Partnership Classification - General

  1. Partnership returns are identified by three categories; DIF, non-DIF, and automatics. Returns which do not meet automatic criteria, are scored under the DIF system. Returns which meet automatic criteria, regardless of size, are not computer scored. Automatic criteria are contained in IRM 3.11.15.19.1, Audit Codes.

  2. Screening procedures for DIF scored partnership returns are essentially the same as for other DIF returns.

  3. Significant issues identified on partnership returns will be reflected on Form 10264, Revenue Agent - Classification Checksheet.

Potentially Productive Issues on a Partnership
  1. The general instructions for individual and corporate returns apply equally to partnership returns. The returns must be scrutinized both as to line items and the return as a whole in selecting returns with the highest audit potential. Issues to consider include but are not limited to:

  2. Initial or first year returns are often productive. Common issues are:

    1. Contributions to capital for possible recognition of gain or loss at the partners’ levels.

    2. Partners with no contributed capital where services may have been performed in exchange for the partnership interest.

    3. Large loss claimed on returns commencing business late in the year.

    4. Large loss claimed in relation to investment.

    5. Loss claimed in excess of investment through non-recourse financing. Loan and prepaid interest costs should be amortized over the life of the loan.

    6. Large depreciation deduction where property may not have been placed in service during the year.

    7. Start-up expenses (management fees, license fees, etc.) which should be capitalized.

  3. Final year returns are often productive. Common issues are:

    1. Negative capital account considerations.

    2. Resolution of liabilities.

    3. Proper consideration of distribution of assets.

  4. Other areas applicable to partnerships:

    1. Additional contributions by a partner which could constitute a sale or exchange.

    2. Special allocation of losses or specific deductions to partners.

    3. Determine if there has been a change of ownership and consider proper allocations of distributive share items and potential basis adjustments.

    4. Withdrawal by partners may include "phantom gain" through assumption of liabilities by others.

    5. The sale or exchange of partnership assets may result in recapture of ordinary income.

    6. Component or other depreciation method resulting in shorter than guideline lives.

    7. Disguised sales or mixing bowl transactions triggered by improper use of contribution and distribution benefits.

Employment Tax issues

  1. Be cognizant of potential employment tax issues when classifying income tax returns.

    Caution:

    Worker classification determinations can create safe harbor under Section 530 of the Revenue Act of 1978.

  2. Known or probable areas on non-compliance are listed in IRM 4.23.3, Classification, Selection and General Procedures for Employment Tax Cases.

Excise Tax Issues

  1. Be cognizant of potential excise tax liabilities when screening income tax returns. Be alert for:

    1. Gasoline tax credit for aviation gasoline or gasoline used for non-highway purposes. The first credit is not allowable. The second instance indicates the taxpayer could be liable for highway use tax.

    2. Taxpayers with trucking operations may be liable for highway use tax, further manufacturers excise tax, and/or diesel fuel-gasoline taxes.

    3. Returns indicating issuance of policies by foreign insurers. This would involve returns of insurance agencies, brokers, etc.

    4. Returns reporting manufacturing or use of pistols, revolvers, and firearms.

      Example:

      Gun shops, target ranges, etc.

    5. Returns reporting flying services or aircraft sales.

      Example:

      Charter service, flying schools, airplane repairs, etc.

  2. Excise classification procedures can be found in IRM 4.24.18.6, Overview of Workload Classification.

Fiduciary Returns

  1. Screening of fiduciary returns requires consideration of issues peculiar to fiduciary returns. While income tax issues will not be overlooked, quality classification requires consideration of the following issues and areas:

    1. Estate unduly prolonged (should not be more than 5 years unless very large) (Treas. Reg. 1.641(b)–3(a)).

    2. Business trust taxable as a corporation (IRC 7701(a)(3)) and Rev. Rul. 75–258. Or, it could be treated as a sham and the income is taxable to the grantor.

    3. Exemption — estate $600; simple trust $300; complex trust $100.

    4. Indication of multiple trusts, which may be taxable as one trust (Treas. Reg. 1.663(c)–1(b)).

    5. Minimum tax (IRC 56) — tax preference items and/or exemption not apportioned between the estate or trust and beneficiaries based on share of income; also, prorate for short year.

    6. Wrong tax rate schedule used.

    7. Foreign tax credit and job tax credit not apportioned between estate or trust and beneficiaries based on income.

    8. Trusts normally cannot show Subchapter 5 income (IRC 643(a)).

    9. Indication of income taxable to grantor or another (IRC 671 through IRC 678) (e.g., sale and leaseback among related parties).

    10. Error in computation of distributable net income (DNI) (IRC 643(a)).

    11. Rental or other income (e.g., from non-probate assets) may be taxable to devisees (IRC 691).

    12. Partnership income; decedent’s death before close of partnership taxable year. Share of partnership income erroneously included on Form 1040 instead of Form 1041.

    13. Special tax for trusts electing to report gain realized on the sale of property acquired from a transferor under installment method (IRC 644).

  2. Distributions to Beneficiaries:

    1. Beneficiaries not listed may not have picked up income.

    2. Estates are normally not required to distribute all income currently. No deduction is allowable if amount was not actually distributed.

    3. Estates and simple trusts normally do not distribute capital gains.

    4. Simple trusts must distribute all ordinary income (IRC 651) except income allocable to corpus (typically, capital gains.)

    5. Final year—all income deemed distributed, including capital gains (IRC 643(a)(3) and IRC 662(a)(2).

    6. Losses or excess deductions are not distributable except in final year (IRC 642(h)).

    7. Distribution deduction may include: Specific legacy — not deductible (IRC 663(a)); or widow’s allowance — deductible if from current income (Treas. Reg. 1.661(a)–2(c)) and taxable to widow.

    8. Excess (accumulated) distribution may indicate a complex trust. A separate Schedule J may be missing — reported by beneficiaries (Throwback Rule IRC 665(b)).

    9. Administrative and other expenses may actually be a disguised distribution to beneficiary. Failure to file Form K–1 (e.g., family allowance).

    10. Excess distributions may indicate payment of specific legacies on which estate may have realized a gain.

    11. Nonresident alien beneficiary — where Form 1042S, Foreign Person's U.S. Source Income Subject to Withholding filed and required amounts of tax withheld?

    12. Terms of governing instrument (local law issues).

    13. Family trust?

  3. Capital Transactions:

    1. Significant capital losses normally should not occur in the first year of an estate.

    2. Capital loss (net) improperly claimed as a capital loss is limited to a maximum of $3,000.

    3. Deduction limited to fiduciary’s portion of capital gains (IRC 1202).

    4. Basis of assets: Estate of testamentary trust—carryover basis (IRC 1023); inter-vivos trust—usually the donor’s basis (IRC 1015); or income in respect of a decedent (IRC 691).

    5. Redemption of closely held stock may be dividend unless IRC 303 is complied with (IRC 302).

    6. Sale or exchange between related parties for inadequate consideration.

    7. Estate tax marital deduction — executor satisfies pecuniary bequest with appreciated assets, thus triggering a capital gain.

    8. Specific bequest — executor satisfies with appreciated assets, thus triggering a capital gain.

  4. Expenses and Deductions:

    1. Allocation of expenses to tax-free income not made (IRC 265).

    2. Depreciation taken (basis).

    3. Allocation of expenses.

    4. Funeral and medical expenses not deductible (IRC 641(b) and IRC 162(a)).

    5. Other personal expenses and losses not deductible (IRC 641(b) and IRC 162(a)) (e.g., child care, funeral costs, medical expenses).

    6. Administrative expenses (e.g., attorney and CPA fees, and executor commissions) not deductible unless waiver for estate tax purposes made (IRC 642(g)). Also, no "double deduction" allowed for selling expenses used to offset the sales price on a sale of property in determining gain or loss if deducted for federal estate tax purposes.

    7. Federal estate tax on income in respect of a decedent (computation omitted or erroneous) (IRC 691(c)). Estate tax examination will affect the computation.

    8. Inheritance taxes are not deductible (IRC 164(b)(4)).

    9. Charitable contributions — "set aside" amount is generally not deductible (IRC 164(b)(4)) unless the trust was created prior to October 10, 1969.

    10. Executor commissions or attorney fees appear unreasonable under local law guidelines.

Storage of Returns

  1. The PSP territory manager is responsible for monitoring return inventories. Lean inventories should be maintained to limit costly excess surveys and to allow for changing workload priorities. However, a high percentage of unstarted inventory may be warranted at specific times: for example,

    1. Providing returns for training.

    2. Major computer programming changes that may delay the filling of return orders. For example, implementation of major changes to Audit Information Management System (AIMS), Examination Records Control System (ERCS), etc.

  2. AIMS Centralized Information System (A-CIS), Table 37, Statistical Sampling Inventory Validation (SSIVL) and ERCS, can be used for monitoring inventory aging by month for status 08 and status 10 returns. A large volume of returns in status 08 and status 10 for over two to four months could indicate inefficient use of the return order and delivery system. If the Compliance Data Environment (CDE) system is being used, two months of inventory should be sufficient. If the Martinsburg Computing Center (MCC) system is used, four months of inventory should be sufficient.

  3. The inventory of selected returns may be stored in the area office or the campus.

  4. Although the inventory of selected returns may be stored in the area office or the campus, storage at the campus for paper returns produces certain cost savings and operating efficiencies. These include the following:

    1. More control over and information about inventories.

    2. Reduction of simultaneous audits.

    3. Assurance that priority returns and returns with the highest DIF scores are scheduled first.

    4. Clerical efficiencies.

    5. Reduction in shipping costs.

    6. Reduction in storage costs.

    7. Uniformity among the examination areas.

    8. Weekly information from AIMS. For example, address changes are automatically made when the Centralized Files and Scheduling (CF&S) database is matched weekly against the AIMS database.

    Reminder:

    CDE returns are part of virtual inventory and no storage is required at the campus or area office.

AIMS Update Process for Centralized Storage

  1. As selected field returns are received by CF&S from centralized classification, the AIMS status will be updated to Status 08 with one of the following EGCs: 1020, 1066, 1067, 1068, 2020, 2050, 2051, or 2066.

  2. Selected returns received from classification will be placed inside a file folder and filed in AIMS serial number sequence. The returns are updated to status 08 and one of the appropriate EGCs.

Stored at the Campus

  1. The following EGCs are used to store selected exam returns:

    Employee Group Code Description
    1020 RA exam missing returns
    1066 RA Returns - formally RA Grade 11 and below
    1067 Reserved - formally RA Grade 12
    1068 Reserved - formally RA Grade 13
    2020 TCO missing returns
    2050 TCO
    2051 TCO GS-11
    2066 TCO returns with errors
Research SSIVL
  1. PSPs are responsible to monitor unclassified inventory within the area.

Surveys at the Campus
  1. The PSP territory manager has sole authority to approve the survey of previous file year returns from the CSDB. CF&S managers must have written authorization from the PSP territory manager before surveying returns from the area’s CSDB. The survey letter should be sent to the classification department manager.

  2. Although surveys are normally done on an area-by-area basis using the tax file year as the main criterion, surveys may be requested for a specific activity code, specific POD, specific year, or a combination thereof. A survey may be done any time the PSP Territory Manager determines the returns are not needed.

  3. Prior year returns should be surveyed as soon as there are sufficient current year returns in the inventory, normally by December 31.

  4. CF&S will pull the surveyed returns, stamp them with a survey stamp, and package them for closing. Disposal code 35 will be used to close the returns off AIMS. Late filed returns (those with statute dates in the calendar year following those being surveyed) will remain on the CSDB. They will not be surveyed at this time.

Stored in PSP or CDE

  1. The following EGCs are used to virtually store selected exam returns:

    Employee Group Code Description
    1911 Revenue Agent (formally Grade 11 and below - Revenue Agent)
    1912 Reserved (formally Grade 12 - Revenue Agent)
    1913 Reserved (formally Grade 13 - Revenue Agent)
    1918 Info Reports - RA
    1924 Training - Revenue Agent
    1979 AT - Revenue Agent
    1989 CIP - Revenue Agent
    1990 RPP - Revenue Agent
    2909 Grade 09 and below - Tax Compliance Officer
    2911 Grade 11 - Tax Compliance Officer
    2918 Info Reports - TCO
    2923 Training - Tax Compliance Officer 1
    2924 Training - Tax Compliance Officer 2
    2925 Training - Tax Compliance Officer 3
    2979 AT - Tax Compliance Officer
    2989 CIP - Tax Compliance Officer
    2990 RPP - Tax Compliance Officer

Special Requests for Returns Assigned to CF&S

  1. Periodically, there will be requests for returns assigned to an area office in status 08 EGC 2050, which indicates the return is part of the CSDB. These requests may come from exam personnel in the area or from functions other than exam, such as criminal investigation.

  2. Area personnel should be instructed to contact a PSP Territory Manager (or designee) if they need a return which is currently assigned to CF&S. In addition, area personnel should be instructed never to update a record from status 08 EGC 2050 even if they are working from a copy.

  3. Specific returns requested by an area examination function must be deleted from the CSDB. The return will be updated on AIMS to the requesting status and EGC by CF&S and forwarded to the area.

  4. Requests for returns from area functions other than exam are handled differently. The returns are assigned on AIMS to a specific area. The returns will be deleted from the CSDB and forwarded to exam in an area office for coordination with the requesting function. A copy will be provided to the requester until the original return is received in the area office.

Employee Returns

  1. Employee returns require special processing depending on what system was used to classify the return.

Employee Returns Selected via MCC (Campus)
  1. When an employee return generated through the DIF system is classified and selected for exam, it will be shipped in a security envelope to the PSP Territory Manager.

  2. Employee returns selected for exam will not be stored at the campus.

Employee Returns Selected via CDE
  1. Returns classified in CDE will need to be delivered out of CDE prior to assignment to ensure employees are not audited in their same POD.

Coordination With Centralized Files and Scheduling

  1. Problems identified with returns received from CF&S should be brought to the immediate attention of the CF&S manager by either the PSP Territory Manager or the group manager.

  2. It is important for the area PSP Territory Manager to have frequent discussions with CF&S management to keep abreast of the return orders and other issues.

Miscellaneous Items for Centralized Storage

  1. Centralized storage related return(s) are two or more returns for the same taxpayer where one or more of the taxpayer's returns are being maintained in centralized storage (status 08), while another return is open in an exam status 10 or 12.

  2. For returns located in the area office, the CF&S will pull the centralized stored return, update AIMS to status 10 for the same EGC as the other return(s) located in the area, and mail the return to that group for association.

  3. For returns located in correspondence examination (EGC 5XXX) no action will be taken.

  4. Multiple Returns: Multiple returns occur when two or more returns for the same taxpayer are concurrently maintained in centralized storage (status 08). CF&S will match the primary return to the multiple return, cross reference the folders, and file both returns in the file by the respective AIMS serial number.

  5. Survey of returns from centralized storage: It is the responsibility of the area PSP staff to inform the campus when it is time to survey returns from centralized storage. See IRM 4.1.2.12.1, Procedures for Surveying Excess Inventory in PSP, for more information. Returns should be surveyed as they become out-of-cycle or more frequently if needed.

  6. EGC 2066 will also be used to store certain office examination returns with errors. Area PSP staff should review the EGC 2066 inventory to ensure these returns are ordered out. There should be a minimum number of these returns.

Delivery of Selected Returns

  1. This chapter discusses the delivery of selected returns.

  2. Generally, the exam plan provides a mix of both DIF and Non-DIF Strategy work. There is no ranking among these strategies (i.e.: Strategy 1 is not required to be delivered before Strategy 2). Instead, the exam plan is designed as a mix, and consequently Non-DIF strategy work should be delivered to meet pro-rata volume for each Non-DIF strategy in the exam plan. Category and Activity Code are of no consequence for Non-DIF strategy work. Deviations in pro-rata starts by strategy are expected, but the cause of any material deviation should be identified and documented by the Area. The PSP Territory Manager is responsible for ensuring returns are available for exam by the groups in a manner that accomplishes the plan. As of Fiscal Year 2017 the strategies and initiatives are as follows:

    1. Current headquarters studies. These studies usually involve a finite number of cases with specific completion goals. For example, National Research Project (NRP) and Partnership Study, etc.

    2. Current SB/SE exam plan strategies. For example, return preparer, abusive transactions, etc.

    3. Current headquarters initiatives. For example, Non-Filing Tax Gap, Under-Reporting Tax Gap, etc.

    4. Cases governed by the IRM requirements—Cases with input deadlines, mandatory subsequent/prior year follow-up examinations, or special processing. For example, claims; joint committee; bankruptcy; tax shelters; audit reconsiderations; locally initiated cases; direct referrals; TEFRA investors received from the campus TEFRA function for non-TEFRA issue development; inadequate records notice subsequent years; Form 906, Closing Agreement on Final Determination Covering Specific Matters, etc.

    5. Locally identified projects—For example, Compliance Initiative Project (CIP), and Program Action Cases/Return Preparer Projects (PAC), etc.

    6. DIF and DIF related returns.

      Note:

      The return starts analysis in IRM 4.1.2.3, Return Starts Analysis, should also be used as a guide.

  3. To ensure consistent treatment when delivering returns PSP coordinators will identify returns from CDE, PSP and/or campus EGCs.

  4. Deliveries to examination groups should be based on historic start capacities.

  5. Deliveries should be calculated to meet the SB/SE exam plan by activity code and/or strategy on a pro-rata basis.

Delivery of Returns From Central Storage

  1. Returns are assigned from Central Storage and Centralized Files and Scheduling as outlined in IRM 4.1.5.4.2, Stored at the Campus.

  2. Field Exam cases are generally assigned to the receiving group in status 10 from Central Storage. Office exam cases are generally assigned to the receiving group from Centralized Files and Scheduling in status 10 as "Pre-contact" cases.

Control and Management of Tax Return and Return Information

  1. All tax return information, including Compliance Data Environment (CDE), TRDBV, and RTVUE/BRTVU facsimiles, must be distributed to the offices outside PSP via a Form 3210, Document Transmittal. The sender must retain a copy of the Form 3210 for group control to monitor the transmittal of tax returns or return information via Form 3210. If acknowledgement is not received within 10 days, immediate follow-up should be made by phone, secured e-mail, or mail.

  2. The same level of security should be provided for any tax return information produced or received in connection with other source work as is given an actual tax return and all other confidential taxpayer information. Tax return information includes, but is not limited to CDE, TRDBV, and RTVUE/BRTVU prints and copies of taxpayer returns from external sources. Any documents containing taxpayer identifying information distributed outside the PSP office should be transmitted via Form 3210.

  3. Returns and facsimiles distributed for the purpose of making an audit determination must be returned to PSP within 30 calendar days. PSP staff will dispose of them as soon as it is determined they are no longer needed. If the audit determination is made within PSP, the AIMS controls should be perfected or updated.

Form 5546, Examination Return Charge Out Sheet

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