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4.10.3  Examination Techniques

Manual Transmittal

February 26, 2016

Purpose

(1) This transmits revised IRM 4.10.3, Examination of Returns, Examination Techniques.

Material Changes

(1) Minor editorial changes have been made throughout this IRM. In addition, website addresses, legal references, and IRM references were reviewed and updated as necessary.

(2) Significant changes to this IRM are reflected in the table below.

Reference Description
IRM 4.10.3.1(3) Moved prior content related to "depth" of examination to IRM 4.10.3.2, Risk Analysis.
IRM 4.10.3.2 Added new subsection titled "Risk Analysis" including new subsections on the "80/20 Concept" and "Mid-Audit Decision Point (50% Rule)" .
IRM 4.10.3.3 (6) Added requirement that examiners verify and document the taxpayer's receipt of Publication 1 and Notice 609 during initial interviews, if not already accomplished during the pre-contact analysis. Added requirement that examiners briefly communicate taxpayer rights and dispute resolution options available during initial interviews.
IRM 4.10.3.3.1 (2) Added a "Note" to provide guidance to examiners when representatives advise that a taxpayer will not be appearing at an interview.
IRM 4.10.3.3.1.2 Added reference to "limited liability companies (LLC)" and removed reference to S corporations in discussion of Tax Matters Partner (TMP).
IRM 4.10.3.3.1.4 (1) Added a "Reminder " addressing 3rd party contact procedures.
IRM 4.10.3.3.1.4 (3) Added an "Exception" to explain limited disclosures for the purpose of securing 3rd party information.
IRM 4.10.3.3.2 (2) Added an "Exception" to identify when office examinations will be held at the office closest to the taxpayer’s home or business.
IRM 4.10.3.3.5(7) Added content addressing mandatory use of Lead Sheet 125 by SB/SE examiners.
IRM 4.10.3.3.6 (1) Added additional background on "audio recorded interviews" and added two "Cautions" to advise examiners that audio recording of "telephone conversations" and "video recording" are always prohibited.
IRM 4.10.3.3.6 (2) Reorganized content from paragraph (4) into paragraph (2) and added content from Notice 89-51 to identify circumstances where taxpayer requests for audio recording will be allowed.
IRM 4.10.3.3.6 (3) Added new paragraph to clarify that taxpayer requests for audio recordings must be directed to the employee conducting the interview at least 10 days prior to the scheduled meeting and that Service employees may "waive" the notice requirement and proceed with the audio recording or may cancel the interview.
IRM 4.10.3.3.6 (4) Revised content to reflect use of published letter 2156 in place of prior Pattern Letter 2156 and removed reference to Exhibit 4.10.3–1.
IRM 4.10.3.3.6 (5) Removed requirement to recite taxpayer’s social security number during audio recorded interviews due to concerns over identity theft. Added additional recital requirements for audio recorded interviews to mirror requirements in IRM 5.1.12.3.4, Audio Recording Procedures.
IRM 4.10.3.3.7.2 Moved content from IRM 4.10.3.3.7.1(5) into new subsection titled "Request for Representation - Suspension of Interview" to emphasize taxpayers right to retain representation and clarify actions that examiners must take when a taxpayer states they wish to consult with an authorized representation during an interview.
IRM 4.10.3.3.8 Added content related to establishing a mutual commitment date (MCD) and estimated completion date (ECD) in SB/SE Revenue Agent examinations.
IRM 4.10.3.3.9 Added content from Interim Guidance Memorandum SBSE-04-1015-0063, Interim Guidance for Group Manager Concurrence Meeting (GMCM), dated October 1, 2015, providing an increased time frame for completion of the GMCM.
IRM 4.10.3.6.1(2) Added content on inspection of audited and certified financial statements. This added content was taken from IRM 4.35.2.2, Preliminary Work at Taxpayer’s Office, which will be obsoleted.
IRM 4.10.3.6.3(8) Updated content on CFR 1.442-1(c).
IRM 4.10.3.7 Changed title of subsection to add reference to Schedule M–3 and provided legislative background.
IRM 4.10.3.7.1 Reorganized and revised content in former paragraph (2) into new paragraphs (2) and (3) to address the differences between the Schedule M–1 for C corporations and S corporations/partnerships. This added content was taken from IRM 4.35.2.4.2, S Corporations, which will be obsoleted.
IRM 4.10.3.7.1.2 Added new subsection to provide Schedule M–1 reconciliation audit technique for use with S corporations.
IRM 4.10.3.7.1.3 Added new subsection to provide Schedule M–1 reconciliation audit technique for use with partnerships.
IRM 4.10.3.7.2 Added content to discuss the differences in Schedule M–2 between C corporations, S corporations and partnerships. Added content on reconciliation of retained earnings for S corporations taken from IRM 4.35.2.4.2, S Corporations, which will be obsoleted. The former content of this subsection has been moved to a new subsection IRM 4.10.3.6.2.1, Schedule M–2: Audit Techniques for C Corporations.
IRM 4.10.3.7.2.2 Added new subsection titled "Schedule M–2: Audit Techniques for S Corporations" to add new content taken from IRM 4.35.2.4.2, S Corporations, which will be obsoleted.
IRM 4.10.3.7.2.3 Added new subsection titled "Schedule M–2: Audit Techniques for Partnerships" to add new content on reconciliations made for partnerships taken from IRM 4.35.2.4.3, Partnerships, which will be obsoleted.
IRM 4.10.3.7.3 Added new content to discuss the purpose of Schedule M–3.
IRM 4.10.3.9.2 (1) Added content to describe some partnerships’ use of fair market value to book assets on the balance sheet. This added content was taken from IRM 4.35.2.4.3, Partnerships, which will be obsoleted.
IRM 4.10.3.9.4.3 Reorganized existing content and added new language from IRM 4.10.2, Pre-Contact Responsibilities, related to examination techniques for "inventories" .
IRM 4.10.3.9.4.23 Added new subsection titled, Retained Earnings for S Corporations, to add new content taken from IRM 4.35.2.4.2, S Corporations, which will be obsoleted.
IRM 4.10.3.17.1 (1) Removed item (d) from list. The use of Project Code 129 was discontinued on 1/30/2009 and Aging Reason Code 99 is no longer valid.
Exhibit 4.10.3–1 Removed Exhibit 4.10.3–1. Exhibit consisted of Pattern Letter 2156 which has been updated to published Letter 2156, Recording Interviews.
Exhibit 4.10.3–3 Removed Exhibit 4.10.3–3 as this letter is no longer used.

Effect on Other Documents

IRM 4.10.3, dated March 1, 2003 is superseded. This IRM incorporates Interim Guidance Memorandum SBSE-04–1015–0063, Interim Guidance for Group Manager Concurrence Meeting (GMCM), dated October 1, 2015. This IRM also incorporates provisions of IRM 4.35.2, Partnerships and S Corporations, Audit Techniques for Business Returns, which will be obsoleted after the publishing of this revision.

Audience

Small Business/Self-Employed (SB/SE) and Large Business & International (LB&I) Examiners.

Effective Date

(02-26-2016)

Scott E. Irick
Director, Examination/AUR Policy, SE:S:E:HQ:EP
Small Business/Self-Employed (SB/SE) Division

4.10.3.1  (02-26-2016)
Overview

  1. The purpose of this section is to provide guidelines for procedures and techniques that should be used in conducting an effective examination.

  2. Auditing includes the accumulation of evidence for evaluating the accuracy of the taxpayer’s tax return(s). Evidence takes many forms, including the taxpayer’s testimony, the taxpayer’s books and records, the examiner’s own observations and documents from third parties.

  3. It is important to obtain sufficient competent evidence to determine the accuracy of the taxpayer’s return. Every examiner must determine the appropriate amount of evidence to accumulate and establish the proper depth of the examination. This decision is a matter of judgment and is important because of the prohibitive cost of examining and evaluating all available evidence. See IRM 4.10.3.2 (6) for additional guidance on determining the depth of the examination.

  4. Methods for accumulating evidence include:

    1. Analytical Tests — such as analysis of balance sheet items to identify large, unusual, or questionable accounts. Analytical tests use comparisons and relationships to isolate accounts and transactions that should be further examined or determine that further inquiry is not needed.

    2. Documentation — such as examining the taxpayer’s books and records to determine the content and accuracy of items claimed on the tax return.

    3. Inquiry — such as interviewing the taxpayer or third parties. Information from independent third parties can confirm or verify the accuracy of information presented by the taxpayer.

    4. Inspection — such as physically examining the taxpayer’s assets, e.g., inventory or securities.

    5. Observation — such as conducting a tour of the taxpayer’s business to observe the taxpayer’s daily business operations.

    6. Testing — such as tracing transactions to determine if they are correctly recorded and summarized in the taxpayer’s books and records.

  5. Factors to consider when choosing an examination technique are:

    1. Will the examination technique provide the needed evidence?

    2. Will the benefits derived from using a particular technique justify the associated costs to both the examiner and the taxpayer?

    3. Are there less expensive alternatives that will provide the same evidence?

  6. The following Examination techniques used to gather evidence are discussed in this section:

    IRM Reference Examination Technique
    IRM 4.10.3.3 Interviews
    IRM 4.10.3.4 Tours of Business Sites and Inspection of Residences
    IRM 4.10.3.5 Evaluating the Taxpayer’s Internal Controls
    IRM 4.10.3.6 Examining the Taxpayer’s Books and Records
    IRM 4.10.3.7 Analyzing Schedules M–1, M–2 and M–3
    IRM 4.10.3.8 Bank Record Reconciliations
    IRM 4.10.3.9 Balance Sheet Analyses
    IRM 4.10.3.10 Testing Gross Receipts or Sales
    IRM 4.10.3.11 Testing Expenses: Cost of Goods Sold
    IRM 4.10.3.12 Testing Expenses: Operating Expenses
    IRM 4.10.3.13 Sampling Techniques
  7. Accounting systems and the organization of books and records are discussed in IRM 4.10.3.14, and IRM 4.10.3.15, respectively.

4.10.3.2  (02-26-2016)
Risk Analysis

  1. Risk analysis is the process of comparing the potential benefits to be derived from examining a return or issue to the resources required to perform the examination. Risk analysis is an integral part of the examination process to ensure the efficient and effective use of resources and should be based on experience, judgment, and objective analysis. Risk analysis techniques include the 80/20 concept and mid-audit decision point (50% rule). Factors to consider include:

    1. Fraud potential;

    2. Materiality (see IRM 4.10.7.4.4, Significant Items);

    3. Corollary effect of adjustment (e.g., whipsaw, NOL, related returns, etc.);

    4. Compliance impact (e.g., strategic or emerging issue);

    5. Type of adjustment (i.e., permanent or timing);

    6. Accuracy of books and records; and

    7. Hours required to audit.

  2. Risk based decision making should be used throughout the course of the examination, but at a minimum, must be considered:

    1. During the pre-audit phase of the examination;

    2. At the midpoint of the examination (50% rule); and

    3. When a significant event occurs.

  3. Risk analysis provides the following benefits:

    1. Increased productivity;

    2. Improved audit planning process;

    3. Reduced cycle time;

    4. Increased audit coverage; and

    5. Reduced taxpayer burden.

  4. Risk analysis techniques help the examiner determine the "scope" and "depth" of the examination.

  5. Scope of Examination – relates to the selection of "issues" that warrant examination.

    1. During the pre-contact phase, examiners determine the scope of the examination. See IRM 4.10.2.3, In-Depth Pre-Contact Analysis.

    2. At the mid-point of the examination, the examiner will re-evaluate and adjust the scope of the examination, if necessary. See IRM 4.10.3.2.2.

  6. Depth of Examination – relates to the degree in which examination techniques will be utilized to verify the accuracy of an issue. Factors to consider when establishing the depth of the examination include:

    1. The risk that the taxpayer has made errors that are individually or collectively material. The factors involved are addressed during the evaluation of the taxpayer’s internal controls.

    2. The risk that the audit tests will fail to uncover material errors. The factors involved are the examination techniques used, the nature of the errors (intentional or unintentional), and the reliability of available evidence.

4.10.3.2.1  (02-26-2016)
The 80/20 Concept

  1. The goal of an examination is to determine the "substantially correct" tax liability. The 80/20 concept is “value-added” decision making that weighs the impact of our decisions (potential results) with the investment of additional case time (cost) and is applicable throughout the audit to evaluate and determine the scope of the examination. See IRM 4.10.2.7.1.1, Risk Analysis, for further discussion of the 80/20 concept.

  2. The examiner must consider the facts and circumstances, evaluation of internal controls (in business examinations) and use professional judgment to determine whether the scope should be expanded or contracted.

  3. Examiners must document the reasons for expanding or contracting the examination on Lead Sheet 110, or workpaper or Form 9984 indexed to Lead Sheet 110.

4.10.3.2.2  (02-26-2016)
Mid-Audit Decision Point (50% Rule)

  1. The mid-audit decision point or 50% rule refers to performing a risk-based analysis of the examination at its mid-point.

  2. The mid-point of the examination can be determined based on the number of issues classified/identified or the number of hours expended.

  3. At the mid-point of the examination, the examiner should determine whether the remaining classified/identified issues should be examined. This decision should be based on the facts and circumstances, evaluation of internal controls (in business examinations) and the examiner’s judgment. For example, the resulting additional tax is not expected to be material, or the time to develop additional issues is not justified, based on the potential for additional tax.

  4. Examiners are expected to use their professional judgment to determine if it is in the government’s best interest to continue the examination. If it is not in the government’s best interest to continue the examination, the examiner must document this determination. See IRM 4.10.3.2.1 for additional guidance.

4.10.3.3  (02-26-2016)
Interviews: Authority and Purpose

  1. An interview is a meeting between two or more individuals (e.g., in person, by phone, by video conference, etc.) for the purpose of gathering information to investigate and/or resolve issues. Initial interviews should be conducted face-to-face. See IRM 4.10.3.3.2 for additional guidance.

  2. IRC 7602, Examination of books and witnesses, authorizes the Secretary or a delegate to examine books and records and to take testimony under oath.

  3. Interviews are used to develop information and establish evidence. The testimony of witnesses and statements made by taxpayers or their representatives are major factors in resolving tax cases.

  4. Interviews provide information about the taxpayer’s financial history, business operations, use of internal controls and books and records. This information helps the examiner make informed judgments about the scope and depth of the examination.

  5. Oral testimony is a significant factor in resolving tax cases. See IRM 4.10.7.3.2, Oral Testimony, for additional guidance. Oral testimony can:

    1. Provide information not otherwise available from physical documentation;

    2. Corroborate return information;

    3. Provide relevant information not reflected on the return; and

    4. Establish the taxpayer’s intent.

  6. If not already addressed during the pre-contact phase of the examination, the examiner must take the following actions during the initial interview:

    1. Verify the taxpayer's receipt of Pub 1, Your Rights as a Taxpayer, and Notice 609, Privacy Act Notice.

    2. Briefly describe the rights discussed in Pub 1 and Notice 609 and respond to any questions.

    3. Briefly describe the examination process and inform the taxpayer and/or representative of the resolution options available for unagreed cases (e.g., managerial conference, Fast Track Settlement, formal appeal, right to petition the United States Tax Court, etc.).

    4. Document the confirmation of receipt of Pub 1, Your Rights as a Taxpayer, and Notice 609, Privacy Act Notice, and the discussion held with the taxpayer and/or representative on Form 9984, Examining Officer’s Activity Record.

  7. The examiner should also inform the taxpayer that Appeals will only accept income, gift and fiduciary tax cases with 365 days and estate tax cases with 270 days remaining on the statute of limitations. (See IRM 8.2.1.4 , Receipt of New Assignment by an Appeals Technical Employee (ATE).) In addition, Appeals will generally return the case to Examination if:

    1. The taxpayer submits new information or evidence that in the judgement of Appeals warrants additional analysis or investigation by Examination, or

    2. The taxpayer raises a new issue. (See IRM 8.2.1.5(2), Returning a Case to Examination - ATE, letter (i) and (j).)

  8. See IRM 4.10.2.8.1(2), Contacting the Taxpayer or Representative by Telephone, letter (c), for guidance related to what information may be provided to taxpayers about the reason for the selection of their returns for examination.

4.10.3.3.1  (02-26-2016)
Who To Interview

  1. Interviews should always be held with the person(s) having the most knowledge concerning the total financial picture and history of the person or entity being examined.

  2. IRC 7521(c) states that an examiner cannot require a taxpayer to accompany an authorized representative to an examination interview in the absence of an administrative summons. However, the taxpayer’s voluntary presence at the interview can be requested through the representative as a means to expedite the examination process.

    Note:

    If the representative indicates the taxpayer will not be present for the initial interview, the examiner should confirm with the representative that they have first-hand knowledge of the taxpayer’s business, business practices, bookkeeping methods, accounting practices, and daily operations. Questions about the location of financial accounts held, the types of books and records maintained, whether the taxpayer engaged a bookkeeper, and other questions about the taxpayer's business operations will help reveal the level of knowledge that the representative possesses and identify any potential need to interview the taxpayer directly. This information may also assist the examiner and/or group manager in securing the representative's consent to the taxpayer’s appearance without the need for an administrative summons.

4.10.3.3.1.1  (03-01-2003)
Powers of Attorney

  1. When a taxpayer obtains representation, the examiner will ensure that the authorization, Form 2848, Power of Attorney and Declaration of Representative; Form 8821, Tax Information Authorization; or a similar privately designed form, is properly executed. See IRM 4.11.55.1.7 , Authorized Forms, and IRM 4.11.55.1.8 , Receipt of POA or TIA Form, for additional guidance.

  2. Service personnel are prohibited from disclosing confidential tax information to any unauthorized individual.

  3. Practice before the Service is restricted to persons recognized or qualified under provisions of Treasury Department Circular No. 230, Regulations Governing Practice before the Internal Revenue Service. See IRM 4.11.55.1.2.1, Who May Represent a Taxpayer?, for additional guidance.

  4. If the taxpayer's representative impedes or delays the examination by failing to promptly submit the taxpayer's records or information requested by the examiner, failing to keep scheduled appointments, or failing to return telephone calls and written correspondence, the examiner may initiate procedures to bypass the representative and deal directly with the taxpayer, as outlined in IRM 4.11.55.3, By-Pass of a Representative.

4.10.3.3.1.2  (02-26-2016)
Corporate and Partnership Examinations

  1. In corporate examinations (including limited liability companies (LLCs) that file corporate returns), a current officer or managing member with the most knowledge of the business operations should be identified and interviewed.

  2. In Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership examinations (including LLCs that file partnership returns), the Tax Matters Partner (TMP) must be identified. The TMP should be asked to designate the company personnel or representative(s) who are most knowledgeable to be present at any interviews. See IRM 4.31.2, TEFRA Examinations - Field Office Procedures, for additional guidance.

    Note:

    TEFRA provisions do not apply to S corporations for tax years that begin after December 31, 1996.

  3. In non-TEFRA partnership examinations (including LLCs that file partnership returns), the general partner or managing member with the most knowledge of the business operations should be interviewed.

4.10.3.3.1.3  (03-01-2003)
Specialists

  1. Examiners should identify, in advance, all the persons the taxpayer will have present at an interview and ensure that appropriate Service personnel will be in attendance. For example, if technical issues outside the examiner’s area of expertise will be discussed at the interview, the Service’s specialists should be at the meeting.

  2. Examiners should also determine if any specialist referrals will be made as early in the examination as possible. See IRM 4.10.2.7.5, Referrals for Specialists, for additional guidance.

  3. If the return has been selected on classification as a mandatory referral to International, the examiner should make the referral during the pre-contact phase of the examination. If complex international issues are discovered during the course of the examination, the case should be referred to International at that time.

4.10.3.3.1.4  (02-26-2016)
Third Party Interviews

  1. IRC 7602 allows examiners to obtain testimony from third parties who can provide information that may be relevant to determining a taxpayer's liability or ascertaining the correctness of a return.

    Reminder:

    Examiners must follow the third party contact provisions discussed in IRM 4.11.57, Third Party Contacts, and IRM 25.27.1, Third Party Contact Program, prior to making a third party contact. Also see CFR 301.7602-2 for definitions, duties and procedures for third-party contacts.

  2. The taxpayer’s right to privacy will be protected when contacting third parties for information.

    1. Information will be collected, to the greatest extent practicable, directly from the taxpayer to whom it relates.

    2. No information will be collected or used with respect to the taxpayer that is not necessary and relevant for tax administration or other legally mandated or authorized purposes.

    3. Information about taxpayers collected from third parties will be verified to the extent practicable with the taxpayer before action is taken.

  3. Caution should be taken to not disclose any tax information of a confidential nature when contacts are made with third parties.

    Exception:

    IRC 6103(k)(6) provides that Service employees may make investigative disclosures to the extent necessary in obtaining information, which is not otherwise reasonably available, with respect to the correct determination of tax, liability for tax, or the amount to be collected. See IRM 11.3.21.3, Requirements for Investigative Disclosures, for additional guidance.

  4. Tax Compliance Officers/Tax Auditors, under prescribed conditions, may contact taxpayers outside the Service office in the course of completing their examinations.

4.10.3.3.2  (02-26-2016)
Where to Conduct Interviews

  1. The time and place of interviews will be set by the Secretary as long as they are reasonably scheduled. This authority is provided in IRC 7605(a) and the related regulations at 301.7605–1. In general, the Service will determine if an office or field examination is to be performed.

  2. Office examinations will be conducted at the Service office closest to the location of the taxpayer.

    Exception:

    If the office closest to the location of the taxpayer does not have an examination group or appropriate personnel to conduct the examination, it generally is reasonable for the Service to require the taxpayer to attend an examination at the closest Service office within the assigned area that has an examination group or the appropriate personnel. See CFR 301.7605-1(d)(2)(ii).

  3. Field examinations should be conducted at the taxpayer's residence, place of business, or where the taxpayer’s original books and records are maintained. In the case of a sole proprietorship or business entity, this will usually be the taxpayer's principal place of business. See IRM 4.10.2.9.2, Place and Time of Examination, for additional guidance.

  4. An exception to the rule for field examinations would be for some frivolous filers/nonfilers. Group managers should consider the potential hazards to the personal safety of examiners examining these returns. Meetings between the examiner and the non-compliant taxpayer should be held, where practical, in a government facility. The group manager may make other arrangements to facilitate the examination when it would not compromise the safety of the examiner.

4.10.3.3.3  (03-01-2003)
Preparation and Planning for Interviewing

  1. Timing — Proper timing of the interview is essential in obtaining information that is material in resolving a case.

  2. Review Available Information — Prior to any interview, the examiner should review all of the available information relating to the case. Such information may then be divided into three general categories:

    1. Information that can be documented, and need not be discussed;

    2. Information that may be documented, but needs to be discussed (i.e., requires further clarification or collaboration); and

    3. Information that must be developed by testimony.

  3. Prepare Outline — Before the interview, the examiner should determine the goal of or purpose for questioning the taxpayer or witness. The topics that will enable the examiner to accomplish this goal should be outlined in more or less detail, depending upon the examiner’s experience and the complexity of the case. The outline should contain only information that is relevant and material, including hearsay (see IRM 4.10.7.3.5, Hearsay). Extraneous matters should be excluded because it may be confusing and may adversely affect the development of relevant topics. Important topics should be set off or underscored and related topics listed in their proper sequence. Specific questions should be kept to a minimum, since they tend to reduce the flexibility of the examiner. The outline should include the following:

    1. Identification of the taxpayer or witness;

    2. Purpose of the interview;

    3. Identification of topics to be addressed; and

    4. Reference to pertinent documents or exhibits that will be shared during the interview.

  4. A separate interview file may be utilized for purposes of conducting an interview. This file should contain only data or information arranged in the order it is to be discussed or covered in the interview.

4.10.3.3.4  (03-01-2003)
Types of Interviews

  1. Initial Interviews — Generally, the initial interview should be held as soon as possible after opening a case. The pre-contact analysis should include the preparation for the interview. See IRM 4.10.2.3, In-Depth Pre-Contact Analysis, for details concerning the pre-contact analysis.

    Note:

    SB/SE examiners should refer to IRM 4.10.2.9, Scheduling the Appointment: Overview, for specific time frames to hold an interview after the first action on the case.

  2. Subsequent Interviews — Subsequent interviews with the taxpayer should be held if:

    1. The taxpayer does not provide all the information requested;

    2. More detailed explanations are needed; or

    3. A review of the examination’s progress is needed. The review should address information provided to date as well as outstanding information needed to complete the audit.

  3. Third Party Interviews — Third party interviews may be necessary when the taxpayer does not or cannot provide documentation regarding a transaction, a deduction, or an income item. See IRM 4.10.3.3.1.4 for additional guidance.

  4. Closing Interviews (Conferences) — Closing interviews should be held to solicit agreement to proposed adjustments. See IRM 4.10.7.5, Proposing Adjustments to the Taxpayer and/or Representative, for additional guidance.

4.10.3.3.5  (02-26-2016)
Documenting Interviews

  1. Interviews provide information not available from other sources. A properly planned and executed interview will provide an understanding of the taxpayer's financial history, business operations, and accounting records.

  2. The case file should reflect in-depth planned interviews throughout the examination. Sufficient questions should be asked to gain a clear understanding of the taxpayer, as well as the operations of the taxpayer.

  3. The elements of an adequately documented interview include:

    1. Interview outline addressing items specific to the taxpayer under examination. The type of return and relevant facts and circumstances are considered in the interview outline.

    2. Sufficient depth to give a clear understanding of the nature of the taxpayer's financial history, business history, and day-to-day operations.

    3. Explanations of large, unusual or questionable (LUQ) items and whether such explanations resolve the potential issues.

    4. Description of financial status or overall assessment of return validity, when appropriate.

    5. Description of books and records maintained and their availability.

    6. Complete explanation of the taxpayer's accounting system and accounting methods, including any changes when appropriate. This may also include an explanation of the accounting method used for tax, if different from book accounting, and any adjustments that were made.

    7. Explanation of the taxpayer's internal controls as discussed in IRM 4.10.3.5 below.

  4. Case files may be reviewed by many individuals after closing from the examiner, especially if the examination is unagreed. This includes the examiner, who may need to provide testimony during litigation. The interview(s) should be documented in sufficient detail that no unanswered questions remain.

  5. It is important for the examiner to ask appropriate follow-up questions and properly document the interview without hindering the flow of information. Examiner’s should:

    1. Take brief notes during the interview for significant responses to questions and note those areas that need additional development. It is not advisable to take extensive notes during the interview as it can be distracting and hinder the flow of the interview.

    2. Prepare a memorandum of interview (MOI) immediately following the meeting or shortly thereafter, fully documenting the statements and replies made by the taxpayer. The MOI and the handwritten interview notes will serve to document statements made by the taxpayer, refute subsequent contradictory statements, and support examination positions taken.

  6. As an alternative, questionnaires may be used to record taxpayer responses instead of a memorandum. If an interview questionnaire is used, the examiner should ask follow-up questions as needed. The original questions and responses should be included in the case file.

  7. Use of Lead Sheets in RGS — RGS contains various lead sheets for use by SB/SE Examination.

    1. Tax Compliance Officers — SB/SE Tax Compliance Officers are required to use the following lead sheets.

      Title of Lead Sheet When Used:
      Lead Sheet 125-1, Initial Taxpayer Contact - TCO Pre-contact or Interview
      Lead Sheet 125-2, Initial Interview Questions - TCO Interview
      Lead Sheet 125-3, Initial Interview Questions - TCO Business Supplement Interview
    2. Revenue Agents — SB/SE revenue agents use Lead Sheet 125-2, Initial Interview Questions.

4.10.3.3.6  (02-26-2016)
Requests to Audio Record Interviews

  1. IRC 7521(a) provides that taxpayers and IRS employees may audio record an "in-person" interview, provided that advance notice is given to the other party.

    Caution:

    The taxpayer or representative does not have the right to record a telephone interview, with or without the Service's knowledge. If a taxpayer begins to record a conversation during a telephone call, and the examiner becomes aware of it, the examiner should advise the taxpayer or representative that the recording must be stopped. If the recording is not stopped, the examiner should terminate the call and document the incident on Form 9984, Examining Officers Activity Record. See IRM 5.1.12.3(3), Taxpayer Recording of Interviews, for additional guidance.

    Caution:

    Cameras, video taping equipment and electronic image recording devices are never permitted. At no time however, should employees try to physically confiscate this equipment. See IRM 25.5.5.4.4, Right to Make an Audio Recording of the Proceeding, for additional guidance.

  2. Taxpayer Requests — In accordance with IRS Notice 89–51, Procedures Involving Taxpayer Interviews, requests by taxpayers or their authorized representatives to make audio recordings of examination proceedings will be allowed by the Service official or employee conducting the interview under the following conditions:

    1. The taxpayer or authorized representative supplies the recording equipment;

    2. The Service may produce its own recording of the proceedings (using the Service's equipment);

    3. The recording takes place in a suitable location, ordinarily in an Internal Revenue Service office where equipment is available to produce the Service’s recording; and

    4. All participants in the proceeding other than Service personnel must consent to the making of the audio recording and all participants must identify themselves and their roles in the proceeding.

  3. Requests by taxpayers or authorized representatives to make audio recordings of examination proceedings must be addressed to the officer or employee of the Service who is conducting the interview and must be received by the Service no later than 10 calendar days prior to the interview that is to be recorded. If 10 calendar days’ advance notice is not given, the Service may, in its discretion, conduct the interview as scheduled (permitting the recording) or set a new date.

  4. IRS Initiated Recordings — The Service can initiate an audio recording provided it notifies the taxpayer 10 calendar days in advance of the interview using Letter 2156, Recording Interviews. The Field Territory Manager must approve all Service initiated recordings.

  5. At the outset of the recording, the examiner conducting the interview will identify themselves, the date, the time, the place, and the purpose of the interview. The audio recording will also contain the following:

    1. Name of the taxpayer or witness;

    2. Identification of all participants on the recording, along with a statement of each participant’s role in the examination;

    3. Identification of participants when they arrive or when they leave throughout the meeting;

    4. Description of any written documentation presented or discussed during the proceeding in sufficient detail to make the audio recording a meaningful record when matched with the other documentation contained in the case file;

    5. At the conclusion, state that the proceeding is completed, state the total recording time for the interview (i.e., time audio recording was running), and that the recording is ended.

  6. The audio recording will be labeled with the taxpayer’s name, SSN, year(s) examined, date of interview, total time of the recording and sealed in a manila envelope that should be stapled into the body of the workpapers. The Form 5344 , Examination Closing Record, will be marked at the top "RECORDED INTERVIEW AUDIO RECORDING ENCLOSED."

4.10.3.3.7  (03-01-2003)
Interview Techniques

  1. Interviews provide information about the taxpayer's financial history, business operations, and books and records that are not available from other sources. Interviews should be used to obtain information needed to make informed judgments about the scope and depth of the examination and correctly resolve issues. Interviews are used to obtain leads, develop information and establish evidence.

  2. It is important to create an environment where the taxpayer feels comfortable. Examiners should maintain a friendly and professional demeanor. Suggestions for establishing rapport include:

    1. Examiners should introduce themselves.

    2. Examiners should explain what will happen during the examination.

    3. Examiners should be prepared to explain return selection procedures, rights to representation, and appeal rights. See Pub 3498, The Examination Process.

    4. Examiners should recognize that an IRS audit is often a once-in-a lifetime experience for the taxpayer and therefore the taxpayer may be tense or nervous.

    5. Examiners should exhibit openness, honesty and integrity and be calm and objective.

    6. Examiners should listen carefully to all details, be receptive to all information volunteered, regardless of its nature, and be patient and persistent in extracting the facts necessary to achieve the goals of the interview.

4.10.3.3.7.1  (02-26-2016)
Conducting the Interview

  1. Be Adaptable and Flexible — The examiner should keep an open mind and be receptive to all information provided, regardless of its nature, and be prepared to develop facts as appropriate. The examiner should be flexible, pay close attention to the testimony provided, and adjust the line of questioning as appropriate. Examiners should avoid strictly following a line of questioning when the taxpayer’s testimony has already answered one or more intended questions. The questionnaire or interview outline should serve as an aid to ensure that all pertinent matters are addressed, but the examiner should also be prepared to ask original and spontaneous questions as new facts become known. A carefully planned outline will provide enough leeway to allow the examiner to better cope with any situation that may occur and permit him/her to develop leads that may arise.

  2. Follow Through — Incomplete and unresponsive answers have little or no probative value. Any reply, relative to a pertinent matter, that is not complete and to the point should be followed up by questioning the taxpayer about all knowledge they have concerning every facet of the topic. The examiner should follow through on every pertinent lead or incomplete answer and continue asking questions until all information which can reasonably be expected has been secured.

  3. The following suggestions will help the examiner obtain answers that are complete and accurate:

    1. Use short questions confined to one topic that can be clearly and easily understood.

    2. Ask questions that require narrative answers, avoiding " yes" and "no" answers, whenever possible.

    3. Whenever possible, avoid questions that suggest part of the answer, i.e., leading questions.

    4. Ask how the taxpayer learned what they state to be fact. The taxpayer should also be required to provide a factual basis for any conclusions stated.

    5. Be alert to instances where the taxpayer starts wandering or going off topic, and redirect the taxpayer's attention to the current talking point. Where possible, ask questions that require a direct response.

    6. Concentrate on the answers of the witness, not the next question.

    7. To ensure the accurate collection of facts, the examiner should clearly understand each reply provided and ensure that any lack of clarity is eliminated before continuing.

    8. When all important points have been resolved, terminate the interview. If possible, leave the door open for further meetings with the subject.

  4. Maintain control of the interview and establish its pace and direction. Continually assess whether the taxpayer is providing pertinent information or rambling.

4.10.3.3.7.2  (02-26-2016)
Request for Representation - Suspension of Interview

  1. Taxpayers have the right to representation at any time during the examination.

  2. IRC 7521(b)(2) provides if a taxpayer clearly states, during any interview, that they wish to consult with an attorney, certified public accountant, enrolled agent, enrolled actuary, or any other person permitted to represent the taxpayer before the Internal Revenue Service, the interview must be suspended regardless of whether the taxpayer may have answered one or more questions.

    Exception:

    An interview will not be suspended if required by a court order or initiated by an administrative summons issued under IRC 7602. If the interview is initiated by an administrative summons and the summoned individual is uncooperative or invokes their Fifth Amendment right against self-incrimination, refer to IRM 25.5.5.4.7, Noncompliance by the Witness or a Representative, for additional guidance.

  3. Once a taxpayer states they wish to consult with an authorized representative, the examiner will suspend the interview and allow the taxpayer a minimum of 10 business days to permit such consultation and secure representation (extensions of time may be granted on a case-by-case basis). The taxpayer should be informed of the consequences if the examiner is not contacted within 10 business days, and if necessary, a Form 4564, Information Document Request (IDR), should be provided to the taxpayer via hand delivery or mail. If mailed, the examiner should advise the taxpayer that an IDR will be sent and document this on Form 9984.

  4. While an interview may be suspended, there are situations where examination activities involving correspondence with the taxpayer (e.g., issuance of a 30-day letter, third party contacts, etc.) should not be delayed, such as cases with statutes expiring in 270 days or less, or cases requiring the collection of third-party evidence scheduled for destruction or deletion.

    Note:

    Examination activities that can be performed at the examiner’s work location and are transparent to the taxpayer (e.g., audit work on information previously secured, case write-up, case file documentation, etc.) do not need to be suspended as a result of suspension of an interview per IRC 7521(b)(2).

  5. An administrative summons should be issued if the taxpayer abuses this process through repeated delays or suspensions of interviews.

  6. Examiners must document the taxpayer's request to consult with an authorized representative and all actions taken related to that request on Form 9984.

4.10.3.3.7.3  (03-01-2003)
Question Construction

  1. The areas to be addressed during the interview should be based on analyses completed prior to conducting the interview. Questions are the principal tools of interviewing.

  2. There are four types of questions: open-ended, closed-ended, probing, and leading. Each is described below:

    Type Description
    Open-Ended Questions Open-ended questions are framed to require a narrative answer. They are designed to obtain a history, a sequence of events, or a description. Ask open-ended questions about the taxpayer’s business, employment, education, and sources of income which may not be reflected on the return. The advantage of this type of question is that it provides a general overview of some aspect of the taxpayer’s history. The disadvantage is that this type of question can lead to rambling.
    Close-Ended Questions Close-ended questions are more appropriate for identifying definitive information such as dates, names, and amounts. These questions are specific and direct. Ask close-ended questions for personal background information such as the number of dependents or current address. Close-ended questions are useful when the taxpayer has difficulty giving a precise answer. They are also useful to clarify a response to an open-ended question. The disadvantage to close-ended questions is that the response is limited to exactly what is asked and can make the taxpayer uncomfortable.
    Probing Questions Probing questions combine the elements of open and close ended questions. They are used to pursue an issue more deeply. For example, when questioning a taxpayer’s travel expense, ask "How many miles is it from your residence to your practice and where do you first travel to in the morning?" The advantage of this type of question is that the taxpayer’s response is directed, but not restricted.
    Leading Questions Leading questions suggest that the interviewer has already drawn a conclusion or indicate what the interviewer wants to hear. Limit the use of leading questions. Use them when looking for confirmation, since the answer is stated in the form of a question. For example: "So you did not keep a log or other written record of your auto expenses?"
  3. Use the interview questionnaire or outline as a guide; it should not be inflexible. Allow flexibility to respond to new information as it is received and to ask follow-up questions when clarification is needed.

  4. Vary the types of questions and pause between questions. This technique can help establish a more conversational atmosphere.

  5. Obtain as much information as possible during an interview. There may not be an opportunity to conduct another interview.

4.10.3.3.7.4  (03-01-2003)
Listening Skills

  1. The question, no matter how important, becomes irrelevant if the response is not accurately understood. Ways to enhance listening include:

    1. Making sure that non-verbal communication contributes to a comfortable atmosphere. If the examiner appears overly relaxed and is not looking at the taxpayer, the taxpayer may believe the examiner is not interested and will respond accordingly.

    2. Listening for the meaning of words. If the taxpayer’s response is unclear, try paraphrasing or repeating what was said.

    3. Not interrupting the taxpayer and allowing a brief pause at the end of the response. Use the time to analyze the response and, if appropriate, formulate a follow-up question.

    4. Maintaining eye contact with the taxpayer. This demonstrates interest and non-verbal responses can be observed.

4.10.3.3.8  (02-26-2016)
Mutual Commitment Date (SB/SE Revenue Agents Only)

  1. The mutual commitment date (MCD) is a tool used by SB/SE revenue agents to promote cooperation and the timely submission and review of records, resulting in a more efficient examination.

  2. The MCD is the date the parties agree the SB/SE revenue agent will issue the audit report (generally the closing conference date) and should be established with the input of the taxpayer and/or representative at the end of the first appointment. If the initial appointment is scheduled for multiple days, then the MCD should be established at the end of the last day.

  3. The MCD process establishes mutual responsibilities such as:

    1. Identifying and discussing potential areas of examination (including issues raised by the taxpayer);

    2. Requesting, providing and reviewing pertinent information necessary to determine the deductibility of an expense or inclusion of an income item;

    3. Applying relevant tax law, including the Internal Revenue Code, the Treasury Regulations, court cases, etc., required to make a correct determination;

    4. Keeping all parties advised of unavoidable delays;

    5. Addressing all parties’ questions and concerns raised during the audit; and

    6. Keeping all parties fully informed about the adjustments being proposed, and the progress of the audit.

  4. The MCD should be reasonable and attainable. The following factors should be considered when determining the MCD:

    1. Number of anticipated additional visits;

    2. Days needed between visits to get information properly prepared; and

    3. Availability of records.

  5. SB/SE revenue agents must:

    1. Document the MCD on Lead Sheet 110, Revenue Agent Audit Plan;

    2. Discuss the MCD with the group manager during the Group Manager Concurrence Meeting (GMCM) and ensure the discussion is documented on Lead Sheet 115, Group Manager Concurrence Meeting; and

    3. Promptly notify the group manager if a taxpayer and/or representative declines to establish a MCD or fails to cooperate. If this occurs, the group manager should contact the taxpayer and/or representative to discuss expectations and responsibilities of the Service and taxpayer or representative during the course of the examination. Based on the results of the discussion, the group manager and examiner will establish and document an estimated completion date (ECD).

  6. Both the MCD and ECD may be extended if:

    1. The examination is expanded to new issues;

    2. The examination is expanded to pick up prior, subsequent, or related returns;

    3. New information is discovered;

    4. The taxpayer and/or representative become uncooperative; or

    5. Unforeseen circumstances arise.

  7. An extension of the MCD must be communicated to the taxpayer/representative. If the MCD is extended more than 30 calendar days, the revenue agent must also notify the group manager and discuss the reasons for the extension. The revenue agent must document the discussions with the taxpayer/representative and group manager on Lead Sheet 110, a workpaper, or Form 9984.

  8. Whether or not the taxpayer or representative agrees to establish a MCD, in the event a taxpayer and/or representative fails to work with the Service in a collaborative manner, the revenue agent will be expected to use the full extent of the authority allowed by the Internal Revenue Code to obtain the information necessary for an effective examination, make an appropriate determination, and conclude the examination in a timely manner.

  9. Pertinent case actions and related discussions concerning the MCD/ECD should be documented on Lead Sheet 110, a workpaper, or Form 9984.

4.10.3.3.9  (02-26-2016)
Group Manager Concurrence Meeting (SB/SE Revenue Agents Only)

  1. The group manager concurrence meeting (GMCM) is an opportunity for the group manager and SB/SE revenue agent to discuss the scope and depth of the examination, as well as the MCD. Group manager involvement in the early stages of an examination results in fewer delays, increased efficiency and higher quality cases.

  2. The GMCM should occur within 30 business days following the completion of the initial appointment. The GMCM may also be conducted prior to the initial appointment, for example, when the taxpayer or representative is procrastinating and has rescheduled the initial appointment multiple times.

  3. The revenue agent should schedule the GMCM meeting as soon as the date of the initial appointment is scheduled.

  4. GS-12 revenue agents and below are required to use the GMCM.

  5. GS-13 revenue agents are encouraged to utilize a GMCM in order to provide updates on cases and obtain guidance from managers.

  6. At a minimum, the revenue agent should be prepared to discuss:

    1. The initial appointment and MCD;

    2. Accomplishments and planned actions for completing the case;

    3. Issues currently identified;

    4. Required filing checks;

    5. Location of the audit work; and

    6. Concerns or barriers to closing the case.

  7. The GMCM should be documented on Lead Sheet 115, Group Manager Concurrence Meeting.

4.10.3.4  (03-01-2003)
Tours of Business Sites and Inspection of Residences

  1. The physical observation of the taxpayer’s operation, or tour of business site, is an integral part of the examination process. Viewing the taxpayer’s facilities and observing business activities is an opportunity to:

    1. Acquire an overview of the business operation;

    2. Establish that the books and records accurately reflect actual business operations;

    3. Observe and test internal controls;

    4. Clarify information obtained through interviews; and

    5. Identify potential audit issues.

  2. See IRM 4.10.3.4.5 for guidance related to inspection of a taxpayer’s residence.

4.10.3.4.1  (03-01-2003)
Authority to Conduct Tours of Business Sites

  1. Regulation 301.7605–1(d)(3)(iii) states: "regardless of where an examination takes place, the Service may visit the taxpayer’s place of business or residence to establish facts that can only be established by direct visit, such as inventory or asset verification. The Service generally will visit for these purposes on a normal workday of the Service during the Service’s normal duty hours."

4.10.3.4.2  (03-01-2003)
Conducting Tours of Business Sites

  1. Tours of business sites should be conducted during examinations of all business entities. Generally, the principal location, and any locations acquired during the period under examination, should be visited. However, consideration should be given to the cost effectiveness and practicality of conducting the tour. When appropriate, alternatives should be considered.

    Example:

    A fish processing company owns more than a dozen vessels and several on-shore processing plants in three states. Rather than conducting tours of the different business sites, the examiner reviewed video tapes the company had prepared for insurance purposes. The tapes helped the examiner understand the taxpayer’s operation and how various pieces of heavy machinery were used.

  2. Tours should be conducted after the initial interview and early in the examination process. This clarifies what was said during the interview and provides a frame of reference when interpreting information in the books and records. This assists examiners to correctly determine the scope and depth of the examination and avoid unnecessary audit steps.

  3. Tours should be conducted with knowledgeable individuals. Taxpayers, or their representatives, can often explain business practices that appear unusual to the examiner.

  4. Tours should be planned to address large, unusual, or questionable items identified during the pre-contact analysis or interviews.

  5. Design the tour to fit the type of business. The Audit Technique Guides (ATGs) include descriptions of business operations which can help determine what examiners should expect to see. The ATGs are available at: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Audit-Techniques-Guides-ATGs.

  6. Tours should not disrupt business operations or interfere with the taxpayer’s interactions with customers.

4.10.3.4.3  (03-01-2003)
Audit Techniques for Tours of Business Sites

  1. Observe and be alert to the physical surroundings. Confirm that assets identified on the tax return (and identified as having audit potential during the pre-contact analysis) are physically present and identify assets that are physically present but are not represented on the return.

  2. Ask questions to confirm understanding of what is observed and avoid confusion.

  3. Trace common business transactions through the system. Look for discrepancies between what the transactions "should" look like and what actually happens. Look for weaknesses in the internal controls such as a lack of separation of duties. This will help determine what degree of reliance can be placed on the books and records and what audit steps will be needed.

4.10.3.4.4  (03-01-2003)
Examples for Tours of Business Sites

  1. The following examples emphasize how tours of business sites can assist examiners to determine the correct scope and depth of examinations, identify significant issues, and avoid unnecessary and time consuming procedures.

    1. Example 1 – An examination of an auto dealership was conducted at the representative’s office due to limited space at the business site. During the tour of the business, the examiner asked what was on the second floor above the work area and the POA stated that some obsolete parts were kept there. The examiner asked to take a look and found a well stocked inventory of parts used for repairs. The inventory, as represented on the return, included only the vehicles held for sale and not the parts used to complete repairs.

    2. Example 2 – During the tour of a pharmacy, the examiner noticed that a large billboard was mounted on the roof of the building. It was determined that the income from the rental of the billboard was omitted from the tax return.

    3. Example 3 – Touring a new building included questions about a demolition loss claimed on the return. The examiner determined that the expense was for the demolition of the old building on the site of the new facility and was not properly accounted for on the tax return.

    4. Example 4 – During the tour of an auto repair shop, an examiner observed a new computerized alignment rack, an air conditioning evacuation and charging station, two brake lathes, and an elaborate engine analyzer. The depth of the examination into depreciation was minimized because the examiner was able to inspect and observe many of the assets listed on the depreciation schedule.

4.10.3.4.5  (03-01-2003)
Inspection of a Taxpayer’s Residence

  1. An examiner may consider inspecting the taxpayer’s residence. Due to privacy issues and the intrusiveness of such inspections, their use should be limited. The purpose of inspecting the taxpayer’s residence includes (but is not limited to):

    1. Determining the validity of deductions for an office or business located in the residence.

    2. Determining the taxpayer’s financial status.

4.10.3.4.5.1  (03-01-2003)
Inspection of a Business in the Home

  1. When determining the validity of office in the home deductions, the office or business should be toured as any other business site. In order for any portion of a personal residence to qualify, it must be used exclusively for business purposes. This can only be determined by inspecting the business portion of the residence.

4.10.3.4.5.2  (03-01-2003)
Other Inspections of the Taxpayer’s Residence

  1. When determining the taxpayer’s financial status, an inspection of the interior of the home is not required. The following techniques are suitable alternatives:

    1. Ownership, sales price and mortgage information can be obtained from public records.

    2. The examiner can drive through the taxpayer’s neighborhood to estimate the taxpayer’s standard of living.

  2. These activities should be completed early in the examination process. Coordination with the taxpayer is not necessary.

4.10.3.4.6  (03-01-2003)
Case File Documentation

  1. Examiners should document that a tour or inspection was completed and describe the results, including observations and resolution of any questions. The tour of the business site or inspection of the taxpayer’s residence should also be noted on the activity record.

  2. If a tour of the taxpayer’s business facilities is not conducted, the reason(s) should be documented in the workpapers.

4.10.3.5  (03-01-2003)
Evaluating the Taxpayer’s Internal Controls

  1. This section discusses examiner responsibility for evaluating internal control.

  2. Examiners are required to evaluate the existence and effectiveness of internal control for all types of business returns as described in IRM 4.10.4, Examination of Income.

  3. Many of the businesses will be sole proprietorships or small, closely-held corporations. In this environment, the owner-managers usually control the entire operation through direct supervision of the business activities. It is not uncommon for one person or a small group of people to have the ability to override vital elements of a system of internal controls. Even in this environment, however, it is essential to evaluate internal controls to determine the appropriate audit techniques to be used during the examination.

  4. The evaluation of internal controls will assist examiners in determining the accuracy and reliability of the taxpayer’s books and records. Additionally, the evaluation of internal controls should be part of the decision making process used to select the appropriate method for the examination of income and expenses. Examiners should consider the type of business, the type of records maintained and the taxpayer’s financial status and not just the income and expenses reflected on the tax return.

4.10.3.5.1  (03-01-2003)
Purpose of Evaluating Internal Controls

  1. An evaluation of a taxpayer’s internal controls is necessary to determine the reliability of the books and records.

  2. It is essential to evaluate internal controls to determine the appropriate audit techniques to be used during the examination.

  3. The evaluation of internal controls gives examiners the opportunity to identify high risk accounts and eliminate verification of accounts that have little or no tax consequence.

  4. An evaluation of internal controls is used to determine the scope of an audit and the extent of audit procedures to be used.

  5. An evaluation of internal controls is used to assess the level of control risk and establish the depth of the examination. "Control risk " is defined as the risk that a material misstatement could occur and it will not be prevented or detected on a timely basis by the business’s internal control structure, policies or procedures.

4.10.3.5.1.1  (03-01-2003)
Evaluation of Internal Controls in a Small Business Environment

  1. Internal controls are often limited to the consideration of controls for segregation of duties and safeguarding assets. With this limited perspective, the evaluation of internal controls in small businesses are often viewed as unimportant because control procedures in such environments are often weak or non-existent. This may be due to cost factors, lack of staffing, or a lack of concern with this aspect of the business.

  2. The fact that internal controls may be weak in a small business environment does not preclude the necessity of determining the reliability of the books and records. Every taxpayer has a method of conducting business and safeguarding business operations.

4.10.3.5.2  (03-01-2003)
Internal Controls Defined

  1. Internal Controls are defined as the "taxpayer’s policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information."

  2. Examiners should obtain an understanding of three key elements of the taxpayer’s business:

    1. The control environment;

    2. The accounting system; and

    3. The control procedures.

4.10.3.5.3  (03-01-2003)
Key Steps for Evaluating Internal Controls

  1. The evaluation of internal controls can be described as an analysis completed by the examiner to understand and document the entire business operation. The key steps of the evaluation process are:

    1. Understanding the control environment;

    2. Understanding the accounting system; and

    3. Understanding the control procedures.

  2. Each of these steps is discussed in the following subsections. To add clarity, a flowchart of the process of evaluating internal controls is included as Exhibit 4.10.3–1. The flowchart identifies the minimum steps to be taken by the examiner to understand and document the entire business operation.

  3. While the flowchart appears to be a linear process, the evaluative process is not linear and the steps illustrated need not be followed in the order shown in the exhibit.

4.10.3.5.3.1  (03-01-2003)
Control Environment

  1. The first area examiners must understand is the control environment of the business. The control environment is made up of many factors that affect the policies and procedures of the business, including:

    • Management philosophy;

    • Management operating style;

    • Organizational structure;

    • Personnel policies; and

    • External influences that affect the business.

  2. To make an assessment of the control environment, examiners must understand, in detail, how the business operates. Therefore, the first step on the flowchart is to draw an overview of business operations. Interviewing the taxpayer and/or representative and touring the business are integral steps for completing the flowchart.

4.10.3.5.3.2  (03-01-2003)
Accounting System

  1. The second key area of internal control that examiners must understand is the taxpayer's accounting system. Gaining knowledge of the accounting system provides information about many of the taxpayer’s transactions.

  2. The examiner should become familiar with the normal flow of each type of transaction, including:

    1. The accounting records which are involved in the processing, and

    2. Reporting of transactions.

  3. Generally, there are two significant elements to a transaction:

    1. The recordation of the transaction from its initiation to its inclusion in the financial statement, and

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

  4. Examiners must acquire knowledge of how the business operates on a day-to-day basis with respect to customers, suppliers, management, sales, work performed, pricing, location, employees, assets used, production and record keeping.

4.10.3.5.3.3  (03-01-2003)
Control Procedures

  1. Control procedures are the policies and procedures established by management to achieve the objectives of the business. The control procedures are the methods established to assure that the business operates as intended. Separation of duties is the primary control procedure that concerns the examiner. If properly executed, separation of duties will reduce the opportunity for any person to both perpetrate and conceal errors or irregularities in the normal course of their duties. Other specific procedures include:

    1. Documentation of procedures and transactions;

    2. Supervision of work and periodic review by independent third parties; and

    3. Timely recording of all transactions.

  2. Many small businesses have one owner and no employees. Although no separation of duties can exist in this situation, other control procedures might be in place to assure accurate reporting of income and expenses. The greater the number of employees, and the more complex the structure of the business, the more likely some formal control procedures will exist.

4.10.3.5.4  (03-01-2003)
Industry Examples

  1. Not all businesses are susceptible to the same level of control risk. In some businesses, internal controls are required by third parties (such as when a franchise is involved) . Moreover, internal controls for businesses within the same industry may vary significantly.

4.10.3.5.4.1  (03-01-2003)
Franchises

  1. Internal controls are usually very good in franchise companies due to independent audits and verifications performed by the franchisor. Typically, the franchise fee is based on the gross revenue of the business. The franchisee usually must buy products from the franchisor to keep the franchise. The franchisor also requires that minimum records be kept. Regular audits, some announced and some unannounced, are performed by the franchisor. Franchise businesses may be operated in either corporate or non-corporate form.

4.10.3.5.4.2  (03-01-2003)
Cash Businesses

  1. Many small businesses that deal almost exclusively in cash are likely to have few internal controls. Practically all income is received in cash. No independent third parties review the operation. Many expenses are paid in cash and documentation for transactions is often lacking.

4.10.3.5.4.3  (03-01-2003)
Vertically Integrated Industries

  1. Generally, accounting methods and procedures are rigid in vertically integrated industries. Periodic checks are made to ensure compliance with the system. The majority of income is not generated by cash transactions. Most expenses are paid by check and are well documented. The new car market segment is a good example of an integrated industry.

  2. By contrast, few used car dealers are integrated or incorporated and most do not maintain double-entry books and records. Until recently, no third parties, other than law enforcement personnel looking for stolen cars, would review these operations. Since many buyers arrange their own financing, dealers often receive cash payments. It may also be difficult to trace the origin of the inventory.

4.10.3.5.5  (03-01-2003)
Summary of Internal Control Evaluations

  1. An examination of a taxpayer cannot be undertaken without an overview of the entire operation. An in-depth review of taxpayers’ financial status can only be accomplished through an evaluation and documentation of internal controls, including the control environment, the accounting system and the control procedures.

4.10.3.5.5.1  (03-01-2003)
Evaluation Methods and Tests

  1. The examiner’s role in evaluating internal controls must encompass a complete review of existing procedures. Adequate tests to validate the taxpayer’s records and testimony should be carried out as applicable.

  2. Information regarding internal controls may be obtained by interviewing the taxpayer and/or representative, inspecting the documents and records, and observing the taxpayer’s activities and operations.

  3. To complete a comprehensive evaluation of internal controls, the examiner should document the business operation and document the accounting system.

  4. Document the Business Operation — Draw-up an overview of the business operations. At a minimum, the information obtained should depict by whom, with what, how many, where, when and how business is transacted.

  5. Document the Accounting System — Identify what books and records are maintained. At a minimum examiners should determine:

    1. What the books of original entry are, whether they are automated, what types of subsidiary records (invoices, etc.) are maintained, what kinds of reports are prepared, how often they are prepared, and by whom.

    2. How income is received, how expenses are paid, and who is responsible for receiving and recording income and expenses.

    3. Who opens mail, deposits funds, writes checks, approves expenditures (both regular and extraordinary), signs checks, makes book entries, prepares invoices, matches invoices, has access to cash registers, and receives and reconciles bank statements.

  6. Document Assets — Identify the taxpayer’s business and personal assets, including capital acquisitions, bank accounts and cash. At a minimum, the taxpayer and/or representative should be questioned regarding capital asset transactions, cash in bank, cash on hand, bartering, number and location of bank accounts, non-taxable sources of funds, and total assets held.

  7. Document the Flow of Transactions — Outline the flow of receipts and expenditures through the books and records. Are there changes in the books? Is there a system of accounting for non-taxable receipts? Do the books and records have a system of accounting for cash receipts and expenditures? Does the taxpayer rely on information generated by third parties? Is the taxpayer’s mark-up identifiable? Does the taxpayer use the books and records for purposes other than tax? Do the books and records reflect regulatory or licensing requirements?

  8. Document Procedures Established to Safeguard Business Operations — Review procedures designed to safeguard the taxpayer’s business. Assets should be insured and employees who handle cash may be bonded.


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