- 4.22.7 Area Office - Examination of S Corporation Returns
- 22.214.171.124 Initiating Examinations
- 126.96.36.199 S Corporation Examination Guidelines
- 188.8.131.52.1 S Corporation SAIN Specific Examination Guidelines
- 184.108.40.206.2 S Corporation Shareholder Examination Guidelines
- 220.127.116.11 Case Management and NRP Monitoring
Part 4. Examining Process
Chapter 22. National Research Program (NRP)
Section 7. Area Office - Examination of S Corporation Returns
All possible efforts should be made to contact taxpayers whose cases are to be examined.
Letter 2205-B (2-2005) was specifically developed for NRP S Corporation key case examinations. Letter 2205-B will be used to arrange an appointment for all NRP S Corporation key case examinations. This letter requests a taxpayer to call the Revenue Agent to schedule an appointment. If no contact is made see the following IRM sections for guidance:
IRM 18.104.22.168.2, Locating the Taxpayer, should be used for guidance in those situations where there is no response to the initial contact letter.
IRM 22.214.171.124.6, Undeliverable Initial Contact Letter, should be consulted in those situations where mail is returned as "Undeliverable " .
Any other letters or correspondence to taxpayers or their representatives should utilize standard examination letters (correspondences). This would include but not be limited to confirmation letters, no-change letter, and no-change with adjustment letter.
Notice 1332 (8-2004) and Publication 1 and Notice 609 will be used as enclosures to Letter 2205-B. Notice 1332 explains to the taxpayer how and why their return was selected for an NRP examination.
NRP S Corporation key case examinations will be conducted consistent with procedures for other return types in NRP studies. See IRM 126.96.36.199.1.
In determining whether to pick up a related entity return, the same judgment should be used as is used in performing operational examinations. Mere relationship to NRP returns does not in itself mandate that related and prior or subsequent-year returns be examined. However, the Revenue Agent should consider the taxpayer’s financial interests when deciding whether to examine these returns. Related return pick-ups are not NRP sample returns. The scope of the examination on the related entity will be determined by the Revenue Agent. Related returns are not subject to the NRP classification guidelines.
When establishing AIMS control for prior and subsequent year returns or related entities, source code 91 and project code 0674 are to be used. Each NRP S Corporation key case has a case control number assigned. The purpose of the number is to allow IRS Research to compare adjustments and tax results from the related entities to the NRP key case. Revenue Agents will ensure that the case control number is used on related entity returns opened for examination that are included on the NRP RGS-1120S file server (Forms 1040, 1040A, 1040EZ, 1065, 1120, 1120S).
NRP S Corporation key case returns and related return types noted above in (3) need to be on the NRP RGS 1120S file server.
The data requirements of a NRP study necessitate specific treatment of certain tax return items. RGS and EOAD have been programmed to assist the Office of Research obtain the statistical information necessary to determine compliance levels. The NRP classification check sheet contains Standard Audit Index Numbers (SAIN) to tie audit results to corresponding line items on business returns. The SAIN system works with RGS and EOAD to provide the statistical information desired by the research community and its stakeholders. Below are specific instructions for certain SAIN items that must be followed to assure the accuracy of the data collection process.
SAIN 401 through 410-01: For the income probe, the Revenue Agent should examine all income. The Revenue Agent also needs to insure that the income was properly categorized by the entity (ordinary income vs. separately stated income item).
SAIN 502-04, 502-05: The classification of 502-04 and 502-05 indicates the Revenue Agent must examine the "Other Cost Grouping." If the classifier has included a written comment that identifies a specific item as having significant examination potential, the Revenue Agent must (at a minimum) examine that item. If no item is specifically noted by the classifier, the Revenue Agent has the discretion to set the scope of audit work within the 502-04, 502-05 section.
SAIN 512 through 526: Throughout the examination process, Revenue Agents need to consider the proper categorization of expenses. The Revenue Agent needs to ensure that the expenses were properly categorized as expenses related to ordinary income vs. a separately stated item.
SAIN 901a: When examining Ordinary Income classified on a 1120S, (SAIN item 901a), if schedule K line 1 does not equal line 21 page 1 of the 1120S, the items should be reconciled. One valid reason for the variance could be the built-in gains tax. The built-in gains tax should be from disposition of an ordinary asset previously held as a C Corporation that has converted to an S Corporation.
SAIN 903-01, 904-11, 906, 519, 908, 909,910,914-07, 915-04, 915-09, and 915-12: The classification of these indicates that the Revenue Agent must examine the "attached schedule." If the classifier has included a written comment that identifies a specific item as having significant examination potential, the Revenue Agent must (at a minimum) examine that item. If no item is specifically noted by the classifier, the Revenue Agent has the discretion to set the scope of audit work within the " attached schedule" classified.
SAIN 528: If classified, Schedule M-1 must be reconciled to the net income per book.
SAIN Series 100 (Assets), 200 (Liabilities), and 300 (Shareholders’ Equity): When a balance sheet item is classified the Revenue Agent must audit the item. Revenue Agents do not need to provide corrected balance sheet account dollar figures for the NRP study. If a balance sheet item results in an adjustment to income, you will have two issues in RGS; one for the balance sheet item with the adjustment and agreed amounts entered (categorized as memo by clicking the box next the categorization drop down arrow) and; a 2nd adjustment for the income/expense adjustment (completely filled in). These adjustments should be categorized as Memo adjustments by checking the Memo field in RGS. If an adjustment is made to a balance sheet account, the Revenue Agent should complete the Adjustment and Agreed amount fields to reflect applicable adjustment amount(s). If as a result of auditing the balance sheet account item a related income or expense issue is identified, the Revenue Agent should create a new issue by selecting the New Issue Resulting From Classified Issue option from the Actions menu. Select the applicable SAIN number for the new issue and modify the issue name accordingly (the entry in the Issue name field is what will print on the RAR). The new issue must be categorized in RGS and Per return and Per exam information must be entered.
Additional RGS guidance for Non-Balance sheet/Income/Expense/tax/credit issues is as follows: These classified issues are entered in RGS based upon how (or if) the issue is reflected on the actual return. For a classified issue that does not identify a specific balance sheet, income, expense, tax, credit, or etc. line item, the classified issue will be treated in the same manner as a balance sheet item above – RGS will reflect a Memo issue and a New Issue Resulting From Classified Issue (i.e., the classified issue will be categorized "memo" and any resulting adjustment will result in the creation of a New Issue Resulting From Classified Issues). For example, if the classified issue is "change in accounting method" or "related party transaction" and there is no specific line item on the return (such as an income/expense item that states "change in accounting method" or a related party transaction such as a sale to a shareholder that is reported on Schedule D or Form 4797), the classified issue will be categorized as Memo and a New Issue Resulting From Classified Issues will be created to record the actual adjustment. However, if the classified issue references a specific line item and amount on the return, no memo entry is required and the classified issue will be completed per NRP guidelines. In both scenarios (memo adjustment or regular adjustment), the following fields must be completed: per return, per exam, adjustment, agreed amount, reason code, UIL code (LMSB only), form number, line number and NAICS code (any fields autopopulated by RGS must be verified for accuracy). SAIN codes should not be changed for any issue (Memo or non-Memo) unless it is an obvious error and agreed to by your local NRP Coordinator.
Ultimate Tax Consequence - In order to determine the compliance levels of flow-through entities, the ultimate tax consequence of adjustments to the shareholder’s share of income, credits and deductions must be measured at the individual level.
In an effort to ensure that the research data is complete, any S Corporation adjustment that impacts Schedule K (Shareholders’ Share of Income, Credits, Deductions) will require the examination of all shareholder returns to determine the ultimate tax consequence of the adjustment(s).
In certain instances the adjustment to the shareholder(s) return(s) would result in an immaterial amount of tax due. Revenue Agents should use operational guidelines on materiality when determining if this applies to shareholder(s) that are controlled by the Revenue Agent in the Area/local office. Factors to consider include relative dollar amount, estimated hours to complete, type of adjustment or compliance impact. For example, assume the examination results in a $4,000 adjustment in net income on the S Corporation. A 5% shareholder's allocable share of the flow through change to net income is $200. Assuming the taxpayer's marginal rate is 25%, the additional tax on the shareholders return would be $50.00.
If immaterial adjustments are applicable to any of the individual shareholder(s) that would be controlled by the Agent in the in the Area office (PCS controls not established) than the Revenue Agent will complete the NRP S Corporation Key Case Immaterial Individual Shareholder Adjustment Checksheet and notate this in the case file. These individual shareholder(s) returns will not be opened for examination. The checksheet and attachments will be included in the NRP S Corporation key case file when the return is closed. The NRP Coordinator will forward the completed checksheet and attachments to NRP support specialists who will ensure that the results are included in the NRP database.
>Loss< S Corporation Returns - S Corporation returns with losses present the opportunity for several potential issues at the individual level. Consequently, these returns require special consideration in terms of audit scope and specialized issues. The following decision matrix will assist the Revenue Agent to determine the proper scope and required actions in these cases:
IF THEN If the NRP S Corporation return has reported a loss for the tax year. (Regardless of whether the examination of the S Corporation entity results in any adjustments). Special rules apply in terms of the examination of the shareholders. (see below) If any shareholder owns (directly or indirectly as defined by IRC section 267) a 20% or more interest in the loss of the S Corporation. The shareholder (s) that meet this criteria will be examined and the audit scope (at a minimum) will include the following issues:(The examination depth of these issues is a matter of the professional judgment of the Revenue Agent.)
Basis (for loss)
Passive Activity Loss (PAL)
If the shareholder’s returns are audited for the three specialized issues and no other large, unusual or questionable (LUQ) items are present on the return. The audit scope of these shareholders will be limited to the issues identified above and the decision to limit the audit scope properly documented in the examination workpapers.
The following examples provide guidance on the application of the 20 percent loss individual shareholder guidelines discussed above. Example A: The NRP S Corporation key case is a no-change and there is no flow-through loss claimed by the 20% or greater 1040 shareholder(s). An examination of the 1040 shareholder is not warranted since it is assumed that the loss was properly limited. This should be documented in the case file. Example B: The NRP S Corporation key case is a no-change and the 1040 and the flow-through loss is being claimed by the 20% or greater 1040 shareholder(s). An examination of the 1040 shareholder(s) is warranted per existing requirements for basis, at risk and PAL. Note: If the determination of the basis, at risk and PAL issues can be determined at the NRP S Corporation key case level and the related shareholder(s) properly treated these items on their 1040s this should be documented in the NRP key case workpapers. The shareholder(s) would not have to be opened and placed under examination. Example C: The NRP S Corporation key case has audit changes and the 1040 shareholder(s) returns have not claimed the flow-through losses due to basis, at risk or PAL limitations. The Revenue Agent will prepare all the necessary key case audit reports showing all of the flow-through changes to the individual shareholder(s). The NRP S Corporation should ensure that the shareholder(s), that properly limited their loss, receive a copy of the key case examination report so they can make appropriate adjustments to basis, at risk or PAL for future tax years. An examination of the 1040 is not warranted if there is no tax effect. This should be documented in the case file. Example D: If the 20 percent loss shareholder(s) have not claimed a loss from the NRP key case to which they are entitled, the Revenue Agent will open these returns for examination and make the necessary adjustments.
Trusts as Shareholders of the NRP S Corporation key case. The following summarizes guidelines on trust shareholders.
Trust ownership of S Corporation stock is very restrictive. In order to qualify as a shareholder of S Corporation stock, a trust must be either a grantor type trust (within the meaning of IRC sections 671-677) a Qualified Subchapter S Trust (QSST defined under IRC section 1361(b)) or an Electing Small Business Trust (ESBT defined under IRC section 1361(e)). Under no circumstances may a foreign trust be considered to be a qualifying shareholder. Some trust shareholders may file Form 1041 while others will not. An ESBT will be subject to tax on S Corporation income.
Revenue Agents should refer to their technical training material for additional guidance on qualifying S Corporation Shareholders. Revenue Agents can also refer to (http://abusiveshelter.web.irs.gov/) for additional information on Trusts.
Trust shareholder returns are not included on the NRP RGS-1120S file server file server. As is the case with any related return source code 91 and project code 0674 should be utilized. The number of beneficiaries in a trust is usually 2 or less. If the S Corporation key case Revenue Agent decides not to input PCS controls on the trust shareholder, they need to ensure that the adjustments are made/flowed to the individual beneficiaries. The individual beneficiary returns need to be included on the NRP RGS 1120S file server along with the NRP key case control number.
Related/Not Related Adjustments- The purpose of the NRP study is to measure the compliance of flow-through entities. Adjustments at the individual level "not related" to the results of the S Corporation examination will distort the study results. Consequently, RGS has been redesigned to differentiate between S Corporation related adjustments and non-S Corporation adjustments. Revenue Agents should refer to their NRP training material to ensure their S Corporation adjustments are properly identified in RGS.
(1) This section contains information about case management and NRP S Corporation monitoring.
The NRP Office and Operating Division Compliance functions will analyze the data gathered from the various reviews completed and take appropriate action to ensure the quality of the NRP examinations.
Various processes will be utilized to ensure quality NRP cases. These include Group/Team Manager in-process reviews, mandatory non-evaluative closed case reviews and in process reviews completed by the SB/SE Area Quality Review Teams and the LMSB NRP Quality Review Team. In addition, NRP cases will be subject to the same national sample review as any operational examination.
Group/Team Managers play a pivotal role in all aspects of case development. The Group/Team Manager is responsible for maintaining a work flow through out the entire examination cycle that will ensure timely completion of quality examinations.
In-process reviews are critical in guaranteeing the highest quality of NRP cases. At a minimum one in-process review should be completed within 90 days of the first NRP S Corporation key case being placed in status 12. The review should take place after the concurrence meeting (SB/SE) and after the initial appointment (LMSB) and prior to the report being issued. Any trends identified by the SB/SE Group Manager should be shared with the Area NRP Territory Manager. Any trends identified by the LMSB Team Manager should be shared with LMSB NRP Team Lead.
Group/Team Managers will complete a 100% non-evaluative closed case review of all NRP examinations. The objective of the reviews is to ensure the overall quality of NRP examinations. For SB/SE Group Managers these reviews will be documented on a NRP S Corporation Closed Case Review Check Sheet and included in the case file. For LMSB Team Managers these reviews will be documented in a format of the Team Manager’s choosing and should be included in the case file. The LMSB Team Manager may use the SB/SE case closing check sheet. NRP 100% closed case reviews will focus on the following:
Technical correctness of the examination.
Adherence to NRP examination guidelines (all classified issues completed), procedural requirements and case closing/data accuracy requirements.
Review of the NRP Questionnaire, for accuracy and completeness and inclusion in the case file.
Each SB/SE Area will establish a NRP Quality Review Team. The SB/SE Area Quality Review Team will consist of the NRP Area Territory Manager, Group Managers and other members deemed appropriate by the NRP Area Territory managers. The purpose of the Review Team is to identify overall quality issues and the reviews completed will be non-evaluative. The following are guidelines for conducting the in-process reviews:
A total of 20 in-process reviews will be completed per Area during each of the two review cycles. The first review cycle will be completed during the second quarter of FY 2006. The second review cycle will be completed sometime after the tax year 2004 NRP returns have been opened for examination.
The Area NRP Territory Managers will be responsible for developing the sample methodology for the cases to be reviewed. Any sample methodology is acceptable as long as a representative number of territories, groups and sample/activity codes are considered.
The reviews will be completed on the NRP S Corporation In-Process Case Review Check Sheet and will ensure technical issues were examined in sufficient scope and depth, ensure correct technical conclusions were reached and serve as a means to identify trends to be communicated with Management and Revenue Agents involved in the study. The results of the Area reviews will also be communicated to the SB/SE Compliance Policy for analysis.
LMSB will establish a NRP Quality Review Team. The LMSB Quality Review Team will consist of the LMSB NRP Team Lead and Industry Territory Manager, or Team Managers. The LMSB Quality Review Team may also consist of other members deemed appropriate by the LMSB NRP Team Lead. The purpose of the Review Team is to identify overall quality issues. Therefore, these reviews will be non-evaluative. The following are guidelines for conducting the reviews:
The LMSB NRP Team Lead will be responsible for developing the sample methodology for the cases to be reviewed. Any sample methodology is acceptable as long as a representative number of territories and groups are considered.
The reviews will ensure technical issues were examined in sufficient scope and depth, ensure correct technical conclusions were reached, and serve as a means to identify trends to be communicated with Management and Revenue Agents involved in the study.
All SB/SE closed S Corporation key cases and related returns will be subject to the same operational national review sample guidelines as other examinations. All LMSB NRP closed cases will be entered into the calculation to arrive at the statistical sample population of closed cases. As such they will be subject to the normal LMSB Quality Measurement System if they fall into the statistical sample.