“But I’ve Always Done It That Way!” Practitioner Considerations on Subsequent Year Exams

Stop me if you’ve heard this one. A taxpayer and a tax attorney walk into a room. The taxpayer pulls out an IRS examination letter and says, “I’ve always filed my returns this way, and the IRS has never cared in the other years. Why is the IRS suddenly out to get me?” The tax attorney looks at the return and the letter. “Ah. The answer is simple: You’ve always filed your returns wrong. This is just the first time the IRS has noticed.”

And everyone in the room shares a good laugh.

Or, more likely, the tax attorney begins shifting uncomfortably in their seat the moment they see the problem -specifically, that there are a lot of erroneous returns filed by your client that have not been caught and may realistically never be. The obligation (or lack thereof) to file an amended return to fix errors has previously been covered by Keith (co-author: Calvin Johnson) in an article here. In a different context, I have written about when you do or do not have an obligation to correct IRS mistakes here and here.

In this post I’d like to take the conversation in a slightly different direction. Specifically, I want to wrestle with the issue of advising clients on exposure to future audits -a thorny topic in the tax community.  

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In my most recent post I covered a TIGTA report suggesting improvements to correspondence examinations, prompting my own suggestions to focus more on high-income earners and non-filers. That same TIGTA report included a raft of recommendations for examining taxpayers that appear to have the same tax issue over multiple years (“subsequent year exams”). Those recommendations are what caught my eye and inspired this post.

TIGTA’s concerns were that the IRS didn’t appear to be initiating as many subsequent year exams as it should, and the IRS could increase efficiency by considering subsequent year returns as part of the already open exam. In a nutshell, TIGTA’s recommendations hinged on the idea that if a taxpayer erroneously claimed a deduction/took a credit in one year, there is a good chance that the same deduction/credit is erroneous in the next year as well. And I’d say that is a fair assumption. But it carries some interesting considerations that I believe tax practitioners should be aware of.

The recommendations put forth by TIGTA were more narrowly focused than just increasing audits on those that have been audited already. For one, it pertained only to subsequent returns with the same issue identified as in the year audited (the same “project code”). Second, it focused on taxpayers that actually resulted in an increased assessment of tax, thereby filtering out those who were selected for exam but ultimately demonstrated that their return was correct. Third, and importantly, TIGTA particularly keyed-in on subsequent returns where the taxpayer defaulted – that is, where they never responded to the exam in the open year and had similar identified issues in subsequent years.

“Silence is Violence”

A key takeaway from this may be that when the IRS selects you for examination, generally the worst thing you can do is to do nothing at all. The TIGTA recommendation (which IRS management agreed with) is to “change the subsequent return process to address only subsequent year returns in which the taxpayer did not respond to the [Initial Contact Letter] for the current examination.” Page 12 of the TIGTA Report (emphasis added).

In other words, if you don’t do anything (or don’t respond to the very first letter) it may carry worse consequences than if you respond with a full concession owning up to your error. Apart from just doing the “right thing,” it may be in your self-interest to proactively agree with the IRS rather than just letting things run their course.

Note also that the IRS also has internal policies against “repetitive” audits. They are a bit narrow (I covered an unsuccessful attempt to raise the policy in court here) and don’t apply to Schedule C returns (even though the prohibition is explicitly mentioned on the IRS Publication for Schedule C Filers: Pub. 334, page 45). However, whatever protections the policy does offer are more likely to apply when the taxpayer actually responds to the audit. See IRM 4.10.2.13.2.

All of this taken together, I think, should factor into any advice that is given to a client. I think it is important to impart the wisdom you’ve gleaned as a practitioner on the black-box of audit: “if you don’t respond to the IRS letter, there may be a heightened possibility that you will be audited on subsequent years.” If I was the average taxpayer that is definitely something I’d want to know and take into consideration.

The Audit Lottery

And now, the backlash.

“You can’t advise your client on the likelihood of audit!” Chants of “audit lottery!” and “Circular 230!” drum in the background as the torches are lit. My demise (the stripping of my ability to practice before the Service) is nigh.

Or so it would seem. But only based on a misunderstanding of what prohibited advice about audit likelihood actually entails. When I talk to (or test) my students about the “audit lottery” some take that it to mean you cannot talk to a client about audit risks. Period. In this understanding, when a tax lawyer reads the (publicly available) IRS Stat Book and sees the (abysmal) exam rate, that knowledge is forbidden fruit. One must never utter a word of it to the innocent, untainted client.

This misunderstanding of the audit lottery is not limited to students. There is, in fact, enough confusion about the topic that Professors Michael Lang and Jay Soled wrote a helpful article in the Virginia Tax Review on it here.

To be clear, there is no blanket prohibition on telling clients about audit rates and general likelihoods of audit. Consider the absurdity and inability to effectively counsel or communicate, while meeting the requirements of the MPRC (specifically MRPC 1.4) if such a blanket prohibition did apply. As an example:

I frequently have clients where the problem is that their ex claimed a child of theirs. The client is the custodial parent and has the right to claim their child under IRC § 152. However, the ex was first in the race to the e-file button. Because of this, any subsequent attempt to claim the child (generally through a paper return) will very likely trigger an exam. I know this both from experience as a tax practitioner and because of my familiarity with “whipsaw” and “correlative US Taxpayer” procedures. See IRM 4.10.13.5.

Am I not allowed to tell my client that if they do file a paper return claiming the child they are at a high risk of audit?

Believe it or not, audit exposure is something that matters to clients even when they are 100% substantively right on the return position. Some of my clients simply would rather not deal with the IRS or, importantly, the ire of their ex. Similarly, I know of a few people that claim a smaller charitable deduction than they actually are entitled to solely because of their (inflated, inaccurate) fear of audit. It is wholly within these taxpayers’ right to make that determination, since they are not legally required to claim the child or the charitable contribution, but only have the right to do so. For a discussion on that point, see the law review article, “No Thanks, Uncle Sam, You Can Keep Your Tax Break.”

So in advising the client with a previously claimed child, what must I do? As a lawyer and as a counselor, I would go so far as to say under the Model Rules I must disclose the risk of audit to the client in that situation, rather than keep it stored away as secret knowledge. To me, a lawyer in that situation should advise the client that on the information they have: the client is entitled to claim their child if they wish, but they are at a heightened risk if they do so. The lawyer should then calm the client down and explain what an audit would actually look like in these circumstances (a few letters back and forth), so that they can make an informed decision about what they’d like to do. To me, getting the client to a more-fully informed decision considering the myriad legal and non-legal issues at hand is the bedrock of being a counselor. See MPRC 2.1.

All of this is to say that one does not “play” the audit lottery simply by speaking of or considering audit likelihood. The prohibition is on advising individuals to take a return position based on the likelihood that it might be “caught” in audit. You play a lottery hoping you win, not simply for the fun of playing. Winning, in the prohibited sense, is having a questionable (or crazy) return position pass by the IRS because of their low audit rates rather than the merits. And you cannot let your knowledge of the odds of success (in this case, the perversely high chance of winning the lottery) color your responsibilities towards the IRS. See, e.g. Circ. 230 § 10.22, 10.34 and 10.37.

Now, rant completed, let’s bring this back to advising someone as to whether they should respond to an IRS letter after an audit has been initiated. In this case you are not counseling them on prospectively taking a return position at all. If they’ve made that same mistake year-over-year, the position has already been taken before they even came to you. What you are doing is simply letting them know that failing to respond to an IRS audit might make future audits more likely. If that is true (and there is reason to believe it is), it is unclear to me how keeping that important information to yourself doesn’t run afoul of your many responsibilities to the client under the MPRC (loyalty and communication, foremost among them).

I want to close with a note to those feeling squeamish about the preceding paragraphs: I feel your pain. If someone has previously taken an incorrect tax position I counsel them to change it. I want them, genuinely, to change it, because I believe we all have an obligation to pay the correct amount of tax. However, I cannot tell them that they must change it, because that would be my imposing my own personal morality on a legal question that has different considerations. (Note that this all changes if and when there is an actual controversy for that tax year before the IRS.)

But there is more to this than just hand wringing and pleading that someone do the right thing while acknowledging they don’t technically have to. Once the taxpayer knows (through the counseling of their tax attorney) their position is untenable they cannot freely take that position in as-yet unfiled tax years. Now, your advice changes: “Look, you should fix the back years, but you don’t technically have to. However, now that you know those positions are wrong, you cannot take them moving forwards and if you do there could be criminal exposure.”

Thus, the tax attorney sleeps at night.

Memoirs of the Last Century: Some Notes on Economic Reality and Section 7602(e)

We welcome back Bob Kamman who writes today about the past and how it matters in having a full understanding of the current debate forbidding the use of financial status or economic reality examination techniques.  Like Bob, I remember when the IRS rolled out economic audits.  His remembrances and insights help inform the current debate.

Les and I will be working with the Pittsburgh Tax Review to create a special edition on RRA 98 for its 25th birthday.  Maybe this will become one of the resources Bob seeks for Caleb’s students.  We welcome stories and comments from others who remember the lead up to that memorable tax procedure legislation.  Keith

In two recent posts available here and here, Professor Caleb Smith has discussed the current status and future implications of Code Section 7602(e), which forbids the use of “financial status or economic reality examination techniques” unless there is a “reasonable indication that there is a likelihood of unreported income.” 

Whatever that means.

The prohibition was part of the IRS Restructuring and Reform Act of 1998, and therefore has been law during all of Professor Smith’s professional career.  I am sure he knows much of the history behind RRA98, but are there resources for explaining its meaning to his students?

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Allow me to reminisce about the events of 27 years ago, because a page of history may be worth a volume of statutory analysis.  I was there.  In fact, I was among the first to see it coming.

The first mention I encountered of “lifestyle audits” was at a regional gathering of 400 tax practitioners in Ogden, Utah in September, 1994.  We had been invited to seminars and a rare tour of the Service Center by former IRS Assistant Commissioner Robert Terry, who had stepped down from his position in Washington to become Director of that facility in his home state. Commissioner Margaret Milner Richardson was a keynote speaker.  (I asked her when IRS would implement the long-promised program of providing a PTIN so that preparers would not have to enter their SSN on every return they prepared.  She had no idea what I was talking about.)

The details on “Economic Reality” audits, meanwhile, came from John Monaco, the IRS Assistant Commissioner for Examination.  I wrote about it in an article for the November 1994 edition of “Tax Savings Report.”  From that article:

Every IRS auditor is going back to school for a week this Fall to learn a radical new approach to the job.

For years, IRS auditors have focused on paper and numbers – tax returns and the entries on them.  Now, auditors are being told to take a closer look at individual taxpayers using the increased capacity of computer matching.  When they see the whole picture, they ask, “What’s wrong with it?”

In an Economic Reality audit, inquiring minds at the IRS want to know:

– Your net worth.  Has it grown over a period of years due to hidden income?

– Your lifestyle, and especially your personal living expenses.  Do you indulge champagne tastes, when your Form 1040 shows a beer budget?

– How you make a living.  The IRS will pay attention to typical ways it has caught others in the same business who understate income or exaggerate deductions.

Auditors will go into an Economic Reality examination armed with data assembled through improved computer technology. [They] will already know whether you live in an affluent neighborhood and how much your car is worth.

Will the public approve of this increased interest by the federal government in private financial affairs?  Privacy concerns have to be addressed, acknowledged [Monaco], in a recent presentation to tax preparers on Economic Reality.

“You don’t get into these questions until there is an indication of unreported cash.  Most of the public demands that we do it,” Monaco said. “What else do you do when you see someone buy a $100,000 boat, and support a family of four in a wealthy neighborhood, on a reported income of $20,000 for each of the last three years?”

In IRS field tests, Monaco said, Economic Reality has succeeded.  When confronted with questions concerning their lifestyle and net worth, taxpayers readily signed agreements to pay more tax.  “Our problem is deciding how many to refer for criminal investigation, and how many stay as civil matters only,” Monaco said.

And one local audit manager pointed out that Economic Reality can occasionally benefit a taxpayer, too.  One planned audit was canceled when a three-year review of a computer business showed that, after early profits from a software product, it became obsolete, and the taxpayer lived on savings and pursued unprofitable ventures.

To refine safeguards against auditors being too aggressive, the IRS has also scheduled them for follow-up training sessions, of two to four hours, every two weeks after the basic Economic Reality boot camp.

“If we’re not careful how we do it,” Monaco said, “we won’t be doing it for very long.  That’s when Congress will add provisions to the Taxpayer Bill of Rights.”

Four years before RRA98, he was certainly prophetic.

The newsletter editor Ellen M. Katz wanted to make sure that I had this scoop right, so she did some fact checking herself.

We asked IRS spokesman Wilson Fadely to describe the new “Economic Reality” audit program.  His reply:

“An auditor will no longer just say ‘let me see your canceled checks or cash journal.’ We’ll be looking at it a different way, by examining whether the tax return fits the economic situation.  Now, we’ll ask questions, like: ‘Are there very large interest payments or large mortgage payments and not much income?  If so, something is not right.  A lot of agents have been doing this for years.  But now the practice will be institutionalized and put in the training program for auditors to follow.”

In June 1995, I followed up with a newsletter article after trying to get more information on the program.  The IRS was beginning to sense the public was uncomfortable.  So I wrote:

When IRS Commissioner Margaret Milner Richardson was asked recently about the new audit methods that investigate taxpayer lifestyles, she shrugged off the major policy change as nothing innovative. 

“It’s the same technique we used on Al Capone” she said in a PBS interview.  So now, with the help of the auditing technique called “Economic Reality,” American citizens in the 1990s can be treated like Chicago mobsters of the 1930s.

But today, it only takes a few strokes of a computer keyboard for IRS to yield vast amounts of personal financial data on a targeted taxpayer.  “The IRS ‘culture’ as to how audits are done is changing and the ‘culture’ of our clients is also changing,” according to the training material the IRS uses to teach auditors about the new program.  The materials were released by the tax agency under a Freedom of Information Act request, but they were not obtained easily. 

In September, a FOIA request was submitted for Tax Savings Report.  Such requests are supposed to be filled in thirty days, and often are.  Five months later, after repeated letters and phone calls, IRS finally sent part of the materials.

IRS auditors learning how to conduct “Economic Reality” audits are told that “to be effective, we need to adapt” to the changing culture.  They are told to discuss various topics, including the following subjects, but the training materials do not elaborate on what should be said:

– Diversity

– Respect for Government Authority

– Influx of Immigrants

– Emphasis on Expeditious Closing (how quickly an audit is completed)

– Aggressive vs. Kinder/Gentler (approach toward taxpayers).

Auditors learn that Economic Reality “finds meaning through a process of gathering information about a taxpayer,” and “is built upon a universe of financial information about the taxpayer and their lifestyle.”  In a later session, auditors learn “to develop a picture, or profile of the taxpayer’s lifestyle and its cost.  The process is designed to compare lifestyle cost with available resources and to alert you to inconsistencies.”

Shortly after my first article was published in November 1994, the Washington Post picked up on the story.  Noted Washington Post financial writer Albert Crenshaw, in a story syndicated to other newspapers, wrote:

After years of checking W-2s and 1099s and making sure that taxpayers have receipts for their deductions, the Internal Revenue Service is adding a new weapon to its audit arsenal.  It’s called “economic reality,” and it means that IRS agents are going to start looking beyond the numbers of the return to make sure the report jibes with the taxpayer’s assets and lifestyle.” …. The agency already has begun training auditors in “economic reality” techniques, and agents will be expected to implement them as soon as they complete the course. 

IRS officials say the training includes a heavy emphasis on privacy and ethics, designed to make sure taxpayers’ rights are protected.  Nonetheless, some experts and a number of the agency’s regular critics are voicing concern.

Crenshaw’s article finished with a quote.  “This represents a fundamental shift in the philosophy behind audits,” said Pete Sepp of the National Taxpayers Union.  NTU was the publisher of the Tax Savings Report newsletter.

Later that month, financial columnist Kathy Kristof of the Los Angeles Times also reported the latest news about tax audits:

…[IRS] just launched an auditing initiative called economic reality, an expanded and improved method of nabbing people who understate their incomes.

…When these folks get audited, they’ll also find that the IRS is not focusing completely on their tax returns.  Through the wonders of computer matching, IRS agents can find out if you own a boat, a plane or a luxury car.  They can determine the size of your mortgage.  And they can subpoena your bank records to find out just how much money is going in and out of your accounts, says Bob Kamman, a Phoenix tax accountant.

(Journalists sometimes have a problem with identifying me as a lawyer.)

It wasn’t until July 28, 1996 that the New York Times discovered the issue. The story by Barbara Whitaker led with an anecdote:

When an Internal Revenue Service agent said she wanted to audit Dave and Lucille Miller’s 1993 and 1994 tax returns, the couple thought it sounded like a simple thing.

“She called my wife, asked her a few questions and said, ‘Well, you seem to be pretty well in the know of what’s going on,’ ” said Mr. Miller, an auto salvage dealer in Clearwater, Minn. ” ‘Maybe we’ll just sit down at the kitchen table and hash this out.’ “

They hashed it out for a month and never once made it into the kitchen. The meetings, at Mr. Miller’s salvage yard and at his accountant’s office, were a free‑for‑all of questions about expenditures on everything from the most mundane items, like groceries and clothing, to past vacations.

“Can you tell me just off the top of your head how many groceries you bought two years ago?” Mr. Miller asked rhetorically. “How many vacations did you take? Well, what do you call a vacation? If you went away for the weekend?”

At the heart of Mr. Miller’s frustration is what the I.R.S. calls its “financial status auditing technique,” more commonly known as an “economic reality” or “life style” audit. The principle is simple. Rather than just examine a tax return to see that all the items add up, as in a regular audit, revenue agents look at whether the figures mesh with how the person lives. If the taxpayer has a new Mercedes in the garage and declares only $20,000 in income, the I.R.S. would likely raise an eyebrow.

…Anita L. Horn, a spokeswoman for the American Institute of Certified Public Accountants, said her organization had received more than 100 complaints about life‑style audits since September, when the group started keeping track. She said there were complaints about the nature of the questions and about agent demands to interview taxpayers rather than deal with their representatives. The group said the technique often led to drawn‑out audits.

Looking over some of the complaints, Ms. Horn cited a case in which an agent asked what a woman kept in her bedroom drawers. Another taxpayer was asked how much cash was buried in the backyard, and a California couple had to meet with an agent in their home when the woman was on bed rest, eight months pregnant with triplets.

As Professor Smith points out, “financial status or economic reality” audits are not defined by Code Section 7602(e).  Students of tax history, though, should realize that both Congress and IRS knew in 1998 exactly what they were talking about.

IRC § 7602(e) Will Not Save You (From Bank Information Return Exams)

Lately there has been much fury and gnashing of teeth on the Biden administration proposal to vastly increase bank reporting requirements to the IRS. In a nutshell, the proposal would require banks and credit unions to send a year-end information return to the IRS when an individual hits a threshold amount of “inflows and outflows” from their account, or certain other activity (transfers to foreign accounts) takes place. The proposal is in its embryonic stages, but the initial suggestion was that the reporting requirement could be triggered by as little as $600 in annual inflows/outflows. In other words, virtually everyone reading this would have additional information reported to the IRS every year.

Naturally, there are strong opinions about the unprecedented surge of information reporting this would entail. The Treasury provided a pretty bland defense and explanation here at page 88 (more info reporting means less tax gap!). The NYT has covered some of the outrage from banks and privacy-minded individuals here.

But more interesting to me was the technical focus of a Forbes article here quoting an expert from Brookings here. Specifically, what caught my attention was the argument that even if the provision became law the IRS couldn’t really do anything with the information returns because of the IRC § 7602(e) prohibition on “financial status or economic reality examination techniques[.]”

As someone that teaches Federal Tax Procedure, I was aware of IRC § 7602(e). Yet the idea that it would meaningfully constrain the IRS was novel to me. I had to dig deeper…

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The results of my digging, I’m afraid, do not lead me to believe that IRC § 7602(e) provides any robust protections against the use of bank information reporting. My research definitely did not lead me to the conclusion that in 1998 Senator Biden (and essentially all of the rest of Congress) voted to foreclose the use of information by the IRS that President Biden now wants. Let’s take a look at the statute and legislative history to see why.

IRC § 7602(e): Statutory Language and Intent

The statute at issue was enacted as part of the IRS Restructuring and Reform Act of 1998 (“RRA 98”). With the (sometimes overzealous) goal of curbing perceived IRS abuses, RRA 98 enacted a raft of taxpayer protections. Subtitle E of the bill was titled “Protections for Taxpayers Subject to Audit or Collection Activities,” and included Sec. 3412 (present-day IRC § 7602(e)). That code section reads:

(e) Limitation on examination on unreported income

The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.

This may seem fairly straightforward, but it allows for a fair amount of ambiguity. As applied to the potential bank reporting requirement, one might ask what exactly is a “financial status” or “economic reality” examination technique?

Neither term is defined in the tax code, so there is already some wiggle room there. The general understanding, however, is that they pertain to “indirect methods” of proving unreported income. At its simplest, indirect methods are used where there is not a specified “source” of taxable income. If the IRS suspects that you have unreported income but can’t point to a specific source, indirect methods come into play. The IRS might look at the income on a tax return and compare it to some other data (depicting the individual’s “financial status or economic reality”) that strongly suggests there was more income than reported. The most common indirect method that the IRS uses to show unreported income is bank accounts analysis -a method routinely upheld by courts. For purposes of consistency, I will refer to these indirect income audits as “financial status” audits throughout the post.

An information return from a bank showing just inflows and outflows certainly smells like a review of financial status. But does it run afoul of IRC § 7602(e)?

Maybe (it really depends on what the IRS is using the information return for).

But likely not. Let’s hold that thought for a second and look a bit more at the legislative intent behind this statute.

In the words of the Senate (and House) Reports:

“The Committee believes that financial status audit techniques are intrusive, and their use should be limited to situations where the IRS already has indications of unreported income.” See S. Rept. 105-174 and H. Rept. 105-364.

From this terse description we can surmise that the intent wasn’t to eliminate financial status audits, but to limit their use and protect innocent taxpayers from being subject to intrusive IRS requests for information. Again, the IRS can still subject taxpayers to financial status audits, but only where they have some (vague) other indication of unreported income first. What the IRS can’t do is lead with an intrusive financial status audit.

So Would The IRS Be Precluded From Using Bank Information Reports for Examination?

Let’s start with an uncontroversial proposition: the requirement that banks and other third parties provide information returns to the IRS is neither an exam of the bank nor of the taxpayer that the information pertains to. Accordingly, the collection of the information returns from the banks in itself is not a violation of IRC § 7602(e). I think it is equally uncontroversial to say that the IRS using data from these information returns is not in itself an IRC § 7602(e) prohibited “financial status or economic reality examination technique[].” Just using data reported to you can be quite different from conducting a financial status audit.

With this understanding the IRS using bank information returns on file as part of the selection process (but not the determination of unreported income) arguably would not run afoul of IRC § 7602(e). It basically would just be one more number plugged into a DIF score.

The protections of IRC § 7602(e), under this reading, come after the return has been selected and protect against “audit techniques” taking place during the actual (not theoretical) exam. This jives with the language and intent of the statute, since the “selection” for potential exam itself is not particularly intrusive on the taxpayer and the scoring of a return (which doesn’t always or even usually lead to audit) is definitely not an audit “technique.” This is also how I think the information returns would be likely used by the IRS in practice: as part of an algorithm for selecting returns to potentially examine thereafter.

But I can already hear the cries of my detractors. The statute contemplates a prohibition on the processes leading to the determination of the unreported income (i.e. the “examination techniques.”) Isn’t the selection of a return for further examination based on these information returns prohibited as part of the examination, even if an earlier step?

I don’t think that argument is going to win the day.  To me, that argument misunderstands how examinations work in order to give an overly broad sweep of IRC § 7602(e). To better understand, it is helpful to understand when IRC § 7602(e) comes into play under current law.

The Current IRC § 7602(e) Landscape

As detailed in the very informative PT post here, IRC § 7602(e) “puts the brakes on IRS examiners.” Before 1998 the IRS examiner could decide to escalate their review into an intrusive financial status examination on a hunch. Under present procedures (I assume adopted in response to IRC 7602(e)), the examiner must first run through various “minimum income probes” (outlined in the IRM here) before they can even begin to escalate the intrusiveness. Those minimum income probes are what provide the “reasonable indication that there is a likelihood of such unreported income,” which in turn allows or precludes the financial status exam. But if the IRS initiates a financial status examination without running those minimum income probes (or some other method giving them the needed “reasonable indication”) they would be in violation of IRC § 7602(e).

That, at least, was the argument made by Professor David Breen in the PT post linked above. And Prof. Breen would have excellent insight on the subject, having seen the inner machinations of the IRS as a revenue agent, exam group manager, and Chief Counsel attorney for many years.

As far as I can tell, the IRS actually takes a slightly dimmer view of the protections of IRC § 7602(e) than those advanced by Prof. Breen. At least that’s the sense one would get under an IRS memo on the topic. In that memo, the IRS contends that it doesn’t even need to have “reasonable indication” of unreported income before it can initiate a financial status exam. For example, an examiner given a return selected under the “National Research Program” (that is to say, a return selected entirely at random) can still initiate the audit by requesting all sorts of bank account information from the taxpayer. The reason this doesn’t run afoul of IRC § 7602(e) is because at that stage the IRS hasn’t “determined” there is unreported income just yet. Because IRC § 7602(e) only comes into play when there is such a “determination” it would be “premature” for it to apply at this initial stage.

Or so the IRS argues.

There may certainly be policy justifications for why NRP exams should be exempt from IRC § 7602(e). Indeed, it is hard to think of how the NRP would work in collecting statistics as a random, detailed audit without being fairly intrusive. Nonetheless, the IRS memo’s reasoning, I think, is probably wrong (but arguable) under the language of the statute. Let me also just hint (to be covered in my next post), that the remedies against the IRS if they are wrong on that interpretation are probably quite limited. The IRS rationale hinges on the word “determine” which carries a lot of meaning in the administrative law context, but seems to be misapplied in the memo. Either way, for now it suffices to say that the IRS probably wouldn’t be of the opinion that IRC § 7602(e) precludes them from using bank information returns to initiate further examination activities. And I think they’d be right about that.

Again, the cries of my detractors ring out. “You’re putting the cart before the horse here, Caleb. The IRS is using prohibited techniques (financial status/economic reality) the very moment it takes that information and plugs it into the DIF equation, or any other selection method it may come up with. Don’t get bogged down in the minutiae of how examinations actually work. Focus on the fact that the IRS would be using financial status/economic reality information to determine unreported income by baking it into the processes.”

This is certainly the big-picture view of the issue. But it only works by taking the statutory language and converting it into a broad policy it never really contemplated, and which would be essentially unenforceable. More to the point, it requires return selection criteria to be synonymous with “examination techniques.” That is a bridge too far to me, as they are vastly different animals. It goes well beyond both the language of the statute and its legislative intent. Again, I don’t think it would win the day in any court of law.

The Potential Unintended Interplay of IRC 7602(e) and Bank Reporting

Recall the proviso that financial status/economic reality can be used where the IRS “has a reasonable indication that there is a likelihood of such unreported income.” Taking this into consideration, it is possible that increased bank reporting may have the exact opposite effect than that suggested by Forbes/Brookings. It could conceivably allow more financial status/economic reality examinations, because those information returns could provide the IRS a “reasonable indication” of the “likelihood of such unreported income.”

In other words, far from requiring an amendment to IRC § 7602(e) for the bank reporting to have use, the new law could actually weaken whatever protections IRC § 7602(e) currently provides. I’ve been purposefully avoiding the normative question of whether this increased bank reporting is advisable (and especially whether it is advisable for inflows and outflows as low as $600). But I do think that considering its effect on IRC § 7602(e) (rather than the effect of IRC § 7602(e) on the proposal) should also weigh in on the normative question, at least if Congress is still concerned about overly intrusive audits. I get the impression that the current proposal, if it survives at all, is likely to survive in a vastly different form. But no matter what form it takes, I seriously doubt it will be rendered useless under IRC § 7602(e). There could be ways that the IRS goes too far with it, and there could be consequences for the IRS when it does so. But those consequences (and the chance they ever come to fruition) are very likely to be limited. Or so I’ll discuss in my next post.

IRS Large Case Examination Rate Collapses

For those interested in the IRS audit coverage pre-COVID-19 here are graphs taken from the IRS 2019 Databook.  The graphs depict just how low the audit coverage was before the IRS shut down for months.  One can only imagine how low the coverage is at this point.  Today’s post is one where we are adopting the philosophy that a picture is worth a thousand words.  These pictures make this a very long post albeit one with few written words.  For anyone who thinks it’s actually a good idea for the IRS to audit a reasonable number of returns to keep the system honest, the pictures here do not provide much encouragement.

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Unreal and Real Audits: Surgeon Finds No Relief From IRS’s “Byzantine” Exam Procedures

The recent Tax Court case of Essner v Commissioner highlights a problem when the IRS conducts both a traditional examination of taxpayer’s books and records while simultaneously contacting the taxpayer under its automated underreporter program.

Here is a simplified version of the still somewhat messy Essner facts. In 2013, Essner, a surgeon, inherited an IRA from his mother, who in turn had inherited the IRA from her husband (Essner’s father).  In 2014 Essner took a distribution of over $360,000 from the IRA.  He researched on his own the tax treatment of the distribution and concluded that the distribution was not gross income because it reflected his father’s original investment in the account. Despite Essner’s belief that the IRA reflected a nontaxable distribution, the financial institution that held the IRA issued an information return both to the IRS and Essner reflecting the distribution as taxable. Essner’s 2014 return, however, did not include the distribution as gross income.

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In March and May of 2016, Essner received letters generated from the IRS automated underreporter (AUR) program essentially noting the discrepancy between the income reported on Essner’s return and the income reported by third parties. That discrepancy was attributable to the IRA distribution that Essner did not include as income on his return. In late June of 2016 Essner sent a handwritten letter to the AUR unit saying that he disagreed with the proposed changes. The next letter Essner received from the AUR unit was a January 3, 2017 notice of deficiency reflecting the full amount of the IRA distribution as gross income.

Here is where things get even messier. After Essner sent his letter in response to the AUR notices, but before the IRS sent the notice of deficiency, Essner received a letter from IRS Tax Compliance Officer Joshi saying that the IRS was examining his 2014 federal income tax return.  The letter Joshi sent mentioned that IRS was looking into Essner’s business expenses but did not mention the IRA distribution that the AUR unit had flagged.

The opinion states that Joshi was not aware of the AUR contact and continued with his examination, focusing on expenses. On January 10, 2017, a week after IRS sent Essen a notice of deficiency, Joshi sent an examination report and proposed adjustments. A month later, in February, Joshi sent a revised exam report for 2014. Neither the original or revised report included any income from the IRA distribution. 

On March 10, 2017 Essner sent a letter to Joshi requesting that Joshi send the report to confirm that the IRA distribution was not taxable. Essner received another report and it too did not include the IRA distribution as gross income.

Recall however that the AUR office generated a notice of deficiency reflecting the IRA distribution as gross income. Essner filed a timely pro se petition, arguing initially that the distribution was not gross income. Unfortunately for Essner, at trial he was unable to secure proof of the alleged nondeductible contributions, as well as any prior distributions or withdrawals of those contributions, so he was unable to carry his burden of proof on the issue.

At trial, he also alleged that the IRS actions amounted to a duplicative examination of the same year and tax. While IRS has broad powers to examine tax returns to ensure that the return reflects a taxpayer’s liability, Section 7605(b) contains a general statutory protection against unnecessary or repeat taxpayer examinations for the same tax year. The idea behind 7605(b) is to limit burdens on taxpayers, including time and expense associated with responding to multiple requests for information.

Essner’s argument was that because the AUR contacts and Joshi’s examination ran concurrently, taken together they violated the duplicate exam restriction of Section 7605(b). In addition, he argued that the correspondence showed that “Joshi’s examination was unnecessary (given that it extended past the date when the AUR program generated the notice of deficiency with respect to 2014) and that it required an unauthorized second inspection of petitioner’s books and records (given that Officer Joshi’s examination ran parallel to and appears to have come to positions at odds with the AUR adjustments that underlie the IRS’ position taken in the notice).” 

The IRS argued, as it has in the past, that any contact stemming from AUR is not an examination for purposes of 7605(b) because it derives from a review of third-party records and not the taxpayer’s books and records.

The opinion sympathized with Essner but held that 7605(b) provided no basis for relief on this case:

At the outset, we note that petitioner’s interactions with the IRS–both through the AUR program and his correspondence with Officer Joshi–would be confusing to an ordinary taxpayer. Various offices of the IRS contacted petitioner without coordination, without clarity as to what the other parts were doing, and without providing petitioner a clear explanation as to why the IRS was speaking out of many mouths. A taxpayer ought not to have been subjected to such a byzantine examination. However, we are not empowered to police what ought to have occurred in an examination; we are limited to considering whether section 7605(b), as written, was violated. See Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974). (emphasis added)

The opinion continues and notes that 7605(b) does not address contacts that stem from the IRS’s receipt of information returns:

Under section 7605(b), the AUR program’s matching of third-party-reported payment information against petitioner’s already-filed 2014 tax return is not an examination of petitioner’s records. See Hubner, 245 F.2d at 38-39. Therefore, no second examination of petitioner’s books and records could have occurred, regardless of the concurrent actions of Officer Joshi. Additionally, as we have found above, petitioner failed to properly report income from the 2014 distribution from the retirement account, and he has conceded other adjustments for tax year 2014. Therefore, respondent’s examination of petitioner’s 2014 tax return was not unnecessary. While we understand petitioner’s frustration with the process of this examination, we cannot say that a failure to communicate and coordinate within the IRS–standing alone–violates section 7605(b). We therefore agree with respondent. 

Conclusion

The IRS’s failure to coordinate its communications as typified in Essner is likely to generate confusion. It is inconsistent with the right to finality, impinges on a taxpayer’s right to be informed and is in tension with a taxpayer’s right to a fair and just tax system. Carving out from 7605(b) protection “unreal” audits like AUR contacts is an issue that the Taxpayer Advocate Service has repeatedly flagged in its annual reports as a most serious problem. (For some more on the TAS view and IRS disagreement with TAS see the FY 2019 Objectives Report at page 38). 

The opinion in Essner rightly reflects concern with the IRS practice. IRS should revisit the limited rights taxpayers are afforded in unreal audits like AUR correspondence (including no right to Appeals review prior to the issuance of a 90-day letter), and should at a minimum strive to ensure that a concurrent examination sweeps in any issues that are raised in AUR correspondence.  Subjecting taxpayers to inconsistent and uncoordinated communication is far from best practice and creates burdens that are inconsistent with a taxpayer rights–based tax administration and the concerns that underlie Section 7605(b). Absent IRS policing itself perhaps it is time for a legislative fix that more directly addresses the growing importance of unreal audits and the burdens they impose.

Breaking Rule 36: When IRS Fails To Answer a Petition

Bob Kamman returns with a tale of woe that will hopefully be short-lived. I trust the matter will be resolved promptly once Bob is able to communicate with the Chief Counsel attorney assigned to the case. The situation shows the importance of the Answer telling the petitioner or representative who they can call to resolve their case. Too frequently it seems that IRS correspondence exam jumps the gun and issues an unnecessary notice of deficiency. Like Bob, my practice is to file a petition in these cases without waiting the full 90 days. I have not had any luck asking the IRS to rescind a notice of deficiency under section 6212(d) on the basis that exams reviewed and accepted my client’s substantiation after issuing the SNOD, so I may as well get the petition done early. A streamlined rescission process for cases like these would avoid unnecessary petitions filed by us cautious and pessimistic lawyers. Christine

I’m the Rodney Dangerfield of tax practitioners.  I get no respect.  At least from IRS, in Tax Court.

Other lawyers who blog or comment here: They file a Tax Court petition, IRS files an answer.  When I file a petition? It’s ignored. 

See Docket No. 19789-19.  Filed November 1, served on IRS November 6. Tax Court Rule 36 grants IRS a generous 60 days to file an answer.  That time expired January 6 (because January 5 was a Sunday). 

Compare that to  Docket No. 19787-19P , filed a few days after my case  and served the same day as mine.  The petitioner there is represented by Keith Fogg, who gets respect.  IRS filed an answer in that case on December 20, even though they had to send it to Kentucky for a lawyer who handles passport cases. 

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You might notice that I requested Washington, D.C., as the place of trial.   I thought that would expedite settlement.  Maybe IRS has less respect for practitioners who seem to be forum shopping.   I knew there was no way this case would go to trial, because it would be easy to settle once I could talk to a real person.  The disputed tax with interest  involves about $2,000, enough that a 3% filing fee was not out of line. 

It’s not like an IRS answer reflects more than a cursory look at the petition.  Most answers consist of a couple pages denying everything for lack of sufficient knowledge or information, up to but usually not including that the sun sets in the west.  But at least they provide the name of the attorney assigned to the case.

The lack of respect, however,  did not begin with IRS ignoring my Tax Court petition.  Its notice of deficiency was issued because my response to an IRS notice was ignored.   I had explained the mistake  on Schedule D was due to some missing Form 1099-B stock sales.

IRS sent its infamous CP-2000 on July 22, 2019, proposing a tax increase of $4,761.  (Being less than $5,000,  it was not quite enough to slap on the computer-generated Section 6662 penalty of another 20%.)

My letter to IRS on August 6 provided correct information.  It included copies of the relevant Forms 1099-B; and a 1040 (marked “Information Only, Do Not File”) showing the tax computation and a balance due of $2,847.  

On September 20, IRS mailed my clients a notice acknowledging they received my letter on August 12 and informing them that it would need another 60 days to respond.  But perhaps not coincidentally, the federal government fiscal year was ending soon.  Did Ogden Service Center managers exert  pressure to close cases so  year-end statistics would shine?  Not that they would admit.

Whatever the reason, a notice of deficiency dated October 15 was issued, showing the same adjustments as those on the original CP-2000.  It completely ignored the explanation I gave two months earlier.  Obviously, I get no respect. 

Hoping to move this case closer to settlement before the busiest days of the 2020 tax season, I filed the Tax Court petition a couple weeks later.  At some other time, in some other case, I would just wait and see how long it would take for IRS or the Tax Court to discover I had fallen through the cracks.  But my clients want to be done with the matter, and have already made an advance payment (Code Section 6603, Rev. Proc. 2005-18) of what they actually owe. 

(No, they are not paying me a fee, other than what I have received from them and their family in the last three decades as clients.   I could try to pursue IRS for fees, but life is too short for such bureaucratic ordeals.)

And filing the petition did get us some attention from IRS.  On November 18 – two weeks after Chief Counsel received the petition – IRS in Ogden mailed a revised CP-2000 proposing tax of only $3,057.  The $210 difference from our figures was due to keeping the tuition tax credit instead of changing it to a deduction, which saved money at the higher AGI.

The November 18 notice tells us, toward the bottom of Page 6, that “to recalculate your tax, we used . . .the new information you provided.”

Respectfully, may I ask anyone in charge at IRS (if that label is not an oxymoron): Why do you issue a notice of deficiency first, then look at the information provided?  Would it not be more efficient to do it the other way around?

The word “respect” does not appear in the part of the Taxpayer Bill of Rights (as explained in Publication 1) under “The Right To Quality Service.” It does promise, “Taxpayers have the right to receive prompt, courteous, and professional assistance in their dealings with the IRS.”

Oddly enough, “respect” appears later, in this context:

Taxpayers have the right to expect that any IRS inquiry, examination, or enforcement action will comply with the law and be no more intrusive than necessary, and will respect all due process rights, including search and seizure protections, and will provide, where applicable, a collection due process hearing.

The heading for that paragraph is “Right To Privacy.”  Tax Court proceedings offer little privacy.  Well, there is that thing about redacting SSN’s. 

I did some research on Tax Court procedures when IRS files a late answer.  The issue does not appear often, if at all.  I think it is safe to say: File a petition late, and the Court will dismiss the case for  jurisdictional reasons.  File an answer late, and the Court will excuse IRS on equitable grounds. 

Proposed Regulations Narrow Ability of Private Attorneys to Participate on Behalf of IRS in Exams

A few years ago we discussed litigation involving Microsoft (see, eg., Keith’s Enforcing the Summons Against Microsoft), which implicated Treasury regulations that allowed private lawyers to participate in exams. While the litigation did not strike down that practice, it was heavily criticized, and Treasury now proposes to scale back the practice significantly.

Last week Treasury has proposed to “significantly narrow the scope of the current regulations by excluding non-government attorneys from receiving summoned books, papers, records, or other data or from participating in the interview of a witness summoned by the IRS to provide testimony under oath, with a limited exception.”

The exception relates to lawyers who have expertise in issues other than federal tax law, such as state, local or other countries’ tax laws, or in other substantive areas, like patent law. The exception does not extent to nonsubstantive specialized knowledge (like litigation skills).

Treasury regulations still permit other outside specialists like economists to “receive and review summoned information and fully participate in the summons interview, including questioning witnesses.” The proposed regs also allow for lawyers who are not acting as lawyers but who are performing services associated with outside permitted specialists to participate.

The proposed regs attempt to restrike the balance between the need for outside assistance to help administer the tax laws with the “perceived risk that the IRS may not be able to maintain full control over the actions of a non-government attorney hired by the IRS when such an attorney, with the limited exception described below, questions witnesses.”

Perhaps the rebalancing of these interests will inspire a fresh look at the private debt collection issue, an area that likewise has raised questions about risks associated with non-government employees performing essential IRS functions.

4/3 Update: Title Changed to clarify we are talking about IRS limitations!

Tax Court Determines IRS Actions Do Not Violate Restrictions on Second Examinations

The moral of the story in Planty v. Commissioner, T.C. Memo. 2017-240 is that if you ask the IRS to take another look at your return you cannot successfully claim that this “look” is a second examination of the return subject to the rules and approvals that limit the IRS’s ability to take a second look. In this case, the IRS examined the taxpayers’ return and seemed to have some difficulty coming to the final answer. After some fits and starts, the IRS made a determination and an assessment of $2,755. I could not determine from the description of the case how the IRS obtained permission to make the assessment but it does not seem to be a troublesome aspect of the case for the parties or the court.

After the IRS made the assessment and before paying the additional assessed tax, the taxpayers immediately submitted a Form 1040X claiming a refund of $1,560. The IRS treated the Form 1040X as a request for abatement. After looking at the request, the IRS decided that the taxpayer really owed a corrected tax liability of $64,704. Petitioners concede that the adjustment is correct subject to their argument that the adjustment resulted from an impermissible second examination of the tax year. Additionally, the IRS imposed an accuracy related penalty on this additional tax.

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Second Exam

The Court states that “we may deal summarily with petitioners’ claim that they were subjected to an impermissible second examination of their 2010 return.” The Court cites to IRC 7605(b) which sets out the rules on second exams. The Code does not prohibit second exams but does require that the IRS go through a high level approval process. Most of the time the IRS will not do this because it spotlights that the original examiner and exam manager made a large mistake and provides proof of the mistake to their high level manager. Bureaucrats do not like to highlight their mistakes to high level management since doing so has a tendency to suppress future advancement and current bonuses.

In response to the taxpayers’ argument that the IRS engaged in an impermissible second examination, the IRS responded that IRC 7605 has “no bearing upon the Commissioner’s authority to examine tax returns already in his possession.” The Court points out that it would have been very difficult for the IRS to make a determination regarding their claim for refund without pulling the return and looking at it. Since the IRS was looking at the return to satisfy petitioners’ own request, doing so did not run afoul of IRC 7605.

Petitioners’ actions here point to the problem taxpayers have when they want to file an amended return. They think they are due a refund which they would like to receive ASAP; however, making the request for the refund will cause the IRS to scrutinize their return. Here, the quest for a $1,500 refund results in a $64,000 liability, plus a 20% penalty for good measure. Petitioners should have waited to file their request until the statute of limitations on assessment was about to expire. Had they waited, the IRS would still have denied their refund request but would not have hit them with the large assessment. Their impatience proves very costly.

So, the lesson here is not only should you not argue about an impermissible second exam when you have caused the IRS to look at the return but you should not make the request with gobs of time left on the assessment statute of limitations.

Accuracy Related Penalty

Taxpayers here not only brought unnecessary attention on their return costing themselves over $60,000, but they ramped up the liability to the point where the IRS felt obliged to penalize them adding insult to injury regarding their mistake for filing the Form 1040X too early. The Court finds that taxpayers’ return contains an understatement of the tax. It states that based on the proof provided by the IRS, taxpayers’ only hope of averting the penalty is to mount a credible defense based on substantial authority, adequate disclosure, or reasonable cause.

Taxpayers’ understatement resulted from their erroneous claim of almost $150,000 of real estate losses. The Court quoted from the regulations on the standard for substantial authority which requires that “the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” The Court also pointed out that this is an objective and not subjective standard, and that the existence of a legal opinion does not by itself create substantial authority. Here, the IRS disallowed the loss because of the passive activity loss rules. As authority, taxpayers pointed to an opinion from a tax attorney and the failure of the IRS to notice the issue when it first looked at their return.

Unfortunately, at trial taxpayers did not call the tax attorney to testify. So, the Court says it does not have any evidence to know why she gave the advice and whether her opinion had a basis in tax authorities that would allow the taxpayers to meet the substantial authority test. The Court also finds that the failure of the IRS to notice the issue initially does not constitute substantial authority pointing to provisions in the regulations on precisely this point.

The Court points out that adequate disclosure has no effect unless the return position has a reasonable basis and the failure of the tax attorney to testify leaves the Court without an ability to determine if there was a reasonable basis. With respect to reasonable cause, the taxpayers admitted that the tax attorney did not prepare their return and they could not show that the return preparer gave them advice with respect to this item that could cloak them with a reason for taking the erroneous position on their return.

Conclusion

The penalty portion of the opinion follows routine patterns but points to the need to obtain the testimony of any tax professional upon whom the taxpayer relies for the position taken on the return. It is not clear that taxpayers would have won if the professional had testified, but without the testimony a loss on the penalty issue was almost a foregone conclusion costing the taxpayers another $10,000 on top of the over $50,000 liability they picked up by filing the amended return.