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

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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…


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.

Caleb Smith About Caleb Smith

Caleb Smith is Associate Clinical Professor and the Director of the Ronald M. Mankoff Tax Clinic at the University of Minnesota Law School. Caleb has worked at Low-Income Taxpayer Clinics on both coasts and the Midwest, most recently completing a fellowship at Harvard Law School's Federal Tax Clinic. Prior to law school Caleb was the Tax Program Manager at Minnesota's largest Volunteer Income Tax Assistance organization, where he continues to remain engaged as an instructor and volunteer today.

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