The Limits of the “One Inspection” of Taxpayers’ Books and Records Rule

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We have discussed parties’ challenges to IRS administrative summons on a few occasions. Courts give IRS wide latitude in seeking documents and evidence in the exam process. One limitation on IRS powers is the Code itself, as Section 7605(b) provides that “only one inspection of a taxpayer’s books of account shall be made for each taxable year unless ․ the [Treasury] Secretary ․ notifies the taxpayer in writing that an additional inspection is necessary.” A recent case out of the Seventh Circuit, US v Titan International, illustrates that despite the one bite at the apple rule, the IRS gets another bite when a subsequent request for records that IRS previously may have requested relates to a differing year’s tax liability.

Here are the facts and the basic issue before the court.

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Titan received an IRS summons issued in connection with an audit of its 2010 tax year. The summons ordered Titan to turn over records relating to 2009, including its general ledger and travel records. Titan had previously turned over those records in connection with the IRS’s audit of its 2009 year. The 2010 audit concerned a loss carry-forward from 2009.

Titan refused to comply with the summons. It argued before the district court and on appeal that Section 7605(b) prevents the IRS from inspecting the 2009 records it had already provided unless the IRS “makes a finding of necessity and notifies the taxpayer in writing of that finding.”

Titan argued that the prohibition in Section 7605(b) that IRS gets “only one inspection of a taxpayer’s books of account shall be made for each taxable year…” means that absent a finding of necessity and notice, the IRS cannot request information relating to the same year even if IRS needed the documents in another year’s examination:

Titan argues that the statute limits the IRS to a single inspection of a “taxpayer’s books of account” created for a particular taxable year, unless the Secretary finds a second inspection “necessary” and sends written notice to that effect. In other words, Titan reads “for each taxable year” as modifying “taxpayer’s books of account.” On this interpretation, Titan’s 2009 records—already inspected during the audit of its return for tax year 2009—cannot be inspected again in connection with the audit of its 2010 tax return (or any subsequent tax-year audit, for that matter) unless the Secretary first sends written notice of necessity.

The Seventh Circuit rejected that interpretation on two main grounds: a plain reading of the statute and applying a couple of cases that illustrate the statute’s limits.

On the matter of statutory interpretation, the court felt that Titan’s argument was strained:

Titan’s interpretation is disjointed and curiously omits some of the language of the statute. The key statutory phrase is this: “[O]nly one inspection of a taxpayer’s books of account shall be made for each taxable year.” The more natural reading of this language limits the IRS to one inspection of a taxpayer’s books per audit of a given year’s tax return (subject, of course, to notice and a finding by the Secretary that a second inspection is necessary). Read in this more natural way, § 7605(b) does not bar the summons of Titan’s 2009 records for the purpose of auditing its 2010 tax return.

The Seventh Circuit’s discussed two main cases, one decided in favor of the taxpayers and the other in the IRS favor. The taxpayer-friendly case was Reineman v. United States, 301 F.2d 267 (7th Cir.1962). In that case, the taxpayer purchased horses for a breeding business and deducted costs on its 1954 tax return. IRS requested records in an audit of the taxpayer’s 1954 tax return. IRS made adjustments to the 1954 return. IRS then audited the 1955 tax return, but in so doing took another look at the 1954 adjustments. IRS “reopened the 1954 audit (without written notice from the Secretary) and again adjusted the [1954] deduction for the six horses.” The Seventh Circuit said that ran afoul of Section 7605(b):

The 1954 records inspected by the IRS to adjust the deduction for the second time were wholly irrelevant to the 1955 audit. We concluded that the second inspection of those records violated § 7605(b) because it was an “additional inspection” of the taxpayers’ books for the purpose of reopening the 1954 tax return.

The second relevant case is Digby v. Commissioner, 103 T.C. 441 (1994). In that case IRS audited a 1987 tax return and during the examination looked at records pertaining to a couple’s S Corp stock basis to determine whether the couple could claim losses. The couple was able to demonstrate that it had basis to support a deduction. The IRS later also examined the 1988 individual tax return, which also had reflected losses from the S Corp. In the second audit, the IRS found that the couple did not have sufficient basis and disallowed the losses for both 1987 and 1988. The couple argued that the second request ran afoul of Section 7605(b). The Tax Court disagreed, and in so doing gave a detailed walk through the statute and its legislative history and its relation to the Supreme Court Powell decision. “[In Powell] the Supreme Court held, with respect to section 7605 (b) that, generally, “no severe restriction was intended”, and regarding unnecessary examinations, courts are not required “to oversee the Commissioner’s determinations to investigate.” As the Seventh Circuit explained:

The tax court concluded that the second inspection of the records was not a violation of § 7605(b) because that inspection was undertaken for the purpose of examining the 1988 tax return, and—unlike Reineman—those records were necessary to complete that audit. The court ruled that an additional adjustment of the tax return for an earlier taxable year is not a violation of § 7605(b) so long as it was not coupled with an additional inspection of the taxpayer’s books for the purpose of adjusting that year’s tax liability.

Naturally, Titan argued that its case was like Reineman. The Seventh Circuit disagreed:

This case is more like Digby than Reineman. The IRS first inspected Titan’s 2009 records to verify its net operating loss in connection with an audit of its 2009 tax return. The IRS now seeks to inspect those same records for the purpose of auditing Titan’s 2010 tax return in order to determine the validity of its 2010 net-operating-loss carryforward. Much like the pass-through loss at issue in Digby (and unlike the deduction at issue in Reineman), the net-operating-loss carryforward on the 2010 tax return cannot be verified unless the IRS inspects the 2009 records.

Conclusion

In our past discussion of summons litigation (e.g., the Clarke case still percolating post Supreme Court and on appeal following the district court order I discussed last year, IRS efforts to get records for offshore accounts, and in the IRS’s examination of Microsoft that Keith discussed here), the courts tend to give IRS wide powers to get access to relevant documents. As Titan shows, IRS can make a second request for documents it received in an earlier year’s audit if those documents relate to another year’s potential tax liability. As the discussion of Digby illustrates, so long as the IRS in seeking enforcement of a summons can connect the requested documents to a later year’s potential tax consequences, IRS not only gets a second look at the documents but also gets a chance to reopen that earlier audit.

About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. Barry Goldwater says

    Didn’t the IRS already have the records? If not, why not? Neither the post nor the case make that clear.
    Yet another example of government waste and incompetence.

  2. The Posner-dominated Seventh Circuit Court of Appeals has struck again. That court has never met a taxpayer who had a right.

    Congress has known since 1913 that some tax laws, as in Titan, affect multiple tax years. Nonetheless, for almost as long, Congress has maintained on the books the now § 7605(b), which guarantees that “no taxpayer shall be subjected to unnecessary examination or investigations.”

    That important law also directs the IRS to make “only one” inspection of a taxpayer’s books and records “for each taxable year.” The sole exception to that directive is if the IRS furnishes the taxpayer with written notice that an additional inspection is “necessary.”

    The IRS subjected Titan to an unnecessary examination because it had (a) already examined Titan’s 2009 books and (b) neglected to inform Titan in writing that a second examination of those books is necessary. Case dismissed.

    The IRS’s mere self-professed “need” to examine Titan’s 2009 books to ascertain the company’s 2010 tax liability is immaterial. For § 7605(b) anticipates a “necessity.” So, if the IRS sends a § 7605(b) written notice to the taxpayer, it complies with the law; if it fails to send a § 7605(b) written notice to the taxpayer, the IRS (yet again) violates the law. The Seventh Circuit’s contrary view renders § 7605(b) meaningless.

    Another important issue arises from Titan:

    Bob Kamman, and many others, have wailed for years that the people’s representatives both understaff and underfund the IRS. The Titan case shows their cries are unjustified.

    The IRS marshaled its purportedly “scarce administrative resources” to first issue an administrative summons; then to collaborate with the DOJ to hale Titan into a U.S. District Court because the company relied on its statutory rights; and then to assist the DOJ in litigating in a federal appeals court. The IRS chose to institute and maintain all those activities when § 7605(b) requires it to merely send the taxpayer a written notice.

    The IRS’s actions in Titan tell me it requested that company’s 2009 books for a nefarious purpose. Were it otherwise, the IRS would have issued the one-page § 7605(b) written notice rather than further deplete its precious staff and budget.
    After Titan and similar cases, the Kamman-type cries that Congress is short-shrifting our invaluable IRS must fall on dead ears.

    Titan should march onto the Supreme Court. Let’s see if the IRS then, in concert with the Solicitor General, discovers some spare administrative resources to waste.

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