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

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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.

Leslie Book About Leslie Book

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

Comments

  1. The detail I noticed in the Essner opinion was that the “Compliance Officer” (that must be what IRS calls auditors these days) had to ask for copies of the taxpayer’s 2013 through 2015 returns, while examining the one from 2014. Those should be available to auditors already, from IRS files, along with a transcript that shows all of the information documents related to the case like the 1099R’s for IRA distributions and all of the activity by other IRS offices. But I have been asked by revenue agents to provide a copy of the return assigned for examination, because even that one shows up only in their case file as an abbreviated print-out. How are these people expected to do their jobs if they work in a metaphorical mushroom factory? How are they expected to stay, when the private sector provides software tools from the current century?

    Speaking of audits, I occasionally wonder how long that one of Donald Trump’s returns, started at least four years ago, will endure. Or maybe a Tax Court petition has already been filed under seal. Tomorrow is the third anniversary of the petitions in the Bloomberg cases being filed, under seal but with the name of the petitioner entities made known. (Docket Nos. 003755-17 and 003756-17.) The most recent development in that litigation was February 3, when Judge Goeke signed the “Order That Petitioners’ Unredacted Response to First Request for Admissions, Filed January 31, 2020, Is Sealed.”

  2. I have run into similar problems (i.e the left hand doesn’t know what the right hand is doing) when taking to PPS or CDP. I am telling then what I don’t agree with and they don’t see anything like it on their “screen”. In other words I have more information than the IRS does! In other words they don’y have one log file, but several unconnected files.

    • Kenneth H. Ryesky says

      Richard, it goes beyone the left hand not knowing what the right hand is doing; the left pinkie does not know what the left thumb is doing!

      During my time with the IRS (not quite as ancient as the Jurassic period, but getting close) I had various cases where the taxpayer I was auditing, unbeknownst to me, had also received correspondence from some other corner of the vast IRS bureaucracy (in one case it was during the previous week).

      And yes, it was far easier to request copies of other returns from the directly from the taxpayer than to get copies (or even transcripts) through internal IRS channels.

  3. A key proposition of the Essner opinion is: “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.” Essner v. Commissioner, T.C. Memo 2020-23, *4.

    I have a difficult time seeing how Hubner v. Tucker, 245 F.2d 35, 38-39 (9th Cir. 1957) is remotely supportive of the court’s proposition. Further, the proposition is overbroad to the extent it implies that an AUR program audit is not an examination of petitioner’s records under Section 7605(b).

    It is not the name of the audit that matters. It is the documents inspected that count. Section 7605(b) refers to inspections “of a taxpayer’s books of account.” If the IRS does not inspect a taxpayer’s books of account, then there can be no second inspection within the meaning of Section 7605(b). Benjamin v. Commissioner, 66 T.C. 1084, 1097-1098 (1976), aff’d, 592 F.2d 1259 (5th Cir. 1979); Redstone v. Commissioner, T.C. Memo. 2015–237, at *18–*19; see also Grossman v. Commissioner, 74 T.C. 1147, 1156 (1980) (holding that mere examination of a taxpayer’s income tax return and accompanying schedules does not constitute a second inspection of that taxpayer’s books within the meaning of section 7605(b)); Rev. Proc. 2005–32 (matches information on the return with other information in its possession, such activity does not constitute an examination or inspection). This is essentially the argument that the IRS made in Essner.

    “[T]o inspect the ‘books of account’ would require, at a minimum, that the [Service] have access to and physically view a taxpayer’s books and records.” Benjamin, 66 T.C. at 1098. The Essner AUR program audit “provided petitioner with the opportunity to agree to the proposed changes or to provide more information regarding the discrepancy identified. . ..” The taxpayer responded with “a handwritten note” that disagreed with the proposed changes. It is unclear whether this response also included any taxpayer books and records. There is an ambiguous statement in the opinion, namely, “respondent contends that the AUR program’s review was based entirely on third-party information returns and petitioner’s already-filed 2014 income tax return–in other words, without reference to petitioner’s books and records.” The IRS can certainly make a determination based on a Form 1099 and the return and without reference to the taxpayer’s books and records. But, that misses the point. Did the IRS have those records and inspect them? If it did, then then there likely was a second inspection.

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