Contrary to popular belief, the IRS remains active in their core business operations of conducting taxpayer examinations. Returns are identified for examination through an internal IRS process designed to identify issues and returns having significant audit potential. The IRS has been attempting to identify and reduce non-compliance through efficiency, tax form simplification, education, and enforcement. In addition, the IRS has significantly modified its examination process in a manner designed to increase the available resources and experience of its examiners.
The international arena will continue to test the enforcement resources of the IRS for years to come. Issues regarding undeclared foreign source earnings and financial accounts (FBAR filings are due June 30 for the prior calendar year) will continue to generate considerable interest from the IRS and the Department of Justice. The IRS has long encouraged participation in the voluntary disclosure process for all taxpayers, those with interests in offshore accounts and otherwise. The Department has a somewhat similar policy regarding the non-prosecution of taxpayers who have made a timely voluntary disclosure. The IRS policy concerning voluntary disclosure provides that a taxpayer’s voluntary disclosure is a factor that “may result in prosecution not being recommended.” To obtain this qualified benefit, the disclosure must be “truthful, timely, complete,” and must demonstrate a willingness by the taxpayer to cooperate, and actual cooperation, in determining the tax liability, and must include “good faith arrangements” by the taxpayer to pay the tax, interest, and any penalties in full.
Those with interests in foreign financial accounts that have not previously been disclosed should immediately consult competent counsel. They likely remain eligible for the benefits of the current IRS Offshore Voluntary Disclosure Program (OVDP) or pehaps the longstanding IRS voluntary disclosure program mitigating the possibility of a future criminal prosecution. The IRS is expected to at least continue its current procedures for a criminal pre-clearance and for disclosures made according to the “three-page letter”. Undeclared foreign financial accounts present a target rich environment for the government. The IRS is committed to enforcement concerning offshore accounts and the changing environment concerning bank secrecy may lead the government to many taxpayers with undisclosed interests in foreign financial accounts. For those with undeclared foreign accounts, now is the time to come into compliance – waiting is not a viable option.
Other examination priorities based on a perceived degree of noncompliance include:
A. Mortgage Interest Deduction Limitations
Code Section 163(h)(3) limitations – $1 million acquisition indebtedness incurred in acquiring, constructing or substantially improving a qualified residence of the taxpayer secured by the residence; refinanced indebtedness but only to the extent the amount of such refinancing does not exceed the amount of the refinanced indebtedness; and home equity indebtedness to the extent it does not exceed the lesser of: (i) $100,000, or, (ii) the FMV of the residence reduced by the acquisition indebtedness of the residence. Acquisition and refinancing indebtedness.
B. Section 1031 Like-kind Exchanges Key examination issues include:
1. 45-Day Rule Violations – Like-kind property must be identified within 45 days following relinquishment of the taxpayers property. The identification period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the 45th day thereafter. This deadline is exactly 45 calendar days, so if the 45th calendar day lands on a Saturday, Sunday or legal holiday, the 1031 exchange due date is NOT extended to the next business day. The identification must be in writing, signed by the taxpayer and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified. Failure to identify like-kind replacement properties within the 45 calendar day window will result in a failed 1031 exchange transaction and the transaction must be recharacterized as a taxable sale transaction rather than a tax-deferred exchange. Treas. Reg §1.1031(K)-1 (Treatment of Deferred Exchanges).
2. 180-Day Rule – The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of the tax imposed for the taxable year in which the transfer of the relinquished property occurs.
3. If, as part of the same deferred exchange, the taxpayer transfers more than one relinquished property and the relinquished properties are transferred on different dates, the identification period and the exchange period are determined by reference to the earliest date on which any of the properties are transferred.
4. Replacement property is identified only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either – (i) The person obligated to transfer the replacement property to the taxpayer (regardless of whether that person is a disqualified person); or (ii) Any other person involved in the exchange other than the taxpayer or a disqualified person. Examples of persons involved in the exchange include any of the parties to the exchange, an intermediary, an escrow agent, and a title company. An identification of replacement property made in a written agreement for the exchange of properties signed by all parties thereto before the end of the identification period will be treated as satisfying the foregoing requirements.
5. Replacement property is identified only if it is unambiguously described in the written document or agreement. Real property generally is unambiguously described if it is described by a legal description, street address, or distinguishable name (e.g., the Mayfair Apartment Building). Personal property generally is unambiguously described if it is described by a specific description of the particular type of property. For example, a truck generally is unambigously described if it is described by a specific make, model, and year.
6. The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties that the taxpayer may identify is – (A) Three properties without regard to the fair market values of the properties (the “3-property rule”), or (B) Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer (the “200-percent rule”). (ii) If, as of the end of the identification period, the taxpayer has identified more properties as replacement properties than permitted, the taxpayer is treated as if no replacement property had been identified. The preceding sentence will not apply, however, and an identification satisfying the foregoing requirements will be considered made, with respect to – (A) Any replacement property received by the taxpayer before the end of the identification period, and (B) Any replacement property identified before the end of the identification period and received before the end of the exchange period, but only if the taxpayer receives before the end of the exchange period identified replacement property the fair market vlaue of which is at least 95 percent of the aggregate fair market value of all identified replacement properties (the “95-percent rule”). For this purpose, the fair market value of each identified replacement property is determined as of the earlier of the date the property is received by the taxpayer or the last day of the exchange period. (iii) For purposes of applying the 3-property rule, the 200-percent rule, and the 95-percent rule, all identifications of replacement property, other than identifications of replacement property that have been revoked, are taken into account.
C. Real Estate Dispositions Key examination issues include:
1. Verifying the amount realized,
2. Verifying the adjusted basis of the property, and
3. Verifying the that the requirements for gain deferral are met timely.
4. Final Year Returns – Ensuring the proper recapture of items when a negative capital account exists.
D. Rental Income
Rental income includes any payment received for the use or occupation of property. Most landlords operate on a cash basis reporting payments as income in the period they are received and deducting expenses in the period they are paid. Other forms of rental income that may need to be declared may also include:
1. Advance rent payments
2. Early-termination fees on lease agreements
3. Expenses paid by tenant for the landlord (These may also be deductible as rental expenses.)
4. Property or services received in lieu of money.
5. Lease payments with option to buy (These payments are usually counted at rental income. If the tenant buys the property, payments received after the sale date are generally counted as part of the selling price.)
6. Payments for renting a portion of the taxpayers home may or may not be taxable income depending on certain thresholds. See IRS Publication 527, Residential Rental Property.
E. Final Year Tax Returns
Ensuring the proper recapture of items when a negative capital account exists.
F. Partnership Interests Key examination issues include:
1. Sales of Partnership Interests. Verifying that the interests are properly reflected, that income is properly recognized on distributions of installment notes, and that debt cancellation is correctly reported.
2. General income and expense items reported on partners’ tax returns, including checking that partners properly report items from their K-1s.
G. S-Corporations Key examination issues include:
1. Built-in-gains tax with emphasis on the valuations placed on the C Corporation assets on the date the entity converted to an S-Corporation.
2. Tax-exempt employee stock ownership plans (ESOP) acquiring an ownership of an S-Corporation in an attempt to shield from taxation the income the ESOP receives as flow-through income.
3. Verifying that installment income is correctly reported.
4. Verifying that tax credits are claimed correctly.
5. Wage Compensation for S Corporation Officers. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” See IRS Fact Sheet FS-2008-25 (August 2008).
6. Reasonable Compensation – S corporation and C Corporations. Relevant factors re the reasonableness of compensation include: Training and experience; Duties and responsibilities Time and effort devoted to the business; Dividend history; Payments to non-shareholder employees; Timing and manner of paying bonuses to key people; What comparable businesses pay for similar services; Compensation agreements; The use of a formula to determine compensation.
H. Estates and Trusts Key examination issues include:
1. Grantor trusts, and charitable remainder trusts.
2. Investment management fees deducted erroneously under IRC Section 67(e).
3. Valuations and discounts associated with closely-held entities and properties.
5. Sales that occur close to death.
6. Fractional interests.
7. Under-funded marital trusts and over-funded bypass trusts upon the death of the surviving spouse.
I. Employment Taxes and Worker Classifications
There have been approximately 6,000 National Research Program (NRP) examinations since February 2010 significantly focused on Worker classifications, executive compensation and fringe benefits.
J. Unreported Foreign Source Earnings and Undeclared Foreign Accounts. See above.
K. Non-Filers – a forever class of taxpayers challenging the desires and resources of the government. If discovered before coming into compliance, a non-filer can anticipate a long, sometimes unfriendly examination process, at best.
L. Return Preparers – those who prepare returns on behalf of others should exercise a significant degree of due diligence with respect to the preparation of their own returns. when discovered,the non-compliant preparer will likely be penalized.
M. NOL Carryforwards
Verification of losses incurred in the down economy of 2008-2013.
N. Schedule C Taxpayers and “Cash Intensive” Businesses. Audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. A cash intensive business is one that receives a significant amount of receipts in cash. This can be a business such as a restaurant, grocery or convenience store that handles a high volume of small dollar transactions. It can also be an industry that practices cash payments for services, such as construction or trucking, where independent contract workers are generally paid in cash.
O. Tax Exempt Entities
A few years ago, Form 990 was revised. Those operating within the tax exempt arena would be well served to identify the changes to the Form 990 as providing a roadmap of concerns the government may have regarding governance of non-profit organizations. Key examination issues include:
1. Executive compensation (upper management and key employees). Reasonable?
2. Conflicts of interest. Independence, family or business relationships; written policy?
3. Investments. Written procedures and policies? Outside investment advisors?
4. Fundraising costs reasonable?
5. Donor-Advised Funds. Can donor exercise control for private benefit? Relationship of fund to for-profit investment firms; donor control over investment decisions; and payouts.
6. Section 509(a)(3) Supporting Organizations. Do they actually support another public charity? Set up to avoid private foundation status?
7. Facilitating Abusive Transactions – Accommodation Parties.
If a notice of IRS examination is received, become familiar with IRS Audit Technique Guides (ATG). There are many publicly available ATGs that have been prepared by the IRS. The ATGs coupled with the government’s specialization of examiners is designed to improve compliance by focusing on taxpayers as members of particular groups. Each ATG instructs the agent on typical methods of auditing a particular group of taxpayer, including typical sources of income, questions to be asked of the taxpayer and their representative during the audit, etc. These groups have been defined by type of business (i.e., gas stations, grocery stores, etc.), technical issues (passive activity losses), types of taxpayer (i.e., returns lacking economic reality), or method of operation (i.e., cash businesses).
Before engaging an IRS examiner in an audit, review all potentially relevant ATGs. Preparation and diligence can will help streamline the examination process.