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Posted by: Taxlitigator | January 11, 2012

Qualified Amended Returns Can Eliminate Accuracy Related Tax Penalty

Improved tax compliance requires taxpayers (and those who ought to be taxpayers) to voluntarily come into compliance. When errors are discovered in a filed return, tax practitioners often pave the road to compliance through assurances that the tax-equivalent of water-boarding is not a typical government response to receipt of an amended return. Some assurances are purportedly provided in Treasury Regulation (Treas. Reg.) §1.6664-2(c)(2) relating to the timely filing of a Qualified Amended Return (QAR). Generally, the QAR Regulations are intended to encourage voluntary compliance by permitting taxpayers to avoid accuracy-related penalties if an amended return is filed before the IRS begins an investigation of the taxpayer or the promoter of a transaction in which the taxpayer participated.

Penalties Based on “Underpayment” of Tax. Internal Revenue Code (Code) §§ 6662(a) and (b) provide for a 20% penalty on an “underpayment” resulting from negligence, a “substantial understatement of income tax”, a substantial valuation misstatement, a substantial overstatement of pension liabilities, or a substantial estate or gift tax valuation overstatement.^[i] Code § 6663 provides for a 75% civil fraud penalty on the portion of any “underpayment” attributable to fraud. For purposes of Code §§ 6662 and 6663, an “underpayment” is defined in Code § 6664 and the regulations as the difference between the correct amount of tax (determined without regard to payments and credits) and the “amount shown as the tax by the taxpayer on his return” (including amounts previously assessed and credits or refunds received). ^[ii]

Qualified Amended Return and the Civil Fraud Exception. Under certain situations, a timely filed an amended return may reduce or eliminate accuracy-related penalties. The “amount shown as the tax by the taxpayer on his return” includes an amount shown as additional tax on a QAR, except that such amount is not included if it relates to a fraudulent position on the original return.^[iii] Treas. Reg. § 6664-2(c)(3) provides that a QAR is an amended return, or a timely request under Code § 6227 (regarding a request for an administrative adjustment of partnership items), filed after the due date of the original return for the specific tax year (determined with regard to extensions) and before the earliest of—

(A). The date the taxpayer is first contacted by the IRS concerning any examination (including a criminal investigation) with respect to the return. Note that the contact must be by the IRS; a QAR can be filed if the taxpayers has not been contacted by the IRS even though they were contacted by others. Also, the IRS contact must be “with respect to the return.” An initial IRS contact does not always identify the exact reason for the contact. Also, a contact for one tax year should not bar the filing of a QAR for a different tax year;

(B). The date any person is first contacted by the IRS concerning an examination of that person under Code § 6700 (relating to the penalty for promoting abusive tax shelters) for an activity with respect to which the taxpayer claimed any tax benefit on the return directly or indirectly through the entity, plan or arrangement described in Code § 6700(a)(1)(A). Contacts of a promoter under Code § 6700 must be examined to determine whether such promoter was a “person” contacted concerning the taxpayers’ particular transaction. Consistent with its promoter strategy, the Service has initiated a significant number of promoter examinations to obtain (among other objectives) tax shelter client lists. The IRS frequently conducts examinations under Code § 6707 (failure to register penalty) and Code § 6708 (failure to maintain investor list penalty), not under Code § 6700 (promoting abusive tax shelters)^[iv];

(C). With respect to a pass-through item^[v], the date the pass-through entity^[vi] is first contacted by the IRS in connection with an examination of the return to which the pass-through item relates. Practitioners should determine whether any such contacts were “in connection with an examination of the return to which the pass-through item relates.” A contact for one tax year should not bar the filing of a QAR for a different tax year;

(D). The date on which the IRS serves a “John Doe” summons^[vii] relating to the tax liability of a person, group, or class that includes the taxpayer (or pass-through entity of which the taxpayer is a partner, shareholder, beneficiary, or holder of a residual interest in a REMIC) with respect to an activity for which the taxpayer directly or indirectly claimed any tax benefit on the return. The foregoing applies to any return claiming a direct or indirect tax benefit from the type of activity that is the subject of the John Doe summons, regardless of whether the summons seeks the production of information for the taxable period covered by such return. This represents a distinction from the requirements relating to individual returns and partnership items for particular tax years; and

(E). The date on which the IRS announces by revenue ruling, revenue procedure, notice, or announcement, to be published in the Internal Revenue Bulletin, a settlement initiative to compromise or waive penalties, in whole or in part, with respect to a “listed transaction”. The foregoing only applies to a taxpayer who participated in the listed transaction and for the tax year(s) in which the taxpayer claimed any direct or indirect tax benefits from the listed transaction. Essentially, once the IRS announces an administrative settlement for a listed transaction, the taxpayer can no longer obtain penalty relief through the filing of a QAR^[viii]

A QAR effectively eliminates accuracy-related penalties, by removing amounts shown on the amended return from the penalty calculation. Significantly, even if timely, an amended return does not qualify as a QAR if the tax deficiencies that are corrected in the amended return relate to a fraudulent position on the original return. Why? Taxpayers should be encouraged to voluntarily amend all returns, even returns that for some reason may be deemed to include fraudulent positions, before the occurrence of any of the events set forth in Treas. Reg. § 6664-2(c)(3). Historically, the IRS rarely examined amended returns setting forth a deficiency. The IRS is presently conducting examinations of good faith QARs and is aggressively seeking interviews of the taxpayer, the return preparer and others. What is an appropriate interview response as to the reason a taxpayer decided to amend a return and report an additional tax liability? Patriotism? Sleep therapy? Should we care?

It is not recommended that practitioners routinely allow the IRS to interview the taxpayer. The taxpayer’s representative may represent the taxpayer in an examination and is not required to produce the taxpayer for questioning, unless an administrative summons is served on the taxpayer.^[ix] Agents typically seek to interview taxpayers near the commencement of an examination. Unfortunately, at that time the representative typically does not have sufficient information to determine the nature and scope of the examination. IRS examinations are typically focused and occur because of a specific reason. Determining that reason, especially following the good faith filing of a QAR, is the foundation of every representation.

Practitioners can not effectively represent their clients without knowing the nature and scope of any examination. During every examination involving an amended return (and otherwise), consider submission of a Freedom of Information Act (FOIA)^[x] request seeking a copy of the IRS administrative file, which would include the internal memoranda and documents prepared by the examining agent or received from third parties. In the event the IRS Disclosure Office might determine that an exemption applies to some or all of the requested information, the FOIA request should include a request that a privilege log be provided in the form of a Vaughn Index.^[xi] There may be meaningful surprises lurking within the FOIA response. Also, request information regarding any third parties the IRS may have contacted at any time regarding the examination of the taxpayer.^[xii]

Efficient tax administration should seek to encourage, rather than restrict, the filing of QAR in a resource-challenged environment. Taxpayers and practitioners must carefully consider whether submission of a good faith QAR is actually in the best interest of the taxpayer. Code § 6664 and Treas. Reg. § 6664-2 specifically preclude the IRS from asserting the Code § 6662 accuracy-related penalties following the filing of a timely QAR. The informal IRS voluntary disclosure practice mostly precludes a criminal referral to the Department of Justice if a taxpayer has come into compliance in a timely manner.^[xiii] Although the IRS has the burden of proving civil fraud by clear and convincing evidence, taxpayers must now be advised that it can be anticipated that the IRS will use the purported QAR as a roadmap in attempting to determine whether to assert the 75% fraud penalty under Code § 6663. Examinations of QARs for the stated or unstated purpose of determining a civil fraud penalty are simply inappropriate and do anything but promote the desired perception of the fairness of tax administration within the United States.

Examinations of amended returns are appropriate if to determine the accuracy of the amended return. However, the current QAR examinations are targeting items reflected on the original return that were changed in the amended return for the sole purpose of determining the possibility of a civil fraud penalty. The government should graciously accept the amended return and payment of the tax and interest deficiencies, determine whether it is substantially accurate, and thank the taxpayer for their contribution to the continued operations of the U.S. government. It is not good policy to shoot the fish in the barrel simply because the others are more difficult to catch.

As a result of RRA ‘98, we should have learned that inappropriately allocated enforcement resources may only serve to foster future non-compliance. If your neighbor filed a good faith QAR and then had to defend a civil fraud examination associated with the originally filed return there is no chance you or others would similarly consider filing a QAR. Those who amend returns in a timely and voluntary manner should be treated fairly and with respect. Burning down the village in an effort to save it is bad policy for future tax compliance.

The complexity found within the Code will long continue to be a significant problem for effective tax administration. We live in a country founded by smugglers and those resisting the exercise of government powers in England. Inappropriately asserting penalties will not improve tax compliance. Penalties only impact those who are actually penalized. Notwithstanding a strong, wide-ranging international enforcement effort and an increasingly significant possibility of detection and potential punishment, enforcement efforts alone will not reduce the Tax Gap. Fairness or at least the perception of fairness in enforcement will have a significant impact on the future of tax compliance in the United States. Compliant taxpayers and supportive practitioners will reduce the Tax Gap.

Taxpayers who are aware of questionable issues within their returns and are not presently under examination should seriously consider filing a QAR to avoid the exposure to the accuracy-related penalties. When representing a taxpayer considering or following submission of a good faith QAR, the representative should proceed with extreme caution. Next time they ask “Who’s the chump?”…make sure it is not while defending the assertion of a civil fraud penalty on behalf of a taxpayer who attempted to come into compliance by timely filing a good faith QAR….

________________________________

[i]. Under Code §6662(h), this penalty can increase to 40% of an underpayment if a taxpayer’s adjusted basis is grossly misstated (i.e., overstated by 400% or more). In many tax shelter transactions, an asset’s basis can become “enhanced” by more than 400%, and the IRS has been proposing the 40% penalty.

[ii]. Code §6664(a) and Treas. Reg. §§ 1.6664-2(a), (b) and (c).

[iii]. Treas. Reg. Sec. 1.6664-2(c)(2).

[iv]. Bergmann v. Commissioner, T.C. Memo. 2009-289 (February 16, 2009).

[v]. See Treas. Reg. §1.6662–4(f)(5).

[vi]. See Treas. Reg. §1.6662–4(f)(5).

[vii]. See Code § 7609(f). A “John Doe” summons does not identify the specific person with respect to whose liability the summons is issued but must relate to the investigation of a particular person or an ascertainable group.

[viii]. Treas. Reg. § 6664-2(c)(3).

[ix]. Code § 7521(c).

[x]. 5 U.S.C. §552

[xi]. In Vaughn v. Rosen, 484 F.2d 820 (D.C. Cir. 1973), cert. denied, 415 U.S. 977 (1974), the court rejected an agency’s conclusory affidavit stating that requested FOIA documents were subject to exemption. Id. at 828. “A Vaughn Index must: (1) identify each document withheld; (2) state the statutory exemption claimed; and (3) explain how disclosure would damage the interests protected by the claimed exemption.” Citizens Comm’n on Human Rights v. FDA, 45 F.3d 1325, 1326 n.1 (9th Cir. 1995). A Vaughn Index ” ‘permit[s] the court system effectively and efficiently to evaluate the factual nature of disputed information.’ ” John Doe Agency v. John Doe Corp., 493 U.S. 146, 149 n.2 (1989) (quoting Vaughn, 484 F.2d at 826).

[xii]. See Code §7602(c).

[xiii]. See Internal Revenue Manual (IRM) 9.5.11.9 (June 26, 2009) available at irs.gov

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Posted in Uncategorized | Tags: amended return, irs audit, tax, tax controversy, tax dispute, tax enforcement, tax fraud, tax penalty, tax return, taxpayer

Posted by: Taxlitigator | January 11, 2012

FOIA Requests: A Look Into the IRS Examination File

Practitioners should consider submission of a Freedom of Information Act (FOIA)^[i] request to the IRS following the unagreed resolution of every tax examination. Although not always a wealth of information, the government response to a FOIA request will provide insight into why the examining agent made certain adjustments and asserted penalties. It will also help tailor your discussions before an IRS Appeals Officer at the next administrative level and provide insight into what the Appeals Officer will be looking at before meeting with the practitioner. Often, the FOIA response will include the agents notes and thoughts which may prove invaluable in later explaining why the matter was not resolved (or capable of resolution) during the initial examination.

The FOIA requires that federal agency records be made available to the public unless specifically required or permitted to be withheld. If information is not prohibited from disclosure, an IRS Disclosure Officer must consider whether, as an exercise of administrative discretion, the information should be released or withheld. Any IRS discretionary decision to release information protected under the FOIA should be made only after considering the institutional (i.e., public accountability, safeguarding national security, law enforcement effectiveness, and candid and complete deliberations), commercial, and personal privacy interests that could be implicated by disclosure of the information.

The form in which IRS maintains a record does not affect its availability. A request may seek a printed or typed document, tape recording, map, photograph, computer printout, computer tape or disk, or a similar item. The IRS must provide the requested information in any format requested if it is readily reproducible by the IRS in that format and must make reasonable efforts to maintain its information in formats that are reproducible for such purposes. Generally, there is no charge for the first 100 pages and $ 0.20 per page thereafter.

The IRS is only required to look for an existing record or document in response to a FOIA request. FOIA does not require the IRS to collect information it does not have, or to research or analyze data for a requester. The IRS is not obliged to create a new record to comply with a FOIA request. However, when records are maintained in a computer, the IRS may be required to retrieve information in response to a FOIA request. The process of retrieving the information may result in the creation of a new document when the data is printed out on paper or written on computer tape or disk.

Form of FOIA request. There is no required form FOIA request. It can be an informal letter requesting each and every document contained in the administrative files of the government relating to the tax liabilities of the taxpayer for the tax years at issue. IRS FOIA requests should be submitted to the IRS Disclosure Office based on the location of the taxpayer. IRS Disclosure Offices are listed at www.irs.gov (Search FOIA). The request should identify the documents as specifically as possible. A general form of FOIA request, addressed to the appropriate IRS Disclosure Office, should be tailored to the specific client situation involved and state substantially as follows:

We represent [Client] and have attached an Internal Revenue Service Power of Attorney (Form 2848) confirming the foregoing. This letter is intended to formally request, under the Freedom of Information Act, 5 U.S.C. § 552, and the regulations promulgated thereunder, each and every document (exclusive of the filed tax income tax returns) contained in the administrative files of the Internal Revenue Service relating to the individual income tax liabilities of [Client)] (TIN 123456789) for taxable years (state the tax years).

This request does not include copies of the foregoing tax returns, nor does it include copies of correspondence generated by our office. Subject to the foregoing, the requested information includes, but is not limited to:

1. The Examination Division Administrative File for the audit. This information should include any worksheets, workpapers, notes, emails, documents, memoranda, computations and other materials prepared or accumulated relative to this examination by employees of the IRS, any other governmental agency, or otherwise, including internal documents, memoranda, memoranda of all interviews of persons regarding the individual income tax liabilities of the taxpayer, copies of all statements (sworn or otherwise) given by individuals in connection with the investigation of the individual income tax liabilities of the taxpayer, Case Activity record, written reports and recommendations concerning the proposed assessment of additional tax and penalties and any other information that is related to the determinations by the IRS as set forth in the Revenue Agents Report (30 Day Letter).

2. A list of any information and documents maintained electronically identifying each document by subject matter and format (i.e., tape, disk, etc.).

3. Any and all files relative to this audit that include information and documents obtained pursuant to summonses issued to third parties which are not otherwise included in the Administrative File.

4. Any and all files relative to this audit that may have been prepared by independent consultants, international examiners, economists, engineers, and any other specialists assigned to this case which are not otherwise included in the Administrative File.

5. We have determined that the information requested is not exempt under disclosure laws, is not a classified document, is not a protected internal communication, is not protected by “privacy”, and is not a “protected investigative record” within the meaning of the Freedom of Information Act. If any material is deemed to be exempt, we hereby request a detailed statement of the portion deleted or withheld, a full statement of the reasons for the refusal or access, and specific citations or statutory authority for the denial. Specifically, if the Disclosure Section determines an exemption applies to some or all of the requested information, we request that a Privilege Log be provided in the form of a Vaughn Index. In Vaughn v. Rosen, 484 F.2d 820 (D.C. Cir. 1973), cert. denied, 415 U.S. 977 (1974), the court rejected an agency’s conclusory affidavit stating that requested FOIA documents were subject to exemption. Id. at 828. “A Vaughn Index must: (1) identify each document withheld; (2) state the statutory exemption claimed; and (3) explain how disclosure would damage the interests protected by the claimed exemption.” Citizens Comm’n on Human Rights v. FDA, 45 F.3d 1325, 1326 n.1 (9th Cir. 1995). A Vaughn Index ” ‘permit[s] the court system effectively and efficiently to evaluate the factual nature of disputed information.’ “ John Doe Agency v. John Doe Corp., 493 U.S. 146, 149 n.2 (1989) (quoting Vaughn, 484 F.2d at 826). With a Vaughn Index we will have the means to adequately assess if any claimed exemptions have merit thereby avoiding potentially costly litigation to seek such item.

Since the requested information relates directly to [Client], we have determined that the information requested is not exempt under disclosure laws, is not a classified document, is not a protected internal communication, is not protected by “privacy,” and is not a “protected investigative record” within the meaning of the Freedom of Information Act.

We believe that your office has custody of the requested information, but if not, we hereby request prompt notice of the current location of such information. To expedite this request, we are willing to discuss specific instances of deletion or other exemption claims in advance of a final decision. If any material is deemed to be exempt, we hereby request a detailed statement of the portion deleted or withheld, a full statement of the reasons for the refusal of access, and specific citations or statutory authority for the denial.

This letter shall confirm that [Client] hereby agrees to pay for all reasonable search and copying costs that may be associated with this request. However, we would appreciate the opportunity to inspect these records before any documents are copied If search and copying costs exceed $200, please telephone us in advance for an agreement as to such additional costs.

The FOIA Response. Under the FOIA, the IRS is required to determine within 20 days (excluding Saturdays, Sundays, and legal public holidays) after the date of receipt of a request whether to comply with the request.^[ii] IRS can extend the 20 day period by an additional 10 days in unusual circumstances.^[iii] These circumstances generally include the need to collect information from field locations, review large numbers of documents, and consultations with other agencies. ^[iv] If a request is denied in whole or in part, the IRS must state the reasons for the denial that there is a right to appeal any adverse determination to the Commissioner of the IRS or his designee.^[v]

A delay resulting from a predictable IRS workload is not an unusual circumstance. IRS may seek to limit the scope of the request or arrange an alternative time frame for processing the request. If the request is denied to any extent, the IRS is required to state the reasons for the denial. If IRS fails to comply with the request within the applicable time limitations, any person making a request is deemed to have exhausted their administrative remedies with respect to the request and they may proceed to the filing of an action in Federal District Court. In practice, the IRS typically requests an additional 30 days within which to provide the requested information. It is often appropriate to grant this request since the IRS usually provides the requested information within the additional time period and any appeal would likely exceed the additional time in any event.

FOIA Exemptions. The IRS may withhold an IRS document that is specifically exempted or excluded by statute. The exemptions protect against the disclosure of information that would harm national security, the privacy of individuals, the proprietary interests of a business, the functioning of the government, and other important recognized interests.

When a document contains some information that qualifies as exempt, the entire document is not necessarily exempt. Instead, the FOIA specifically requires that any reasonably segregable portions of a document must be provided after the deletion of the portions that are exempt. The IRS must identify the location of deletions in the released portion of the document and, where technologically feasible, show the deletion at the place on the document where the deletion was made, unless including that indication would harm an interest protected by an exemption.

Exemption 1 – Classified Documents Pertaining to National Defense and Foreign Policy.^[vi] This exemption permits the withholding of matters specifically authorized under criteria established by an Executive order to be kept secret in the interest of national defense or foreign policy and which are in fact properly classified under such executive order. IRS does not generally deal with these types of matters, thus this exemption is rarely used.

Exemption 2 – Internal Personnel Rules and Practices.^[vii] This exemption covers matters that are related to IRS’s internal personnel rules and practices. There are two separate classes of documents that are generally held to fall within this exemption: (a) The information relating to personnel rules or internal IRS practices may be exempt if it is a trivial administrative matter of no genuine public interest; and (b) More substantial internal IRS matters, the disclosure of which would risk circumvention of a legal requirement.

Exemption 3 – Information Exempt Under Other Laws.^[viii] This exemption incorporates into the FOIA other laws that restrict the availability of information. To qualify, a statute must require that matters be withheld from the public in such a manner as to leave no discretion on the issue or if the statute establishes particular criteria for withholding or refers to particular types of matters to be withheld. One example of a qualifying statute is Section 6103 of the Internal Revenue Code (IRC) which governs the disclosure of tax returns and return information. By law, tax records may not be disclosed to any individual unless specifically authorized by IRC Section 6103.

Exemption 4 – Trade Secrets and Confidential Commercial or Financial Information^[ix]. This exemption protects from public disclosure both trade secrets and confidential commercial or financial information. A trade secret has been narrowly defined by the courts under the FOIA as a commercially valuable plan, formula, process, or device that is used for making, preparing, compounding or processing trade commodities and that can be said to be the end product of either innovation or substantial effort. The second type of protected data is privileged or confidential commercial or financial information obtained from a person.

Exemption 5 – InterAgency or IntraAgency Memorandums or Letters.^[x] This exemption applies to interagency or intraagency memorandums or letters which would not be available by law to a party other than an agency in litigation with the agency. An example may be a letter from one IRS office to another about a decision that has not yet been adopted. One purpose of this is to safeguard the deliberative policymaking process of government (the “deliberative process privilege”) which encourages open discussion of policy matters between IRS officials by allowing certain predecisional, deliberative documents to be withheld from public disclosure. It also protects against premature disclosure of deliberations before final adoption of an agency policy or position.

This exemption protects the policymaking process, but it does not generally protect purely factual information related to the policy process that is protected under the deliberative process privilege. The deliberative process privilege distinguishes between documents that are predecisional and postdecisional. Once a policy is adopted, the public has a greater interest in knowing the basis for the decision. Therefore, the deliberative process privilege does not ordinarily apply to postdecisional documents. This exemption also incorporates other privileges that apply in litigation involving the government, including the attorney-client and work-product privileges. For example, certain documents prepared by IRS lawyers may be withheld in the same way that documents prepared by private lawyers for clients are not available through discovery in civil litigation.

Exemption 6 – Personal Privacy.^[xi] This exemption covers personnel, medical, and similar files the disclosure of which would constitute a clearly unwarranted invasion of personal privacy. It protects the privacy interests of individuals by allowing IRS to withhold personal data kept in its files where there is an expectation of privacy. Only individuals have privacy interests. Corporations and business associations have no privacy rights under this exemption, with the exception of closely held corporations or similar business entities.

Exemption 7 – Law Enforcement.^[xii] This exemption allows agencies to withhold records or information compiled for law enforcement purposes, but only to the extent that disclosure could reasonably be expected to interfere with ongoing enforcement proceedings, would deprive a person of a right to a fair trial or an impartial adjudication, could reasonably be expected to constitute an unwarranted invasion of personal privacy, the information may be exempt from disclosure, could reasonably be expected to reveal the identity of a confidential source (including a State, local, or foreign agency or authority, or a private institution that furnished information on a confidential basis), would reveal techniques and procedures for law enforcement investigations or prosecutions or that would disclose guidelines for law enforcement investigations or prosecutions if disclosure of the information could reasonably be expected to risk circumvention of the law, or could reasonably be expected to endanger the life or physical safety of any individual.

Exemption 8 – Financial Institutions.^[xiii] This exemption protects information that is contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions (such as FDIC, the Federal Reserve, or similar agencies).

Exemption 9 – Geological Information. The ninth FOIA exemption covers geological and geophysical information, data, and maps, concerning wells.^[xiv]

FOIA Exclusions. The FOIA also contains special protection provisions that expressly authorize federal law enforcement agencies to treat especially sensitive records under certain specified circumstances as not subject to the FOIA. IRS may not be required to even confirm the existence of these types of records. If requested, IRS may respond that there are no records responsive to the request. However, these exclusions do not broaden the authority of the IRS to withhold documents from the public. The exclusions are only applicable to information that is otherwise exempt from disclosure.

Exclusion 1 – This exclusion may be used when a request seeks information described in subsection (b)(7)(A) of the FOIA if the investigation in question must involve a possible violation of criminal law, there is reason to believe that the subject of the investigation is not already aware that the investigation is underway and disclosure of the existence of the records could reasonably be expected to interfere with enforcement proceedings. When each of these conditions exist, the IRS may respond to a FOIA request for investigatory records as if the records are not subject to the requirements of the FOIA. The IRS response does not have to reveal that it is conducting an investigation.

Exclusion 2 – This exclusion applies to informant records maintained by IRS criminal law enforcement filed under the informant’s name or personal identifier. IRS is not required to confirm the existence of these records unless the informant’s status has been officially confirmed. This exclusion is intended to protect the identity of confidential informants.

Exclusion 3 – This exclusion is limited to to records maintained by the Federal Bureau of Investigation pertaining to foreign intelligence, counterintelligence, or international terrorism. When the existence of these types of records is classified, the FBI may treat the records as not subject to the requirements of FOIA.

FOIA Administrative Appeal Procedures. Whenever a FOIA request is denied, the IRS must clearly state the reasons for the denial and state the right to appeal the denial. An appeal may be based upon the withholding of a document, denial of a fee waiver request, the type or amount of fees charged, failure by the IRS to conduct an adequate search for the requested documents or any other type of adverse FOIA determination.^[xv] However, an appeal may not be filed for the lack of a timely response. If a request is granted in part and denied in part, the appeal would solely relate to the part that was denied. If IRS has agreed to disclose some but not all requested documents, the filing of an appeal does not affect the release of the documents that are otherwise disclosable. A FOIA appeal is an administrative appeal. The procedural requirements for filing an appeal are found at. There is no charge for filing an administrative appeal.

The appeal should include reasons why the IRS response to the FOIA was inadequate and must be postmarked within 35 days after the date of the letter of denial or the date of other adverse determinations.^[xvi] An administrative appeal for denial of a request for expedited processing must be made by letter postmarked within 10 days after the date of the response letter denying expedited processing.^[xvii] An appeal is filed by sending a letter to IRS Appeals, Attn: FOIA Appeals, 5045 E. Butler Avenue, M/Stop 55201, Fresno, California 93727-5136. The appeal should include copies of the FOIA request and the initial IRS decision responding to the request. The envelope containing the appeal should be marked in the lower lefthand corner with the words “Freedom of Information Act Appeal.” When a FOIA request is filed, the IRS assigns it a number which should be set forth in the appeal.

IRS is required to make a decision on an appeal within 20 days (excluding Saturdays, Sundays, and legal holidays) after the date of receipt of the appeal unless extended.^[xviii] It is possible for the IRS to extend the time limits by an additional 10 days under unusual circumstances.^[xix] If the IRS fails to comply with the time limitations, the FOIA requester shall be deemed to have exhausted administrative remedies and may proceed with a judicial appeal in a Federal District Court.^[xx]

Judicial Action. If an administrative appeal is denied, a complaint against the IRS may be filed to a federal district court seeking disclosure of the requested information.^[xxi] The complaint must be served upon the Commissioner of Internal Revenue, Attention: CC:PA, 1111 Constitution Avenue, NW., Washington, DC 20224. Attorneys fees and litigation costs reasonably incurred may be awarded if the requestor substantially prevails in litigation.

Summary. The FOIA request represents an important component of every practitioners procedural toolbox when pursuing the administrative appeal following an examination. The information received will almost always justify the limited effort required to submit a FOIA request. Sometimes it might be a key document or some comment within the agents narrative statement. At other times, it might simply represent affirmation of the lack of adverse information within the government administrative file. If not requested, the information will not be forthcoming. If requested…the responsive information may be the key to a favorable resolution!

301318.1

[i]. 5 U.S.C. § 552

[ii]. 5 U.S.C. § 552 (a)(6)(A)(i).

[iii]. 5 U.S.C. § 552 (a)(6)(B)(i)-(iii) and Treasury Regulation 601.702 (c)(11)(i)(A)(1)-(4)

[iv]. 5 U.S.C. § 552 (a)(6)(B)(i).

[v]. 5 U.S.C. § 552 (a)(6)(A)(i)

[vi]. 5 U.S.C. § 552 (a)(7)(B)(1).

[vii]. 5 U.S.C. § 552 (a)(7)(B)(2).

[viii]. 5 U.S.C. § 552 (a)(7)(B)(3).

[ix]. 5 U.S.C. § 552 (a)(7)(B)(4).

[x]. 5 U.S.C. § 552 (a)(7)(B)(5).

[xi]. 5 U.S.C. § 552 (a)(7)(B)(6).

[xii]. 5 U.S.C. § 552 (a)(7)(B)(7).

[xiii]. 5 U.S.C. § 552 (a)(7)(B)(8).

[xiv]. 5 U.S.C. § 552 (a)(7)(B)(9).

[xv]. Treasury Regulation 601.702 (c)(10)

[xvi]. Treasury Regulation 601.702 (c)(10)

[xvii]. Treasury Regulation 601.702 (c)(10)

[xviii]. Treasury Regulation 601.702(c)(10)(iii).

[xix]. Treasury Regulation 601.702( c)(11)(i)

[xx]. Treasury Regulation 601.702( c)(12)

[xxi]. 5 U.S.C. 552(a)(4)(B); Treasury Regulation 601.702(c)(13)

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Posted in Uncategorized | Tags: irs, irs audit, tax, tax audit, tax controversy, tax dispute, tax enforcement

Posted by: Taxlitigator | January 11, 2012

IRS Global High-Wealth Industry Group: Evaluation of an IRS Wealth Squad IDR

The IRS Large Business and International Division (LB&I), formerly known as the Large & Mid-Sized Business Division, recently formed a new Industry Group known as the Global High-Wealth Industry Group, commonly referred to as the “Wealth Squad.” The purpose of the Wealth Squad is to bring together an IRS team of specialists to coordinate the compliance review and, if necessary, detailed examination of complex returns of high wealth individuals and their related entities.

The stovepipe fashion of historical IRS examinations, by design, missed various compliance issues lurking within layers upon layers of related limited liability companies, partnerships, trusts, private foundations, etc. Based on their professional experience and training, examiners reviewed sufficient documents/information to determine the accuracy of the taxpayer’s return. The amount of documents/information to be reviewed and the depth of the examination has been a matter of professional judgment based on the information developed – or not – during the examination. The Wealth Squad is now coordinating examiners and related specialists in an effort to unwind the complex legal structures behind sophisticated domestic and foreign business and investment arrangements. Similar examination groups are employed by tax authorities in Japan, Germany, the UK, Canada, Australia and elsewhere.

LB&I Industry Groups. LB&I serves corporations, S corporations, partnerships and other pass-through entities having more than $10 million in assets. These entities typically have large numbers of employees, deal with complicated issues involving tax law and accounting principles, and conduct their operations in an expanding global environment. LB&I operates within various Industry Groups which include Communications, Technology, and Media; Financial Services; Heavy Manufacturing and Transportation; Natural Resources and Construction; Retailers, Food, Pharmaceuticals and Healthcare; and the Global High Wealth Industry. Additionally, LB&I maintains a Field Specialists examination support function that includes Computer Audit Specialists, Employment Tax Specialists, Economists, Engineers, and Financial Products and Transactions Specialists.

Communications, Technology, and Media Industry Group – headquartered in Oakland, California serves taxpayers involved in computer production, media (including communication and software), sports franchises, and recreational firms covering approximately 15,300 taxpayers (comprised of 1,100 large businesses and 14,200 mid-size businesses).

Financial Services – headquartered in New York City, serves more than 43,000 taxpayers involved in commercial and foreign banking, securities, insurance companies, investment bankers, mutual funds, law and accounting firms, and other financial intermediaries. Financial Services is also responsible for the US withholding agent and qualified intermediary programs, and has leadership and oversight for the technical tax shelter promoter program.

Heavy Manufacturing and Transportation – headquartered in Iselin, New Jersey, serves approximately 58,750 taxpayers (comprised of 200 large businesses and 58,550 mid-size businesses) involved in air transportation, railroads, aerospace, motor vehicles, trucking, shipping, and real estate.

Natural Resources and Construction – headquartered in Houston, Texas, provides end-to-end tax administration services to over 17,000 large and mid-size businesses nationwide that are engaged in the oil and gas, mining, utilities, forestry, chemical, waste management, and construction industries.

Retailers, Food, Pharmaceuticals and Healthcare – headquartered in Downers Grove, Illinois, serves approximately 18,300 taxpayers (consisting of approximately 300 large businesses and 18,000 mid-size businesses) related to food and beverage, retailing, pharmaceuticals, agricultural commodities, farms, and healthcare.

Global High Wealth – headquartered with LB&I in Washington, D.C., conducts tax compliance reviews of high wealth individuals and the networks of enterprises and entities they control.

The Wealth Squad. In announcing the creation of the Global High-Wealth Industry Group, IRS Commissioner Douglas Shulman stated “For a variety of reasons – including valid business reasons – many high wealth individuals make use of sophisticated financial, business, and investment arrangements with complicated legal structures and tax consequences. Many of these arrangements are entirely above board. Others mask aggressive tax strategies.” ^[i] As recently stated by the Eleventh Circuit, “It is no surprise that a knowledgeable tax attorney would use numerous legal entities to accomplish different objectives. This does not make them illegitimate. Unfortunately such ‘maneuvering’ is apparently encouraged by our present tax laws and codes.” ^[ii] Tax planning is anything but sinister; it is why sophisticated, well-intentioned practitioners spend countless hours of their personal time educating and re-educating themselves on the ever-changing interpretations of the Internal Revenue Code found within the minds of Members of Congress and the judiciary.

Wealthy taxpayers often engage teams of sophisticated tax, business and estate planning lawyers, accountants and other professional advisors to legitimately minimize their potential tax liabilities. A well-designed business and estate plan may include some or all of various domestic and foreign business entities such as limited liability companies, S corporations, revocable and irrevocable trusts, real estate investments and private foundations. The plan may also include revenue-based or equity sharing arrangements together with royalty and licensing agreements and retirement plans. In this world of specialization, few private practitioners have the expertise to be specialists with respect to developing a comprehensive plan encompassing every potential tax, business, estate and gift related issue.

Although there are many sophisticated IRS representatives, few could realistically expect to unravel the intricacies of a well-designed business and estate plan employing multiple domestic and foreign entities and investment arrangements. The Wealth Squad is designed to allow the IRS to better understand the sophisticated financial, business and investment arrangements of the taxpayer by engaging a team of specialists to take a unified, holistic look at the entire web of inter-related entities controlled by a high wealth individual to discover the entire economic picture of the enterprise and to assess the tax compliance of that overall enterprise.

The initial examination focus has been on individuals with tens of millions of dollars in assets or income. Following a review of the initial examinations, the selection criteria will likely evolve to take into account information obtained in the examinations as well as to utilize the expertise of the expanding group of Wealth Squad specialists which will include flow-through specialists, international examiners, economists to identify economic trends, appraisal experts to advise on valuation issues, and technical advisors to provide industry or specialized tax expertise. It will draw upon resources throughout the IRS including the Tax Exempt and Government Entities (TE/GE) Division, the Small Business/Self-Employed (SB/SE) Division, and numerous international information exchange agreements. In egregious situations, it will likely be making referrals of taxpayers and/or their advisors to Criminal Investigation.

Information Gathering. The IRS has the general authority to gather evidence and request information during the course of an examination.^[iii] IRS requests are initially in the form of an Information Document Request – Form 4564 (IDR) – which must be reasonably designed to obtain information and documents relevant to a legitimate examination purpose. IDRs are to be specific, clear and concise.^[iv] If the taxpayer fails to appropriately respond to an IDR, the IRS may issue a Summons. The IRS has broad authority to summons books and records, the taxpayer, or any person having custody of records in order to ascertain the correctness of the taxpayer’s return, to make a return, or to determine the liability of a taxpayer.^[v]

The Summons will set forth the date, time and place, where the summoned party is to appear, although at least ten (10) days’ prior notice of appearance is required.^[vi] Compliance with the Summons may take the form of a formal question-and-answer session under oath, an informal interview, or the submission of (or providing access to) the records being summoned. The witness summoned is entitled to decline to produce documents or to answer particular questions if a good-faith basis exists for an objection to compliance.

Neither an IDR nor a Summons are self-enforcing. If a taxpayer fails to reasonably comply with a Summons, the IRS may proceed with Summons enforcement. Jurisdiction to enforce a Summons is in the United States District Court for the District in which the summoned person resides.^[vii] In such event the IRS must demonstrate that: (1) the investigation is being conducted pursuant to a legitimate purpose; (2) the inquiry is relevant to that purpose; (3) the information sought is not within the possession of the IRS; and (4) the IRS has followed the administrative steps required by the Internal Revenue Code.^[viii] A District Court Judge has the power to imprison anyone required to respond to a Summons. Typically, if the IRS proceeds to issue a Summons, it intends to enforce compliance with the Summons through a District Court proceeding, if necessary.

In addition to the issuance of an IDR (or Summons), other audit techniques used to gather information during a typical examination include:

Interviews – interviews of the taxpayer and their advisors are designed to obtain leads, develop information, and establish evidence about the taxpayer’s financial history, business operations, and books and records^[ix];

Tour of the Business Operations – tours are designed to acquire an overview of the business operation, establish that the books and records accurately reflect actual business operations, observe and test internal controls, and identify potential audit issues ^[x];

Internal Controls – an evaluation of the taxpayer’s internal controls is performed to determine the reliability of the books and records, determine the appropriate audit techniques to be used during the examination, an opportunity to identify high risk accounts and eliminate verification of accounts that have little or no tax consequence, determine the scope and depth of the examination and the extent of audit procedures to be used, and assess the level of control risk ^[xi];

Examining the Books and Records – a review of the books and records is performed to determine the flow of transactions, method of accounting, etc.^[xii];

Analyzing Schedules M-1, M-2, M-3 – a review of Schedule M-1 or M-3 is important to identify potential tax issues resulting from both temporary and permanent differences between financial and tax accounting^[xiii];

Balance Sheet Analyses – the balance sheets and financial statements often reveal significant differences between tax years, timing differences between tax and book accounting, and a reconciliation with any Schedule M-1 or M-3 adjustments^[xiv];

Testing Gross Receipts or Sales – a review of gross receipts or sales is performed to determine taxable income which may not readily appear as income on the taxpayer’s books due to differing accounting methods, timing of recognition, deferred income, constructive receipts, foreign source income, and related foreign transactions, etc.^[xv];

Testing Expenses: Cost of Goods Sold – expense testing often entails a review of the beginning and ending inventories, compliance with the absorption rules in the regulations for Code § § 263A and 471, and variance accounts when standard costing is use^[xvi];

Testing Expenses: Operational Expenses – operational expenses are reviewed to determine those which are significant, unusual, or questionable to better understand the taxpayer’s accounting methods and their application to timing and economic performance, expense versus capitalization, tax shelter write-offs, contingent liability accruals, material write-offs for tax and not for books, net operating loss carryforward and carryback, etc.^[xvii];

Wealth Squad IDRs. The initial IDR issued in connection with the commencement of a Wealth Squad examination will seem overwhelming to even the most seasoned tax practitioners. The IRS has somewhat standardized their IDR in these matters by requesting everything imaginable with respect to the taxpayer under examination and all related entities. For the year under examination, the Wealth Squad IDR requests that the taxpayer:

1. Provide copies of all original and amended returns for the year under examination, the prior year and the current year if filed or when filed.

2. Reconcile all adjustments to all original and amended returns and explain each adjustment.

3. Identify all sources of your income, including who paid it and how it was paid.

4. Identify all of your assets, tangible or intangible, owned directly or indirectly, inside and outside the U.S.

5. Identify all liabilities owed, directly or indirectly, by you or any entity you controlled, inside and outside the U.S.

6. Indicate any properties that you directly or indirectly leased or rented.

7. Provide the full name, TIN, classification for U.S. tax purposes (e.g., C corporation, S corporation, disregarded entity, or trust), your position title and describe your responsibilities for or relationship with and U.S. or foreign entity of which you:

a. Owned at least a 20%, direct or indirect, capital interest, including hybrid instruments convertible to 20% or more capital ownership;

b. Had a 20% or more interest in profits/losses;

c. Were a trustee or acted in a fiduciary capacity;

d. Were a grantor or beneficiary;

e. Had a nominee acting in your capacity or on your behalf;

f. Were on the Board of Directors;

g. Were an Officer or had signatory authority over funds and accounts controlled by the entity;

h. Were a surety for or guaranteed debt or other liabilities.

8. For any entity referenced above, from the inception of the entity to the present, provide:

a. Identification of each and every current and former officer, trustee, and manager;

b. Minutes, resolutions and records regarding the appointment, resignation or termination of all officers, trustees, and managers;

c. Records regarding all assets transferred into or from the entity;

d. Records regarding the ownership of all certificates of beneficial interest;

e. A statement explaining the purpose for operating the business activity inside this type of entity together with the reason this entity was created, tax benefits explained to you regarding the operation of the business activity within this type of entity; who assisted you in forming the entity; fees charged with respect to the formation of the entity;

f. Bank statements, deposit slips, debit/credit memos, and cancelled checks for all financial accounts, U.S. and foreign;

g. Records to establish the basis of all assets held by the entity including invoices, purchase agreements, and the names and addresses of persons who transferred property to the entity;

h. Records for sales or other transfers from the entity;

i. Copies of any contracts for business services to be rendered by the entity.

9. Provide complete copies of all financial statements and method of accounting used to compile them, net worth computations, or other financial data probative of your assets, liabilities, net worth, income and losses, and cash flows form all sources, within and without the U.S., including all underlying documents and any exhibits associated therewith, and if not apparent, please identify the preparer of such documents.

10. Identify all assets transferred and/or sold to your children or other relatives.

11. Identify all assets transferred or sold to a charitable organization or foundation and provide TIN and legal name of entity and describe your role or position with such entity.

12. Provide complete copies of the tax preparation workpapers, including adjusting trial balances, tax mappings, and closing adjustments used to prepare your return.

13. Identify any asset transferred and/or sold utilizing estate planning to reduce potential estate tax obligations, including Family Limited Partnerships (FLPs), Living Trust Agreements, Grantor Retained Annuity Trusts (GRATs), Private Foundations (PFs), Community Foundations (CFs), Donor Advised Funds (DAFs), Qualified Personal Residence Trusts (QPRTs), Charitable Remainder Trusts (CRATs) and/or Intentionally Defective Grantor Trusts (IDGTs).

14. Provide complete copies of any audited financial statements, including applicable exhibits and/or footnotes, for any entity referenced above.

12. Provide copies of all organizational charts (including all tax organizational charts) of any related entity or for any entity referenced above.

13. For any partnership referenced above,

a. Provide copies of all organizational documents, including but not limited to, the partnership agreements, and all amendments, modifications, supplemental agreements, operating agreements, by-laws, side letters, and side pocket agreements.

b. Describe all of your reasons and/or objectives for entering into the partnership.

c. Describe the business/ investment model for the partnership’s activities.

d. Describe the background pertaining to the formation of the partnership.

14. Provide copies of all tax opinions received impacting any return under examination.

15. Detail any fees you paid with regard to tax or estate planning including the amount paid, provider who received the fee, description of the planning that was done for the fee, whether a confidentiality agreement was signed, and copies of any marketing materials received with regard to the planning.

16. Indicate whether you had an interest or signatory authority over a foreign financial account with assets in excess of $10,000 and provide copies of FBARs.

17. Provide a copy of the annual brokerage account statement for each brokerage account you held.

18. Describe any securities lending agreements you entered, exited, or were engaged in and provide a copy.

19. Provide copies of all information filed for any disclosures to the IRS regarding any offshore or cross-border transactions and/or accounts. If no disclosures were required, provide an affirmative statement to that effect and the reason that no disclosure was required.

20. Describe any offshore or cross-border financial transaction you treated differently for tax purposes in the U.S. than you treated in a foreign taxing jurisdiction.

21. For any assets (tangible or intangible) you sold or transferred from the U.S. to any foreign person or entity or vice versa, indicate each asset sold or transferred, the value at the time of sale or transfer, and describe how the value was determined. Provide copies of any appraisal or reports received that indicate how the value was determined.

22. For each of the following investments held directly or indirectly, describe the investment, the name of the financial institution and account where the investment was held and provide copies of all documents received regarding the investment:

a. Financial derivatives;

b. Notional principal contracts, swaps, swaptions;

c. Prepaid forward contracts;

Hedge funds;

d. Private equity funds;

e. Foreign partnerships, foreign limited liability companies, foreign corporations or other foreign entities;

f. Real Estate Investment Trusts (REITs);

g. Real estate Mortgage Investment Conduits (REMICs);

h. Financial Asset Securitization Trusts (FASITs);

i. Other collateralized debt obligations (CDOs, including any pay-through bonds);

j. U.S. or Foreign distressed assets or non-performing loans;

k. Securities reported as worthless;

l. Debt reported as a loss on your return;

m. Gains or losses from foreign currency;

n. IRC §1256 contracts;

o. Debt instruments with OID.

23. For each hedge fund or private equity fund investment identified above,

a. Provide Schedules K-1 received from each investment;

b. Provide the name and TIN for each entity in which you were a general partner, managing partner or Tax Matters Partner;

c. If a party to a deferred compensation arrangement with such an entity, provide a copy of the deferred compensation agreement;

d. Provide the name and TIN for each foreign hedge fund in which you owned an interest directly, indirectly or through a nominee.

Detailed responses to detailed requests for information often generate additional detailed requests for information. As such, Wealth Squad IDRs typically conclude with the admonition that additional information or records may be requested in order to complete the examination. Further, taxpayer’s are cautioned to retain all potentially relevant and previously requested records or documents until the examination is concluded.

Practitioners specializing in transactional and wealth transfer (estate, gift and charitable planning, etc.) matters should carefully review the foregoing list of information requested in a Wealth Squad examination. There is no better time to prepare for a later examination than when the documents are being drafted and executed. Files for relevant documents and schedules should be coordinated with a view towards accelerating any later examination. If the transaction has any unique concerns, those issues should be well documented. It is sometimes difficult to later recall why documents were drafted in a certain manner or with unique provisions.

Resolution of Wealth Squad Examinations. Near the commencement of the Wealth Squad examination, the taxpayer will be requested to sign an audit plan that will set forth audit mutual audit expectations, timeframes, responsiveness, etc. The IRS may require responses within a relatively short timeframe. If the practitioner believes they may be unable to satisfy the projected time schedule for responses, that fact should be raised before execution of the audit plan. Do not sign on for something that may later turn against you in the examination process. If documents are not readily available, make that fact known in advance.

They are likely to also receive the standardized IDR that may cause the practitioner to wonder about their ability to effectively respond as well as their ethical responsibilities. Upon request by the IRS, practitioners must promptly submit non-privileged records & information to the IRS, notify the IRS of the location of requested records & information in possession of others, and make reasonable inquiries of the taxpayer regarding the location of requested records & information in possession of others.^[xviii] Further, a practitioner may not unreasonably delay the prompt disposition of any matter before the IRS. ^[xix]

How can any practitioner promptly and effectively respond to an IDR that requests everything imaginable with respect to the investment and business activities of a typical high wealth taxpayer having numerous domestic and foreign related entities? The initial thought of most practitioners is that such IDRs are overbroad and essentially penalize the taxpayer for being wealthy through the required expenditure of significant of accounting and legal fees in order to respond appropriately. Initially, the practitioner should coordinate a meeting with the Wealth Squad examination team to determine whether it might be possible to streamline the examination process. Provide an overview of the taxpayer’s business operations, internal controls and review procedures, etc. Neither the taxpayer nor the IRS have any desire to unnecessarily prolong the audit process. However, the IRS often has little, if any, information initially available to help it determine whether the returns, as filed, were substantially accurate. That is the purpose of the examination.

The practitioner’s duty of representation to the client must be balanced with the effort to reasonably cooperate with the examination process. The practitioner should attempt to reasonably limit the scope of the inquiry and limit the information provided so as to avoid the waiver of any potential privileges. If matters are privileged, the correspondence and relevant files should be appropriately labeled. Be aware of any potential privileges that may apply and make sure not to inadvertently waive any privilege. Separate files should be maintained for relevant documents that might be requested by the IRS as well as documents that contain potentially confidential, privileged information. It is important to know exactly which documents are deemed important to the IRS. Copies of documents provided during the course of the examination should be made in duplicate – one copy for the IRS and an extra copy to be maintained in a separate audit file specifically identifying documents provided during the course of the audit.

It is generally advisable to attempt to resolve any examination at the earliest opportunity. However, the design of Wealth Squad examinations mostly precludes any ability for a prompt resolution. Practitioners must respect the nature of these examinations and exercise discretion and their best judgment in responding to each request for information. The IRS has determined that high wealth taxpayers represent a compliance challenge worthy of devoting substantial enforcement resources to the creation, funding and operation of the Wealth Squad. Taxpayers and their representatives must be prepared to respond in kind. We are not in Kansas anymore….

[i]. Remarks of Douglas H. Shulman, Commissioner of Internal Revenue, before the AICPA National Conference on Federal Taxation, October 26, 2010, Washington, D.C.

[ii]. Ballard v. Commissioner 522 F. 3rd 1229 (11th Circuit, April 7, 2008)

[iii]. Internal Revenue Code § 7602, et. seq.

[iv]. IRM 4.46.4.4.1 (03-01-2006).

[v]. Internal Revenue Code §7602, et. seq.; See also United States v. Powell, 379 U.S. 48, 57-58 (1964).

[vi]. Internal Revenue Code §7605.

[vii]. Internal Revenue Code §7604.

[viii]. United States v. Powell, 379 U.S. 48, 57-58 (1964).

[ix]. Internal Revenue Manual (IRM) 4.10.3.2 (03-01-2003) and 4.46.4.2.1 (03-01-2006).

[x]. IRM 4.10.3.3 (03-01-2003) and 4.46.4.2.2 (03-01-2006)

[xi]. “Control risk ” is defined as the risk that a material misstatement could occur and it will not be prevented or detected on a timely basis by the business’s internal control structure, policies or procedures. IRM 4.10.3.4 (03-01-2003) and 4.46.4.2.3 (03-01-2006)

[xii]. IRM 4.10.3.5 (03-01-2003) and 4.46.4.2.3 (03-01-2006)

[xiii]. IRM 4.10.3.6 (03-01-2003) and 4.46.2.5 (03-01-2006)

[xiv]. IRM 4.10.3.8 (03-01-2003) and 4.46.4.2.6 (03-01-2006)

[xv]. IRM 4.10.3.9 (03-01-2003) and 4.46.4.2.7 (03-01-2006)

[xvi]. IRM 4.10.3.10 (03-01-2003) and 4.46.4.2.8 (03-01-2006)

[xvii]. IRM 4.10.3.11 (03-01-2003) and 4.46.4.2.9 (03-01-2006)

[xviii]. Treasury Department Circular No. 230 (CIR 230), Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, Enrolled Retirement Plan Agents, and Appraisers before the Internal Revenue Service, §10.20

[xix]. CIR 230 §10.23

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Posted in Uncategorized | Tags: idr, irs, irs audit, tax dispute, tax enforcement, tax penalty

Posted by: Taxlitigator | January 11, 2012

Basic Audit Techniques: Taxpayer Interviews

Requests to interview the taxpayer and return preparer during an otherwise normal IRS examination have become somewhat common. During an examination where the government is in possession of potentially incriminating evidence, such requests are routine. Near the inception of the recent IRS Voluntary Disclosure Program relating to previously undeclared foreign accounts, ^[i] the IRS examining agents were instructed to “utilize the full range of information gathering tools … with special emphasis on detecting unreported income … including interviewing taxpayers, making third party contacts and timely issuing summonses to taxpayers and third parties” as well as requesting foreign-based information through treaties and tax information exchange agreements. Examining agents were also instructed to “be alert to the badges of fraud and consult with Fraud Technical Advisors in developing cases for criminal referrals or for the assertion of the fraud penalty.” Essentially, IRS required interviews of taxpayers who knocked on the door of IRS Criminal Investigation desiring to pursue a voluntary disclosure leading to the amendment of previously filed tax returns for the stated purpose of developing fraud issues and referrals. The amended returns of those who came forward were not deemed trustworthy?

During the examination, the representative is typically trying to determine the nature and scope of the examination, gather responsive documents and information, etc. It is nearly impossible for the representative to be able to determine why an examination commenced but a good starting point is to simply ask the examining agent. A typical response may be that the return was randomly selected for examination.^[ii] However, there are actually few random audits. Examinations are typically focused on issues, areas, or industries having a historically high rate of non-compliance. Other examinations begin because the IRS received information from a related examination of another taxpayer or, perhaps, someone purposely provided information to the IRS relating to the taxpayer. Informants usually include disgruntled employees, ex-spouses or business partners, competitors or financial mercenaries seeking a whistleblower reward.^[iii]

Code §7602 authorizes the IRS to examine books and records and to take testimony under oath. A taxpayer has the right to resist an examining agent’s request for an interview. Pursuant to Code §7521(c), the taxpayer’s representative may represent the taxpayer before the examining agent and is not required to produce the taxpayer for questioning, unless an administrative summons has been served on the taxpayer. A question often presented is whether the taxpayer and others should consent to interviews, force the issuance of Summonses or invoke various Constitutional protections. There are several considerations that the taxpayer’s representative should weigh before allowing the taxpayer to submit to an interview, especially if potential fraud issues are involved.

The government may seek to interview the corporate officers in a corporate scenario; the Tax Matters Person (TMP) and designated person most knowledgeable in a TEFRA or S corporation scenario; and the member-manager of the LLC, the general partner of the partnership or officer/shareholder most knowledgeable of the S corporation in the non-TEFRA scenario. Certainly, if there are extremely sensitive (i.e., potentially criminal) issues, the taxpayer should not consent to an interview and should invoke their Fifth Amendment privilege against self-incrimination. It is always preferable for a taxpayer to avoid providing incriminating information when compared with the possibility of propelling a civil tax examination into a criminal tax investigation/ prosecution.

Representatives should rarely consent to having the taxpayer interviewed, especially before having a sense of the nature and scope of the examination and a feel for the reason the return was selected for audit. Even then, taxpayer interviews should rarely occur near the commencement of an audit, if at all. Taxpayers engage representatives to prepare returns and handle any examinations of the returns due to the expertise and sophistication of the representative to provide such services. Few taxpayers understand why their presence might be required if the representative was in possession of supporting information to prepare the return and sign it as the preparer. Taxpayers desire to conduct their business and expect the representative to represent them in the examination. It is usually not a confidence builder for a taxpayer to be advised that they will have the opportunity to meet the examining agent.

Interviews of the taxpayer serve a dual purpose: (i) to further the tax examination and (ii) to identify violations by a tax return preparer.^[iv] During the initial interview and throughout the examination process, the examiner can be expected to ask questions regarding the return preparation as appropriate to the case and issues being developed. Whether through the interview process or other documentation, the examiner will also be determining whether return preparer penalties might be appropriate to the situation. Interview questions are often tailored to the individual taxpayer and situation.

Questions which may be asked include: Did you meet with the preparer? What documentation was provided to the preparer? Did you receive a copy of the return or claim? How was the preparer compensated? Are you aware of any errors, omissions or mistakes on the return under examination? Did you disclose this transaction on your tax return? Why? Why not? Were there any concerns about how the transaction was reported? What sort of process is used to address those concerns and on what basis are decisions made? Was there any discussion regarding potential penalties? Was there any discussion regarding whether the transaction is subject to disclosure?

When interviewing the taxpayer or preparer the agent may ask if any other services have been provided by the preparer’s firm and how long the preparer has been preparing returns for the taxpayer? These questions provide insight into the extent of the preparer’s knowledge regarding the taxpayer’s financial situation/status and may alert the agent to the applicability of penalties. A tax return preparer who has been preparing a client’s return for a number of years is more knowledgeable than a firm that is preparing a client’s return for the first time.

Preparation for the Interview. In preparing for the interview, agents are instructed to review all available information and categorize it as information that can be documented, and need not be discussed; information that may be documented, but needs to be discussed; and information that must be developed by testimony.^[v] Their interview file should contain only data or information arranged in the order it is to be discussed or covered during the interview so as not to distract or confuse the agent during the interview.

The representative should try to obtain actual questions, or areas that the agent will question, in advance of the interview. This will substantially assist the representative in preparing the taxpayer for the interview, especially for the “hard questions.” The taxpayer should be strongly cautioned against lying, making damaging admissions or giving an explanation which does not fit within the overall parameters of the defense to the fraud issue.

Timing of the Interview. Agents are instructed to conduct an initial interview as soon as possible after opening a case and subsequent interviews if all requested information is not provided, more detailed explanations are required or to review the progress of the examination.^[vi] The pre-audit analysis should include the preparation for the taxpayer interview. The representative should attempt to obtain as much information about the issues, the information within the agent’s possession, and the agent’s position with regard to the issues, before agreeing to submit the taxpayer to an interview. Ideally, the interview should occur toward the end of the audit, possibly with an understanding that if the taxpayer submits to an interview and answers the questions, the agent will proceed to close the audit. However, the representative must take extreme caution, since such an understanding is probably not a basis for challenging the use of statements in a later proceeding.

Place of the Interview. The location of interviews will be set by the examining agent.^[vii] In general, the Service will determine if an office or field examination is to be performed. Office examinations will be conducted at the closest IRS office to the location of the taxpayer. Field examinations can be conducted at the taxpayer’s residence, place of business, or where the taxpayer’s books and records are kept.^[viii]

The taxpayer’s representative should attempt to have the interview at the representative’s office. This is a much more supportive environment for what could be an extremely agonizing experience for the taxpayer. Conversely, the taxpayer should be less intimidated and should hold up better under the pressure of the agent’s questioning if the taxpayer is not in the unfamiliar confines of an Internal Revenue Service office. Also, the representative should in most instances attempt to keep the interview from occurring at the taxpayer’s place of business, to help ensure the taxpayer is better focused for the interview and also to avoid the intrusion in the taxpayer’s daily activities.

Asserting the Fifth Amendment Privilege. If fraud issues are manifest, it may not be possible for the taxpayer to answer questions relating to problematic transactions without self-incrimination. In this situation, tax counsel must consider having the client assert the Fifth Amendment privilege against self-incrimination. Unfortunately, invoking the Fifth Amendment privilege will, in most instances, dramatically increase the odds of a referral to IRS Criminal Investigation. However, it is almost always better to allow the taxpayer to claim the Fifth Amendment and place the burden back on the government to prove its case, rather than allowing the taxpayer to provide damaging, irreversible admissions. For obvious reasons, this is usually the most difficult judgment call to make during a sensitive civil audit.

Recording the Interview. All participants must consent to the recording of the interview^[ix]. Taxpayers may request to tape record an interview proceeding as long as 10 calendar days advance notice of intent to record is provided to the IRS. In addition, the taxpayer must supply his recording equipment. The IRS has the right to simultaneously produce its own recording and has the right to reschedule the interview if the IRS does not or will not have equipment in place. The IRS can initiate an audio recording provided it notifies the taxpayer 10 calendar days in advance of the interview using Pattern Letter 2156 on Area Director letterhead. The Field Territory Manager must approve all IRS initiated recordings.

Interview Techniques. Interviews are designed to provide information about the taxpayer’s financial history, business operations, and books and records that are not available from other sources. They are be used to obtain information needed to make informed judgments about the scope and depth of the examination and correctly resolve issues, to obtain leads, develop information and establish evidence. Agents are to maintain control while establishing the pace and direction of the interview. If at any time during the interview or any other phase of the examination process, the taxpayer indicates they want to obtain representation, examination activity must be suspended and the taxpayer must be allowed a minimum of 10 business days to secure representation.^[x]

Agents are instructed to conduct the interview in an environment where the taxpayer feels comfortable.^[xi] To establish a rapport with the taxpayer, when introducing themselves the agent is to maintain a friendly and professional demeanor; explain what will happen during the examination; be prepared to explain return selection procedures, rights to representation, and appeal rights; recognize that an IRS audit is often a once-in-a lifetime experience for the taxpayer and therefore the taxpayer may be tense or nervous; exhibit openness, honesty and integrity and be calm and objective; and should listen carefully to all details, be receptive to all information volunteered, regardless of its nature, and be patient and persistent in extracting the facts necessary to achieve the goals of the interview.^[xii]

Government representatives have been trained to utilize various interview techniques, including the need to make appropriate eye contact, putting the taxpayer at ease, use of appropriate types of questions (probing, leading, open-ended, etc.), using “silence” appropriately, to paraphrase or restate comments received, listen, how to pace the interview, knowing when to move on to the next question, the need to maintain a calm manner, have the taxpayer demonstrate the flow of transactions, read the taxpayer’s non-verbal language (body language), being aware of the agent’s non-verbal language, being conscious of note taking so as not to distract the taxpayer, use of humor when appropriate, to be courteous, to be business-like and firm in their approach, to consider issues in the proper order (volatile vs. non-volatile), to schedule the interview at a convenient time and allow adequate time for completion, appear interested in responses, how to control the interview, to appear confident, maximize the value of what they know (such as various audit technique guides) and to adapt the agent’s appearance to be appropriate for the circumstances.

Additional interview techniques are to provide feedback to the taxpayer, to be observant, feign (act dumb) when appropriate (there are different levels of training for this), to be prepared, use spontaneous follow-up questions (react when they receive new information), know their limitations, read the taxpayer (know when they have lost the taxpayer’s attention), read the taxpayer’s perception of the agent, attempt to dispel any negative image of the agent, to be on time, to use appropriate small talk and easily understood language (single syllable words are generally the best), to not anticipate answers, clarify responses received, use reflection, ask for examples, recognize the agents biases, be assertive and persistent, avoid debate or argument, give the taxpayer an opportunity to ask questions, express appreciation, verbally pin down the taxpayer on important issues when appropriate, have an open mind, maintain composure, adapt questions to the situation, have the taxpayer explain their terminology, be precise, come from a position of knowledge, work to establish rapport with the taxpayer, respect the taxpayer’s views, know their authority, make a positive first impression, maintain an inquisitive mind, contain their excitement (and surprise… “You didn’t report what?!?!”), note unusual hostility or irritability on the part of the taxpayer, consider the need to question both spouses, don’t interrupt the taxpayer, be methodical, and to refresh the taxpayer about important points in prior interviews.

Agents are trained that, no matter how important the question, it is irrelevant if the response is not accurately understood.^[xiii] As such, they are to demonstrate an interest in the responses from the taxpayer and make sure that their non-verbal communication contributes to a comfortable atmosphere. If they appears overly relaxed and are not looking at the taxpayer, the taxpayer may believe they are not interested and will respond accordingly. Agents are not interrupt the taxpayer and allow a brief pause at the end of a response.

The types of questions should be varied to establish a conversational atmosphere. When developing questions, agents are to focus on four types of questions: open-ended, closed-ended, probing, and leading described as: (i) Open-ended questions are framed to require a narrative answer. They are designed to obtain a history, a sequence of events, or a description and are often asked regarding the taxpayer’s business, employment, education, and sources of income which may not be reflected on the return. The advantage of this type of question is that it provides a general overview of some aspect of the taxpayer’s history. The disadvantage is that this type of question can lead to rambling; (ii) Close-ended questions are specific and direct intended to identify definitive information such as dates, names, and amounts. They are frequently asked for personal background information such as the number of dependents or current address and are useful to help focus the taxpayer when they have difficulty giving a precise answer. They are also useful to clarify a response to an open-ended question. The disadvantage to close-ended questions is that the response is limited to exactly what is asked and can make the taxpayer uncomfortable; (iii) Probing questions combine the elements of open and close ended questions and are used to pursue an issue more deeply. For example, when questioning a taxpayer’s travel expense, the agent may ask “How many miles is it from your residence to your practice and where do you first travel to in the morning?” The advantage of this type of question is that the taxpayer’s response is directed, but not restricted; (iv) Leading questions suggest that the interviewer has already drawn a conclusion or indicate what the interviewer wants to hear. Agents are to limit the use of leading questions and typically will only use them when looking for confirmation, since the answer is stated in the form of a question. For example: “So you did not keep a log or other written record of your auto expenses?”^[xiv]

Summary. It is generally advisable to attempt to resolve an examination at the earliest opportunity. A lengthy audit may be costly from the perspective of the expenditure of time and effort involved, as well as the taxpayer’s degree of frustration with the normal administrative process. Further, a prolonged audit is more likely to uncover potentially sensitive issues that could generate increased tax deficiencies, penalties, or other sanctions.

Every examination is different – different taxpayer, different agent, different facts and issues, etc. Representation during an examination entails knowledge of the administrative process as well as the personal ability to handle each stage of the examination. However, most examinations can be expected to involve a request to interview the taxpayer. Representatives should not routinely agree to such a request without first determining whether the information can otherwise be provided without the interview or the nature and scope of the intended interview questions. Testing the heat of the examination waters before allowing the taxpayer to enter may be the difference between a quick resolution and a criminal tax referral….

[i]. In a memorandum dated March 23, 2009 from Deputy SB/SE Commissioner Faris R. Fink, Deputy LMSB Commissioner Barry B. Shott, and Deputy Chief of Criminal Investigation Victor Song, to SB/SE Examination Area Directors, LMSB Industry Directors, and CI Directors of Field Operations (the “Case Routing Memorandum”), the IRS stated that voluntary disclosures concerning offshore issues will continue to be screened in the first instance by Criminal Investigation “to determine if the taxpayer is eligible to make a voluntary disclosure”. After a preliminary determination is made, “voluntary disclosure requests containing offshore issues … will now be forwarded by CI to the Philadelphia Offshore Identification Unit (POIU) for civil processing.” Any voluntary disclosures that were already in process prior to March 23, 2009, were also to be forwarded to the POIU.

In a separate memorandum dated March 23, 2009 from Deputy SB/SE Commissioner Faris R. Fink and Deputy LMSB Commissioner Barry B. Shott, to SB/SE Examination Area Directors and LMSB Industry Directors (the “Case Development Memorandum”) the IRS stated that it was acting “to ensure that examinations with offshore transactions and/or entities continue to be emphasized and receive priority treatment during the examination process.” The memorandum stated: “Offshore cases sent to the field are work of the highest priority.” In developing these cases, IRS examiners were instructed to “utilize the full range of information gathering tools … with special emphasis on detecting unreported income.” The Case Development Memorandum recommended “interviewing taxpayers, making third party contacts and timely issuing summonses to taxpayers and third parties” as well as requesting foreign-based information through treaties and tax information exchange agreements. Examining agents were also instructed to “be alert to the badges of fraud and consult with Fraud Technical Advisors in developing cases for criminal referrals or for the assertion of the fraud penalty.”

In the third and certainly the most significant of the March 23, 2009 memoranda, from IRS Deputy Commissioner for Services and Enforcement Linda E. Stiff to LMSB Commissioner Stephen Miller, and SB/SE Commissioner Chris Wagner (the “Penalty Memorandum”) the IRS announced a “penalty framework” for those taxpayers who come forward as part of a voluntary disclosure to address offshore issues. The penalty framework was initially to be in place for only six months from March 23, 2009 (until September 23, 2009) but was subsequently extended to October 15, 2009.

[ii]. The examining agent may not actually know what triggered the examination. However, Section 3503 of the IRS Restructuring and Reform Act of 1998 (RRA 98) and IRM 4.10.2.10.3 (05-14-1999), Advising Taxpayers of the Reasons for Their Examination, require the publication of the general criteria and procedures for selecting taxpayers for examination. Publication 1 has been revised to provide an overall explanation of how returns are selected and providing this publication to the taxpayer may be deemed to satisfy Section 3505. However, IRM 4.10.2.10.3 (05-14-1999) provides that as a matter of policy, if a taxpayer under examination requests the specific reason for his/her examination, the examiner will provide the taxpayer with a response that is as accurate as possible, without revealing restricted use information.

[iii]. Code § 7623; If the IRS uses information provided by an informant, the informant can receive up to 30% of the additional tax, penalty and other amounts collected.

[iv]. IRS LMSB Memorandum “Procedures for Tax Return Preparer Penalty Cases” (April 2008)

[v]. IRM 4.10.3.2.3 (03-01-2003)

[vi]. IRM 4.10.3.2.4 (03-01-2003)

[vii]. The authority is provided in Code section 7605(a) and the Treasury Regulations § 301.7605–1. See also IRM 4.10.3.2.2 (03-01-2003).

[viii]. IRM 4.10.3.2.2 (03-01-2003)

[ix]. Code §7521(a); IRM 4.10.3.2.6 (03-01-2003)

[x]. IRM 4.10.3.2.7.1 (03-01-2003)

[xi]. IRM 4.10.3.2.7.1 (03-01-2003)

[xii]. IRM 4.10.3.2.7.1 (03-01-2003)

[xiii]. IRM 4.10.3.2.7.3 (03-01-2003)

[xiv]. IRM 4.10.3.2.7.2 (03-01-2003)

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Posted in Uncategorized | Tags: interview, irs, irs audit, irs examination, tax disute, tax fraud, taxpayer

Posted by: Taxlitigator | January 11, 2012

IRS Audit Techniques Guides

Historically, Internal Revenue Service examiners were assigned to audit taxpayers in many different industries. On one day, an examiner audited a grocery store and on the following day the examiner may have audited a computer retailer or a medical doctor. As a result, experience gained in one audit did not significantly enhance the examiner’s experience for purposes of conducting other audits. More recently, 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 IRS Audit Techniques Guides (ATGs) focus on developing highly trained examiners for a particular market segment or issue. A market segment may be an industry such as construction or entertainment, a profession like attorneys or real estate agents or an issue like passive activity losses, hobby losses, litigation settlements or executive compensation – fringe benefits. These guides contain examination techniques, common and unique industry issues, business practices, industry terminology, interview questions and procedures and other information to assist examiners in performing examinations.

The ATGs have significantly improved audit efficiency and compliance by focusing on taxpayers as members of particular groups or industries. These groups have been defined by type of business (artists, attorneys, auto body shops, bail bond industry, beauty shops, child care providers, gas stations, grocery stores, entertainers, liquor stores, pizza restaurants, taxicabs, tour bus industry, etc.), technical issues (passive activity losses, alternative minimum tax), and types of taxpayer or method of operation (i.e. cash intensive businesses). As examiners focus on the tax compliance of a particular industry, they have gained experience on specific issues to be examined for a particular type of business, whether or not the issues are set forth on a tax return. Examiners often spend the majority of their time auditing taxpayers in the particular market segment for which the examiner has become a specialist. Some may specialize in examining the construction industry while others may specialize in examining restaurants.

IRS examiners are routinely advised about industry changes through trade publications, trade seminars and information sharing with other examiners. As such, there is an increased understanding of the market segment, its practices and procedures, and the appropriate audit techniques required to identify issues unique to the market segment under examination. Utilizing an ATG, examiners attempt to reconcile discrepancies when income and/or expenses set forth on a taxpayer’s return are inconsistent with a typical market segment profile or where the reported net income seems inconsistent with the standard of living prevalent in a geographical area where the taxpayer resides. As a result, information and experience gained through the examination of returns for other taxpayers becomes the barometer for judging the accuracy of a particular return under examination.

Issues are continually being identified by their unique features requiring specialized audit techniques, technical or accounting knowledge, or the need to comprehend the specific business practices, terminology and procedures. The IRS has published numerous ATGs, including attorneys, auto body/repair shops, bail bondsmen, beauty/barber shops, car washes, child care providers, check cashing establishments, childcare businesses, construction contractors, farmers, restaurants and bars, various segments of the entertainment industry (motion picture/television, athletes and entertainers, music), garment industry, gasoline distributors, grocery stores, insurance agencies, jewelry dealers, liquor stores, mobile food vendors, parking lot operators, pizza parlors, real estate agents/brokers, real estate developers, recycling businesses, scrap metal businesses, taxicabs, the trucking industry, direct sellers and auto dealers.

Once the IRS identifies a particular market segment project, an audit group may develop an ATG based upon the market segment’s unique business activities. The audit guides are used by examiners to develop a pre-audit planning strategy. The ATGs explain the nature of each respective market segment or industry, the type of documentation that should generally be available, and the nature and type of information to search for during a tour of the business premises. They identify potential sources of additional income not otherwise readily apparent from the type of business activity being examined. Copies of many of the ATGs are available at http://www.irs.gov/businesses/small/article/0,,id=108149,00.html

The ATGs identify issues to be raised during an audit interview with the business owner/operator, including the need for a detailed discussion about internal controls (weak internal controls in a small business environment does not preclude the necessity of determining the reliability of the books and records since every taxpayer has a method of conducting business and safeguarding business operations), source of funds utilized to start the business, a complete list of suppliers, identification or business records that might be available and the individual that maintains the business records. The examiner will also explore the manner of business operations, including the hours and days it is open, the number of employees, the responsibilities of each employee, identification of the individual that maintains control over inventory (beer, wine, etc.), cash and credit card receipts, and the cash register tapes. Examiners are advised to search out payments of non-business or personal living expenses by the owner/operator from the business operations.

ATGs are designed to focus IRS examiners on the typical methods of operation for businesses operating within a particular market segment. For example, with respect to cash intensive businesses, the audit guides identify the potential for skimming in liquor stores, pizza restaurants, gas stations, retail gift stores, auto repair shops, restaurants and bars. However, the ATGs acknowledge that “chain” or “franchise” businesses may not participate in skimming to the same extent due to the somewhat intensive internal controls typically required in their operations. Internal controls are often stronger in franchises due to independent audits and verifications performed by the franchisor. Typically, the franchise fee is based on the gross revenue of the business. The franchisee usually must buy products from the franchisor to maintain the franchise. The franchisor also requires maintenance of certain books and records in a format determined by the franchisor and may conduct audits of the franchise operations.

Specific Industry Applications of Audit Techniques. IRS examiners are advised to make specific inquiries based on the type of taxpayers under examination. For example, in the retail liquor industry, examiners are advised to search for off-book inventory including purchases outside of the liquor distributor, i.e. local wholesaler, bottle redemption and check cashing as well as contacting for check with local/state beverage department for pending or completed investigations involving taxpayer and/or known suppliers of the taxpayer. For pizza restaurants, examiners are cautioned to reconcile the difference of the number of boxes sold verses the number of boxes used (less some account for spoilage boxes) as possible additional unreported sales. For gasoline service stations, examiners are advised use the indirect mark-up method of determining income (gallons purchased multiplied by the average selling price as representing total sales) and inquire about imaging reimbursements, incentive agreements, accommodations, blending and rebates.

For restaurants and bars, examiners are advised to inquire about rebates to franchisees from suppliers, compare restaurant averages (sales v. cost), reported net profits as compared to the industry average, spillage, whether “point of sales” machines, using bar averages (pour) to calculate income, etc. With respect to grocery stores, examiners are advised to search for potential sources of unreported income that might include coupon processing rebate fees, cash discounts from vendors, rebates from vendors, receipt of high dollar promotional items from vendors, use of vending machines (i.e. newspaper), pinball machines/arcade games, bottle/can redeeming, money orders, credit card sales, food stamp sales and prepaid telephone cards.

Financial Status Audit Techniques (FSAT). There are various audit and investigative techniques available to corroborate or refute a taxpayer’s claim about their business operations or nature of doing business. 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. The use of indirect methods of proving income, also referred to as the FSAT, is not prohibited by Code Section 7602(e)^[i]. Indirect methods include a fully developed Cash T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of underreported or unreported income. Examiners must then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary. Common FSATs include:

• The Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period.^[ii] This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the adjustment to income. The Source and Application of Funds Method is typically used when the review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported, the taxpayer’s cash does not all flow from a bank account which can be analyzed to determine its source and subsequent disposition, or the taxpayer makes it a common business practice to use cash receipts to pay business expenses.

Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately. Specific sources of funds include the decrease in cash-on-hand, in bank account balances (including personal and business checking and savings accounts), and decreases in accounts receivable; increases in accounts payable; increases in loan principals and credit card balances; taxable and nontaxable income, and deductions which do not require funds such as depreciation, carryovers and carrybacks, and adjusted basis of assets sold.

Application of funds are ways the taxpayer used (or expended) money during the year. Examples of applications of funds include increases in cash-on-hand, increase in bank account balances (including personal and business checking and savings accounts), business equipment purchased, real estate purchased, and personal assets acquired; purchases and business expenses; decreases in loan principals and credit card balances, and personal living expenses. Determining the beginning amount of cash-on-hand and accumulated fund for the year is important. See IRM 4.10.4.6.8.3 below for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.

• The Bank Account Analysis compares total deposits with the reported gross income. for all accounts, whether designated as personal or business. The examiner will review the taxpayer’s business and personal bank accounts (including investment accounts); i.e., statements, deposit slips, and canceled checks, etc. looking for unusual deposits (size or source), the frequency of deposits, deposits of cash, specific deposits that do not follow the taxpayer’s normal routine or pattern, nontaxable deposits such as loans and transfers, commingling of personal and business activities, and cash-backs when a deposit occurs.

The examiner will attempt to total the deposits and reconcile deposits of nontaxable funds and transfers between accounts focusing on transfers in, out, and between accounts as previously unknown accounts may be identified. Checks deposited by the taxpayer but later returned by the bank (e.g., the maker of the check did not have sufficient funds in the account to pay the check) are categorized as nontaxable transactions. Nontaxable funds, transfers-in, and returned deposits need to be subtracted from total deposits to get “taxable deposits.” The examiner will determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance. To the extent possible, cancelled checks will be reviewed to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the amount. If cancelled checks are unavailable, transactions will be traced from the bank statement to the check register and the original document. Significant commingling of accounts may warrant a more in-depth analysis by the examiner. When nondeductible expenditures are deducted from the total disbursements the remainder should approximate the deductible business expenses on the tax return (other than non-cash expenses such as accruals and depreciation).

If the analysis results in the identification of excess deposits over the reported gross income, the excess represents potential unreported income. If specific transactions or deposits can be identified as the source of the understatement, the examiner may assert a specific item adjustment to income supported by the direct evidence of excess deposits. If the specific transactions or deposits creating the understatement are not identified, an adjustment to taxable income may be made based on the circumstantial evidence. If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds. If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records may be unreliable.^[iii]

• The Bank Deposits and Cash Expenditures Method is distinguished from the Bank Account Analysis by the depth and analysis of all the individual bank account transactions, and the accounting for cash expenditures, and a determination of actual personal living expenses. The Bank Deposits and Cash Expenditures Method computes income by showing what happened to a taxpayer’s funds based on the theory that if a taxpayer receives money it can either be deposited or it can be spent^[iv]. This method is based on the assumptions that proof of deposits into bank accounts, after certain adjustments have been made for nontaxable receipts, constitutes evidence of taxable receipts; expenditures as disclosed on the return, were actually made and could only have been paid for by credit card, check, or cash. If outlays were paid by cash, then the source of that cash must be from a taxable source unless otherwise accounted for and it is the burden of the taxpayer to demonstrate a nontaxable source for this cash.

The examiner will consider whether there are unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income? The examiner may limit the examination to large deposits or deposits over a certain amount. However, the identification of smaller regular deposits may be indicative of dividend income, interest, rent, or other income, leading to a source of investment income. An item of deposit may be unusual due to the kind of deposit, check or cash, in its relationship to the taxpayer’s business or source of income. An explanation may be required if a large cash deposit is made by a taxpayer whose deposits normally consist of checks. Also, a bank statement noting only one or two large even dollar deposits, in lieu of the normal odd dollar and cents deposits, would be unusual and require an explanation.

Many taxpayers, due to the nature of their business or the convenience of the depository used, will follow a set pattern in making deposits. Deviation from this pattern may be reason for more in depth questioning. Bank statements or deposit slips which indicate repeat deposits of the same amount on a monthly basis, quarterly or semi-annual basis may indicate rental, dividend, interest or other income accruing to the taxpayer.

The examination of deposit slips may indicate items of deposit which appear questionable due to the location of the bank on which the deposited check was drawn. It is common practice when preparing a deposit slip to list either the name of the bank, city of the bank or identification number of the bank upon which the deposited check was drawn. If an identification number is used, the name and location of the bank can be determined by reference to the banker’s guide. In all cases, if the location of the bank on which the check for deposit was drawn bears little relation to the taxpayer’s business location or source of income, it may indicate the need for further investigation.

The examiner should identify all loan proceeds, collection of loans, or extraneous items reflected in deposits. If loan proceeds are identified, the examiner may request the loan application documents to verify the source and amount of the nontaxable funds and attempt to determine whether such information is consistent with other information; i.e., cash flows, assets, anticipated gross receipts, etc.

If repayments of loans are identified, the examiner will request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and redeposits must be eliminated. For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then redeposits these payroll checks, the examiner would be incorrect if total deposits were compared to receipts reported without adjusting for this amount. The taxpayer has done nothing more than redeposit the same funds in the form of someone else’s checks.

• The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability.^[v] It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s gross receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit, or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. If known, use of the taxpayer’s actual markup is required.

The Markup Method is similar to how state sales tax agencies conduct audits. The cost of goods sold is verified and the resulting gross receipts are determined based on actual markup. The Markup Method is often used when inventories are a principal income producing factor and the taxpayer has nonexistent or unreliable records or the taxpayer’s cost of goods sold or merchandise purchased is from a limited number of sources such that these sources can be ascertained with reasonable certainty, and there is a reasonable degree of consistency as to sales prices.^[vi]

• The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.

The theory of the Net Worth Method is based upon the fact that for any given year, a taxpayer’s income is applied or expended on items which are either deductible or nondeductible, including increases to the taxpayer’s net worth through the purchase of assets and/or reduction of liabilities. The taxpayer’s net worth (total assets less total liabilities) is determined at the beginning and at the end of the taxable year. The difference between these two amounts will be the increase or decrease in net worth. The taxable portion of the income can be reconstructed by calculating the increase in net worth during the year, adding back the nondeductible items, and subtracting that portion of the income which is partially or wholly nontaxable.

The purpose of the Net Worth Method is to determine, through a change in net worth, whether the taxpayer is purchasing assets, reducing liabilities, or making expenditures with funds not reported as taxable income. The use of the Net Worth Method of proof requires that the government establish an opening net worth, also known as the base year, with reasonable certainty; negate reasonable explanations by the taxpayer inconsistent with guilt; i.e., reasons for the increased net worth other than the receipt of taxable funds. Failure to address the taxpayer’s explanations might result in serious injustice; establish that the net worth increases are attributable to currently taxable income, and; where there are no books and records, willfulness may be inferred from that fact coupled with proof of an understatement of taxable income. But where the books and records appear correct on their face, an inference of willfulness from net worth increases alone might not be justified.^[vii] The government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.

Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference; irregularities in the taxpayer’s books and weak internal controls; gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; the taxpayer’s bank accounts have unexplained deposits; the taxpayer does not make regular deposits of income, but uses cash instead; a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; there are no books and records (examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, the examiner will attempt to determine who destroyed them, why, and when); no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income as required by Code section 446(b).

When considering an indirect method, the examiner will look to the industry or market segment in which the taxpayer operates, whether inventories are a principle income producing activity, whether suppliers can be identified and/or merchandise is purchased from a limited number of suppliers, whether pricing of merchandise and/or service is reasonably consistent, the volume of production and variety of products, availability and completeness of the taxpayer’s books and records, the taxpayer’s banking practices, the taxpayer’s use of cash to pay expenses, expenditures exceed income, stability of assets and liabilities, and stability of net worth over multiple years under audit.

Cash Intensive Business ATG. 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.

The IRS has long been interested in business operations that receive most of their income in cash. Since certain businesses do not always deposit all of their cash receipts, the Cash Intensive Business ATG provides various methods by which an examiner may be able to reconstruct total gross receipts and expenditures. Cash transactions are believed to be anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can be unreported and escape detection. Cash can be misappropriated cash from a business by being skimmed from receipts and pocketed before it is recorded. If this happens it will not be discovered by auditing the books. It can be stolen after it has been recorded by being removed from the cash register or goods stolen from the shelf for future resale. A fraudulent disbursement can be created such as a payment to a vendor that is actually cashed by the owner.

A significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. Other indicators of unreported income include a life style or cost of living that can’t be supported by the income reported; a business that continues to operate despite losses year after year, with no apparent solution to correct the situation; a Cash T shows a deficit of funds; bank balances, debit card balances and liquid investments increase annually despite reporting of low net profits or losses; accumulated assets increase even though the reported net profits are low or a loss; debt balances decrease, remain relatively low or don’t increase, but low profits or losses are reported; a significant difference between the taxpayer’s gross profit margin and that of their industry; and unusually low annual sales for the type of business.

If the examiner believes the business may not be reporting all of its income, the examiner may issue a summons to suppliers and other third-parties for records of sales or deliveries to the business, including original purchase invoices, during the period under examination. The examiner may then mark-up the purchases by a reasonable amount based upon ATG industry standards to determine what are known as the audited sales for the business. Absent a reasonable explanation for a discrepancy between audited sales and reported sales, the IRS will determine income tax adjustments (and maybe penalties) based upon the discrepancy.

The examiner will formulate interview questions based on the preliminary Cash-T information, and, at the initial interview, the taxpayer may respond that no loans or gifts were received nor was a cash hoard maintained. When questioned the some taxpayers respond that unexplained deposits or cash represents loans and gifts from relatives who may live outside the United States although there are no records to support the claim that the amounts are loans or gifts, except a copy of a letter from a relative stating that the relative gave the amounts at issue.

If the examiner believes the unexplained amounts represent unreported income, the ATG advises the examiner to ask the taxpayer for the specific dates and amounts of the currency received from friends or family – a vague and self serving letter from a friend or relative is not likely a sufficient response. The examiner will inquire about exactly how much currency was received on each specific date. Was it U.S. currency or foreign currency? Can the loan be verified by any other source? Can the lender show it was withdrawn from their bank on that date? Were FinCEN forms filed if currency was brought into the country? What day did the taxpayer get the money?

How much did the taxpayer receive on that day? What did the taxpayer do with the money that day?

The examiner will ask for the name, address, telephone number of each person providing cash loans and inform the taxpayer that the examiner will be contacting these individuals for proof, including requesting copies of their tax returns or other documents. How the foreign currency was converted to U.S. currency? Where did the lender convert the currency? The examiner will ask for a copy of the exchange receipt issued by the bank or whomever exchanged the foreign currency for U.S. currency. If the lender converted the currency and brought it into the U.S., the examiner will request a copy of their passport showing entry to the U.S. on that day. If the taxpayer converted the currency, the examiner will request a copy of the exchange receipt.

The examiner is advised to get specific information from the taxpayer and that the taxpayer must have records of this, because if currency was received, the taxpayer would know how much it was. If it is a loan, the taxpayer would typically know amounts borrowed so they can pay it back. They will need to know when it was borrowed to calculate interest. If the taxpayer cannot provide specific information the examiner is advised that they should question the credibility of the statements. This questioning is often intensive and highlights inconsistencies if the cash loans do not exist.

Specific dates and amounts are important, because a large cash expenditure in January can’t be explained by a trip to a foreign country to obtain cash in March of the same year. The examiner should consider issuing an IDR to obtain this information. If the taxpayer has sufficient detailed information, the examiner is to summons the lenders or cash donors for an interview and additional documents would be appropriate. Also, summonsing bank records for the specific deposits would be appropriate.

When foreign currency is given by gift or loan, exchange rates can be found for the transfer dates. If they were not favorable, it is unlikely a friend or relative would have exchanged the currency at that time unless it was absolutely necessary. And, if it was absolutely necessary, the money would go into the bank or into the business immediately. If the amounts in issue are asserted to be a loan, the examiner is advised to inquire about repayment and how interest is calculated. The loan will have occurred in the examination year, and by time of the later examination, the taxpayer should have paid some of it back. If the taxpayer is repaying by taking currency to the foreign country, the examiner will ask for the same type of specific information (exchange receipts and copies of their passport, etc.). Does the business show enough profit to be able to pay back loans on those dates If only one payment is made during the year, it would likely be a larger than normal loan payment. Can withdrawals be found in the amount claimed to be paid back? Examiners are advised to analyze the cash in and cash out for the week of the repayment.

Examiners are to interview the lenders and review their tax returns. They will inquire about the specific dates and amounts provided to the taxpayer? Was it foreign or U.S. currency? Who converted the currency to U.S.? When? Where? What records do you have to prove this? What records do you have to guarantee the money will be repaid? Have any repayments been made? When? Where? How much? If not, why not? They will ask to see copies of their passports to show they traveled into the country when they say they did and copies of their bank withdrawals if money was withdrawn to lend to the taxpayer. It is possible that, when face to face with the examiner, the lender will make statements inconsistent with the taxpayer’s statements or give some evidence that they did not really have the ability to make these suggested loans.

Typical Interview Questions Addressing Accumulated Funds. Taxpayers often assert that unexplained amounts represent accumulations of wealth over a period of time. Common interview questions include whether the taxpayer keeps more than $1,000 on your person, at your home, at your business, or in any other location?^[viii] What do the accumulated funds consist of? (For example, paper money, coin, money orders, cashier checks, etc.). In what denominations were the funds accumulated? Where are the accumulated funds maintained? How long have the accumulated funds been kept in the foregoing location? What kind of container were the accumulated funds kept in?

Further questions could include how much accumulated funds did the taxpayer have on hand at the beginning and end of the year under audit? How much in accumulated funds does the taxpayer have on hand presently? Over what period of time were the funds accumulated? Do the accumulated funds solely belong to the taxpayer or does it belong to more than one person? Identify each person having ownership of these accumulated funds. Do any of the other owners have access to these accumulated funds? Identify the increase or decrease in accumulated funds for each access. Identify the type of records kept to identify the name(s), date(s) and effect on the accumulated funds each time there was an access.

Why were the funds accumulated and not deposited in a financial account? What is the original source of the money included in the accumulated funds? How often are the accumulated funds accessed? What is the effect of each access? Are there additions or withdrawals from the accumulated funds? Was the taxpayer accompanied by another individual when the accumulated funds were accessed? If yes, provide the name and address of the persons involved. Does the taxpayer count the accumulated funds every time they are accessed? If not, provide the dates and purpose for when the funds were counted. Does anyone else know about the accumulated funds? If yes, provide the name, relationship, address, and phone number for the person. Also determine whether these persons have access to the accumulated funds and if so, the manner and circumstances under which their access was made.

[i]. Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

[ii]. See IRM 4.10.4.6.3 (09-11-2007) and United States v. Johnson, 319 U.S. 503 (1943).

[iii]. See IRM 4.10.4.3.3.4. (08-09-2011)

[iv]. See IRM 4.10.4.6.4.1 (09-11-2007) and Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935).

[v]. See IRM 4.10.4.6.5.1 (08-09-2011) and United States v. Fior D’Italia, Inc., 536 U.S. 238 (2002).

[vi]. See IRM 4.10.4.6.5.2 (05-27-2011).

[vii]. See IRM 4.10.4.6.7.1 (06-01-2004). And Holland v. United States, 348 U.S. 121 (1954).

[viii]. See IRM Exhibit 4.10.4-1

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Posted in Uncategorized | Tags: ATG, badges of fraud, cash business, Financial Status Audit Techniques, fraud, FSAT, irs, irs audit, tax, tax dispute, tax enforcement, tax evasion, tax examination, tax fraud

Posted by: Taxlitigator | January 11, 2012

IRS Voluntary Worker Classification Settlement Program

The IRS recently launched a new program designed to enable many employers to resolve past worker classification issues and achieve certainty by voluntarily reclassifying their workers on a prospective basis. The Voluntary Classification Settlement Program (VCSP)^[i] is designed to allow eligible employers to obtain substantial relief from federal payroll taxes they may have owed for the past, if they agree to prospectively treat their workers as employees. It is available to many businesses, tax-exempt organizations and government entities that might be erroneously treating their workers or a class or group of workers as nonemployees or independent contractors, and now want to treat these workers as employees. The VCSP allows employers the opportunity to get into compliance by making a relatively minimal payment covering past payroll tax obligations rather than waiting for an IRS examination and an uncertain financial liability associated with a worker status reclassification.

Definition of Employee. Before an employer can know how to treat payments made to workers for services, they must first know the business relationship that exists between the employer and the person performing the services. The worker may be: (a) a common-law employee, (b) a statutory employee, (c) a statutory nonemployee, or (d) an independent contractor. The determination of whether a worker is an employee or an independent contractor is generally made under a facts and circumstances test that seeks to determine whether the worker is subject to the control of the service recipient, not only as to the nature of the work performed, but the circumstances under which it is performed.

(a). Employee (Common-Law Employee). Under common-law rules, anyone who performs services is an employee if the employer can control what will be done and how it will be done. The most significant issue is the right to control the details of how the services are performed. In Rev. Rul. 87-41^[ii], the IRS developed a list of 20 factors (attached) that may be examined in determining whether an employer-employee relationship exists. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed. The 20 factors are designed only as guides for determining whether an individual is an employee; special scrutiny is required in applying the 20 factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement (that is, whether the person or persons for whom the services are performed exercise sufficient control over the individual for the individual to be classified as an employee).

The IRS has also identified three categories of evidence that may be relevant in determining whether the requisite control exists under the common-law test and has grouped illustrative factors under these three categories: (1) behavioral control (whether the business has the right to control how the worker does the contemplated task); (2) financial control ((whether the business has the right to control the business aspects of the contemplated task); and (3) relationship of the parties (such as whether there are contracts describing the relationship, permanency of the relationship, the extent to which the services performed are a key aspect of the regular activities of the business, and whether the business provides the worker with employee-type benefits such as insurance, a pension plan, etc.).^[iii]

Businesses must consider all relevant factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another. The entire relationship must be examined including the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

(b). Statutory Employees. For purposes of FICA,^[iv] the term “employee” means– (1) any officer of a corporation; or (2) any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. Under the Regulations, an employer-employee relationship generally exists if the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished.^[v] That is, an employee is subject to the will and control of the employer, not only as to what is to be done, but also as to how it is to be done. It is not necessary that the employer actually control the manner in which the services are performed, rather it is sufficient that the employer have a right to control. Whether the requisite control exists is determined on the basis of all the relevant facts and circumstances.

Accordingly, workers will be deemed a statutory employee if they are an officer of a corporation or are deemed an employee under the foregoing common law rules.^[vi] Additionally, even if workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute (statutory employees) for certain employment tax purposes if they fall within any one of the following four categories (1-4) and meet the three conditions described under Social Security and Medicare taxes (5)^[vii]:

(1). A driver who (i) operate their own trucks or the trucks of the persons for whom they perform services, (ii) serve customers designated by their principals and customers they solicit on their own initiative, (iii) make wholesale or retail sales, and (iv) are paid commissions on their sales or earn the difference between what they charge their customers and what they pay their principals for the products or services they sell. Such drivers are “statutory employees” if they distribute beverages (other than milk), meat, vegetables, fruit, or bakery products, or if they pick up and deliver laundry or dry cleaning.

(2). A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.

(3). An individual who works at home on materials or goods supplied by the employer and that must be returned to the employer or to a person they name, if the employer also furnishes specifications for the work to be done.

(4). A full-time traveling or city salesperson who works on behalf of the employer and turns in orders to the employer from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for the employer must be the salesperson’s principal business activity.

(5). Social Security and Medicare Taxes. Social Security and Medicare taxes must be withheld from the wages of statutory employees if all three of the following conditions apply: (i). the service contract states or implies that substantially all the services are to be performed personally by them. (ii). they do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities). (iv). the services are performed on a continuing basis for the same payer.

(c). Statutory Non-employees. There are generally two categories of statutory non-employees: direct sellers and licensed real estate agents. They are treated as self-employed for all federal tax purposes, including income and employment taxes, if: (a) Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and (b) Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.^[viii]

(d). Independent Contractor. Lawyers, contractors, subcontractors and auctioneers who follow an independent trade, business, or profession, in which they offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

Section 530 of the Revenue Act of 1978 (Section 530)^[ix] generally allows an employer to treat a worker as not being an employee for employment tax purposes (but not income tax purposes), regardless of the worker’s actual status under the common-law test, unless the employer has no reasonable basis for such treatment or fails to meet certain requirements. Section 530(a) generally provides, for purposes of the employment taxes under Subtitle C of the IRC, that to qualify for relief, the business must meet three requirements:

(1). Reporting Consistency: All Federal tax returns (including information returns) required to be filed by the taxpayer with respect to the individual for the period must have been filed by the business on a basis consistent with the business’ treatment of the individual as not being an employee. This test must be applied to each worker separately, since the taxpayer may have filed a Form 1099-MISC for one worker in a class, but not for another worker in the same class. If this is the case, such workers will be treated as separate classes.

(2). Substantive Consistency: The business must have consistently treated similarly situated workers as independent contractors. That is, if the business (or a predecessor) treated a similarly situated worker as an employee, there is no Section 530 relief. This test must be applied to the class of workers having substantially similar job responsibilities and working under substantially similar conditions (i.e., supervisors vs. workers being supervised).

(3). Reasonable Basis: The business must have had some reasonable basis for not treating the worker as an employee. This may consist of reasonable reliance on: a judicial precedent, a published ruling, a private letter ruling or technical advice memorandum issued to the taxpayer; the results of a past audit of the taxpayer; or a long-standing recognized practice of a significant segment of the industry. Any other reasonable basis could also suffice.

The determination of whether any individual who is treated as an employee holds a position substantially similar to the position held by an individual whom the taxpayer would otherwise be permitted to treat as other than an employee for employment tax purposes under Section 530 (a) generally requires an examination of all the facts and circumstances, including particularly the activities and functions performed by the individuals. Differences in the positions held by the respective individuals that result from the taxpayer’s treatment of one individual as an employee and the other individual as other than an employee (for example, that the former individual is a participant in the taxpayer’s qualified pension plan or health plan and the latter individual is not a participant in either) are to be disregarded in determining whether the individuals hold substantially similar positions. The determination is often based on an analysis of Section 530 as applied to the particular factual situation involved.

Employment Taxes. In general, employment taxes consist of the taxes under the Federal Insurance Contributions Act (FICA), the tax under the Federal Unemployment Tax Act (FUTA), and income taxes required to be withheld by employers from wages paid to employees (income tax withholding). ^[x] FICA tax consists of two parts: (1) old age, survivor, and disability insurance (“OASDI”), which correlates to the Social Security program that provides monthly benefits after retirement, disability, or death; and (2) Medicare hospital insurance (“HI”). Unlike the OASDI tax, the HI tax is not limited to a specific amount of wages, but applies to all wages. Under FUTA, employers must pay a tax of 6.2 % of wages up to the FUTA wage base of $7,000.

An employer may take a credit against its FUTA tax liability for its contributions to a State unemployment fund and, in certain cases, an additional credit for contributions that would have been required if the employer had been subject to a higher contribution rate under State law. For purposes of the credit, contributions means payments required by State law to be made by an employer into an unemployment fund, to the extent the payments are made by the employer without being deducted or deductible from employees’ remuneration. Employers generally are required to withhold income taxes from wages paid to employees. Withholding rates vary depending on the amount of wages paid, the length of the payroll period, and the number of withholding allowances claimed by the employee. Wages paid to employees, and FICA and income taxes withheld from the wages, are required to be reported on employment tax returns (Forms 940 and 941) and on Form W-2.^[xi]

The “tax gap” – the difference between what taxpayers should have paid and what they actually paid on a timely basis –based information developed through the National Research Program (NRP) for tax year 2001 is estimated to be $345 billion for tax year 2001. IRS enforcement activities, coupled with other late payments, recover about $55 billion of the tax gap, leaving a net tax gap of $290 billion for Tax Year 2001. Of that amount, approximately $15 billion is believed to be represented by FICA and FUTA underreporting.

Employers must file information reports on all wages paid to employees. Even when Forms 1099 are issued, compliance is somewhat less than when workers are classified as employees and withholding is required. Employers often fail to file requisite Forms 1099 for payments made to independent contractors, and independent contractors often fail to report the unreported payments as income. The NRP for tax year 2001 determined that when substantial information reporting and withholding was required, there was approximately 98.80% reporting accuracy; when substantial information reporting was required, there was approximately 95.50% reporting accuracy; when some information reporting was required, there was approximately 91.45% reporting accuracy; and when little or no information reporting was required, there was approximately 46.10% reporting accuracy.

Responsibility for Employment Tax Compliance / Worker Classification. An employer must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In addition, other tax issues, including the provision of certain employee benefits, depend upon the proper classification of workers. Employment tax responsibility generally rests with the person who is the employer of an employee under a common-law test that has been incorporated into Treasury Regulations.^[xii] The test of whether an employer-employee relationship exists is relevant in determining whether a worker is an employee or an independent contractor. However, the same test applies in determining whether a worker is an employee of one person or of another.

No definitive test exists to distinguish whether a worker is an employee or an independent contractor. The tests used to determine whether a worker is an independent contractor or an employee are complex and subjectively applied. When employees are classified as independent contractors, they may be excluded from coverage under key laws designed to protect workers and may not have access to employer-provided health insurance coverage and pension plans. Moreover, classification of employees can affect the administration of many federal and state programs, such as payment of taxes and payments into state workers’ compensation and unemployment insurance programs.

Significant tax consequences result from the classification of a worker as an employee or independent contractor. These consequences relate to withholding and employment tax requirements, as well as the ability to exclude certain types of compensation from income or take tax deductions for certain expenses. Some consequences favor employee status, while others favor independent contractor status. For example, an employee may exclude from gross income employer-provided benefits such as pension, health, and group-term life insurance benefits. On the other hand, an independent contractor can establish his or her own pension plan and deduct contributions to the plan. An independent contractor also has greater ability to deduct work-related expenses.

Employers have economic incentives to classify employees as independent contractors. Employers are not obligated to make certain financial expenditures for independent contractors that they make for employees, such as paying certain taxes (Social Security, Medicare, and unemployment taxes), providing workers’ compensation insurance, paying minimum wage and overtime wages, or including independent contractors in employee benefit plans.

Significant tax consequences also result if a worker was misclassified and is subsequently reclassified, e.g., as a result of an audit. For the employer, such consequences may include liability for withholding taxes for an undefined number of years, interest and penalties, and potential disqualification of employee benefit plans. For the worker, such consequences may include liability for self-employment taxes and denial of certain business-related deductions.

IRS Worker Classification Settlement Program (CSP). Under the CSP^[xiii], the IRS allows examiners and employers to resolve worker classification cases as early in the enforcement process as possible.^[xiv] CSP is applied separately to each class of worker for each period. In an employment tax examination, the examiner must first determine whether the employer is entitled to Section 530 relief. If so, there is no assessment and the employer can continue to treat the workers in question as independent contractors. If the employer desires to begin treating the workers as employees, it can agree to do so in the future (no later than the beginning of the next year after the examination) without giving up its claim to Section 530 relief for earlier periods.

If the examiner finds that the employer is erroneously treating employees as independent contractors, a series of two graduated CSP settlement offers can occur. It is mandatory for the examiner to offer CSP to businesses with an open employment tax case in either SB/SE, TE/GE, LMSB, or Appeals, even if Form 940 or Form 941 have not been filed (which would be consistent with a belief that the worker is not an employee) or of Forms 1099 are not required to be filed (such as for household workers).^[xv] If the employer has met the reporting consistency requirement of Section 530 but clearly has no reasonable basis for its treatment of the workers as independent contractors or has been inconsistent in its treatment of the workers, the offer would be a full employment tax assessment under Code §3509 for one taxable year, with the employer agreeing to reclassify the workers as employees on a prospective basis, ensuring future compliance. If the employer has met the reporting consistency requirement and can reasonably argue that it met the reasonable basis and consistency of treatment tests, the offer will be an assessment of 25% of the employment tax liability for the audit year under Code §3509, with the employer agreeing to reclassify the workers as employees on a prospective basis, ensuring future compliance.

In the event of a re-characterization of workers as employees from independent contractors under CSP or otherwise, if the employer agrees to the re-characterization with either the Examination Division or the Appellate Division of the IRS (following a timely Protest), and the additional FICA tax is paid in full before the date the current Form 941 would be due for the quarter within which there is an agreement with the IRS as to the re-characterization, no interest will be due on the additional liability arising as a result of the re-characterization.^[xvi] Code Section 6205 allows employers to make adjustments to returns without interest until the last day for filing the return for the quarter in which the error was ascertained. Revenue Ruling 75-464 clarifies that employers can still make interest-free adjustments where the underpayment is discovered during an audit or examination – the employment taxes can be paid free of interest if paid when the employer signs an “Agreement to Adjustment and Collection of Additional Tax”, Form 2504.

Voluntary Classification Settlement Program (VCSP). The VCSP is available for taxpayers who want to voluntarily change the prospective classification of their workers. The program applies to taxpayers who are currently treating their workers (or a class or group of workers) as independent contractors or other nonemployees and want to prospectively treat the workers as employees.

(1). Eligibility. A taxpayer must have consistently treated the workers as nonemployees, and must have filed all required Forms 1099 for the workers to be reclassified under the VCSP for the previous three years to participate in VCSP. Additionally, the taxpayer cannot currently be under audit by the IRS and the taxpayer cannot be currently under audit concerning the classification of the workers by the Department of Labor or by a state government agency.

If the IRS or the Department of Labor has previously audited a taxpayer concerning the classification of the workers, the taxpayer will be eligible only if the taxpayer has complied with the results of that audit. Exempt organizations and Government entities may participate in VCSP if they meet all of the eligibility requirements. An exempt organization that is currently under a Form 990 series examination is considered to be “under audit by the IRS” and is not eligible to participate in the VCSP.^[xvii]

(2). VCSP Agreement. A taxpayer participating in the VCSP must agree to prospectively treat the class or classes of workers as employees for future tax periods. In exchange, the taxpayer will pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Code §3509(a)^[xviii]; will not be liable for any interest and penalties on the amount; and will not be subject to an employment tax audit with respect to the worker classification of the workers being reclassified under the VCSP for prior years. In addition, as part of the VCSP program, taxpayer will agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

(3). Applying for VCSP. To participate in the VCSP, a taxpayer must apply using Form 8952, Application for Voluntary Classification Settlement Program. the IRS will review the application and verify the taxpayers eligibility. Once the IRS accepts the taxpayer into VCSP, the IRS will contact the taxpayer (or the taxpayers authorized representative if an executed Power of Attorney is included with the application) to enter into the VCSP closing agreement with the IRS. The application should be filed at least 60 days from the date the taxpayer wants to begin treating its workers as employees. Taxpayers who want to begin treating a class or classes of workers as employees for the fourth quarter of 2011 should file Form 8952 as soon as possible. Along with the application, the taxpayer should provide the name of a contact or an authorized representative with a valid Power of Attorney (Form 2848). The IRS will contact the taxpayer or authorized representative to complete the process after reviewing the application and verifying the taxpayer’s eligibility. Eligible taxpayers accepted into the VCSP will enter into a closing agreement with the IRS to finalize the terms of the VCSP, and will simultaneously make full and complete payment of any amount due under the closing agreement.

(4). Prospective Reclassification of Workers. The VCSP permits taxpayers to reclassify some or all of their workers. However, once a taxpayer chooses to reclassify certain of its workers as employees, all workers in the same class must be treated as employees for employment tax purposes. The VSCP Frequently Asked Questions (FAQs) provide the following example: ABC Company is a construction firm that currently contracts with its drywall installers, electricians and plumbers to perform services at housing construction sites. ABC Company determines it wants to voluntarily reclassify its drywall installers as employees. ABC Company submits an application, is accepted into the VCSP and enters into a closing agreement with the IRS. Once the VCSP closing agreement is executed, ABC Company must treat all drywall installers as employees for employment tax purposes.^[xix]

(5). VSCP Amount. Payment need not be submitted with Form 8952 but will be required when the VSCP signed closing agreement is returned to the IRS.^[xx] Payment under the VCSP is 10% of the amount of employment taxes calculated under the reduced rates of section 3509(a) of the Internal Revenue Code for the compensation paid for the most recent tax year to the workers being reclassified under the VCSP. Under section 3509(a), the effective tax rate for compensation up to the Social Security wage base is 10.68% in 2010 or 10.28% in 2011, and 3.24% for compensation above the Social Security wage base.

The amount due under the VCSP is calculated based on compensation paid in the most recently closed tax year, determined at the time the VCSP application is being filed. Accordingly, the 10.68% effective rate applies under the VCSP in 2011 since the most recently closed tax year is 2010. The 10.28% effective rate applies under the VCSP in 2012 since the most recently closed tax year is 2011. The rate of 3.24% applies to compensation above the Social Security wage base in both situations. These effective rates constitute the sum of the rates as calculated under Code §3509(a).

The VSCP FAQs provide the following payment examples^[xxi]:

Example: In 2010 you paid $1,500,000 to workers that are the subject of the VCSP. All of the workers that are the subject of the VCSP were compensated at or below the Social Security wage base (e.g., under $106,800 for 2010). You submit the VCSP application on October 1, 2011 and you want the beginning date of the quarter for which you want to treat the class or classes of workers as employees to be 1/01/2012. You look to amounts paid to the workers in 2010 for purposes of calculating the VCSP amount, since 2010 is the most recently completed tax year at the time the application is being filed. Under section 3509(a), the employment taxes applicable to $1,500,000 would be $160,200 (10.68% of $1,500,000). Under the VCSP, your payment would be 10% of $160,200, or $16,020.

Example: The facts are the same as in the example above, except that some of the workers that are the subject of the VCSP were compensated above the Social Security wage base in the amount of $250,000. Under section 3509(a), the employment taxes applicable to $1,250,000 would be $133,500 (10.68% of $1,250,000) and the employment taxes applicable to the other $250,000 would be $8,100 (3.24% of $250,000). Under the VCSP, your payment would be 10% of $141,600 ($133,500 plus $8,100), or $14,160.

Summary. In our recessionary economy, the IRS is to be commended for launching the VSCP! Questionable treatment of workers as independent contractors can, following an IRS examination reclassifying the workers as employees, render many businesses insolvent. The VSCP will save many businesses by getting the past cleared up (without interest) in exchange for treating such workers as employees going forward. Any business utilizing independent contractors should strongly consider participating on the VSCP.

20 FACTORS RE EMPLOYMENT STATUS – Rev. Rul. 87-41, 1987-1 C.B. 296 (Providing Guidance with Respect to Section 530 of the Revenue Act of 1978).

Over the years courts have identified on a case-by-case basis various facts or factors that are relevant in determining whether an employer-employee relationship exists. In Rev. Rul. 87-41, the IRS developed a list of 20 factors that may be examined in determining whether an employer-employee relationship exists. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed; factors other than the listed 20 factors may also be relevant. The 20 factors identified by the IRS in Rev. Rul. 87-41 are as follows:

1. Instructions. A worker who is required to comply with other persons’ instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the right to require compliance with instructions. See, for example, Rev. Rul. 68-598, 1968-2 C.B. 464, and Rev. Rul. 66-381, 1966-2 C.B. 449.

2. Training. Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner. See Rev. Rul. 70-630, 1970-2 C.B. 229.

3. Integration. Integration of the worker’s services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a business depends to an appreciable degree upon the performance of certain services, the workers who perform those services must necessarily be subject to a certain amount of control by the owner of the business. See United States v. Silk, 331 U.S. 704, 91 L. Ed. 1757, 67 S. Ct. 1463, 1947-2 C.B. 167 (1947), 1947-2 C.B. 167.

4. Services Rendered Personally. If the services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results. See Rev. Rul. 55-695, 1955-2 C.B. 410.

5. Hiring, Supervising, and Paying Assistants. If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status. Compare Rev. Rul. 63-115, 1963-1 C.B. 178, with Rev. Rul. 55-593, 1955-2 C.B. 610.

6. Continuing Relationship. A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals. See United States v. Silk.

7. Set Hours of Work. The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control. See Rev. Rul. 73?591, 1973-2 C.B. 337.

8. Full Time Required. If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the amount of time the worker spends working and impliedly restrict the worker from doing other gainful work. An independent contractor, on the other hand, is free to work when and for whom he or she chooses. See Rev. Rul. 56-694, 1956-2 C.B. 694.

9. Doing Work on Employer’s Premises. If the work is performed on the premises of the person or persons for whom the services are performed, that factor suggests control over the worker, especially if the work could be done elsewhere. Rev. Rul. 56-660, 1956-2 C.B. 693. Work done off the premises of the person or persons receiving the services, such as at the office of the worker, indicates some freedom from control. However, this fact by itself does not mean that the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the employer’s premises. Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required. See Rev. Rul. 56-694.

10. Order or Sequence Set. If a worker must perform services in the order or sequence set by the person or persons for whom the services are performed, that factor shows that the worker is not free to follow the worker’s own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set the order infrequently. It is sufficient to show control, however, if such person or persons retain the right to do so. See Rev. Rul. 56-694.

11. Oral or Written Reports. A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control. See Rev. Rul. 70-309, 1970-1 C.B. 199, and Rev. Rul. 68-248, 1968-1 C.B. 431.

12. Payment by Hour, Week, Month. Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission generally indicates that the worker is an independent contractor. See Rev. Rul. 74-389, 1974-2 C.B. 330.

13. Payment of Business and/or Traveling Expenses. If the person or persons for whom the services are performed ordinarily pay the worker’s business and/or traveling expenses, the worker is ordinarily an employee. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker’s business activities. See Rev. Rul. 55-144, 1955-1 C.B. 483.

14. Furnishing of Tools and Materials. The fact that the person or persons for whom the services are performed furnish significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship. See Rev. Rul. 71-524, 1971-2 C.B. 346.

15. Significant Investment. If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on the person or persons for whom the services are performed for such facilities and, accordingly, the existence of an employer-employee relationship. See Rev. Rul. 71-524. Special scrutiny is required with respect to certain types of facilities, such as home offices.

16. Realization of Profit or Loss. A worker who can realize a profit or suffer a loss as a result of the worker’s services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee. See Rev. Rul. 70-309. For example, if the worker is subject to a real risk of economic loss due to significant investments or a bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risk to support treatment as an independent contractor.

17. Working for More Than One Firm at a Time. If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. See Rev. Rul. 70-572, 1970-2 C.B. 221. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.

18. Making Service Available to General Public. The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship. See Rev. Rul. 56-660.

19. Right to Discharge. The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right is an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer’s instructions. An independent contractor, on the other hand, cannot be fired so long as the independent contractor produces a result that meets the contract specifications. Rev. Rul. 75-41, 1975-1 C.B. 323.

20. Right to Terminate. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship. See Rev. Rul. 70-309.

315593.1

[i]. IR-2011-95 (September 21, 2011) and Announcement 2011-64

[ii]. Rev. Rul. 87-41, 1987-1 C.B. 296

[iii]. See Department of the Treasury, Internal Revenue Service, Independent Contractor or Employee? Training Materials, Training 3320-102 (10-96) TPDS 84238I, at 2-7, which is publicly available through the IRS website.

[iv]. 26 U.S.C. § 3121(d)

[v]. Treasury Regulation §31.3121(d)-1(c)(2).

[vi]. 26 U.S.C. §§3121(d)(1) and (2).

[vii]. 26 U.S.C. §3121(d)(3).

[viii]. 26 USC §3508.

[ix]. Section 530 (a) of the 1978 Act, as amended by Section 269(c) of the Tax Equity and Fiscal Responsibility Act of 1982, 1982-2 C.E. 462, 536. See also Internal Revenue Manual 4.23.5.2

[x]. 26 U.S.C. §§3101-3128 (FICA), 3201-3241 (the Railroad Retirement Tax Act), 3301-3311 (FUTA), and 3401-3404 (income tax withholding). 26 U.S.C. §§ 3501-3510 provide additional rules.

[xi]. 26 U.S.C. §§6011 and 6051.

[xii]. Treas. Reg. §§31.3121(d)-1(c)(1), 31.3306(i)-1(a), and 31.3401(c)-1.

[xiii]. Internal Revenue Manual 4.23.6 (10-30-2009)

[xiv]. 26 U.S.C. § 7436 provides the Tax Court with jurisdiction to review determinations by the IRS that workers are employees for purposes of subtitle C of the Code, or that the organization for which services are performed is not entitled to relief from employment taxes under Section 530 – the determination must involve an actual controversy and be made as part of an examination

[xv]. Internal Revenue Manual 4.23.6.1 (10-30-2009)

[xvi]. See Revenue Ruling 75-464 and IRC § 6205.

[xvii]. See CSP FAQ 7 at irs.gov

[xviii]. See CSP FAQ 16 at irs.gov, for information on how payment under the VCSP is calculated. Also see Instructions to Form 8952.

[xix]. See CSP FAQ 2 at irs.gov

[xx]. See CSP FAQs 12 and 16 at irs.gov.

[xxi]. See CSP FAQ 16 at irs.gov.

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Posted in Uncategorized | Tags: common law employee, employee, employment tax, FICA, FUTA, independent contractor, irs, sec 530, Section 530, tax dispute, tax enforcement, tax penalty, VCSP, Voluntary Classification Settlement Program, worker, worker classification

Posted by: Taxlitigator | January 11, 2012

NEW 2012 IRS FBAR Voluntary Disclosure Initiative

For years, the IRS has been pursuing – with mixed success – the disclosure of information regarding undeclared interests of U.S. taxpayers (or those who ought to be U.S. taxpayers) in foreign financial accounts. On January 9, 2012, the IRS announced yet another offshore voluntary disclosure program (the 2012 OVDI) following on the success of the 2009 Offshore Voluntary Disclosure Program (the 2009 OVDP) and the 2011 Offshore Voluntary Disclosure Initiative (the 2011 OVDI), which were announced many years after the 2003 Offshore Voluntary Compliance Initiative (OVCI) and the 2003 Offshore Credit Card Program (OCCP). Such initiatives typically offer reduced penalties in exchange for taxpayers voluntarily coming into compliance before the IRS is aware of their prior tax indiscretions. In part, the success of such initiatives often depends on the perception that they will be followed by strong government tax enforcement efforts.

The 2012 OVDI is patterned after the 2011 OVDI but increases the maximum “FBAR-related” penalty from 25% to 27.5% of the highest account value at any time between 2003 and 2010. The 2012 OVDI does not have a stated expiration date but can be terminated by the IRS at any time as to specific classes of taxpayers or as to all taxpayers. In all, the IRS has seen 33,000 voluntary disclosures from the 2009 and 2011 offshore initiatives. Since the 2011 program closed last September, hundreds of taxpayers have come forward to make voluntary disclosures. Those who have come in since the 2011 program closed last year will be able to be treated under the provisions of the new OVDP program. Participants must file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties.

The IRS recognizes that its success in offshore enforcement and in the disclosure programs has raised awareness related to tax filing obligations. This includes awareness by dual citizens and others who may be delinquent in filing, but owe no U.S. tax. The IRS is currently developing procedures by which these taxpayers may come into compliance with U.S. tax law. More details will be available within the next month on IRS.gov. In addition, the IRS will be updating key Frequently Asked Questions (FAQs) and providing additional specifics on the offshore program.

Previous Offshore Initiatives. In 2003, following significant publicity regarding the use of foreign accounts and credit card arrangements by U.S taxpayers, the IRS offered significant penalty relief for taxpayers participating in the OVCI which coincided with strong tax enforcement efforts under the OCCP. Eligible OVCI taxpayers were required to file amended or delinquent returns for three tax years (1999-2001) but could choose to bring tax years 1996-1998 into the OVCI (and would not be examined for any earlier years). Approximately 1,321 taxpayers from 48 countries participated in the OVCI identifying approximately 400 offshore promoters. The IRS agreed to not assert any 75% civil fraud penalties and the Financial Crimes Enforcement Network (FinCEN) agreed to not assert any civil penalties for the failure to timely file a Report of Foreign Bank and Financial Accounts (FBAR).

Under the Bank Secrecy Act, U.S. residents or a person in and doing business in the United States must file a report with the government if they have a financial account in a foreign country with a value exceeding $10,000 at any time during the calendar year. Taxpayers comply with this law by noting the account on their income tax return and by filing Form 90-22.1, the FBAR. Willfully failing to file an FBAR can be subject to both criminal sanctions (i.e., imprisonment) and civil penalties equivalent to the greater of $100,000 or 50% of the balance in an unreported foreign account— for each year since 2004 for which an FBAR wasn’t filed.

The 2009 OVDP brought in at least 14,700 U.S. taxpayers (disclosing accounts in more than 60 countries) through the front door of IRS Criminal Investigation and untold thousands through a process of quietly amending returns and filing delinquent FBARs with the government. For eligible taxpayers who ventured through the front door, the OVDP provided the certainty of no criminal prosecution and civil penalty relief – they were required to pay back-taxes from 2003 to 2008, interest and a 20-25% penalty on the delinquent taxes. The IRS also imposed a 20% “FBAR-related” penalty equal to the highest aggregate value of the financial account between 2003 and 2008. In limited situations, the FBAR-related penalty could be reduced to 5% of the account value or $10,000 per tax year.

The 2011 OVDI, brought in an additional 12,000 eligible taxpayers who filed original and amended tax returns and agreed to make payments (or good faith arrangements to pay) for taxes, interest and accuracy-related penalties. The 2011 OVDI FBAR-related penalty framework required a 25% “FBAR-related” penalty equal to the highest value of the financial account between 2003 and 2010. Only one 25 percent offshore penalty is to be applied with respect to voluntary disclosures relating to the same financial account. The penalty may be allocated among the taxpayers with beneficial ownership making the voluntary disclosures in any way they choose. Potentially applicable penalties are identified in a series of Frequently Asked Questions available at irs.gov. Participants in the 2011 OVDI also had to pay back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties. Subject to certain limitations, financial transactions occurring before 2003 were generally irrelevant for those participating in the OVDI.

Under the 2011 OVDI, taxpayers who are foreign residents and who were unaware they were U.S. citizens may qualify for a reduced 5% FBAR-related penalty (FAQ 52). Others qualified for the 5% penalty if they: (a) did not open or cause the account to be opened (unless the bank required that a new account be opened, rather than allowing a change in ownership of an existing account, upon the death of the owner of the account); (b) have exercised minimal, infrequent contact with the account, for example, to request the account balance, or update account-holder information such as a change in address, contact person, or email address; (c) have, except for a withdrawal closing the account and transferring the funds to an account in the United States not withdrawn more than $1,000 from the account in any year covered by the voluntary disclosure; and (d) can establish that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation). For funds deposited before January 1, 1991, if no information is available to establish whether such funds were appropriately taxed, it is presumed that they were.

Taxpayers whose highest aggregate account balance (including the fair market value of assets in undisclosed offshore entities and the fair market value of any foreign assets that were either acquired with improperly untaxed funds or produced improperly untaxed income) in each of the years covered by the 2011 OVDI is less than $75,000 qualified for a 12.5% FBAR-related penalty (FAQ 53). IRS examiners have no authority to negotiate a different FBAR-related penalty.

FBARs for 2011 are due on June 30, 2012, without extension. Taxpayers who reported and paid tax on all their taxable income but did not file FBARs, should not participate in the 2012 OVDI but should merely file the delinquent FBARs with the Department of Treasury, Post Office Box 32621, Detroit, MI 48232-0621 (and attach a statement explaining why the reports are filed late). Under the 2011 OVDI, the IRS agreed not to impose a penalty for the failure to file the delinquent FBARs if there were no underreported tax liabilities and the FBARs were filed by August 31, 2010 (FAQ 17). Presumedly, the IRS will follow the same course under the 2012 OVDI since those with no underreported tax liabilities are not truly within the range of taxpayers the IRS is trying to identify.

Under the 2011 OVDI, taxpayers were not to be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes (FAQ 50). A similar provision in the 2009 OVDP has caused considerable frustration among taxpayers and their representatives. The understanding of potentially applicable penalties may differ greatly in the eyes of a taxpayer as compared to an examiner. Anyone considering an offshore voluntary disclosure submission must carefully examine all potential civil penalties and evaluate the risk of criminal prosecution.

Considerations re Coming into Compliance. There are many considerations before a taxpayer should determine whether to pursue a voluntary disclosure of prior tax indiscretions. When reviewing the OVDP and the OVDI, many made decisions based on whether they could be considered a realistic candidate for a criminal prosecution referral by the IRS or prosecution by the Department of Justice? (If so, the determination to participate was relatively quick and easy). Was there a possibility of reducing that prospect by filing amended or delinquent returns and FBARs in lieu of a direct participation in the OVDP/OVDI? What would be the potentially applicable penalties upon a examination of such returns and FBARs? Could the government actually carry their burden of demonstrating that the taxpayer “willfully” violated the FBAR filing requirements? Since the OVDI asserted an offshore penalty based on foreign financial accounts and asset valuations, for many with smaller financial account values the aggregate offshore penalty determination, even for multiple years, was actually less outside the OVDI.

Information Flowing Into the United States. The ability of a U.S. taxpayer to maintain an undisclosed, “secret” foreign financial account is fast becoming nonexistent. Foreign account information is flowing into the IRS under tax treaties, through submissions by whistleblowers, from others who participated in the 2009 OVDP and the 2011 OVDI who have been required to identify their bankers and advisors. Additional information will become available as the Foreign Account Tax Compliance Act (FATCA) and Foreign Financial Asset Reporting (Form 8938 and new IRC § 6038D) become effective.

There are rumors regarding ongoing “John Doe” summons activity seeking to force foreign financial institutions to deliver account-holder information to the U.S. government as well as possible indictments of foreign financial institutions. Recently, several foreign institutions have advised their account holders to consult U.S. tax advisors regarding the IRS voluntary disclosure program and their U.S. tax reporting relating to their foreign financial accounts. It is reasonable to assume that such institutions will take whatever action is necessary to avoid being indicted, beginning with the delivery of information regarding account holders to the U.S. government.

It is likely that the U.S. will require foreign financial institutions doing business in the United States to disclose account holders having relatively small accounts and earnings. There have been rumors of discussions regarding accounts having a high balance of the equivalent of $50,000 at any time between 2002 and 2010. U.S. persons having interests in foreign financial accounts should not find comfort in a belief that their foreign financial institution will somehow refrain from disclosing very small accounts in the current enforcement environment. Those who think too long may be sorely surprised at the high level of ultimate cooperation of their institution with the U.S. government.

Waiting is NOT a Viable Option. Taxpayers having undisclosed interests in foreign financial accounts must consult competent tax professionals before deciding to participate in the 2012 OVDI. Others may decide to risk detection by the IRS and the imposition of substantial penalties, including the civil fraud penalty, numerous foreign information return penalties, and the potential risk of criminal prosecution. Although the 2012 OVDI penalty regime may seem overly harsh for many, the decision to participate should include an economic analysis of the taxpayers projected future earning power that could be generated from the funds held offshore. Participating taxpayers may well benefit by repatriating foreign funds with limited earning potential into a depressed U.S. economy with a suffering real estate market and business opportunities lurking behind every corner. “Cash is king” and the IRS has provided yet another opportunity for formerly non-compliant taxpayers to improve their future U.S. investment and business opportunities.

If a taxpayer is discovered before any voluntary disclosure submission, the results can be devastating. Waiting is simply not a viable option . . .

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Posted in Uncategorized | Tags: compliance, FBAR, foreign account, fraud, offfshore voluntary disclosure, OVDI, OVDP, tax, tax fraud, tax penalty

Posted by: Taxlitigator | June 18, 2011

Making a Voluntary Disclosure Under the 2011 OVDI

How to Make a Voluntary Disclosure Under the 2011 OVDI

The 2011 Offshore Voluntary Disclosure Initiative (OVDI) is offered to those taxpayers having interests in previously undisclosed interests in offshore financial accounts or assets. Frequently Asked Questions (FAQs) are available at http://www.irs.gov/businesses/international/article/0,,id=235699,00.html

Pre-Clearance:

Taxpayers or representatives may fax to the IRS Criminal Investigation Lead Development Center at (215) 861-3050 the taxpayers’ name, date of birth, social security number and address (if the taxpayer is represented by a tax professional, an executed power of attorney must be included).

IRS Criminal Investigation will then notify taxpayers or their representatives via fax whether or not they have been cleared to make a voluntary disclosure using the Offshore Voluntary Disclosures Letter. Taxpayers or representatives with questions regarding the pre-clearance can call (215) 861-3759 or contact their nearest Criminal Investigation Office.

Note: Pre-clearance does not guarantee a taxpayer acceptance into the 2011 OVDI. Taxpayers must truthfully, timely, and completely comply with all provisions of the 2011 Offshore Voluntary Disclosures Initiative.

Offshore Voluntary Disclosure Letter

If the taxpayer chooses to submit a pre-clearance request, after the taxpayer receives a pre-clearance notification, the taxpayer will have 30 days from receipt of the fax notification to complete the Offshore Voluntary Disclosures Letter (available at http://www.irs.gov/pub/irs-utl/2011-ovdi-irs-ci-letter-01-31-2011.doc ). If the taxpayer chooses to bypass the pre-clearance process, the taxpayer must mail the Offshore Voluntary Disclosures Letter to the following address:

Internal Revenue Service

Criminal Investigation

ATTN: Offshore Voluntary Disclosure Coordinator

Philadelphia Lead Development Center

600 Arch Street, Room 6406

Philadelphia, PA 19106

The IRS will review the offshore Voluntary Disclosures Letters and notify the taxpayer or representative by mail whether the voluntary disclosure has been preliminarily accepted or declined.

Complete Voluntary Disclosure Package

Once the voluntary disclosure has been preliminarily accepted, the taxpayer should send the full voluntary disclosure package no later than August 31, 2011 to:

Internal Revenue Service

3651 S. I H 35 Stop 4301 AUSC

Austin, TX 78741

ATTN: 2011 Offshore Voluntary Disclosure Initiative

Information regarding the complete OVDI package submission requirements is available at http://www.irs.gov/businesses/international/article/0,,id=235690,00.html

Opt Out Procedure

Taxpayers may request to opt out of the civil settlement structure of the 2009 Offshore Voluntary Disclosure Program or 2011 Offshore Voluntary Disclosure Initiative. For specific information on the opt out process, see questions 51.1 through 51.3 under the 2011 OVDI Frequently Asked Questions and Answers.

Taxpayers wishing to make a domestic voluntary disclosure that is not covered under the OVDI should contact their local IRS Criminal Investigation (CI) office to speak with a criminal investigator.

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Posted in Uncategorized | Tags: criminal tax, FBAR, irs, irs audit, offshore, OVDI, tax dispute, tax enforcement, tax evasion, tax fraud, tax penalty, voluntary disclosure

Posted by: Taxlitigator | June 18, 2011

Tax Penalty Relief – Reliance on Tax Advisor

The Internal Revenue Manual (IRM) contains a Penalty Handbook intended to serve as the foundation for addressing the administration of penalties by the IRS. It is the “one source of authority for the administration of penalties. . .”( Internal Revenue Manual (IRM) 20.1.1.1.1 (02-22-2008). Refer to IRM 9.1.3, Criminal Investigation – Criminal Statutory Provisions and Common Law, for Criminal Penalty provisions.) and provides a “fair, consistent, and comprehensive approach to penalty administration.” As such, the IRM is often the first stop for IRS examiners attempting to determine whether conduct should be subjected to further review and, potentially, civil penalties.

IRM Approach to Penalty Administration. The IRM’s approach to penalty administration provides:

Consistency: The IRS should apply penalties equally in similar situations. Taxpayers base their perceptions about the fairness of the system on their own experience and the information they receive from the media and others. If the IRS does not administer penalties uniformly (guided by the applicable statutes, regulations, and procedures), overall confidence in the tax system is jeopardized.

Accuracy: The IRS must arrive at the correct penalty decision. Accuracy is essential. Erroneous penalty assessments and incorrect calculations confuse taxpayers and misrepresent the overall competency of the IRS.

Impartiality: IRS employees are responsible for administering the penalty statutes and regulations in an even-handed manner that is fair and impartial to both the government and the taxpayer.

Representation: Taxpayers must be given the opportunity to have their interests heard and considered. Employees need to take an active and objective role in case resolution so that all factors are considered.

Relief Due to Reasonable Cause. Many penalties may be avoided based upon a determination that reasonable cause existed for the positions maintained within a return. Reasonable cause is based on a review of all relevant facts and circumstances in each situation and allows the IRS to provide relief from a penalty that would otherwise be assessed. Reasonable cause relief is generally granted when the taxpayer exercises ordinary business care and prudence in determining their tax obligations but nevertheless failed to comply with those obligations. Ordinary business care and prudence includes making provisions for business obligations to be met when reasonably foreseeable events occur. A taxpayer may establish reasonable cause by providing facts and circumstances showing that they exercised ordinary business care and prudence (taking that degree of care that a reasonably prudent person would exercise), but nevertheless were unable to comply with the law.

Taxpayers have reasonable cause when their conduct justifies the non-assertion or abatement of a penalty. Each case must be judged individually based on the relevant facts and circumstances. Examiners are to consider various factors in determining penalty relief based on reasonable cause. What happened and when did it happen? During the period of time the taxpayer was non-compliant, what facts and circumstances prevented the taxpayer from filing a return, paying a tax, and/or otherwise complying with the law? How did the facts and circumstances result in the taxpayer not complying? How did the taxpayer handle the remainder of their affairs during this time? Once the facts and circumstances changed, what attempt did the taxpayer make to comply?

Death, serious illness, or unavoidable absence of the taxpayer may establish reasonable cause for filing, paying, or delinquent deposits. Information examiners consider when evaluating a request for penalty relief based on reasonable cause due to death, serious illness, or unavoidable absence includes, but is not limited to, the relationship of the taxpayer to the other parties involved, the date of death, the dates, duration, and severity of illness, the dates and reasons for absence, how the event prevented compliance, if other business obligations were impaired, and if tax duties were attended to promptly when the illness passed, or within a reasonable period of time after a death or return from an unavoidable absence.

Explanations relating to the inability to obtain the necessary records may constitute reasonable cause in some instances, but may not in others. Reasonable cause may be established if the taxpayer exercised ordinary business care and prudence, but due to circumstances beyond the taxpayer’s control, they were unable to comply. Relevant information includes, but is not limited to, an explanation as to why the records were needed to comply, why the records were unavailable and what steps were taken to secure the records, when and how the taxpayer became aware that they did not have the necessary records, if other means were explored to secure needed information, why the taxpayer did not estimate the information, if the taxpayer contacted the IRS for instructions on what to do about missing information, if the taxpayer promptly complied once the missing information was received, and supporting documentation such as copies of letters written and responses received in an effort to get the needed information.

In United States v. Boyle, 469 U.S. 241 (1984), Supreme Court Justice Berger stated “When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a ‘second opinion’ or to try to monitor counsel on the provision of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. [Citations omitted.] ‘Ordinary business care and prudence’ do not demand such actions.”

In Henry v. Commissioner, 170 F.2d 1217 (9th Cir. 1999), the Internal Revenue Service asserted a negligence penalty on the theory that it was unreasonable for the taxpayer to rely on their tax accountant based on the taxpayer’s perceived sophistication and the taxpayer’s failure to fully disclose relevant information to their accountant. In reversing the Tax Court on the issue of negligence penalties, the Ninth Circuit succinctly stated: “.　.　.　the Petitioners consulted their long-time accountant and we find they were reasonable in relying on his preparation of their tax returns.” Id. at 1221.

Still further, “.　.　. Knowing there is a risk in filing a tax return such that there may be an audit which could result in an income tax deficiency determination, however, does not provide evidence that the taxpayer knew or should have known of the Tax Regulation and unreasonably disregarded it. Similarly, we could say that all of life is a risk, but certainly one is not negligent for going ahead and living it.” Id. at 1222.

Finally, “.　.　. In conclusion, we find that Petitioners’ reliance on their experienced and long-time accountants’ tax treatment .　.　. was reasonable. Id. at 1223.

First Time Penalty Abatement. The IRS Reasonable Cause Assistant (RCA) is a decision-support interactive software program developed to reach a reasonable cause determination [IRM 20.1.1.3.6.1 (12-11-2009)]. The RCA will be used when considering penalty relief due to reasonable cause. RCA is to be used after normal case research has been performed, (i.e., applying missing deposits/payments, adjusting tax, or researching for missing extensions of time to file, etc.) for the Failure to File (FTF), Failure to Pay (FTP), and Failure to Deposit (FTD) penalties.

RCA provides an option for penalty relief for the FTF, FTP, and/or FTD penalties if the taxpayer has not previously been required to file a return or if no prior penalties (except the Estimated Tax Penalty) have been assessed on the same account in the prior 3 years. If RCA determines a “First -Time Abate” is applicable, the taxpayer will be advised that the penalty(s) was removed based solely on their history of compliance, that this type of penalty removal is a one-time consideration available only for a first-time penalty charge, and that any future (FTF, FTP, FTD) penalties will only be removed based on information that meets reasonable cause criteria.

Summary. Obtaining relief from civil tax penalties during an IRS examination is anything but certain. It is typically preferrable to have a representative objectively summarize the taxpayer’s position for purposes of seeking penalty relief. The Internal Revenue Manual (available at irs.gov by searching “IRM”) provides helpful guidance on seeking an abatement of penalties. Ultimately, penalty relief is often determined by what the taxpayer (and their advisor) did or did not do with respect to the tax-related issues involved.

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Posted in Uncategorized | Tags: abate, abatement, irs, irs audit, penalty, tax penalty

Posted by: Taxlitigator | September 10, 2010

Current IRS Enforcement Priorities

Current IRS Enforcement Priorities. The international arena will continue to test the enforcement resources of the IRS for years to come. There will be ongoing, enhanced coordination with treaty partners and international organizations (six of nine LMSB Tier 1 issues involve international components and LMSB Counsel lawyers have been trained in the fundamentals of international taxation). IRS is attempting to develop a protocol to conduct joint audits with treaty partners, ensuring that the taxpayer provides the same information to both tax authorities, reducing opportunities for arbitrage. In a joint audit conducted with a foreign tax authority, the corporate taxpayer will not need to go through a similar exercise twice but will not be able to gain an advantage between the otherwise competing jurisdictions.

Issues regarding undeclared foreign source earnings and financial accounts (Form TD F 90-22.1 Report of Foreign Bank and Financial Accounts – commonly known as an 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 [see Internal Revenue Manual (IRM) 9.5.11.9 (06-26-2009)] 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 accounts that have not previously been disclosed should immediately consult competent counsel. They likely remain eligible for the benefits of the longstanding IRS voluntary disclosure program mitigating the possibility of a future criminal prosecution. The IRS is expected to at least temporarily continue its current procedures for a criminal pre-clearance and for disclosures made according to the “three-page letter”. However, it is difficult to determine the potential administrative resolution of civil penalties for those who did not participate in the framework set forth in the Penalty Memos. Undeclared foreign 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 the potential abuse of mortgage interest limitations by claiming deductions exceeding limitations in multiple years; Section 1031 like-kind exchanges including the abuse and possible back-dating of documents intended to circumvent the 45-Day Rule, whether the exchange properties are truly “like-kind”, and whether the exchange property is held for the proper purpose; real estate dispositions where the taxpayer is unable to adequately support the amount realized and the adjusted basis or fails to appropriately provide for the recapture of items when a negative capital account exists; employment tax and worker classifications where the IRS is conducting 6,000 employment tax examinations focused on worker classification issues – independent contractor vs employee status- together with issues regarding executive compensation and fringe benefits; S-corporation examinations with an emphasis on determining the built-in-gains tax focusing on asset valuations for the C-corp assets on conversion to S-corp status together with compensation for S-corporation officers; examinations involving sales of partnership interests will attempt to assure that reported interests match the actual ownership interests reflected in the partnership agreements, that income is properly recognized on distributions of installment notes, and that debt cancellation, general income & expense items reported on partners’ returns – including proper reporting from K-1s, is correctly reported.

Additional examination issues include NOL carryforwards (taxpayers should be prepared to fully document losses incurred in the recessionary economy of 2008-2009); examinations of estate and gift tax returns will continue to focus on valuations and discounts associated with closely-held entities and properties, fractional interests, sales that occur close to death, under-funded marital trusts and over-funded bypass trusts upon the death of the surviving spouse. For matters involving tax exempt organizations, the changes between the historical and the recently revised Form 990 provide a roadmap of issues deemed important to the government, including executive compensation for senior management and key employees, conflicts of interest and – an old favorite – abuse of donor-advised funds. Non-filers, Schedule C taxpayers and “cash intensive” businesses provide a target-rich environment for the IRS. Finally, and of significant importance, return preparers & advisors provide a unique opportunity to leverage ongoing IRS compliance efforts that simply won’t be ignored.

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Posted in Uncategorized | Tags: FBAR, irs, tax, tax dispute, tax enforcement, tax evasion, tax fraud

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