Examination

• Author: W. Patrick Cantrell
• Pages: 1-68

1

CHAPTER 1

Examination

IRS Audit Procedures

I. Introduction and Background

A. Background

Anyone who does any significant tax practice inevitably will be

required to deal with the examination personnel of the Internal

Revenue Service (IRS). In the event of an audit, a client justifiably

expects his or her representative to be able to defend positions taken

on tax returns. Thus a certified public accountant (CPA) or lawyer

should be reasonably conversant with the intricacies and pitfalls of

handling a tax audit.

B. Organizational Structure

There are four operating divisions within the IRS that are responsible

for the Examination function. These are as follows:

1. Small Business/Self-Employed (SB/SE)

This division handles the exami nation of 1040s with Schedules C,

E, and F as well as other business returns with assets of less than

$10 million.

2. Large Business and International (LB&I)

This division handles the audits of business return s (1065, 1120,

and 1120S) having assets of more than $10 million. LB&I is orga-

nized into five industry groups:

a. communications, technology, & media,

b. financial services,

c. heavy manufacturing and transportation,

d. natural resources and construction, and

e. retailers, food, pharmaceuticals, and health care.

2 EXAMINATION

3. Tax-Exempt and Governmental Entities (TEGE)

4. Wage and Investment (W&I)

This division handles all other taxpayers; that is, individuals who

have only wage and investment income. W&I does not conduct

field audits. If it is necessary to do a field examination of a W&I

taxpayer, it is done by SB/SE.

C. Initial Screening

In the initial processing of a retur n at regional service centers (now

called “campuses”), returns are manually edited and computer scanned

for math errors, defects in form or execution, and potentially unallow-

able items.1 Returns may be classified as to audit potential according

to various criteria predetermined through National Research Program

(NRP) audits. The NRP is a program designed to provide informa-

tion used in designing the discriminant fu nction (DIF) formulas.2 DIF

is a mathematical technique used to score income tax retur ns as to

examination potential based on NRP-developed data. A DIF formula

is applied to each return, and each is assigned a three-digit DIF score.

The hypothesis is that the higher the score, the greater the potential

for audit deficiency. Corporate returns with balance sheets or assets

over $10 million are not DIF scored.3 The highly sophisticated formulas

developed by the IRS to score tax returns are secret and thus unavail-

able to taxpayers.4

As a subset of the DIF procedures, the IRS has developed a tool

for identifying returns with a high probability of unreported income.

They call it the Unreported Income Discrimina nt Index Formula,

known by its acronym UI DIF.5 All filed return s now receive a UI DIF

score in addition to the traditional DIF score.

D. Selection of Type of Audit

If a DIF score indicates the need for an audit, the IRS first considers the

types of potential issues. If the matter can be satisfactorily resolved by

correspondence, then that will be the method. If not, and only a few

documents need to be inspected, the taxpayer will be asked to bring

them to the office (“office examination”). If several complex issues or

many books are involved, a “field examination” will be made. Typi-

cally, only individuals will be scheduled for office exams. Business

returns (corporations, partnerships, etc.) are always subject to field

exams by revenue agents. The IRS determines whether an examina-

tion should be a field exam or an office exam based on the complexity

of the retur n.6

II. Rules Governing Powers of Attorney

A. During any kind of examination, the taxpayer under audit is

entitled to be represented by a lawyer, CPA, enrolled agent, or other

representative allowed by Circular 230.7 Because of the anti-disclosure

Rules Governing Powers of Attorney 3

laws, the IRS scrupulously observes the rules regarding who is

authorized to receive confidential tax information. Without a properly

executed written authorization, the IRS will not disclose information

to a representative.

B. A power of attorney (POA) need not follow any prescribed form;8

however, the IRS has provided Form 2848 for this purpose.9 It should

be prepared with great care; otherwise, it will be rejected. At a

minimum, it must contain the following:10

1. The taxpayer’s complete name;

2. The taxpayer’s identifying number (employee identification

number [EIN] or Social Security number [SSN]);

3. The representative’s

a. name,

b. address,

c. telephone number,

d. fax number, and

e. Central Authorization File (CAF) number (optional according

to the regulations);11

4. The exact years or periods;12 e.g.,

a. 0903 (i.e., for quarter ended 3-31-2009),

b. 2010, or

c. year ended 12-31-13;

5. The type of tax (e.g., income, estate, or employment) or civil

penalty;

6. The form number (e.g., 1040, 1120, 5500, 941, or SS-8); and

7. The declaration of authority (on the back of Form 2848).

Be careful that the client signs the POA after the representative

does so; otherwise, it may be rejected for having an invalid date.

C. Bypassing the Representative

Examination personnel are forbidden from contacting the taxpayer

directly where there is a valid POA on file, unless the representative

has been dilatory or has unreasonably hindered the exami nation, in

which case the revenue agent must request permission from the appro-

priate supervisory personnel.13

D. Multiple Cases

A 2848 (POA) may cover more than one matter; for example, a 1040 and

a 941 (for employment tax issues).14 For business clients, it is generally

advisable to cover “civil penalties” in addition to other types of taxes.

E. Signature of Representative

Form 2848 does not perm it a representative to sign tax returns on

behalf of the client. Nor does it permit the endorsing of checks.15 How-

ever, a taxpayer may modify a POA to authorize his or her representa-

tive to perform these functions.16