The Examination Audit Process

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The Examination Audit Process

 

The Examination (Audit) Process

 

Back Up

The Examination (Audit) Process  

FS-2006-10, January 2006

The IRS examines (audits) tax returns to verify that the tax reported is correct.

Selecting a return for examination does not always suggest that the taxpayer has either made an error or been dishonest. In fact, some examinations result in a refund to the taxpayer or acceptance of the return without change.

The overwhelming majority of taxpayers files returns and make payments timely and accurately. Taxpayers have a right to expect fair and efficient tax administration from the IRS , including verification that taxes are correctly reported and paid with enforcement actions against those who fail to comply voluntarily.

Taxpayer Rights

The IRS trains its employees to explain and protect taxpayers’ rights throughout their contacts with taxpayers. These rights include:

  • A right to professional and courteous treatment by IRS employees.
  • A right to privacy and confidentiality about tax matters.
  • A right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided.
  • A right to representation, by oneself or an authorized representative.
  • A right to appeal disagreements, both within the IRS and before the courts.

How Returns Are Selected for Examination

The IRS selects returns using a variety of methods, including:

  • Potential participants in abusive tax avoidance transactions — Some returns are selected based on information obtained by the IRS through efforts to identify promoters and participants of abusive tax avoidance transactions. Examples include information received from “John Doe” summonses issued to credit card companies and businesses and participant lists from promoters ordered by the courts to be turned over to the IRS .
  • Computer Scoring — Some returns are selected for examination on the basis of computer scoring.  Computer programs give each return numeric “scores”. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income.  IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.
  • Large Corporations — The IRS examines many large corporate returns annually.
  • Information Matching — Some returns are examined because payer reports, such as Forms W-2 from employers or Form 1099 interest statements from banks, do not match the income reported on the tax return.
  • Related Examinations — Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination.
  • Other — Area offices may identify returns for examination in connection with local compliance projects. These projects require higher level management approval and deal with areas such as local compliance initiatives, return preparers or specific market segments.

Examination Methods

An examination may be conducted by mail or through an in-person interview and review of the taxpayer's records. The interview may be at an IRS office (office audit) or at the taxpayer's home, place of business, or accountant's office (field audit). Taxpayers may make audio recordings of interviews, provided they give the IRS advance notice. If the time, place, or method that the IRS schedules is not convenient, the taxpayer may request a change, including a change to another IRS office if the taxpayer has moved or business records are there.

The audit notification letter tells which records will be needed. Taxpayers may act on their own behalf or have someone represent or accompany them. If the taxpayer is not present, the representative must have proper written authorization. The auditor will explain the reason for any proposed changes. Most taxpayers agree to the changes and the audits end at that level.

Appeal Rights

Appeal Rights are explained by the examiner at the beginning of each audit. Taxpayers who do not agree with the proposed changes may appeal by having a supervisory conference with the examiner’s manager or appeal their case administratively within the IRS , to the U.S. Tax Court, U.S. Claims Court or the local U.S. District Court. If there is no agreement at the closing conference with the examiner or the examiner’s manager, the taxpayer has 30 days to consider the proposed adjustments and their next course of action. If the taxpayer does not respond within 30 days, the IRS issues a statutory notice of deficiency, which gives the taxpayer 90 days to file a petition to the Tax Court. The Claims Court and District Court generally do not hear tax cases until after the tax is paid and administrative refund claims have been denied by the IRS . The tax does not have to be paid to appeal within the IRS or to the Tax Court. A case may be further appealed to the U.S. Court of Appeals or to the Supreme Court, if those courts accept the case.

IRS Implements New Limited Issue Focused Examination ( LIFE ) Process

IR-2002-133, Dec. 4, 2002

WASHINGTON – The Internal Revenue Service Large and Mid-Size Business (LMSB) Division is implementing a new streamlined examination process called the Limited Issue Focused Examination, or LIFE.

This initiative will involve a formal agreement, a Memorandum of Understanding (MOU), between the IRS and taxpayer to govern key aspects of the examination. The MOU will contain dollar-limit thresholds, established on a case-by-case basis, below which the IRS will agree not to raise issues and the taxpayer will agree not to file claims. This will create, with the taxpayer’s assistance, an atmosphere where the examination process is less difficult, less time-consuming, less expensive and less contentious for all involved.

Working together, both the IRS and the taxpayer will focus their resources and time on the issues most significant to the return under examination.

" LIFE is a two-way street,” said LMSB Commissioner Larry Langdon. “Making it work will require taxpayers and the IRS to work cooperatively. Many of the resource benefits of this approach to taxpayers and the IRS will flow from taxpayers meeting the commitments they make at the commencement of a focused examination.”

The LIFE process will be available for taxpayers served by LMSB. The division serves taxpayers with assets in excess of $10 million.

This new approach represents a major culture shift for LMSB.  LIFE  is an effort by LMSB to institutionalize best practices and provide consistency in the treatment of taxpayers. Training of IRS personnel is currently underway.

IR-2002-133, Dec. 4, 2002

WASHINGTON – The Internal Revenue Service Large and Mid-Size Business (LMSB) Division is implementing a new streamlined examination process called the Limited Issue Focused Examination, or LIFE.

This initiative will involve a formal agreement, a Memorandum of Understanding (MOU), between the IRS and taxpayer to govern key aspects of the examination. The MOU will contain dollar-limit thresholds, established on a case-by-case basis, below which the IRS will agree not to raise issues and the taxpayer will agree not to file claims. This will create, with the taxpayer’s assistance, an atmosphere where the examination process is less difficult, less time-consuming, less expensive and less contentious for all involved.

Working together, both the IRS and the taxpayer will focus their resources and time on the issues most significant to the return under examination.

" LIFE is a two-way street,” said LMSB Commissioner Larry Langdon. “Making it work will require taxpayers and the IRS to work cooperatively. Many of the resource benefits of this approach to taxpayers and the IRS will flow from taxpayers meeting the commitments they make at the commencement of a focused examination.”

The LIFE process will be available for taxpayers served by LMSB. The division serves taxpayers with assets in excess of $10 million.

This new approach represents a major culture shift for LMSB.  LIFE  is an effort by LMSB to institutionalize best practices and provide consistency in the treatment of taxpayers. Training of IRS personnel is currently underway.

Topic 151 - Your Appeal Rights

The IRS has an appeals system for people who do not agree with the results of an examination of their tax returns or with other adjustments to their tax liability.

If your examination or other adjustment was conducted through a personal interview with an IRS employee, the employee will explain your appeal rights to you. If you disagree with the findings, you may request a meeting with the interviewer's supervisor. If you still do not reach an agreement, or if the examination or other adjustment was conducted through correspondence, the IRS will send you a report and/or letter that explains the proposed adjustments. The letter also tells you of your right to request a conference with an Appeals officer, as well as how to make your request for a conference. If you request an Appeals conference, be prepared to support your position.

In addition to examinations, many other things can be appealed. Among them are certain penalties, including the trust fund recovery penalty, offers–in–compromise, employment tax adjustments, liens, levies, seizures, denials or terminations of installment agreements, collection due process notices, denials of abatement of interest and other claims.

Appeals conferences are informal meetings. Your conference may be face-to-face, or by telephone, or by correspondence. You may represent yourself at an Appeals conference; or, if you want, you may have an attorney, a certified public accountant, or an individual enrolled to practice before the IRS represent you. If you do not reach agreement with the Appeals or Settlement Officer, or you do not wish to appeal within the IRS , you may appeal certain actions through the courts.

Examination of Returns

Your return may be examined for a variety of reasons, and the examination may take place in any one of several ways. After the examination, if any changes to your tax are proposed, you can either agree with those changes and pay any additional tax you may owe, or you can disagree with the changes and appeal the decision.

Examination selection criteria.   Your return may be selected for examination on the basis of computer scoring. A computer program called the Discriminant Inventory Function System (DIF) assigns a numeric score to each individual and some corporate tax returns after they have been processed. If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability.

 

Your return may also be selected for examination on the basis of information received from third-party documentation, such as Forms 1099 and W-2, that does not match the information reported on your return. Or, your return may be selected to address both the questionable treatment of an item and to study the behavior of similar taxpayers (a market segment) in handling a tax issue.

 

 In addition, your return may be selected as a result of information received from other sources on potential noncompliance with the tax laws or inaccurate filing. This information can come from a number of sources, including newspapers, public records, and individuals. The information is evaluated for reliability and accuracy before it is used as the basis of an examination or investigation.

 

Notice of IRS contact of third parties.    The IRS must give you reasonable notice before contacting other persons about your tax matters. You must be given reasonable notice in advance that, in examining or collecting your tax liability, the IRS may contact third parties such as your neighbors, banks, employers, or employees. The IRS must also give you notice of specific contacts by providing you with a record of persons contacted on both a periodic basis and upon your request.

  

This provision does not apply: to any pending criminal investigation; when providing notice would jeopardize collection of any tax liability; where providing notice may result in reprisal against any person, or when you authorized the contact..

If Your Return Is Examined

Some examinations are handled entirely by mail. Examinations not handled by mail can take place in your home, your place of business, an Internal Revenue office, or the office of your attorney, accountant, or enrolled agent. If the time, place, or method is not convenient for you, the examiner will try to work out something more suitable. However, the IRS makes the final determination of when, where, and how the examination will take place.

Throughout the examination, you can act on your own behalf or have someone represent you or accompany you. If you filed a joint return, either you or your spouse, or both, can meet with the IRS . You can have someone represent or accompany you. This person can be any federally authorized practitioner, including an attorney, a certified public accountant, an enrolled agent (a person enrolled to practice before the IRS ), an enrolled actuary, or the person who prepared the return and signed it as the preparer.

If you want someone to represent you in your absence, you must furnish that person with proper written authorization. You can use Form 2848 or any other properly written authorization. If you want to consult with an attorney, a certified public accountant, an enrolled agent, or any other person permitted to represent a taxpayer during an interview for examining a tax return or collecting tax, you should make arrangements with that person to be available for the interview. In most cases, the IRS must suspend the interview and reschedule it. The IRS cannot suspend the interview if you are there because of an administrative summons.

Third party authorization.   If you checked the box in the signature area of your income tax return (Form 1040, Form 1040A, or Form 1040EZ) to allow the IRS to discuss your return with another person (a third party designee), this authorization does not replace Form 2848. The box you checked on your return only authorizes the other person to receive information about the processing of your return and the status of your refund during the period your return is being processed. For more information, see the instructions for your return.

 

Confidentiality privilege.   Confidentiality protection that you have with an attorney.    Confidential communications are those that:: advise you on tax matters within the scope of the practitioner's authority to practice before the IRS ; would be confidential between an attorney and you, and relate to noncriminal tax matters before the IRS , or relate to noncriminal tax proceedings brought in federal court by or against the United States.

 

 In the case of communications in connection with the promotion of a person's participation in a tax shelter, the confidentiality privilege does not apply to written communications between a federally authorized practitioner and that person, any director, officer, employee, agent, or representative of that person, or any other person holding a capital or profits interest in that person.

 

 A tax shelter is any entity, plan, or arrangement, a significant purpose of which is the avoidance or evasion of income tax.

 

Recordings.    You can make an audio recording of the examination interview. Your request to record the interview should be made in writing. You must notify the examiner 10 days in advance and bring your own recording equipment. The IRS also can record an interview. If the IRS initiates the recording, you must be notified 10 days in advance and you can get a copy of the recording at your expense.

 

Transfers to another area.    Generally, your return is examined in the area where you live. But if your return can be examined more quickly and conveniently in another area, such as where your books and records are located, you can ask to have the case transferred to that area.

 

Repeat examinations.    The IRS tries to avoid repeat examinations of the same items, but sometimes this happens. If your tax return was examined for the same items in either of the 2 previous years and no change was proposed to your tax liability, please contact the IRS as soon as possible to see if the examination should be discontinued.

The Examination

An examination usually begins when you are notified that your return has been selected. The IRS will tell you which records you will need. The examination can proceed more easily if you gather your records before any interview.

Any proposed changes to your return will be explained to you or your authorized representative. It is important that you understand the reasons for any proposed changes. You should not hesitate to ask about anything that is unclear to you.

The IRS must follow the tax laws set forth by Congress in the Internal Revenue Code. The IRS also follows Treasury Regulations, other rules, and procedures that were written to administer the tax laws. The IRS also follows court decisions. However, the IRS can lose cases that involve taxpayers with the same issue and still apply its interpretation of the law to your situation.

Most taxpayers agree to changes proposed by examiners, and the examinations are closed at this level. If you do not agree, you can appeal any proposed change by following the procedures provided to you by the IRS . A more complete discussion of appeal rights is found later under Appeal Rights.

If You Agree

If you agree with the proposed changes, you can sign an agreement form and pay any additional tax you may owe. You must pay interest on any additional tax. If you pay when you sign the agreement, the interest is generally figured from the due date of your return to the date of your payment.

If you do not pay the additional tax when you sign the agreement, you will receive a bill that includes interest. If you pay the amount due within 10 business days of the billing date, you will not have to pay more interest or penalties. This period is extended to 21 calendar days if the amount due is less than $100,000.

If you are due a refund, you will receive it sooner if you sign the agreement form. You will be paid interest on the refund.

If the IRS accepts your tax return as filed, you will receive a letter in a few weeks stating that the examiner proposed no changes to your return. You should keep this letter with your tax records.

If You Do Not Agree

If you do not agree with the proposed changes, the examiner will explain your appeal rights. If your examination takes place in an IRS office, you can request an immediate meeting with the examiner's supervisor to explain your position. If an agreement is reached, your case will be closed.

If you cannot reach an agreement with the supervisor at this meeting, or if the examination took place outside of an IRS office, the examiner will write up your case explaining your position and the IRS ' position. The examiner will forward your case for processing.

Fast track mediation.   The IRS offers fast track mediation services to help taxpayers resolve many disputes resulting from: examinations (audits); offers in compromise; trust fund recovery penalties, and other collection actions.

 

 Most cases that are not docketed in any court qualify for fast track mediation. Mediation can take place at a conference you request with a supervisor, or later. The process involves an Appeals Officer who has been trained in mediation. You may represent yourself at the mediation session, or someone else can act as your representative. For more information, see Publication 3605.

 

30-day letter and 90-day letter.   Within a few weeks after your closing conference with the examiner and/or supervisor, you will receive a package with:  a letter (known as a 30-day letter) notifying you of your right to appeal the proposed changes within 30 days; a copy of the examination report explaining the examiner's proposed changes; an agreement or waiver form; and a copy of Publication 5.

You generally have 30 days from the date of the 30-day letter to tell the IRS whether you will accept or appeal the proposed changes. The letter will explain what steps you should take, depending on which action you choose. Be sure to follow the instructions carefully. Appeal Rights are explained later.

90-day letter.   If you do not respond to the 30-day letter, or if you later do not reach an agreement with an Appeals Officer, the IRS will send you a 90-day letter, which is also known as a notice of deficiency.

You will have 90 days (150 days if it is addressed to you outside the United States ) from the date of this notice to file a petition with the Tax Court. Filing a petition with the Tax Court is discussed later under Appeals to the Courts and Tax Court.

The notice will show the 90th (and 150th) day by which you must file your petition with the Tax Court.

 

Suspension of interest and penalties.   Generally, the IRS has 3 years from the date you filed your return (or the date the return was due, if later) to assess any additional tax. However, if you file your return timely (including extensions), interest and certain penalties will be suspended if the IRS does not mail a notice to you, stating your liability and the basis for that liability, within an 18-month period beginning on the later of: the date on which you filed your tax return, or the due date (without extensions) of your tax return.

 

If the IRS mails a notice after the 18-month period, interest and certain penalties applicable to the suspension period will be suspended.

 

The suspension period begins the day after the close of the 18-month period and ends 21 days after the IRS mails a notice to you stating your liability and the basis for that liability. Also, the suspension period applies separately to each notice stating your liability and the basis for that liability received by you.

  

The suspension does not apply to a: failure-to-pay penalty; fraudulent tax return; penalty, interest, addition to tax, or additional amount with respect to any tax liability shown on your return or with respect to any gross misstatement; penalty, interest, addition to tax, or additional amount with respect to any reportable transaction that is not adequately disclosed or any listed transaction; or criminal penalty.

 

Seeking relief from improperly assessed interest.   You can seek relief if interest is assessed for periods during which interest should have been suspended because the IRS did not mail a notice to you in a timely manner.

 

 If you believe that interest was assessed with respect to a period during which interest should have been suspended, submit Form 843, writing “Section 6404(g) Notification” at the top of the form, with the IRS Service Center where you filed your return. The IRS will review the Form 843 and notify you whether interest will be abated. If the IRS does not abate interest, you can pay the disputed interest assessment and file a claim for refund. If your claim is denied or not acted upon within 6 months from the date you filed it, you can file suit for a refund in your United States District Court or in the United States Court of Federal Claims.

  If you believe that an IRS officer or employee has made an unreasonable error or delay in performing a ministerial or managerial act (discussed later under Abatement of Interest Due to Error or Delay by the IRS ), file Form 843 with the IRS Service Center where you filed the tax return. If the Service denies your claim, the Tax Court may be able to review that determination. See Tax Court can review failure to abate interest, later under Abatement of Interest Due to Error or Delay by the IRS .

 

If you later agree.    If you agree with the examiner's changes after receiving the examination report or the 30-day letter, sign and return either the examination report or the waiver form. Keep a copy for your records. You can pay any additional amount you owe without waiting for a bill. Include interest on the additional tax at the applicable rate. This interest rate is usually for the period from the due date of the return to the date of payment. The examiner can tell you the interest rate(s) or help you figure the amount.

 

 You must pay interest on penalties and on additional tax for failing to file returns, for overstating valuations, for understating valuations on estate and gift tax returns, and for substantially understating tax liability. Interest is generally figured from the date (including extensions) the tax return is required to be filed to the date you pay the penalty and/or additional tax.

 If you pay the amount due within 10 business days after the date of notice and demand for immediate payment, you will not have to pay any additional penalties and interest. This period is extended to 21 calendar days if the amount due is less than $100,000.

How To Stop Interest From Accruing

If you think that you will owe additional tax at the end of the examination, you can stop the further accrual of interest by sending money to the IRS to cover all or part of the amount you think you will owe. Interest on part or all of any amount you owe will stop accruing on the date the IRS receives your money.

You can send an amount either in the form of a deposit in the nature of a cash bond or as a payment of tax. Both a deposit and a payment stop any further accrual of interest. However, making a deposit or payment will stop the accrual of interest on only the amount you sent. Because of compounding rules, interest will continue to accrue on accrued interest, even though you have paid the underlying tax.

To stop the accrual of interest on both tax and interest, you must make a deposit or payment for both the tax and interest that has accrued as of the date of deposit or payment.

Payment or Deposit

Deposits differ from payments in two ways:

 1You can have all or part of your deposit returned to you without filing for a refund. However, if you request and receive your deposit and the IRS later assesses a deficiency for that period and type of tax, interest will be figured as if the funds were never on deposit. Also, your deposit will not be returned if one of the following situations applies: the IRS assesses a tax liability; the IRS determines, that by returning the deposit, it may not be able to collect a future deficiency; the IRS determines that the deposit should be applied against another tax liability.  Deposits do not earn interest. No interest will be included when a deposit is returned to you.

Notice not mailed.    If you send money before the IRS mails you a notice of deficiency, you can ask the IRS to treat it as a deposit. You must make your request in writing.

 

 If, after being notified of a proposed liability but before the IRS mails you a notice of deficiency, you send an amount large enough to cover the proposed liability, it will be considered a payment unless you request in writing that it be treated as a deposit.

 

 If the amount you send is at least as much as the proposed liability and you do not request that it be treated as a deposit, the IRS will not send you a notice of deficiency. If you do not receive a notice of deficiency, you cannot take your case to the Tax Court.

.

Notice mailed.    If, after the IRS mails the notice of deficiency, you send money without written instructions, it will be treated as a payment. You will still be able to petition the Tax Court.

 

 If you send money after receiving a notice of deficiency and you have specified in writing that it is a “deposit in the nature of a cash bond,” the IRS will treat it as a deposit if you send it before either: the close of the 90-day or 150-day period for filing a petition with the Tax Court to appeal the deficiency; or the date the Tax Court decision is final, if you have filed a petition.

Using a Deposit To Pay the Tax

If you agree with the examiner's proposed changes after the examination, your deposit will be applied against any amount you may owe. The IRS will not mail you a notice of deficiency and you will not have the right to take your case to the Tax Court.

If you do not agree to the full amount of the deficiency after the examination, the IRS will mail you a notice of deficiency. Your deposit will be applied against the proposed deficiency unless you write to the IRS before the end of the 90-day or 150-day period stating that you still want the money to be treated as a deposit. You will still have the right to take your case to the Tax Court.

Installment Agreement Request

You can request a monthly installment plan if you cannot pay the full amount you owe. To be valid, your request must be approved by the IRS . However, if you owe $10,000 or less in tax and you meet certain other criteria, the IRS must accept your request.

Before you request an installment agreement, you should consider other less costly alternatives, such as a bank loan. You will continue to be charged interest and penalties on the amount you owe until it is paid in full. There is also a $43 fee if your installment agreement is approved.

For more information about installment agreements, see Form 9465, Installment Agreement Request.

Interest Netting

If you owe interest to the IRS on an underpayment for the same period the IRS owes you interest on an overpayment, the IRS will figure interest on the underpayment and overpayment at the same interest rate (up to the amount of the overpayment). As a result, the net rate is zero for that period.

Abatement of Interest Due to Error or Delay by the IRS

The IRS may abate (reduce) the amount of interest you owe if the interest is due to an unreasonable error or delay by an IRS officer or employee in performing a ministerial or managerial act (discussed later). Only the amount of interest on income, estate, gift, generation-skipping, and certain excise taxes can be reduced.

The amount of interest will not be reduced if you or anyone related to you contributed significantly to the error or delay. Also, the interest will be reduced only if the error or delay happened after the IRS contacted you in writing about the deficiency or payment on which the interest is based. An audit notification letter is such a contact.

The IRS cannot reduce the amount of interest due to a general administrative decision, such as a decision on how to organize the processing of tax returns.

Ministerial act.    This is a procedural or mechanical act, not involving the exercise of judgment or discretion, during the processing of a case after all prerequisites (for example, conferences and review by supervisors) have taken place. A decision concerning the proper application of federal tax law (or other federal or state law) is not a ministerial act.

  

 Example 1.

You move from one state to another before the IRS selects your tax return for examination. A letter stating that your return has been selected is sent to your old address and then forwarded to your new address. When you get the letter, you respond with a request that the examination be transferred to the area office closest to your new address. The examination group manager approves your request. After your request has been approved, the transfer is a ministerial act. The IRS can reduce the interest because of any unreasonable delay in transferring the case.

Example 2.

An examination of your return reveals tax due for which a notice of deficiency (90-day letter) will be issued. After you and the IRS discuss the issues, the notice is prepared and reviewed. After the review process, issuing the notice of deficiency is a ministerial act. If there is an unreasonable delay in sending the notice of deficiency to you, the IRS can reduce the interest resulting from the delay.

Managerial act.    This is an administrative act during the processing of a case that involves the loss of records or the exercise of judgment or discretion concerning the management of personnel. A decision concerning the proper application of federal tax law (or other federal or state law) is not a managerial act.

Example.

A revenue agent is examining your tax return. During the middle of the examination, the agent is sent to an extended training course. The agent's supervisor decides not to reassign your case, so the work is unreasonably delayed until the agent returns. Interest from the unreasonable delay can be abated since both the decision to send the agent to the training class and not to reassign the case are managerial acts.

How to request abatement of interest.    You request an abatement (reduction) of interest on Form 843. You should file the claim with the IRS service center where you filed the tax return that was affected by the error or delay.   

 

 If you have already paid the interest and you would like a credit or refund of interest paid, you must file Form 843 within 3 years from the date you filed your original return or 2 years from the date you paid the interest, whichever is later. If you have not paid any of the interest, these time limitations for filing Form 843 do not apply.

 

 Generally, you should file a separate Form 843 for each tax period and each type of tax. However, complete only one Form 843 if the interest is from an IRS error or delay that affected your tax for more than one tax period or for more than one type of tax (for example, where two or more tax years were being examined). You do not have to figure the dollar amounts of interest that you want lowered.

  If your request for abatement of interest is denied, you can appeal the decision to the IRS Appeals Office.

Tax Court can review failure to abate interest.    The Tax Court can review the IRS ' refusal to abate (reduce) interest if all of the following requirements are met.  you filed a request for abatement of interest (Form 843) with the IRS after July 30,1996; the IRS has mailed you a notice of final determination or a notice of disallowance; you file a petition with the Tax Court within 180 days of the mailing of the notice of final determination or the notice of disallowance.

 

  The following requirements must also be met: for individual and estate taxpayers — your net worth must not exceed $2 million as of the filing date of your petition for review. For this purpose, individuals filing a joint return shall be treated as separate individuals; for charities and certain cooperatives — you must not have more than 500 employees as of the filing date of your petition for review; for all other taxpayers — your net worth must not exceed $7 million, and you must not have more than 500 employees as of the filing date of your petition for review.

Abatement of Interest for Individuals Affected by Presidentially Declared Disasters or Military or Terrorist Actions

If you are (or were) affected by a Presidentially declared disaster occurring after 1996 or a terrorist or military action occurring after September 10, 2001 , the IRS may abate (reduce) the amount of interest you owe on certain taxes. The IRS may abate interest for the period of any additional time to file or pay that the IRS provides on account of the disaster or the terrorist or military action. The IRS will issue a notice or news release indicating who are affected taxpayers and stating the period of relief.

If you are eligible for relief from interest, but were charged interest for the period of relief, the IRS may retroactively abate your interest. To the extent possible, the IRS can take the following actions: make appropriate adjustments to your account; notify you when the adjustments are made; refund any interest paid by you where appropriate.

For more information on disaster area losses, see Disaster Area Losses in Publication 547. For more information on other tax relief for victims of terrorist attacks, see Publication 3920.

Offer in Compromise

In certain circumstances, the IRS will allow you to pay less than the full amount you owe. If you think you may qualify, you should submit your offer by filing Form 656, Offer in Compromise. The IRS may accept your offer for any of the following reasons.

1.         There is doubt about the amount you owe (or whether you owe it).

2.        There is doubt as to whether you can pay the amount you owe based on your financial situation.

3.        An economic hardship would result if you had to pay the full amount owed, or

4.        Your case presents compelling reasons that the IRS determines are a sufficient basis for compromise.

If your offer is rejected, you have 30 days to ask the Appeals Office of the IRS to reconsider your offer.

The IRS offers fast track mediation services to help taxpayers resolve many issues including a dispute regarding an offer in compromise. For more information, see Publication 3605.

Generally, if you submit an offer in compromise, the IRS will delay certain collection activities. The IRS usually will not levy (take) your property to settle your tax bill during the following periods: while the IRS is evaluating your offer in compromise; the 30 days immediately after the offer is rejected; while your timely-filed appeal is being considered by Appeals.

Also, if the IRS rejects your original offer and you submit a revised offer within 30 days of the rejection, the IRS generally will not levy your property while it considers your revised offer.

For more information about submitting an offer in compromise, see Form 656.

Appeal Rights

Because people sometimes disagree on tax matters, the Service has an appeals system. Most differences can be settled within this system without expensive and time-consuming court trials.

However, your reasons for disagreeing must come within the scope of the tax laws. For example, you cannot appeal your case based only on moral, religious, political, constitutional, conscientious, or similar grounds.

In most instances, you may be eligible to take your case to court if you do not reach an agreement at your appeals conference, or if you do not want to appeal your case to the IRS Office of Appeals. See Appeals to the Courts, later, for more information.

Appeal Within the IRS

You can appeal an IRS tax decision to a local Appeals Office, which is separate from and independent of the IRS office taking the action you disagree with. The Appeals Office is the only level of appeal within the IRS . Conferences with Appeals Office personnel are held in an informal manner by correspondence, by telephone, or at a personal conference.

If you want an appeals conference, follow the instructions in the letter you received. Your request will be sent to the Appeals Office to arrange a conference at a convenient time and place. You or your representative should be prepared to discuss all disputed issues at the conference. Most differences are settled at this level.

If agreement is not reached at your appeals conference, you may be eligible to take your case to court. See Appeals to the Courts, later.

Protests and Small Case Requests

When you request an Appeals conference, you may also need to file either a formal written protest or a small case request with the office named in the letter you received. Also, see the special appeal request procedures in Publication 1660. In addition, for the appeal procedures for a spouse or former spouse of a taxpayer seeking relief from joint and several liability on a joint return, see Rev. Proc. 2003-19, which is on page 371 of the Internal Revenue Bulletin 2003-5 at www.irs.gov/pub/irs-irbs/irb03-05.pdf.

Written protest.   You need to file a written protest in the following cases:  all employee plan and exempt organization cases without regard to the dollar amount at issue; all partnership and S corporation cases without regard to the dollar amount at issue; all other cases, unless you qualify for the small case request procedure, or other special appeal procedures such as requesting Appeals consideration of liens, levies, seizures, or installment agreements.

 

 If you must submit a written protest, see the instructions in Publication 5 about the information you need to provide. The IRS urges you to provide as much information as you can, as it will help speed up your appeal. That will save you both time and money.

  

Be sure to send the protest within the time limit specified in the letter you received.

 

Small case request.   If the total amount for any tax period is not more than $25,000, you may make a small case request instead of filing a formal written protest. In figuring the total amount, include a proposed increase or decrease in tax (including penalties), or claimed refund. If you are making an offer in compromise, include total unpaid tax, penalty, and interest due. For a small case request, follow the instructions in our letter to you by sending a letter:  requesting Appeals consideration; indicating the changes you do not agree with; and indicating the reasons why you do not agree.

Representation

You can represent yourself at your appeals conference, or you can be represented by an attorney.  

If your representative attends a conference without you, he or she can receive or inspect confidential information only if you have filed a power of attorney or a tax information authorization. You can use a Form 2848 or any other properly written power of attorney or authorization.

You can also bring witnesses to support your position.

Appeals to the Courts

If you and the IRS still disagree after the appeals conference, you may be entitled to take your case to the United States Tax Court, the United States Court of Federal Claims, or the United States District Court. These courts are independent of the IRS .

If you elect to bypass the IRS ' appeals system, you may be able to take your case to one of the courts listed above. However, a case petitioned to the United States Tax Court will normally be considered for settlement by an Appeals Office before the Tax Court hears the case.

 

If you unreasonably fail to pursue the IRS ' appeals system, or if your case is intended primarily to cause a delay, or your position is frivolous or groundless, the Tax Court may impose a penalty of up to $25,000.

 

Prohibition on requests to taxpayers to give up rights to bring civil action.   The Government cannot ask you to waive your right to sue the United States or a Government officer or employee for any action taken in connection with the tax laws. However, your right to sue can be waived if:  you knowingly and voluntarily waive that right; the request to waive that right is made in writing to your attorney or other federally authorized practitioner; or the request is made in person and your attorney or other representative is present.

 

Burden of proof.   For court proceedings resulting from examinations started after July 22, 1998 , the IRS generally has the burden of proof for any factual issue if you have met the following requirements: you introduced credible evidence relating to the issue; you complied with all substantiation requirements of the Internal Revenue Code; you maintained all records required by the Internal Revenue Code; you cooperated with all reasonable requests by the IRS for information regarding the preparation and related tax treatment of any item reported on your tax return; you had a net worth of $7 million or less and not more than 500 employees at the time your tax liability is contested in any court proceeding if your tax return is for a corporation, partnership, or trust.

  

 

The burden of proof does not change on an issue when another provision of the tax laws requires a specific burden of proof with respect to that issue.

 

Use of statistical information.   In the case of an individual, the IRS has the burden of proof in court proceedings based on any IRS reconstruction of income solely through the use of statistical information on unrelated taxpayers.

 

Penalties.   The IRS has the burden of initially producing evidence in court proceedings with respect to the liability of any individual taxpayer for any penalty, addition to tax, or additional amount imposed by the tax laws.

 

Recovering litigation or administrative costs.   These are the expenses that you pay to defend your position to the IRS or the courts. You may be able to recover reasonable litigation or administrative costs if all of the following conditions apply.  you are the prevailing party; you exhaust all administrative remedies within the IRSyour net worth is below a certain limit (see Net worth requirements, later); you do not unreasonably delay the proceeding; you apply for administrative costs within 90 days of the date on which the final decision of the IRS Office of Appeals as to the determination of the tax, interest, or penalty was mailed to you; you apply for litigation costs within the time frames provided by Tax Court Rule 231.

 

If the IRS denies your award of administrative costs, and you want to appeal, you must petition the Tax Court within 90 days of the date on which the IRS mails the denial notice.

Prevailing party.   Generally, you are the prevailing party if:  you substantially prevail with respect to the amount in controversy or on the most significant tax issue or set of issues in question; and you meet the net worth requirements, discussed later.

  You will not be treated as the prevailing party if the United States establishes that its position was substantially justified. The position of the United States is presumed not to be substantially justified if the IRS :  did not follow its applicable published guidance (such as regulations, revenue rulings, notices, announcements, private letter rulings, technical advice memoranda, and determination letters issued to the taxpayer) in the proceeding (This presumption can be overcome by evidence.); or has lost in courts of appeal for other circuits on substantially similar issues.  The court will generally decide who is the prevailing party.

 

Reasonable litigation costs.   These include the following costs. reasonable court costs; the reasonable costs of studies, analyses, engineering reports, tests, or projects found by the court to be necessary for the preparation of your case; the reasonable costs of expert witnesses; attorney fees that generally may not exceed $150 per hour for calendar year 2005. The hourly rate is indexed for inflation.

.

Reasonable administrative costs.   These include the following costs:  any administrative fees or similar charges imposed by the IRS ; the reasonable costs of studies, analyses, engineering reports, tests, or projects; the reasonable costs of expert witnesses;vattorney fees that generally may not exceed $150 per hour for calendar year 2005.

 

Timing of costs.    Administrative costs can be awarded for costs incurred after the earliest of: the date the first letter of proposed deficiency is sent that allows you an opportunity to request administrative review in the IRS Office of Appeals; the date you receive notice of the IRS Office of Appeals' decision,; or the date of the notice of deficiency.

Net worth requirements.   An individual taxpayer may be able to recover litigation or administrative costs if the following requirements are met.  for individuals — your net worth does not exceed $2 million as of the filing date of your petition for review. For this purpose, individuals filing a joint return are treated as separate individuals; for estates — your net worth does not exceed $2 million as of the date of the decedent's death; for charities and certain cooperatives — you do not have more than 500 employees as of the filing date of your petition for review; for all other taxpayers — as of the filing date of your petition for review, your net worth does not exceed $7 million, and you must not have more than 500 employees.

 

Qualified offer rule.    You can also receive reasonable costs and fees and be treated as a prevailing party in a civil action or proceeding if:  you make a qualified offer to the IRS to settle your case; the IRS does not accept that offer; and the tax liability (not including interest, unless interest is at issue) later determined by the court is equal to or less than the amount of your qualified offer.

 

You must also meet the remaining requirements, including the exhaustion of administrative remedies and the net worth requirement, discussed earlier, to get the benefit of the qualified offer rule.

 

Qualified offer.    This is a written offer made by you during the qualified offer period. It must specify both the offered amount of your liability (not including interest) and that it is a qualified offer.

  To be a qualified offer, it must remain open from the date it is made until the earliest of:  the date it is rejected; the date the trial begins; or 90 days from the date it is made.

Qualified offer period.    This period begins on the day the IRS mails you the first letter of proposed deficiency that allows you to request review by the IRS Office of Appeals. It ends 30 days before your case is first set for trial.

 

Attorney fees.   The basic rate for attorney fees is $150 per hour and can be higher in certain limited circumstances. Those circumstances include the level of difficulty of the issues in the case and the local availability of tax expertise. The basic rate will be subject to a cost-of-living adjustment each year.

  

Attorney fees include the fees paid by a taxpayer for the services of anyone who is authorized to practice before the Tax Court or before the IRS . In addition, attorney fees can be awarded in civil actions for unauthorized inspection or disclosure of a taxpayer's return or return information.

  Fees can be awarded in excess of the actual amount charged if:  you are represented for no fee, or for a nominal fee, as a pro bono service, and the award is paid to your representative or to your representative's employer.

 

Jurisdiction for determination of employment status.    The Tax Court can review IRS employment status determinations (for example, whether individuals hired by you are in fact your employees or independent contractors) and the amount of employment tax under such determinations. Tax Court review can take place only if, in connection with an audit of any person, there is an actual controversy involving a determination by the IRS as part of an examination that either: one or more individuals performing services for that person are employees of that person, or that person is not entitled to relief under Section 530(a) of the Revenue Act of 1978 .

 

 The following rules also apply to a Tax Court review of employment status: a Tax Court petition to review these determinations can be filed only by the person for whom the services are performed; if you receive a Notice of Determination by certified or registered mail, you must file a petition for Tax Court review within 90 days of the date of mailing that notice (150 days if the notice is addressed to you outside the United States); if during the Tax Court proceeding, you begin to treat as an employee an individual whose employment status is at issue, the Tax Court will not consider that change in its decision; assessment and collection of tax is suspended while the Tax Court review is taking place; there can be a de novo review by the Tax Court (a review which does not consider IRS administrative findings);  and at your request and with the Tax Court's agreement, small tax case procedures (discussed later) are available to simplify the case resolution process when the amount at issue (including additions to tax and penalties) is $50,000 or less for each tax period involved.

 

For further information, see Publication 3953, Questions and Answers About Tax Court Proceedings for Determination of Employment Status Under IRC Section 7436.

Section 530(a) of the Revenue Act of 1978.   This section relieves an employer of certain employment tax responsibilities for individuals not treated as employees. It also provides relief to taxpayers under audit or involved in administrative or judicial proceedings.

 

Tax Court review of request for relief from joint and several liability on a joint return.    As discussed later, at Relief from joint and several liability on a joint return under Claims for Refund, you can request relief from liability for tax you owe, plus related penalties and interest, that you believe should be paid by your spouse (or former spouse). You also can petition (ask) the Tax Court to review your request for innocent spouse relief or separation of liability if either:  the IRS sends you a determination notice denying, in whole or in part, your request; or you do not receive a determination notice from the IRS within 6 months from the date you file Form 8857.

 

 If you receive a determination notice, you must petition the Tax Court to review your request during the 90-day period that begins on the date the IRS mails the notice. See Publication 971 for more information.

Your spouse or former spouse may file a written protest and request an Appeals conference to protest your claim of innocent spouse relief or separation of liability.

Tax Court

You can take your case to the United States Tax Court if you disagree with the IRS

You cannot take your case to the Tax Court before the IRS sends you a notice of deficiency. You can only appeal your case if you file a petition within 90 days from the date the notice is mailed to you (150 days if it is addressed to you outside the United States ).

The notice will show the 90th (and 150th) day by which you must file your petition with the Tax Court.

If you consent, the IRS can withdraw a notice of deficiency. Once withdrawn, the limits on credits, refunds, and assessments concerning the notice are void, and you and the IRS have the rights and obligations that you had before the notice was issued. The suspension of any time limitation while the notice of deficiency was issued will not change when the notice is withdrawn.

After the notice is withdrawn, you cannot file a petition with the Tax Court based on the notice. Also, the IRS can later issue a notice of deficiency in a greater or lesser amount than the amount in the withdrawn deficiency.

Generally, the Tax Court hears cases before any tax has been assessed and paid; however, you can pay the tax after the notice of deficiency has been issued and still petition the Tax Court for review. If you do not file your petition on time, the proposed tax will be assessed, a bill will be sent, and you will not be able to take your case to the Tax Court. Under the law, you must pay the tax within 21 days (10 business days if the amount is $100,000 or more). Collection can proceed even if you think that the amount is excessive. Publication 594 explains IRS collection procedures.

If you filed your petition on time, the court will schedule your case for trial at a location convenient to you. You can represent yourself before the Tax Court or you can be represented by anyone admitted to practice before that court.

Small tax case procedure.   If the amount in your case is $50,000 or less for any one tax year or period, you can request that your case be handled under the small tax case procedure. If the Tax Court approves, you can present your case to the Tax Court for a decision that is final and that you cannot appeal. You can get more information regarding the small tax case procedure and other Tax Court matters from the United States Tax Court, 400 Second Street , N.W., Washington , DC 20217 . More information can be found on the Tax Court's website at www.ustaxcourt.gov.

 

Motion to request redetermination of interest.   In certain cases, you can file a motion asking the Tax Court to redetermine the amount of interest on either an underpayment or an overpayment. You can do this only in a situation that meets all of the following requirements: the IRS has assessed a deficiency that was determined by the Tax Court; the assessment included interest; you have paid the entire amount of the deficiency plus the interest claimed by the IRS ; the Tax Court has found that you made an overpayment.

You must file the motion within one year after the decision of the Tax Court becomes final.

District Court and Court of Federal Claims

Generally, the District Court and the Court of Federal Claims hear tax cases only after you have paid the tax and filed a claim for a credit or refund. As explained later under Claims for Refund, you can file a claim with the IRS for a credit or refund if you think that the tax you paid is incorrect or excessive. If your claim is totally or partially disallowed by the IRS , you should receive a notice of claim disallowance. If the IRS does not act on your claim within 6 months from the date you filed it, you can then file suit for a refund.

You generally must file suit for a credit or refund no later than 2 years after the IRS informs you that your claim has been rejected. However, you can file suit if it has been 6 months since you filed your claim and the IRS has not yet delivered a decision.

You can file suit for a credit or refund in your United States District Court or in the United States Court of Federal Claims. However, you cannot appeal to the United States Court of Federal Claims if your claim is for credit or refund of a penalty that relates to promoting an abusive tax shelter or to aiding and abetting the understatement of tax liability on someone else's return.

For information about procedures for filing suit in either court, contact the Clerk of your District Court or of the United States Court of Federal Claims. For information on District Court review of Appeals determinations with respect to lien notices and proposed levies, see Publication 1660.

 

Revenue Procedure 2002-55

Internal Revenue Service

2002-35 I.R.B. 435

 

 

 

Audit Guidance for External Auditors of Qualified Intermediaries

 

Rev. Proc. 2002–55

 

SECTION 1. PURPOSE AND SCOPE

 

This Revenue Procedure contains final Audit Guidance for an external auditor engaged by a qualified intermediary (QI) to verify the QI’s compliance with the withholding agreement entered into with the Internal Revenue Service ( IRS ) pursuant to Rev. Proc. 2000–12, 2000–1 C.B. 387 and Treasury Regulation § 1.1441–1(e)(5) (QI Agreement). Under its QI Agreement, the QI generally must report annually certain aggregate information concerning the beneficial owners of U.S. source payments and make any necessary tax payments to the IRS . In lieu of an IRS audit, the QI may engage an external auditor to conduct an audit to determine whether it is complying with the withholding and reporting obligations covered by the QI Agreement. The external auditor must conduct its audit in accordance with the procedures described in section 10 of the QI Agreement. This Revenue Procedure is intended to assist the external auditor in understanding and applying those procedures. This Revenue Procedure does not amend, modify, or interpret the QI Agreement.

 

SECTION 2. BACKGROUND

 

.01 Comments on Proposed Guidance . The IRS issued proposed audit procedures for external auditors in Notice 2001–66, 2001–44 I.R.B. 396. Because the IRS and Treasury recognize that the audit process must be implemented in a manner that maintains the cooperative nature and effectiveness of the QI system, the IRS engaged in a lengthy dialogue with the financial community following the issuance of Notice 2001–66 to consider ways to implement the audit procedures so as to minimize cost to the QI while preserving the compliance goals of the withholding regulations.

 

.02 IRS Response to Five Areas of Concern. The majority of the comments on Notice 2001–66 reflected concerns about cost in the context of one or more of the following areas: availability of waivers, scope of audit coverage, statistical sampling, projection of underwithholding over the QI’s account population based on the statistical sample, and use of an internal audit. The following is a brief overview of the modifications reflected in the attached Audit Guidance in response to these comments. A more complete discussion is set forth in Section 4 of this Revenue Procedure.

 

(i) Waivers .

 

The financial community commented that the criteria for obtaining a waiver from an external audit were too stringent. In response, the following changes have been made:

 

• The monetary threshold in Waiver One has been increased in the attached Audit Guidelines from $250,000 to $1,000,000 and is based on reportable amounts.

• Waiver Two (which in Notice 2001–66 was based on number of accounts) now is based on whether the QI received between $1,000,000 and $4,000,000 in reportable amounts.

• With respect to the reconciliation of Forms 1042–S and 1099 issued to and by the QI, which are required to request Waivers One and Two, variances are permitted within reasonable limits based on the facts and circumstances.

• Waiver Three (which is available to QIs with a substantial and independent audit staff) is clarified to reflect that the annual internal reviews required for eligibility are not the comprehensive audit described in this Audit Guidance but, rather, those tests and checks that the internal staff deems appropriate.

 

(ii) Scope of Audit Coverage . Comments from the financial community stated that the scope of audit coverage required by the proposed audit guidance was overly broad and would prove to be prohibitively expensive for QIs. In response, to those comments, the following changes have been made:

 

• The accounts subject to audit are changed from those that receive reportable payments (generally, reportable amounts plus certain broker proceeds and certain foreign source income) to those that receive reportable amounts (generally U.S. source fixed or determinable annual or periodical income). However, for accounts of U.S. non-exempt recipients that receive reportable amounts, the external auditor must take reportable payments into account when performing certain procedures.

• Certain procedures and reports are deferred to Phase 2 of the audit.

• In Phase 1 of the audit, the review of withholding rate pools, underwithholding, and reporting in Audit Guidance (“AG”)10.03(B), (C), and (D) may be performed on a “spot check” rather than full sample basis.

• Consolidated audits are allowed for certain related groups.

 

(iii) Sampling .

 

Some commentators asserted that the proposed audit guidance required examination of an excessively large number of accounts, which would greatly increase the cost of the audit. In response to these comments, the following changes have been made:

 

• The maximum number of accounts sampled has been reduced from 1368 accounts to 321 accounts. This reduction results from (1) reducing the number of required samples from three to one with the one sample including all account holders ( i.e., direct account holders that are not U.S. non-exempt recipients, direct account holders that are U.S. non-exempt recipients, and indirect account holders), and (2) reducing the maximum sample size from 456 to 321.

• With respect to accounts reviewed for purposes of withholding rate pools, withholding, and reporting under Phase 1 of the audit, described above, the number of accounts reviewed will be limited to a “spot check.”

 

(iv) Projection .

 

Some commentators expressed concern that the proposed audit procedures appeared to require “automatic” projection of under-withholding in a sample across the QI’s account population, which they believed could result in very large, and potentially un-fair, tax assessments being imposed on the QI. In response to these comments, the following changes were made:

 

• The issue of projection is deferred to Phase 2 of the audit, but in Phase 1 the QI must pay any underwithholding that is discovered in the spot check for underwithholding (AG10.03(C)).

 

(v) Use of Internal Audit .

 

Some commentators asserted that requiring the external auditor to certify that the use of internal audit staff did not affect the accuracy of its report would severely limit the use of internal audit staff, thereby increasing the cost of the audit for the QI. In response to these comments, the following change was made:

 

• A QI’s external auditor that uses the QI’s internal audit staff and internal audit reports will not be required to certify that such use has not affected the accuracy of its report, but the external auditor will remain responsible for the conduct of the entire audit.

 

SECTION 3. OVERVIEW OF AUDIT GUIDANCE — THREE PHASE AUDIT PROCESS

 

The Audit Guidance included in this Revenue Procedure reflects a three phase audit process. As described further below, whether a particular QI’s audit will progress through all three phases generally will depend upon the IRS analysis of the facts reported in each phase. For example, the IRS expects that, if the facts reported in each preceding phase of the audit process do not raise significant concerns for the IRS , the QI will not be required to complete any further phase of the process during that audit cycle.

 

.01 PHASE 1: Basic Fact Finding . Phase 1 consists of basic fact finding. The external auditor performs those tasks detailed in the attached Audit Guidance for Phase 1 of the Audit. Generally, this consists of —

 

• documentation review for all accounts (or the sample), under AG10.03(A)(4) through (A)(7), and (A)(10);

• a spot check review of withholding rate pools, underwithholding, and reporting, under AG10.03(B)(4) through (B)(6), (C)(1), (C)(3), and (D)(2); and

• the completion of the procedures in AG10.03(A)(8) and (A)(9), (C)(2), (C)(4) through (C)(7), (D)(1) and (E).

 

From these fact finding activities, the auditor will develop a report of numerical results. The attached Audit Guidance contains precise directions on what numerical information must be included in the auditor’s report. The auditor will send a hard copy of this initial report to the IRS . The IRS intends to develop a standard report form.

 

Based on the IRS analysis of the numerical report for Phase 1 of the QI’s audit, the IRS will notify the QI whether the audit is complete or whether additional fact finding must be undertaken to resolve concerns. If the audit is complete after Phase 1, the QI must pay any underwithholding that is discovered as a result of the spot check for underwithholding (AG10.03(C)). If the numerical reports suggest that the QI has experienced difficulties in meeting its obligations under its QI Agreement, the IRS will notify the QI that it is proceeding to Phase 2 of the audit process.

 

.02 PHASE 2: Follow Up Fact Finding. In Phase 2 of the audit process, the IRS will contact the auditor to ask about facts and circumstances associated with certain numerical results in the auditor’s report. If additional information is needed, the IRS will direct the auditor to perform additional procedures and to report on the results. Phase 2 of the audit process may include some or all of the procedures in AG10.03 that were not performed in Phase 1 of the audit process, including a full sample review for those procedures for which a spot check review was performed in Phase 1. If, after completion of the full sample review, the external auditor determines that underwithholding under AG10.03(C)(1), (2), (3), (4) or (5) occurred with respect to the sample, the IRS will determine the total amount of under-withheld tax by projecting the underwithholding as provided in AG10.04.12.

 

The goal of this step of the audit process is to identify the cause for the numerical results and to determine whether corrective action readily can be devised. For example, the audit report may show that the auditor was unable to associate beneficial owner information with a specified percentage of the QI’s accounts. Through discussion of facts with the auditor, the IRS then determines that the problem was attributable to deficient account opening procedures in one of the QI’s branches. If the IRS were satisfied that the QI had taken steps to ensure that the branch had appropriately corrected procedures for opening new accounts, and if the QI had otherwise shown a high level of compliance with the QI Agreement, the IRS generally would not proceed to Phase 3 of the audit process.

 

.03 PHASE 3: Audit Meeting with QI . If the concerns arising from the numerical results reported in Phase 1 of the audit process cannot be resolved by directed fact finding in Phase 2, the IRS will propose to meet with the QI to attempt to clarify and resolve those concerns. This phase is designed specifically to provide a forum where a productive dialogue between the IRS and the QI can occur. Treasury and the IRS continue to believe that the QI system, which is intended to allow the IRS ’s compliance goals to be met while minimizing the administrative burdens on financial institutions, is a critical component of the withholding regulations. Accordingly, the IRS will seek to develop mutually acceptable solutions to the issues that arise in the course of administering the QI Agreements so that it will not become necessary to terminate a QI Agreement.

 

SECTION 4. MODIFICATIONS TO THE PROPOSED AUDIT GUIDANCE

 

As mentioned in Section 1, above, the concerns arising from the proposed Audit Guidance published in Notice 2001–66 generally related to the following five areas— waivers, scope of audit coverage, sampling, projection, and use of internal audit staff and reports. This section discusses, in greater detail, the modifications the IRS made to the Audit Guidance in response to those comments.

 

.01 Discretionary Waivers of External Audit . The Audit Guidance allows QIs to request that the IRS waive the performance of an audit by an external auditor in three cases. As a result of the dialogue with the financial community, and continued analysis of the information available to the IRS , the waiver provisions have been revised to increase the availability of waivers while allowing the IRS to continue to manage effectively its compliance objectives. In general, the waiver provisions have been liberalized and simplified. For instance, the waiver based on a threshold number of accounts has been replaced with a waiver based on a dollar threshold, the waiver based on a dollar threshold has been modified to raise the dollar threshold, the dollar thresholds are based upon reportable amounts rather than reportable payments, and with respect to the reconciliation information that must be included in the waiver request, variances are permitted within reasonable limits based on the facts and circumstances. Whether the IRS will waive the external audit in any case is discretionary. The IRS will not agree to waive the performance of an audit for a Private Arrangement Intermediary (“PAI”) or for a group of QIs for which the IRS permits a consolidated audit. The revised waiver provisions are outlined below.

 

(i) Waiver One $1,000,000 Threshold. A QI may request a waiver of the external audit if it has received not more than $1,000,000 in reportable amounts during the audit year. A QI requesting Waiver One must submit a reconciliation (for the audit year) of the Forms 1042–S and 1099 issued to the QI and issued by the QI and information about the number of its account holders in various classes.

 

(ii) Waiver Two $1,000,000 to $4,000,000 Threshold . A QI may request a waiver of the external audit if it has received reportable amounts exceeding $1,000,000 but not exceeding $4,000,000 during the audit year, and the QI has been audited by an external auditor under the QI Agreement for the immediately preceding required audit. Thus, the IRS will not agree to waive the external audit, under Waiver Two, for the first audit year of the first term or any renewal term of the QI Agreement. Waiver Two will be available only for the second audit year of any term of the QI Agreement. As under Waiver One, a QI requesting Waiver Two must submit a reconciliation (for the audit year) of the Forms 1042–S and 1099 issued to the QI and issued by the QI and information about the number of its account holders in various classes.

 

(iii) Waiver Three Annual Internal Review Program . A QI may request a waiver of the audit by an external auditor if it has a substantial and independent internal audit department that has reviewed the QI’s compliance under the QI Agreement for each of the three years preceding the year to be audited. The internal audit department is not required to perform the annual reviews according to the procedures in this Audit Guidance. Instead, it may perform any tests, checks or other procedures that it determines to be appropriate. The internal audit department may request IRS clearance of any proposed program of tests, checks or other procedures by submitting a written description of the proposed program. If this waiver is granted, instead of the required audit by an external auditor, the QI’s internal audit department may perform the audit and report to the IRS in accordance with the attached Audit Guidance. The IRS will not agree to grant this waiver for the first audit year of the first term of the QI Agreement. Waiver Three will be available for any subsequent audit year of any term of the QI Agreement.

 

02. Scope of Audit . In response to comments from the financial community, the IRS has revised the scope of the audit and, in particular, the procedures required for Phase 1 of the audit process. The revised procedures accommodate mutual concerns relating to cost, efficiency and compliance by (i) limiting the accounts initially selected for examination to accounts that have received reportable amounts, (ii) deferring certain tasks to Phase 2 of the audit process, (iii) adopting exploratory “spot check” techniques for certain tasks; (iv) allowing explanatory footnotes or addenda; and (v) allowing consolidated audits for certain groups of related QIs. Set forth below is a discussion of the changes to each of these five areas of the audit.

 

(i) Reportable Amounts . The revised procedures included in the attached Audit Guidance limit the accounts initially selected for examination to those accounts that have received reportable amounts . Under the proposed Audit Guidance, the accounts initially selected for examination would have included accounts that had received reportable payments . Under the QI Agreement, “reportable amounts,” generally consist of U.S. source fixed or determinable, annual or periodical income. “Reportable payments” generally consist of reportable amounts plus certain broker proceeds and certain foreign source income. The financial community expressed concern about the difficulty of making an initial selection of accounts based on reportable payments. The IRS agrees that efficiency may be served by the initial selection of accounts based on receipt of reportable amounts, provided that reportable payments received in those accounts may be examined when required under the Audit Guidance. Accordingly, the revised procedures under this Audit Guidance require the external auditor initially to select for examination only those accounts that have received reportable amounts, and then to examine reportable payments made to accounts within that group when required in Phase 1 of the audit.

 

(ii) Deferral of Certain Tasks to Phase 2 of the Audit Process . During the audit, the external auditor must perform tasks designed to gather certain basic facts about the QI’s compliance with the QI Agreement. The revised procedures included in the attached Audit Guidance defer certain of these tasks to Phase 2 of the audit process. The revised procedures reflect the view that the most accurate facts relating to a QI’s compliance may be obtained by examining how a QI has (a) documented, (b) pooled, (c) withheld on and (d) reported on particular accounts. Accordingly, tasks that require the examination of particular accounts have been retained in Phase 1 of the audit and tasks that do not relate to examination of particular accounts, generally, have been deferred to Phase 2. For example, tasks requiring interviews of QI employees have been deferred to Phase 2.

 

(iii) Spot Check Review under AG10.03(B), (C), and (D) . The IRS recognizes that the withholding system is based on information drawn from account holder documentation and that account holders open and close accounts periodically. It also recognizes that pooling, withholding and reporting depend in large part on the procedures and systems the QI uses to process the information obtained from account holder documentation. The revised procedures reflect the view that a thorough examination of how a QI has documented all, or a representative sample of, its account holders may provide a reliable indication of the QI’s overall compliance, and that its reliability may then be tested by exploratory examination of how the QI has pooled, withheld, and reported based on information drawn from the documentation of a smaller number of account holders.

 

Accordingly, the revised procedures in this Audit Guidance generally require that in Phase 1 of the audit, the external auditor must use all accounts covered by the QI Agreement, or a statistical sample representing all such accounts, in performing the account based tasks that relate to how the QI has documented its account holders. In performing the account based tasks that relate to how the QI has pooled, withheld, and reported, the revised procedures provide the external auditor with the option of using a smaller number of accounts. The number of accounts to be reviewed for a spot check must include all accounts required to be reported as undocumented or as not satisfying documentation criteria under AG10.03(A), and must in any case include at least 20 accounts from each of the following categories of account holders (assuming there are 20 or more accounts in each such category): QI’s direct account holders that are not U.S. non-exempt recipients; QI’s direct account holders that are U.S. non-exempt recipients; and QI’s indirect account holders.

 

(iv) Explanatory footnotes or addenda . This Audit Guidance has been modified to include a provision permitting the external auditor to perform or to propose additional procedures or other fact finding and report the results by way of footnotes or addenda to its report for Phase 1 of the audit. This provision offers the opportunity to clarify problematic results reported for Phase 1 of the audit, which may obviate the necessity for follow up in Phase 2.

 

(v) Consolidated Audits for Certain Related QIs . The financial community has also suggested that cost and efficiency concerns could be mitigated by consolidating the audits of related QIs. In response, the IRS has modified the Audit Guidance to permit a consolidated audit of two or more QIs in circumstances when the consolidated audit may achieve the objectives of separate audits of those QIs. Specifically, the Audit Guidance provides that the IRS , in its discretion, may permit a consolidated audit of two or more QIs when (1) the QIs are members of a group under common ownership, (2) they operate with uniform practices and procedures and shared systems for performing the functions audited, (3) those practices and procedures and shared systems are subject to uniform monitoring and control, and (4) under the terms of the QI Agreement for each QI, the year to be audited for each QI is the same calendar year. The external auditor must submit an audit plan requesting IRS approval of any proposed consolidated audit.

 

.03 Sampling . The Audit Guidance permits an external auditor to use a statistical sample of the QI’s accounts in performing the Phase 1 account based tasks. If the external auditor constructs the sample in accordance with the Audit Guidance, it need not submit an audit plan to obtain IRS approval for use of the sample. A sample constructed under the proposed Audit Guidance would have consisted of a maximum of 456 accounts for each of three populations (direct account holders that are not U.S. non-exempt recipients, direct account holders that are U.S. non-exempt recipients, and indirect account holders), or a total of 1368 accounts.

 

Commentators stated that the cost burdens could be significantly reduced by limiting the overall number of accounts to be selected for statistical sampling. The final Audit Guidance reduces the overall number of accounts to be selected for statistical sampling by allowing a single sample that represents the three groups of account holders. Also, the revised procedures permit the use of a one-sided confidence level in the sample formula. The single sample constructed under the revised procedures of this Audit Guidance will consist of a maximum of 321 accounts.

 

.04 Projection of Underwithholding . The QI Agreement provides that if statistical sampling has been used and the auditor determines that underwithholding has occurred with respect to the sampled accounts, the IRS will determine the total amount of underwithheld tax by projecting the under-withholding over the entire population of similar accounts.

 

The proposed audit procedures would have provided that if the auditor used a sample and found that underwithholding had occurred with respect to an account in the sample, the auditor was required to report the underwithholding in the report for Phase 1 of the audit. In Phase 2 of the audit, the IRS would direct the external auditor to perform any additional procedures necessary to collect the information required to determine whether it was appropriate to project the underwithholding and any information required to make a projection. Finally, in Phase 3 of the audit, the QI could address whether projection was appropriate and could propose a projection using another amount of underwithholding based on a more accurate population, a more accurate projection technique, or an examination of all similar accounts.

 

The financial community expressed concern that the projection of underwithholding under the proposed guidance appeared to be automatic. Although the revised procedures under the attached Audit Guidance continue to follow the pattern adopted in the proposed Audit Guidance, they make clear that the issue of projection is deferred to Phase 2 of the audit. Under Phase 1 of the audit, the QI will be liable for any underwithholding discovered for the particular accounts examined in Phase 1. Whether an entire sample has been examined or the exploratory spot check option has been used, no projection of underwithholding will be required based on the external auditor’s report for Phase 1 of the audit. If, after review of the external auditor’s report for Phase 1, the IRS has concerns about underwithholding, the audit will proceed to Phase 2. Based on the follow up fact finding in Phase 2, the IRS will determine whether projection is appropriate and how to make a projection under the facts and circumstances of the particular case. An external auditor may use the footnote or addendum procedure explained previously to report facts relevant to a potential issue of projection of underwithholding as part of its report for Phase 1 of the audit to help the IRS to review the issue as efficiently as possible.

 

.05 External Auditor’s Reliance on Internal Auditors . The final Audit Guidance, like the proposed guidance, allows the external auditor to use a QI’s internal audit staff and internal audit reports to any extent the external auditor chooses. Nevertheless, the external auditor remains responsible for the conduct of the audit. The external auditor must disclose in the audit report specifically how and when it has used the QI’s internal audit staff and reports.

 

The proposed Audit Guidance would have required the external auditor to certify that the use of a QI’s internal audit personnel and reports has not affected the accuracy of the external auditor’s report. Auditing firms have claimed that such a certification cannot be made without duplicating the efforts of the QI’s internal auditors. To accommodate this concern, this final Audit Guidance has dropped the certification requirement. Based on the external auditor’s disclosure in its report for Phase I of the audit, the IRS will review how the use of a QI’s internal audit personnel and reports may have affected the accuracy of the external auditor’s report, and will take that review into account in determining whether any follow up in Phase 2 of the audit is appropriate.

 

SECTION 5. COMMENTS

 

The IRS and Treasury recognize that the QI system requires an innovative approach to the audit process and that the process will evolve as experience is gained. The IRS and Treasury will consider further modification of the Audit Guidance in light of experience and encourage further dialogue with the financial community.

 

SECTION 6. CONTACT INFORMATION

 

For further information regarding this Revenue Procedure, contact Carl Cooper or Laurie Hatten-Boyd of the Office of the Associate Chief Counsel (International), Internal Revenue Service, 1111 Constitution Avenue, N.W. , Washington , D.C. 20224 . Mr. Cooper and Ms. Hatten-Boyd may be contacted by telephone at 202–622–3840 (not a toll-free call). For general information relevant to qualified intermediaries, see the QI web site at: www.irs.gov/ and search the IRS site for “QI.”

 

 

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