This chapter deals
with classification of returns at the area office.Classification
is the process of determining whether a return should be
selected for examination, what issues should be examined, and
how the examination should be conducted. Classification should
be conducted by an experienced examiner who has received
appropriate tax law training. Examiners with MSSP expertise
should be used to classify business returns. DIF ordered
returns should be classified at the service center.
DIF returns are scored and selected for
examination by computer and delivered for screening by
Non-DIF returns will be manually classified
to select returns that contain significant issues likely to
result in tax changes or that require examination to achieve
voluntary compliance by an identifiable group of taxpayers.
All returns will be identified for
assignment to a revenue agent, a tax auditor or a tax
examiner. For revenue agent or tax auditor, assignment will be
based upon the complexity of the issues involved and the
degree of accounting and auditing skills required to conduct a
quality examination. For tax examiner, assignment will be
based on the degree of knowledge of tax law required.
Returns should be classified by examiners
possessing experience commensurate with the type of return and
activity code; i.e., Tax Examiners classifying DIF
Individual returns selected for examination
by revenue agents should contain issues requiring the full
accounting skills of a revenue agent. Individual returns not
requiring the full accounting skills of a revenue agent may be
selected for examination by revenue agents if tax auditors
(including traveling tax auditors) are not available in the
geographic location of the taxpayer or if the returns are
needed for training. Corporate, partnership, and fiduciary
returns will be designated for examination by revenue agents.
During the classification process, the scope
of the examination will be determined for all tax auditor
returns except for precontact analysis returns. The scope is
not determined for revenue agent returns. However, issues
identified which resulted in the return being selected for
examination, should be identified.
For effective use of our resources, the
classifier must decide which returns are most in need of
examination, and that through examination, will promote the
highest degree of voluntary compliance.
Be alert to items that would result in
potential overassessments as well as items that would
result in potential deficiencies.
Bring to the attention of the manager
any return where the classifier’s relationship with
the taxpayer may create a potential conflict of
Bring to the attention of the manager
any return where the type, industry or potential issue
is unfamiliar to the classifier.
Be alert to fraudulent refund schemes.
Be alert to potential preparer project
All returns received for classification will
be reviewed for international issues. Refer to the Examination
Law Enforcement Manual (LEM) for additional instructions. If
internal issues are present, the return should be referred to
an international examiner.
The following reference material should be
available for classifiers, along with this handbook:
The Examination LEM
ADP and IDRS Information (Document
Handbook containing AIMS information
Uniform Issues Code List
Local Classification Instructions
Discriminant Function (DIF) System
Many returns, both IMF and BMF, that are
examined each year are above the DIF cutoff score.
Therefore, a significant portion of the classifiers’ work
will be to screen DIF returns.
For each examination class, different
items on the return are scored. The score for an individual
item is based on TCMP correlation analyses. The total DIF
score for a return is the sum of the scores of the
individual items; and, the higher the score, the greater the
audit potential. DIF returns with the highest scores are
made available to Examination for manual screening. However,
scores for returns of different examination classes are not
comparable. DIF scores are shown on Form 5546 (Examination
Classifiers must use their skills,
technical expertise, local knowledge and experience to
identify hidden, as well as obvious, issues. The classifier
will determine whether the return should be examined, and if
so, whether by a tax examiner, office auditor, or revenue
agent. Those returns not selected for examination will be
accepted as filed.
Regardless of the type or class of return,
the classifier should first review the return in its
entirety. This action is important in that it:
Quickly gives a complete overview of
the total return to allow consideration of the various
income, expense, and credit items on the return.
Enables the classifier to evaluate
each item as to its significance.
Provides an opportunity to quickly
eliminate from consideration items or areas of the
return with low examination potential.
There are several factors that must be
considered when determining whether an item is significant:
Comparative size of the item: A
questionable expense item of $6,000 with total
expenses of $30,000 would be significant; however, if
total expenses are $300,000, ordinarily the item would
not be significant.
Inherent character of the item:
Although the amount of an item may be insignificant,
the nature of the item may be significant; i.e.,
airplane expenses claimed on a plumber’s Schedule C.
Evidence of intent to mislead: This
may include missing, misleading, or incomplete
schedules, or incorrectly showing an item on the
Beneficial effect of the manner in
which an item is reported: Expenses claimed on a
business schedule rather than claimed as an itemized
deduction may be significant.
Relationship to other item(s) on a
return: Business expenses without corresponding
income. Similarly, the lack of dividends reported when
Schedule D shows sales of stocks.
Sorting of Classified Returns
During the course of classification,
returns should be sorted as follows:
Selected returns for Field
Selected returns for Office
Examination — interview and precontact analysis.
Selected returns for Tax Examiners.
Returns accepted as filed. Returns
not selected for examination will be appropriately
Returns that are unusual in nature,
such as returns where Charge-Out documents are missing
or do not match the return, returns to be transferred,
special program returns (Tax Shelter, International
Issues, etc.), returns where the Charge-Out contains
special messages such as Information Report Available
(if not in the case file), and other returns as
provided by local instructions.
Classifiers will determine whether
individual returns will be examined by revenue agents (RA)
or tax auditors (TA), or tax examiners (TE). Guidelines are
provided in this handbook to determine the type and scope of
examinations for individual returns.
Area Classification Instructions
Each area should prepare local
classification instructions covering the following topics:
Criteria for office audit extended
time slot cases
Criteria for determining whether
individual returns should be examined by tax auditors or
Training return guidelines
District policy on identifying returns
for precontact analysis.
Review of Classification
PSP Support Manager has primary
responsibility for assuring the quality of returns selected
for examination. This is accomplished by assuring all
classifiers have received appropriate training on tax law and
area classification instructions. During each classification
detail the PSP Support Manager, or designee, may review a
representative sample of selected and accepted returns for
each classifier and provide appropriate feedback to the
classifier and Chief, Classification Section.
Standards for Classification
Discriminant Function (DIF) returns are
selected for screening by computer. Each selected DIF return
will be screened by an experienced examiner to eliminate
those returns not worthy of examination.
Non-DIF returns will be manually
classified by experienced examiners to select returns that
contain significant issues.
Where possible, returns should be
classified by market segment examiners.
All returns will be identified for
assignment to a revenue agent, tax auditor, or tax examiner
based on the complexity of the issues involved and the
degree of accounting and auditing skills required to conduct
a quality examination.
During the classification process, the
scope of the examination will be determined for all tax
auditor and tax examiner returns except for precontact
analysis returns and for designated revenue agent returns.
Review of Performance
A manager will conduct reviews of each
classifier. This requirement may be waived if the classifier
is a market segment specialist. Reviews should be performed
for each detail to which an examiner is assigned and on a
regular basis for permanent classifiers. A 10% sample of
classified returns is considered the minimum number if
returns to be reviewed, and will be expanded when problem
areas are identified. Through these reviews the manager will
Returns are selected for examination
or accepted as filed by classification in accordance
with established procedures
Accepted returns have little or no
examination potential or if examined would probably
result in no change cases
Classification checksheets, where
required, are properly completed and should not be
limited to single issues for tax auditor returns
because of the high no-change rate associated with
single issue examinations
Returns are properly selected for
Office and Field Examination
Returns are properly identified for
interview and precontact analysis, or for
The potential tax change is
sufficient to warrant selection, especially on returns
with a negative taxable income
Classifiers are maintaining a high
level of technical proficiency, exercising good
judgment in accepting and selecting returns, and
effectively utilizing their time
Classifiers need additional training
for screening DIF returns or manual classification of
Classification reviews will be documented
and discussed with the classifier prior to the end of the
detail. Form 5126 (Classification Quality Review Record) is
provided for this purpose and will be retained for two years
by the PSP Support Manager. A copy of Form 5126 will be
forwarded to the classifiers’ group manager.
A concurrent documented review of the
returns, selected and accepted as filed by classification,
used during the review of the classifier will be made to
A need for changes in instructions
Reasons for variations in select
rates among different classes of returns.
When the reviewing manager is other than
the PSP Support Manager or Chief, Classification Section,
the PSP Support Manager will be responsible for orienting
the manager regarding classification objectives,
instructions to classifiers, quality review procedures and
the documentation to be maintained. The PSP Support Manager
will retain overall responsibility for the quality of the
returns selected which includes the work performed by other
managers. In order to ensure the desired quality of
selections, the PSP Support Manager must maintain open
communication with the Chief, Classification Section.
These procedures are applicable to
examiners who classify returns for the area office. Note,
however, that quality review of classification should take
place regardless of whether classification is done at the
service center or the district. See Classification Details,
PSP Support Manager will consult with
Service Center Classification to determine the volume of
returns for classification and the average number of returns
classified per staff day. The PSP will determine the number of
classifiers needed considering:
Availability and experience level of
Availability of reviewers
Effectiveness of classifiers on
Impact of shifting examiners from
front-line duties to classification
Space available for classification
Travel costs, including weekends in
Midwest Automated Compliance System (MACS)
MACS can be used to identify issues during
classification. The MACS database contains Return Transaction
File data and certain Master File information for three years
for all taxpayers who filed in the area or campus (IMF and
1120, 1120S and 1065 filers). MACS has stringent operating
requirements to ensure the security of the data and taxpayer
Examination has full responsibility for
MACS, including security and sharing its benefits with other
IRS functions, e.g., Collection, Criminal Investigations,
Field Assistance, PRP and Compliance Research functions such
as Research and Analysis offices. Procedures must be
established at each user site to accommodate and prioritize
requests for MACS data. PSP Support Managers and Service
Center Classification should prioritize requests from other
functions. All requests should be written and approved in
advance before the system is accessed.
MACS may be used to retrieve specific
taxpayer data, e.g., a three-year comparison of a taxpayer’s
returns, including a Cash-T analysis. This information may be
used for case building or return selection decisions. A MACS
facsimile may be used in lieu of the original tax return,
similar to an RTVUE print.
MACS may be used to identify potential
noncompliance within a market segment and to select samples of
returns to test the level of noncompliance.
No taxpayer compliance contact should be
made on specific taxpayers identified using MACS, prior to the
approval of a Compliance Initiative Project (CIP).
Returns selected for compliance contact
using MACS based on any criteria other than activity code,
POD, PIA/PBA code and DIF score equal to or greater than the
locally computed DIF cutoff score must have an approved CIP
before contact is made.
The Automated DIF Delivery and Planning Tool
(ADDAPT) provides a method of classifying, controlling, and
maintaining an inventory of returns using MACS. Use of this
program is optional.
Returns not selected while the classifier is
using the MACS database do not require survey procedures.
The following guidelines apply when
returns are classified using MACS:
Proper approval must be obtained
before screening returns on MACS.
When determining whether a return
should be selected for audit, the classifier should
consider the return as a whole, not just the filter
criteria which caused it to be identified.
When practical, the classifier
should review the 3-year comparison to identify trends
on the return and to determine if issues are present
on multiple years.
If the area desires, a MACS return
may be used in place of an original return, and the
taxpayer may be requested to provide a copy of the
return at the beginning of the examination.
Form 5546—Examination Return Charge-Out
Before actually classifying a return, Form
5546 should be reviewed for information.
The following items on Form 5546 (See
Exhibit 4.1.5–2, Form 5546, Examination Return Charge-Out)
are relevant to the classifier:
Year, Form Number, Form type (TPI
Examination Class and DIF Score) are self-explanatory
Special Messages i.e., Information
Previous Examination Results—This
item will show the results of the two most recent
returns that have been closed by Examination, including
disposal code and amount of tax change. This
information, along with information from the No-Change
Issue Codes, can affect the classifier’s decision to
select or accept the return under consideration.
No-Change Issue Codes identify issues
which resulted in no-change to the taxable income for
any year reflected under Previous Year Examination
Results. The No-Change Issue Codes should be checked to
determine the issue(s) previously no-changed. If the
last examination of the taxpayer occurred in one of the
two preceding tax years and the examination resulted in
no-change (Disposal Code 01 or 02), the return will be
selected for examination only if issues, other than
those previously no-changed, are present on the return.
The charge-out document will also reflect issues
previously examined and no-changed, even though the
examination resulted in change or change/no-change. Each
classifier will be given a copy of the Uniform Issues
Code list for use while screening Forms 1040 and 1040A.
Accounts Receivable Dollar Inventory
(ARDI) Code — see the text dealing with ARDI codes,
later in this chapter.
The following exhibits can be found in IRM
4.4.1 AIMS/Processing Handbook:
Description of Examination Return
Charge-Out, Form 5546
Number/SSN—Social Security Number
Master File Tax Account Codes and Form
Non-Master File Tax Account Codes and
Area and Campus Codes
DIF Selection Codes
Status Codes—Area Office and Appeals
Push Codes and Special Handling
The following checksheets have been
developed to assist examiners in performing their duties. A
classification checksheet should be prepared for each return
classified. Local check may be used in lieu of those listed.
The purpose of the checksheet is to:
Set the scope for office or
correspondence examination cases by identifying all
Indicate if the examination should be
conducted by correspondence, interview or require a
Provide information for preparation of
initial contact letters on office examination cases.
Indicate the examination potential by
checking the appropriate assignment priority code on
selected non-DIF returns.
The checksheet will be stapled to the return
For Field examinations, classifiers should
provide comments to assist the examiner regarding the items
questioned. This information should be provided in the Remarks
Instructions for Preparation of Examination Classification
Checksheet (Form 6754 (6–94))
It is important to note that the
checksheet is designed for both non-business and business
issues and to allow for write-in issues (issue numbers
Since the taxpayer will be requested to
bring in certain records to the initial appointment based on
the items that are classified, it is important that the
classification of each return be accurately completed. Refer
to the Classification Handbook for the standard paragraphs
that show what will be requested from the taxpayer.
Classifiers are to use a red pen on the
checksheet. All blocks should be marked with an
"X" and not check marked, to reduce the
possibility of marking through more than one box.
Special Instructions (All Returns) for Form 6754
The Examination Classification Checksheet
(Form 6754) is composed of three sections:
Non-business issues (left side),
other taxes and tax credits (left side)
Schedule C, E, or F issues (right
write-in issues (bottom)
Care should be taken during the
classification process not to use the right side of the form
(Schedules C, E, or F issues) when these schedules are not
present on the return.
Classifiers will complete the following
blocks for each selected return:
Block A—Taxpayer Name and
SSN—Affix an "Examination" label with
Block B—Type of Examination.
Returns will be identified as either Correspondence,
Interview, or Precontact Analysis. Precontact Analysis
(Item 3) must be marked if any of the items below
More than 13 issues are
The return is selected but no
issues are identified.
The return is designated as an
A Power of Attorney (POA)
designation has been filed.
Form 5546 contains the literal
"PDT" for a potentially dangerous
An Accounts Receivable Dollar
Inventory (ARDI) Collectibility Indicator Code
of "B" (Bankruptcy), "N"
(Currently Not Collectible) or "C"
(Field Collection) appears on Form 5546,
Examination Return Charge-Out Sheet.
Block C—Special Inventory — One
of the items may be marked, if they apply in Figure
Block D—Priority Number—Only
entries listed in Figure 5–2 below may be made in
this block (no others will be accepted):
Block E, F and G are not used for
returns with issues that will require additional
Tax Auditor Phase I training returns. Issues that
may be included in Level 1 are: Non-Business
Expenses, Schedules A & E, Employee Business
Expenses, Exemptions, and Penalties.
Tax Auditor Phase II training returns. Issues that
may be included in Level 2, in addition to the
issues included in Level 1 above are: Schedule C
Expenses, Schedule D, Alternative Minimum Tax,
Asset Dispositions, complex Non-Business returns.
Level 3, optional
be used for revenue agent Phase I training returns
or tax auditor Phase III training returns.
for use at the discretion of the Area. Definition
to be established by the PSP Support Manager.
for use at the discretion of the area. Definition
to be established by the PSP Support Manager.
for an IRMF. Blue Tab case. Issue number 08
(Income W–2/1099) and/or 09 (Other Income)
should also be marked. This designation is used
when the Information Returns Master
File/Information Returns Program issue requires a
district interview to resolve the IRMF/IRP
discrepancy and meets the criteria specified in
Issue Numbers (Block H) are sequential and
generally appear in the same order on the tax return, Form
1040. Each Issue number (except number 32, Alternative
Minimum Tax, number 37, Other Taxes, and numbers 36 and 74,
Self Employment Tax) has a corresponding standard paragraph
which will be included in the initial contact letter. See
the Classification Handbook for the standard paragraphs.
Classifiers should become familiar with the contents of the
paragraphs before beginning the classification detail. Below
is additional information for completing issue numbers:
Number 10, IRMF—Red Tab Criteria,
is to be used when there is an IRMF issue that meets
the criteria specified in the LEM. Paragraph number 08
will be printed for both issue numbers 08 and 10, so
issue number 08 need not be marked if issue number 10
Numbers 50 through 82 are for
business issues. There are three columns available for
each issue. Use Column C–01 if the issue appears on
Schedule C, Column E–02 if the issue appears on
Schedule E, and Column F–03 if the issue appears on
Schedule F. You may use same issue for more than one
Numbers 33–35 are to be used for
issues that do not fit any of the preprinted
categories on the checksheet. Forty five spaces are
available to write in the issue. If the Centralized
Files and Scheduling (CF&S) appointment letter
program or a similar program is used, the computer
will print on the appointment letter exactly what is
shown on the checksheet, so care should be taken to
avoid abbreviations. Also, the write-in should not
duplicate or overlap other items identified on the
checksheet. Whenever possible, the language used on
the tax return should be used for the write-in. The
use of general phrases should be avoided.
The Remarks section should be used for any
comments or explanations the classifier would like to
provide to the examiner. The information is not transmitted
to the taxpayer so this section should not be used to
classify an issue. Do not enter any information that would
be inappropriate for disclosure to the taxpayer.
Special Instructions—Non-Business Returns
In non-business TPL Codes it is possible
to have business schedules where the Schedule C or F is not
the primary source of income.
By checking "specific" issues,
the taxpayer’s appointment letter will contain only the
information requested to examine that particular item, i.e.,
Other Dependents, Interest Expense, Automobile Expenses,
Stock Sales. The result is that we will not burden the
taxpayer with bringing records to the examination that are
not being questioned or to substantiate items which may not
have even been claimed on the return.
Phrases such as "Other Expenses"
should not be used since this will cause the taxpayer to
bring in substantiation for all such expenses. Rather, a
specific phrase should be used. This will also assist the
tax auditor examining the return.
Special Instructions—Business Returns
Business returns are designated by the
following TPI Activity Codes, based on the Total Gross
Receipts (TGR) contained on the return: Schedule C, Activity
Codes 535, 536, and 537; Schedule F, Activity Codes 538 and
If all books and records are needed, or if
gross receipts is a classified item, Issue number 50, Gross
Receipts Schedule C or F Issues, should be marked with an
Information Returns Program
The Information Returns Master File (IRMF)
Transcript is a listing of the information returns that have
been processed for the taxpayer. The IRMF Transcript Summary
is a summation by various payment groups of the information
returns printed on the IRMF Transcript.
The IDRS Terminal Responses IRM contains the
format of the IRMF Transcript with an explanation of the items
shown on the transcript.
Classifying Returns with IRMF Transcripts by Tax Auditors
and Revenue Agents
As part of the regular classification of a
DIF Scored individual return, the classifier will review the
IRMF transcript to identify discrepancies between the return
and the IRMF transcript.
If an income discrepancy exists between
the return and the IRMF transcript and meets the criteria
specified in the LEM, the classifier should determine
whether the IRMF issue can be resolved by interview (Blue
Tab) or correspondence (Red Tab). The appropriate number
will be entered in Block D of Form 6754.
The tax effect of carrybacks and
carryforwards of losses and/or credits should be considered
when applying the LEM criteria.
Adjustments to income should not be
proposed solely on information contained on the IRMF
Transcript concerning USDA payments. Contact with the
taxpayer, either by correspondence or interview, may be
necessary to determine the actual amount of USDA payments
If the return meets the criteria of
repetitive examination procedures, and there is a
discrepancy as outlined above, the return will be selected
for examination of the IRMF issue only.
IMF CTR Screening/Matching
The IRMF Transcripts also contain Currency
Transaction Report (CTR) data. The IDRS Terminal Responses
IRM also gives an explanation of the CTR data contained on
the IRMF Transcript.
The information contained on the IRMF
Transcript relating to CTR’s should assist the classifier
in making decisions on the need to recommend the use of
special auditing techniques, or to question source of income
not subject to withholding tax.
The CTR screening/matching program does
not replace the normal IRMF screening procedures.
BMF CTR Screening/Matching
BMF CTR Transcripts will be generated for
Forms 1041, 1065, and 1120 if there is CTR activity.
The IDRS Terminal Responses IRM contains
the format of the transcript and an explanation for the
items contained on it.
Revenue Agents will classify the BMIF CTR
Transcripts and related returns. The classifier should refer
to criteria specified in the LEM for further classification
Identifying Issues on Individual Returns
Returns containing office examination type
issues will be selected and assigned to tax auditors without
regard to distributive type of income or loss shown on the
return from partnerships (Form 1065), small business
corporations (Form 1120S) and fiduciaries (Form 1041).
Examination by tax auditor may include a comparison of the
individual taxpayer’s retained copy of a K–1 with the
amount of the distributive income or loss shown on the 1040.
If the information provided on the tax return indicates that
the partnership EIN was "applied for" or is left
blank, the K–1 should be inspected, but only if there are
other issues on the individual return that warrant
examination. If the K–1 should be inspected, the
distributor’s name and year of the K–1 to be submitted
should be listed on the classification checksheet. Returns
filed by distributors (Form 1065, 1120S and 1041) will be
classified independent of the Form 1040.
Non-Business Individual Returns
Determination of Office/Field Examination.
Once you determine that the return
will not be accepted as filed, it must be decided if
the examination should be conducted by a revenue agent
or a tax auditor. In making this determination, you
must give consideration to the type(s) of issue(s)
identified for examination.
You should not exclude substantial
issues to convert what would be a revenue agent
examination to a tax auditor examination. Nor do the
number of issues, standing alone, determine whether or
not the return is to be examined by a revenue agent or
a tax auditor.
Below are examples of items which
generally cause the return to be identified for field
Issues which require onsite
inspection of the taxpayer’s books, records or
Complex Schedule D transactions.
Returns with unusually complex
rental income and expenses.
Tax shelter returns.
Donations of real property which
would involve an engineering specialist.
Alimony, if it appears there is a
property settlement involving business property (i.e.,
accounts receivable, inventory).
Training Returns—Selected returns
meeting training criteria will be identified during each
classification detail, unless advised by the area that no
training will be conducted.
Tax Examiner Correspondence Examinations:
A return may be selected for correspondence examination if
all the questioned items are susceptible to direct
verification from records that could be easily submitted by
mail, and there are clear indications from review of the tax
return that the taxpayer can effectively communicate in
writing with the Service. Returns which do not meet this
test generally should not be examined by correspondence even
if the taxpayer is located in a remote area.
You should not exclude substantial
items from the checksheet to convert what might be an
interview examination to a correspondence examination.
Under centralized classification,
returns selected with these criteria should be
designated for the correspondence unit in the service
Some examples of issues which can be
verified by correspondence are: Simple itemized
deductions (exclusive of office-in-the-home, and
education expense); Filing Status; IRMF/IRP for Wages,
Interest, or Dividends; Payments to an IRA/Keough
Plan; Interest penalty on early withdrawal of savings;
Child care credit; Credit for the elderly; Earned
income credit; Residential energy credit; and Self
Single issues should generally not
be examined, as experience has shown that such
examinations frequently result in insignificant or no
tax change when other questionable items are not
present on the return.
HARA returns from examination
classes 530 and 532 may be selected for correspondence
technique if they have only correspondence issues.
Delinquent returns secured by the
Collection Function which appear to have income
omitted from Forms 1099, W–2, etc., should be
referred to Examination for screening. Returns
selected with no issues other than the omitted income
should be examined by area tax examiners, if
available; otherwise, they should be forwarded to the
Correspondence Examination unit at service centers.
Correspondence examinations may
include an inspection of a subsequent year return. If
the classifier determines that inspection of the
subsequent year return is warranted, consideration
should be given to use of RTVUE or MACS prints.
Tax Auditor Interview Examinations:
Individual returns identified for office interview
examinations should contain issues which lend themselves to
an analytical approach and require individual judgment in
addition to direct verification of records.
A classification checksheet will be
attached to each return identified for an office
Regardless of the issue, the return
will be identified for office interview method if, in
the judgment of the classifier, an office interview is
needed to ensure the taxpayer’s rights under the
Certain types of issues lend
themselves to interview examination. Examples:
Dependency exemptions; income from tips, pensions,
annuities, rents, fellowships, scholarships,
royalties, and income not subject to withholding;
deductions for business related expenses; deductions
for bad debts; determinations of basis of property;
deductions for education expenses; capital gain versus
ordinary income determinations; complex miscellaneous
itemized deductions such as casualty and theft, losses
where determinations of fair market value are
required; and deductions for employees business
expenses such as travel and entertainment.
Certain other factors indicate an
interview is necessary. For example, if the
taxpayer’s occupation is of the type that requires
only a limited formal education, or the appearance of
the return (writing, grammar, neatness, etc.)
indicates the taxpayer may not be able to effectively
communicate by letter, a face to face interview should
If the taxpayer’s income is low in
relation to financial responsibilities as suggested
from a review of the return (number of dependents,
interest expense, etc.), a face to face interview is
If the classifier determines that
the issues on the return require inspection or
examination of employment tax returns, the
classification checksheet should be noted to ensure
the initial contact letter includes a request that the
taxpayer bring in copies of employment tax returns.
This applies to examination classes 531 to 534 with a
Schedule C or F only. Examination classes 535 to 539
automatically generate the request for employment tax
information (if CF&S appointment letters are
Business returns may be identified
for office interviews.
All HARA returns will be identified
for office interviews, with the exception of
examination classes 530 and 532 with only
correspondence issues which may be selected for
Claims, Forms 1040X, amended Forms
1040, and Requests for Adjustment (Form 3870) will be
identified for correspondence or office interview
method based on the issues.
Tax Auditor Interview Examinations —
Precontact Analysis: Returns may contain issues, which,
based on the judgment and experience of the classifier,
require examination planning and analysis by a tax auditor
before contacting the taxpayer. Local classification
instructions will be followed in selecting a return for
precontact analysis. These returns should be kept to a
minimum, especially if the CF&S system is used.
Certain types of returns are subject
to precontact analysis. Examples: Returns with complex
issues requiring research before contacting the
taxpayer to arrange for the examination; returns where
income is low in relation to the taxpayer’s
financial responsibilities, and the audit techniques
necessary may involve a net worth statement, gross
profit reconstruction, or a statement of application
of funds (indirect methods); returns exhibiting
factors which indicate a need for visual inspection of
the taxpayer’s place of business or residence; any
returns (business or non-business) selected for
thirteen or more issues; any returns selected for
examination having an indication that a power of
attorney is on file; business returns that contain
more than one business schedule, either C or F, and
both schedules should be examined in depth; and
returns selected for examination identified as an IRS
Precontact analysis returns are
shown separately on the Centralized Files &
Scheduling PSP Inventory Report.
Discussed below are suggested guidelines
to assist in the identification of significant issues on
individual non-business returns. In identifying issues on
the classification checksheet, you should be specific.
Important! Look first at overall potential
based on the amount by which the itemized deductions exceed
the standard deduction.
Verify that itemized deductions are not
claimed elsewhere on the return when the standard deduction
has been elected (i.e., personal real estate taxes and
mortgage interest deducted on rental schedule).
Exemptions claimed by the noncustodial
parent have proven to have high potential for adjustment.
When married persons file separately, both
taxpayers may not have made the same election for standard,
or itemized deductions. If dependent children are claimed,
the other spouse may also be claiming them.
High medical expenses for large families,
deceased taxpayers, or older taxpayers are usually not
Real Estate Taxes—Consider changes in
address (i.e., W–2, 1040, 2119).
Productive issues could come from payments
to individuals, and closing costs on real estate
Home mortgage interest usually is
Check to see if contributions exceed 50
percent of Adjusted Gross Income (AGI).
Check large donations made to questionable
Check for payments which may represent
Check for large donations of property,
other than cash.
Casualty or Theft Loss
Watch for business assets, valuation
methods, and statutory limitations.
Scrutinize large, unusual, or questionable
Gains on sales of rental and other
depreciable property, where the taxpayer has been using an
accelerated method of depreciation or ACRS, should be
questioned since the taxpayer may have to report ordinary
Loss on the sale of rental property,
recently converted from a personal residence, is usually
Current year installment sales and
exchanges of property should be carefully scrutinized as
taxpayers frequently make errors in computing the recognized
Check to see if the gain on a sale is
large enough to require the alternative minimum tax
Pension and/or Annuity
Check whether the taxpayer received a
premature distribution from a pension/profit sharing plan.
Check whether distribution qualifies as a
lump sum distribution.
Consider fair rental value.
If the rental property is located at the
same address as the taxpayer’s residence, consider whether
the allocation is proper between the rental portion and the
portion used personally by the taxpayer.
Repairs may be capital improvements.
Consider whether the cost of land is
included in the basis.
The rental of vacation/resort homes should
Is the income sufficient to support the
Installment sale of property but no
Does the taxpayer show interest and real
estate tax deductions for two residences but no rental
If a taxpayer lists his/her occupation as
waiter, cab driver, porter, beautician, etc., tip income is
a productive issue.
Are there substantial interest expenses
with no apparent source of funds to repay the loans?
Does the taxpayer claim business expenses
for an activity that shows no income on the return (i.e.,
beautician supplies, but no Form 1099 or W–2 for that
Copy of Schedule K–1
Returns containing office examination type
issues will be selected for office examination without
regard to distributive type income from Forms 1065, 1120S,
and 1041. However, if the Schedule K–1 requires
inspection, the entity’s name and year of Schedule K–1
should be listed on the classification checksheet.
Items of self employment income shown on
Schedule K–1 should be matched to Schedule SE to ensure
that the amounts are properly included in the self
employment tax computation.
Review W–2’s for address and other
compensation. Also, consider sale of residence.
Employee Business Expenses
Amounts should be reasonable when compared
to the taxpayer’s occupation and income level.
Avoid auto expenses as an issue where the
standard mileage computation is used and the mileage shown
does not appear excessive.
Transportation expenses for construction
workers, carpenters, etc., who appear to have several
different employers at different locations, have not proven
to be productive. However, be alert for expenses claimed for
travel to a remote job site(s).
Expenses for clubs, yachts, airplanes,
etc., must meet the facilities requirements of IRC 274 and
therefore, are usually productive issues.
Taxpayer’s Previous/Subsequent Year Return
Determine whether the previous/subsequent
year return should be inspected. If so, you must note the
checksheet. Situations where inspection may be warranted
Probable carryover adjustments
(i.e., capital loss carryover, substantial
Items which, if disallowed in the
selected year, may be allowable in the following year.
Files and Scheduling letters are used, the appointment
letter instructs taxpayers to bring in a copy of the prior
year return and the subsequent year return, if filed.
Business Individual Returns
Determination of Office/Field
Examinations—One of the key contributions to the success
or failure of our Examination Program in the business
categories is the selection of the proper function to
conduct the examination. If we are to meet our Program
objectives, it is essential that we input those returns that
are most adaptable for office interview to Office
Examination and those requiring the skills of a revenue
agent to Field Examination. This decision is very important
from several aspects:
The planned time of an examination
of a business return in Office Examination is about
half of that planned for Field Examination. However,
substantial issues should not be excluded as
identified issues to convert what would be a Revenue
Agent assignment, to a Tax Auditor assignment.
Office examinations usually do not
involve a visitation to the taxpayer’s place of
business. Field examination returns should require a
more in-depth knowledge of accounting principles.
Generally, business returns should be
selected for Field Examination when the following conditions
Complex accounting method
Extensive time frame required to
complete the examination
Advisability of on-site inspection
Inventories are substantial and
Termination of business before the
end of the taxable year
Unusual issues that appear to be
complex and time consuming to develop. For example:
Nontaxable transfers; Complex oil or mineral
explorations; Sale of IRC 1231 assets; or Unstated
interest (IRC 483)
The size of a business is also an
indicator of what may be involved when an actual examination
is made of the books and records of any particular taxpayer.
Certain businesses would normally not be
adaptable to Office Examination, such as contractors,
manufacturers, auto dealers, and funeral parlors.
The areas discussed above are meant to
operate only as a guide. In addition to considering these
items, heavy reliance must be placed on judgment and
Is the taxpayer engaged in the type of
business or profession normally considered to be more
profitable than reflected on the return?
Is the standard deduction used with high
gross income and low net profit shown on the business
schedule? Experience has shown that the incidence of fraud
is greater on low business returns when the returns reflect
large receipts ($100,000 or more), sizeable investments, and
standard deductions are claimed.
Do the address, real estate taxes and/or
mortgage interest indicate a higher standard of living than
justified by the reported income?
Does the return reveal large amounts of
interest/dividend income not commensurate with current
sources of income?
Cost of Goods Sold
Check for the possibility of withdrawal of
items for personal use.
Is the ending inventory inclusive of all
costs, direct and indirect?