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 Return Charge-Out).

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:

There are several factors that must be considered when determining whether an item is significant:

During the course of classification, returns should be sorted as follows:

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.

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.

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 ascertain if:

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 identify:

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, next.

The following guidelines apply when returns are classified using MACS:

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 33–35).

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.

The Examination Classification Checksheet (Form 6754) is composed of three sections:

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:

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:

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.

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.

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 539.

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 "X."

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 received.

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.

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 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 instructions.

Determination of Office/Field Examination.

Below are examples of items which generally cause the return to be identified for field examination:

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.

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.

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.

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 productive.

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 transactions.

Home mortgage interest usually is unproductive.

Check to see if contributions exceed 50 percent of Adjusted Gross Income (AGI).

Check large donations made to questionable miscellaneous charities.

Check for payments which may represent tuition.

Check for large donations of property, other than cash.

Watch for business assets, valuation methods, and statutory limitations.

Scrutinize large, unusual, or questionable items.

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 income.

Loss on the sale of rental property, recently converted from a personal residence, is usually productive.

Current year installment sales and exchanges of property should be carefully scrutinized as taxpayers frequently make errors in computing the recognized gain.

Check to see if the gain on a sale is large enough to require the alternative minimum tax computation.

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 be scrutinized.

Is the income sufficient to support the exemptions claimed?

Installment sale of property but no interest reported.

Does the taxpayer show interest and real estate tax deductions for two residences but no rental income?

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 occupation)?

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.

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.

Determine whether the previous/subsequent year return should be inspected. If so, you must note the checksheet. Situations where inspection may be warranted are:

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:

Generally, business returns should be selected for Field Examination when the following conditions occur:

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 experience.

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?

Check for the possibility of withdrawal of items for personal use.

Is the ending inventory inclusive of all costs, direct and indirect?