IRS Audits - Part 4 Examining Process

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IRS Audits

Chapter 14. Statutory Notices of Deficiency

Section 1. Statutory Notices of Deficiency Issued by Area Offices (Cont. 1)

4.14.1  Statutory Notices of Deficiency Issued by Area Offices (Cont. 1)

4.14.1.12 
Overassessments and Claims

4.14.1.12.4  (10-30-2004)
Claims Relating to Net Operating Loss or Capital Loss

  1. Generally, the time to file a claim for refund related to a net operating loss or capital loss carryback is 3 years after the due date of the return (including any extension of time to file) for the tax year of the loss.

  2. Depending upon the circumstances, a Tax Court proceeding may or may not affect a carryback-related refund claim. A Tax Court proceeding is conclusive with respect to an NOL or capital loss carryback which is an issue in the proceeding, even though the loss year itself is not before the court. However, taxpayers may still be entitled to refunds based on the carrybacks that were not at issue, even for deficiency years. For overassessment years, as with non-carryback-related claims, the limitations period for carryback-related claims is unaffected by the issuance of a deficiency notice. An application for tentative refund allowance (Form 1045 or Form 1139) is not a refund claim and does not protect the refund statute.

  3. Because of the complex nature of cases with net operating or capital losses, any update of a carryback statute must be coordinated with, and the files reviewed by, the designated technical person. This is necessary to determine whether the statute may remain open under IRC section 6511 and what actions are appropriate to protect the taxpayer's right of appeal.

4.14.1.13  (10-30-2004)
Special Issues

  1. The following includes instructions for issues requiring nonroutine treatment when preparing notices of deficiency.

4.14.1.13.1  (10-30-2004)
Accumulated Earnings Tax IRC Section 531

  1. In a proceeding before the Tax Court involving accumulated earnings and profits, the burden of proof (as to the allegation that earnings and profits have been permitted to accumulate beyond the reasonable needs of the business) is on the Commissioner, unless notification is sent to the taxpayer under IRC Section 534(b).

  2. If notification is sent to the taxpayer and (1) the taxpayer timely submits the statement (i.e., the grounds on which the taxpayer relies to establish that there has been no accumulation of earnings and profits beyond the reasonable needs of the business) and (2) such grounds are supported by facts contained in the statement, then the burden of proof will be on the Commissioner as to the grounds given in the statement. See section 1.534–2(a)(2) of the Income Tax Regulations.

  3. Pattern Letter 572 (Exhibit 4.14.1–3) is sent by certified or registered mail to notify the taxpayer. Pattern Letter 572 is issued prior to the issuance of the notice of deficiency unless expiration of the statute of limitations is imminent. Officials delegated to sign notices of deficiency pursuant to Servicewide Delegation Order 4-8 (formerly Delegation Order 77) are also empowered to sign notifications under IRC 534(b).

  4. The notice of deficiency is prepared using Letter 531 (DO). The following sample paragraphs may be used for the explanation of adjustments in accumulated earnings tax cases.

  5. Statement Filed — Credit for Reasonable Needs

    " It has been determined that your organization was formed or availed of so your shareholders could avoid income tax by permitting earnings and profits to accumulate instead of being divided or distributed during the taxable year ended__. Accordingly, the accumulated earnings tax provided by Section 531 of the Internal Revenue Code is being asserted."

     

    " In determining your accumulated earnings tax credit under Section 535 of the Code, consideration was given to the statement you filed dated-----, in response to the notification sent to you by certified mail on -----, as required by Section 534(b) of the Code. That part of your earnings and profits for the taxable year ended--------, which was retained for the reasonable needs of your business, was $------. In figuring your accumulated earnings tax, an accumulated earnings credit of $----- is allowed, as follows: (Insert computation of credit.)"

     

  6. Statement Filed — Minimum Credit AIIowed

    " It has been determined that your organization was formed or availed of so your shareholders could avoid income tax by permitting earnings and profits to accumulate instead of being divided or distributed during the taxable year ended-----. Accordingly, the accumulated earnings tax provided by Section 531 of the lnternal Revenue Code is being asserted."


    "In determining your accumulated earnings credit under Section 535 of the Code, consideration was given to the statement you filed dated-----, in response to the notification sent to you by certified mail on-----, as required by Section 534(b) of the Code."


    "The information shown in your statement is not sufficient to establish that any part of your earnings and profits for the taxable year ended __was kept for reasonable needs of your business. Accordingly, the minimum accumulated earnings credit has been allowed and computed as follows: (Insert computation of credit.)"

     

  7. No Statement Filed — Minimum Credit Allowed

    " It has been determined that your organization was formed or availed of so your shareholders could avoid income tax by permitting earnings and profits to accumulate instead of being divided or distributed during the taxable year ended -----. Accordingly, the accumulated earnings tax as provided by section 531 of the Internal Revenue Code is being asserted."


    "In figuring the accumulated earnings tax, the minimum accumulated earnings credit has been allowed and computed as follows: (Insert computation of credit)"


    "Notification was sent to you by certified mail on (date) under Section 534(b) of the Internal Revenue Code, but we have no record of a statement in response to the notification as allowed by Section 534(c) of the Code."

     

4.14.1.13.2  (10-30-2004)
Failure to File and Failure to Pay Penalties (Delinquency Penalties)

  1. The portion of the IRC sections 6651(a)(1), Failure to File Penalty, and 6651(a)(2), Failure to Pay Penalty, attributable to the original liability on a delinquently filed return is not subject to deficiency procedures (see IRC section 6665(b)).

  2. The statute of limitations on assessment with respect to the 6651(a)(1) and 6651(a)(2) penalties on the original liability runs from the date the delinquent return is filed and is not suspended during Tax Court proceedings.

  3. The provisions contained in (1) and (2), immediately above, do not apply to cases where the notice of deficiency is issued before the taxpayer files a late original return.

  4. A notice of deficiency issued on a " substitute for return," for returns due after July 30, 1996, must indicate the appropriate IRC section 6651(a) penalty on the letter and waiver.

    1. If the amount of the addition to tax has accrued for the full fifty-month period (25-percent of the amount of the unpaid tax), then the notice of deficiency should reflect the full amount of the addition to tax owed by the taxpayer as per IRC section 6651(a)(2).

    2. If the amount of the addition to tax has not accrued for the full fifty-month period, then the notice of deficiency should not include a dollar amount for the IRC section 6651(a)(2) penalty, but should state that the amount of the addition to tax cannot be determined at this time. The penalty amount will be shown as an asterisk (*) with the explanation that the amount cannot be determined at this time.

    3. The following explanations should be included with the explanations of adjustments. See section 4.14.1.6.6, Explanation of Adjustments, above.


    "Since you did not file an income tax return for the taxable year ended___ within the time prescribed by law and you have not shown that your failure to file on time was due to reasonable cause, a penalty of 5 percent per month up to a maximum of 25 percent of the tax is added as provided by section 6651(a)(1) of the Internal Revenue Code."

    Note:

    Substitute 4.5 percent and 22.5 percent for 5 percent and 25 percent, respectively, if IRC section 6651(a)(2) penalty is also being asserted.

     


    AND, IF IRC SECTION 6651(a)(2) APPLIES


    "Since you have not shown that the underpayment of tax for the taxable year ended __was due to reasonable cause, a penalty of 0.5 percent per month (but not to exceed a total of 25%) is added to the tax from the due date of the return (without regard to extension) until the date of payment as provided by section 6651(a)(2) of the Internal Revenue Code."


    Note:

    The provisions of IRM 4.14.1.13.2 also apply when the failure to file (section 6651(a)(1)) penalty rates are enhanced by IRC section 6651(f) for fraudulent failure to file.


    Caution:

    Before any notice of deficiency is issued in substitute-for-return situations, the preparer of the notice of deficiency must ensure that a valid section 6020(b) return has been prepared for all nonfiled tax periods included in the notice of deficiency. This is necessary for the Service to sustain the assertion of any penalty under IRC section 6651(a)(2). Generally, a valid section 6020(b) return would include the following documents attached together in the order shown below (see IRM 4.12.1, Nonfiled Returns):

    1) A properly completed and signed (by an official delegated by Servicewide Delegation Order 5-2, formerly DO 182) Form 13496, IRC Section 6020(b) Certification, for each of the nonfiled tax periods included in the notice of deficiency

    2) A copy of the Form 1040 that was used to post the SFR Transaction Code 150, or beginning with substitutes-for-return established on Master File in January 2004 and thereafter through the new systemic input procedure, a transcript of the taxpayer's account reflecting the substitute-for-return TC 150 posting for each nonfiled tax period

    3) Form 4549 or Form 4549-A, Income Tax Examination Changes, signed by a duly authorized IRS employee and Form 886-A, Explanation of Items

    If the notice preparer determines that a valid section 6020(b) return has not been prepared, then he/she must take action to accomplish the preparation and inclusion in the case file of a valid section 6020(b) return for each nonfiled tax period included in the notice of deficiency before any notice of deficiency is issued.

     

4.14.1.13.3  (10-30-2004)
Open Criminal Cases

  1. If a a civil operating division determines that a notice of deficiency is required in an active criminal case, the following procedures apply:

    1. A memorandum (Form 10498A or Form 10498B can be used for this purpose) should be submitted to the appropriate Special Agent in Charge (CI) by the Field Territory Manager or the Technical Services Territory Manager, depending upon the location of the case.

    2. The Special Agent in Charge (CI) will consult with Criminal Tax (Counsel) and the Department of Justice in grand jury cases. The Special Agent in Charge (CI) will transmit a concurrence or provide objections to the issuance of a notice of deficiency to the civil operating division. Disagreements as to the conclusions reached by the Special Agent in Charge (CI) will be elevated to the Area Director level, who will discuss the situation with the Director of Field Operations (CI). If agreement is still not achieved, the case will be elevated to the operating division commissioner level and Chief, CI for resolution.

    3. The Pattern Letter at Exhibit 8.17.4–4 and Form 4089–A, Notice of Deficiency Statement, will be used in a notice of deficiency for an open criminal case.

    4. No waiver or agreement permitting the taxpayer to agree to a deficiency will be prepared.

    5. Area Counsel's written approval of the notice of deficiency is required prior to issuance.

    6. A copy of the issued notice of deficiency should be provided to the appropriate Special Agent in Charge (CI).

     

  2. If only one spouse is liable for the fraud penalty, then separate notices of deficiency are issued. The fraud penalty will be included on the notice for the culpable spouse.

4.14.1.13.4  (10-30-2004)
Civil Fraud Penalty (IRC Section 6663)

  1. If the taxpayer is convicted (after trial or upon guilty plea) of a violation of 26 U.S.C. 7201, Attempt to Evade or Defeat Tax, the taxpayer is collaterally estopped from denying liability for a civil fraud penalty. Thus, the civil fraud penalty is automatic and it cannot be conceded by Examination if the taxpayer is found guilty (after trial or upon a guilty plea) of evasion charges.

  2. The doctrine of collateral estoppel does not apply if the taxpayer was convicted of a violation of 26 U.S.C. 7203, Willful Failure to File Return, Supply Information or Pay Tax, or 26 U.S.C. 7206(1), Declaration Under Penalty of Perjury. Thus, in these circumstances, the civil fraud penalty is not automatic.

  3. For years 1989 and later, the delinquency and fraud penalties can be asserted concurrently. If asserting the IRC section 6651(f), fraudulent failure to file penalty, and the IRC section 6663, fraud penalty, on the same tax period of the taxpayer, see IRM 20.1.5.12.2.

4.14.1.13.5  (10-30-2004)
Alternative to Civil Fraud Penalty

  1. The negligence or accuracy-related penalty (IRC section 6662), and the failure to pay and failure to file penalties, if applicable, should be included in the explanation of adjustments as alternative penalties to the civil fraud penalty except in the following situations.

    • A criminal conviction under 26 U.S.C. 7201 collaterally estops the taxpayer from denying fraud, or

    • The statute of limitation has expired in the absence of a finding of fraud.

     

  2. The following alternative penalty explanation for the accuracy-related penalty may be used following the explanation of the civil fraud penalty.

    In the alternative, if it is determined that the underpayment of tax in the amount of $----- for the taxable year ended ----- is not due to fraud, then it is determined that the underpayment of tax in the amount of $----- is due to negligence or disregard of rules and regulations under section 6662(b)(1) of the Internal Revenue Code or the underpayment constitutes a substantial understatement of income tax under the provision of IRC section 6662(b)(2).

     

4.14.1.13.6  (10-30-2004)
Tax Required to be Withheld at Source

  1. A notice of deficiency with a deficiency from income tax required to be withheld at source under Chapter 3 of the Internal Revenue Code will include the following opening paragraph in Letter 902 (DO):

    "In accordance with the provisions of existing internal revenue laws, notice is given that the determination of your liability for withholding of income tax at source for the taxable year ended ----- discloses a deficiency of $-----. The attached statement shows the computation of the deficiency."

     

4.14.1.13.7  (10-30-2004)
Tip Income and FICA Tax Informational Notice

  1. An informational notice should be sent to the taxpayer with the notice of deficiency when tip income is adjusted and FICA tax and penalties are assessed. The notice informs the taxpayer that a separate notification will be (or has been) sent from the service center for the FICA tax and penalties. The notice will lessen the confusion regarding the receipt of two separate bills for income tax and FICA tax and penalties.

  2. The informational notice is not actually part of the notice of deficiency; therefore, the following actions must be taken when the notice is sent with the notice of deficiency.

    1. The notice must be labeled "For Informational Purposes Only."

    2. The notice must be on a separate page apart from any of the actual parts of the notice of deficiency.

    3. The specific language shown in Exhibit 4.14.1–4 must be used for the notice.

     

4.14.1.13.8  (10-30-2004)
Notices with Prepayment Credit Adjustments

  1. A statement must accompany the notice of deficiency, following the compilation of the statutory deficiency, when there is an understatement of prepayment credits. The following statement should be used to set forth the adjustment to prepayment credits. This statement does not apply to adjustments to earned income credit (EIC) and fuel tax credits.

         
    Prepayment Credit Adjustment
    Statutory Deficiency   $___
    Correct Amount of Prepayment Credits:  
     Federal Income Tax Withheld: $__  
     Estimated Tax Payments: $__  
    Correct Prepayment Credit:   $___
         
    Prepayment Credits Claimed on Return:  
     Federal Income Tax Withheld: $__  
     Estimated Tax Payments: $__  
    Total Prepayment Credits on Return:   $___
         
    Understatement of Prepayment Credits: $___
         
    Net additional tax (or net overpayment): $___
         

     

  2. The Notice of Deficiency waiver will show the full statutory deficiency before adjustments to the prepayment credits.

  3. In no case will the statement accompanying the notice of deficiency reflect an adjustment decreasing the prepayment credits claimed by the taxpayer. Under section 6201(a)(3), assessments based on such adjustments are not subject to deficiency procedures.

    1. Any adjustment decreasing prepayment credits claimed by the taxpayer will be corrected prior to the issuance of the notice of deficiency by Technical Services.

    2. The portion of the administrative file necessary to decrease the prepayment credits will be forwarded to Case Processing. After the adjustment is made by Case Processing, the file will be returned for issuance of the notice of deficiency.

    3. If sufficient time does not remain on the assessment statute for the prepayment credits to forward the file to Case Processing for adjustment of the prepayment credits in the normal course of business, then the notice writer must act to ensure the prepayment credit adjustments are assessed before the statute expires and the notice of deficiency resulting from other issues is timely issued.

     

4.14.1.13.9  (10-30-2004)
Earned Income Credit and Fuel Tax Credits

  1. Adjustments to earned income credit (EIC) and fuel tax credits are included in the deficiency amount for tax computation purposes. However, separate assessments are made for EIC, fuel tax credits and other deficiency amounts due when assessed.

  2. The Special Handling Notice should indicate which credit is includible in the deficiency amount and on the waiver form.

4.14.1.13.10  (10-30-2004)
IRC 6015: Relief from Joint and Several Liability On Joint Return(s)

  1. See IRM 8.17.4.11, Notices of Deficiency Involving "Innocent Spouses" , and related subsections. When referring to IRM 8.17.4.11, SB/SE employees should substitute "Letter 531 (DO)" when "Letter 894 (RO)" is cited in the text and bear in mind that IRM 25.15, Relief From Joint And Several Liability, is the current cross reference, not IRM 104.5.

4.14.1.14  (10-30-2004)
Special Cases

  1. The following includes instructions for cases requiring non-routine treatment when preparing a notice of deficiency.

4.14.1.14.1  (10-30-2004)
Consolidated Returns

  1. If a deficiency represents the consolidated income tax liability of an affiliated group of corporations, a reference to the consolidated group is used in the taxpayer's name line of the Letter 531 (DO), for example, Corporation X and Subsidiaries (a consolidated group).

  2. The summary of the tax liability will show the returns examined on a separate statement following Form 4089, Notice of Deficiency Waiver, illustrated as follows.

    Attachment to Form 4089    
      Statement
           
    Name (Parent Company)      
    Address      
    Returns Examined    
           
      Form TIN Taxable
    Year Ended
    A Company 1120 xx-xxxxxx 12/31/00
          12/31/01
    Subsidiary Companies      
    B Company 1120 xx-xxxxxx 12/31/00
    C Company 1120 xx-xxxxxx 12/31/00
          12/31/01
    D Company 1120 xx-xxxxxx 12/31/00

     

  3. The following statements will be added after the summary of the tax liability.

    The tax liability of A Company and each subsidiary company named above is stated as provided for by the regulations prescribed under section 1502 of the Internal Revenue Code.


    The deficiency shown will be assessed severally against each corporation named above in accordance with the regulations prescribed under IRC section 1502.

     

4.14.1.14.2  (10-30-2004)
Jeopardy and Termination Assessments

  1. A notice of deficiency for a jeopardy assessment case must be issued within 60 calendar days after the jeopardy assessment or the jeopardy assessment is not valid. The notice of deficiency, however, remains valid.

    1. Letter 895 (DO) and Form 4089–A, Notice of Deficiency Statement, will be used for income tax straight deficiency cases involving one or more years.

    2. Letter 896 (DO) and Form 4089–A will be used for income (other than straight deficiency), estate and gift tax cases and special cases such as transferee, affiliated groups, withholding at source, etc.

     

  2. A notice of deficiency for a termination assessment case must be issued within 60 calendar days after the later of the:

    1. due date of the return (including extensions), or

    2. date the taxpayer filed the return.

     

  3. Failure to issue the notice of deficiency within the 60 calendar day period renders the termination assessment invalid, but the notice of deficiency remains valid. The notice will consist of Letter 531 (DO), Form 4089 Statement, and Form 886–A, Explanation of Items.

  4. Special instructions relating to the preparation of a notice of deficiency relating to jeopardy and termination assessments under IRC sections 6851, 6861, 6862, and 6867 are in IRM 4.15.6.

4.14.1.14.3  (10-30-2004)
Bankruptcy Cases

  1. Special instructions relating to the preparation of a notice of deficiency involving bankruptcy cases are in IRM 4.27.3, Bankruptcy – Review & Processing Procedures.

4.14.1.14.4  (10-30-2004)
Transferor — Transferee Liability Cases

  1. A notice of deficiency issued to a transferee will include the following:

    1. Letter 902 (DO) and Letter 1005 (DO) (bankruptcy and receivership) with specific opening paragraphs as provided in section 4.14.1.14.4.1 below.

    2. Statement — Summary of liability of the transferee with specific explanatory paragraphs as provided in section 4.14.1.14.4.3 below.

    3. Form 870 or Form 890 (estate tax), Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment, with specific paragraphs as provided in section 4.14.1.14.4.4, below.

     

4.14.1.14.4.1  (10-30-2004)
Transferee Letter Opening Paragraphs

  1. Letter 902 (DO) or Letter 1005 (DO) (bankruptcy and receivership) will include special opening paragraphs. Since the opening paragraph will identify the name and address of the transferor, the mailing address shown on the 90-day letter to the transferees will include only the name and address of the transferee.

  2. Liability for an unpaid original tax of the transferor:

    "We will assess against you the amount of $---, plus interest as provided by law, constituting your liability as transferee of assets of (Transferor), (Address), for unpaid income tax due from (Transferor), for the taxable year ended ---, as shown in the attached statement."

     

  3. Liability for an unpaid deficiency of the transferor:

    " The determination of the income tax liability of (Transferor), (Address), for the taxable year ended ---, discloses a deficiency in the amount of $---, as shown in the attached statement. The amount of the deficiency, plus interest as provided by law, constitutes your liability as transferee of assets of (Transferor), and will be assessed against you."

     

  4. Unpaid deficiency of the transferor for one year in excess of an overpayment by the transferor for another year:

    "The determination of the income tax liability of (Transferor), (Address), for the taxable years ended --- and ---, discloses a deficiency in the amount of $--- for the taxable year ended ---, and an overassessment for the taxable year ended ---, as shown in the attached statement. The amount of the deficiency, plus interest as provided by law, constitutes your liability as transferee of assets of (Transferor), and will be assessed against you. The overassessment, to the extent that it represents an overpayment of tax, will be refunded or credited as provided by law."

     

  5. Value of the assets received by the transferee is less than the unpaid deficiency of the transferor:

    "The determination of the income tax liability of (Transferor), (Address), for the taxable year ended ---, discloses a deficiency in the amount of $--- as shown in the attached statement. $--- of the amount of the income tax deficiency, plus interest as provided by law, will be assessed against you as transferee of assets of (Transferor)."

     

  6. Transferee of a transferee with respect to their liabilities for an unpaid deficiency of the transferor:

    "The determination of the income tax liability of (Transferor), (Address), for the taxable year ended ---, discloses a deficiency in the amount of $---, as shown in the attached statement. The amount of the