Classification

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Classification

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4.1.5  Classification

4.1.5.1  (05-19-1999)
Overview

  1. 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.
  2. DIF returns are scored and selected for examination by computer and delivered for screening by examiners.
  3. 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.
  4. 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.
  5. Returns should be classified by examiners possessing experience commensurate with the type of return and activity code; i.e., Tax Examiners classifying DIF Correspondence returns.
  6. 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.
  7. 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.
  8. 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.
  9. Classifiers should:
    1. Be alert to items that would result in potential overassessments as well as items that would result in potential deficiencies.
    2. Bring to the attention of the manager any return where the classifier’s relationship with the taxpayer may create a potential conflict of interest.
    3. Bring to the attention of the manager any return where the type, industry or potential issue is unfamiliar to the classifier.
    4. Be alert to fraudulent refund schemes.
    5. Be alert to potential preparer project returns.

     

  10. 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.
  11. The following reference material should be available for classifiers, along with this handbook:
    1. The Examination LEM
    2. ADP and IDRS Information (Document 6209)
    3. Handbook containing AIMS information
    4. Uniform Issues Code List
    5. Local Classification Instructions Handbook

     

4.1.5.1.1  (05-19-1999)
Discriminant Function (DIF) System

  1. 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.
  2. 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).
  3. 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.
  4. 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:
    1. Quickly gives a complete overview of the total return to allow consideration of the various income, expense, and credit items on the return.
    2. Enables the classifier to evaluate each item as to its significance.
    3. Provides an opportunity to quickly eliminate from consideration items or areas of the return with low examination potential.

     

  5. There are several factors that must be considered when determining whether an item is significant:
    1. 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.
    2. 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.
    3. Evidence of intent to mislead: This may include missing, misleading, or incomplete schedules, or incorrectly showing an item on the return.
    4. 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.
    5. 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.

     

4.1.5.1.2  (05-19-1999)
Sorting of Classified Returns

  1. During the course of classification, returns should be sorted as follows:
    1. Selected returns for Field Examination.
    2. Selected returns for Office Examination — interview and precontact analysis.
    3. Selected returns for Tax Examiners.
    4. Returns accepted as filed. Returns not selected for examination will be appropriately stamped.
    5. 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.

     

  2. 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.

4.1.5.2  (05-19-1999)
Area Classification Instructions

  1. Each area should prepare local classification instructions covering the following topics:
    1. Local issues
    2. Questionable practitioners
    3. Criteria for office audit extended time slot cases
    4. Criteria for determining whether individual returns should be examined by tax auditors or revenue agents
    5. Training return guidelines
    6. District policy on identifying returns for precontact analysis.

     

4.1.5.3  (05-19-1999)
Review of Classification

  1. 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.

4.1.5.3.1  (05-19-1999)
Standards for Classification

  1. 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.
  2. Non-DIF returns will be manually classified by experienced examiners to select returns that contain significant issues.
  3. Where possible, returns should be classified by market segment examiners.
  4. 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.
  5. 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.

4.1.5.3.2  (05-19-1999)
Review of Performance

  1. 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:
    1. Returns are selected for examination or accepted as filed by classification in accordance with established procedures
    2. Accepted returns have little or no examination potential or if examined would probably result in no change cases
    3. 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
    4. Returns are properly selected for Office and Field Examination
    5. Returns are properly identified for interview and precontact analysis, or for correspondence examination.
    6. The potential tax change is sufficient to warrant selection, especially on returns with a negative taxable income
    7. Classifiers are maintaining a high level of technical proficiency, exercising good judgment in accepting and selecting returns, and effectively utilizing their time
    8. Classifiers need additional training for screening DIF returns or manual classification of other returns.

     

  2. 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.
  3. 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:
    1. A need for changes in instructions to classifiers
    2. Reasons for variations in select rates among different classes of returns.

     

  4. 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.
  5. 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.

4.1.5.4  (05-19-1999)
Classification Details

  1. 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 classifiers
    • Availability of reviewers
    • Effectiveness of classifiers on extended details
    • Impact of shifting examiners from front-line duties to classification
    • Space available for classification
    • Travel costs, including weekends in travel status.

     

4.1.5.5  (05-19-1999)
Midwest Automated Compliance System (MACS)

  1. 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 privacy.
  2. 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.
  3. 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.
  4. MACS may be used to identify potential noncompliance within a market segment and to select samples of returns to test the level of noncompliance.
  5. No taxpayer compliance contact should be made on specific taxpayers identified using MACS, prior to the approval of a Compliance Initiative Project (CIP).
  6. 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.
  7. 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.
  8. Returns not selected while the classifier is using the MACS database do not require survey procedures.

4.1.5.5.1  (05-19-1999)
MACS Classification

  1. The following guidelines apply when returns are classified using MACS:
    1. Proper approval must be obtained before screening returns on MACS.
    2. 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.
    3. 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.
    4. 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.

     

4.1.5.6  (05-19-1999)
Form 5546—Examination Return Charge-Out

  1. Before actually classifying a return, Form 5546 should be reviewed for information.
  2. The following items on Form 5546 (See Exhibit 4.1.5–2, Form 5546, Examination Return Charge-Out) are relevant to the classifier:
    1. Year, Form Number, Form type (TPI Examination Class and DIF Score) are self-explanatory
    2. Special Messages i.e., Information Report Available
    3. 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.
    4. 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.
    5. Accounts Receivable Dollar Inventory (ARDI) Code — see the text dealing with ARDI codes, later in this chapter.

     

  3. The following exhibits can be found in IRM 4.4.1 AIMS/Processing Handbook:
    • Description of Examination Return Charge-Out, Form 5546
    • EIN-Employee Identification Number/SSN—Social Security Number
    • Master File Tax Account Codes and Form Numbers
    • Non-Master File Tax Account Codes and Form Numbers
    • Area and Campus Codes
    • Special Messages
    • DIF Selection Codes
    • Activity Codes
    • Source Codes
    • Sort Codes
    • Legends
    • Examination Results
    • Disposal Codes
    • Organization Codes
    • Status Codes—Area Office and Appeals
    • Status Codes—Campus
    • Project Codes
    • Push Codes and Special Handling Message Codes

     

4.1.5.7  (05-19-1999)
Classification Checksheets

  1. 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.
    Type of Return Office Examination Field Examination
    1040 Individual 6754 None
    1041 Fiduciary N/A 6255
    1065 Partnerships N/A 6250
    1120 Corporation DIF N/A 6241
     Non-Dif N/A 6241
    1120S Corporation N/A 6256

     

  2. The purpose of the checksheet is to:
    1. Set the scope for office or correspondence examination cases by identifying all significant items.
    2. Indicate if the examination should be conducted by correspondence, interview or require a precontact analysis.
    3. Provide information for preparation of initial contact letters on office examination cases.
    4. Indicate the examination potential by checking the appropriate assignment priority code on selected non-DIF returns.

     

  3. The checksheet will be stapled to the return
  4. For Field examinations, classifiers should provide comments to assist the examiner regarding the items questioned. This information should be provided in the Remarks section.

4.1.5.7.1  (05-19-1999)
Instructions for Preparation of Examination Classification Checksheet (Form 6754 (6–94))

  1. 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).
  2. 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.
  3. 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.

4.1.5.7.2  (05-19-1999)
Special Instructions (All Returns) for Form 6754

  1. 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 side)
    • write-in issues (bottom)

     

  2. 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.
  3. Classifiers will complete the following blocks for each selected return:
    1. Block A—Taxpayer Name and SSN—Affix an "Examination" label with Check Digit.
    2. 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 apply.
      • More than 13 issues are identified.
      • The return is selected but no issues are identified.
      • The return is designated as an Employee Audit.
      • A Power of Attorney (POA) designation has been filed.
      • Form 5546 contains the literal "PDT" for a potentially dangerous taxpayer.
      • 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.

       

    3. Block C—Special Inventory — One of the items may be marked, if they apply in Figure 5–1.
    4. Block D—Priority Number—Only entries listed in Figure 5–2 below may be made in this block (no others will be accepted):
    5. Block E, F and G are not used for area classification

     

    BOX # TITLE USE
    Box 5 Extended Time Slot For returns with issues that will require additional interview time.
    Box 6 Trainee Level 1 For 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.
    Box 7 Trainee Level 2 For 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.
    Box 8 Trainee Level 3, optional May be used for revenue agent Phase I training returns or tax auditor Phase III training returns.
    Box 9 Local Option Available for use at the discretion of the Area. Definition to be established by the PSP Support Manager.

     

    Figure 4.1.5–1

     

      ENTRY USE
      Blank or zero No priority
      2 or 3 Available for use at the discretion of the area. Definition to be established by the PSP Support Manager.
      4 Used 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 the LEM.

     

    Figure 4.1.5–2

     

  4. 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:
    1. 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 is marked.
    2. 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 schedule
    3. 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.

     

  5. 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.

4.1.5.7.3  (05-19-1999)
Special Instructions—Non-Business Returns

  1. 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.
  2. 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.
  3. 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.

4.1.5.7.4  (05-19-1999)
Special Instructions—Business Returns

  1. 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.
  2. 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."

4.1.5.8  (05-19-1999)
Information Returns Program

  1. 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.
  2. The IDRS Terminal Responses IRM contains the format of the IRMF Transcript with an explanation of the items shown on the transcript.

4.1.5.8.1  (05-19-1999)
Classifying Returns with IRMF Transcripts by Tax Auditors and Revenue Agents

  1. 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.
  2. 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.
  3. The tax effect of carrybacks and carryforwards of losses and/or credits should be considered when applying the LEM criteria.
  4. 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.
  5. 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.

4.1.5.8.2  (05-19-1999)
IMF CTR Screening/Matching

  1. 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.
  2. 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.
  3. The CTR screening/matching program does not replace the normal IRMF screening procedures.

4.1.5.8.3  (05-19-1999)
BMF CTR Screening/Matching

  1. BMF CTR Transcripts will be generated for Forms 1041, 1065, and 1120 if there is CTR activity.
  2. The IDRS Terminal Responses IRM contains the format of the transcript and an explanation for the items contained on it.
  3. 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.

4.1.5.9  (05-19-1999)
Identifying Issues on Individual Returns

  1. 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.

4.1.5.9.1  (05-19-1999)
Non-Business Individual Returns

  1. Determination of Office/Field Examination.
    1. 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.
    2. 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.

     

  2. Below are examples of items which generally cause the return to be identified for field examination:
    1. Issues which require onsite inspection of the taxpayer’s books, records or assets.
    2. Complex Schedule D transactions.
    3. Returns with unusually complex rental income and expenses.
    4. Tax shelter returns.
    5. Donations of real property which would involve an engineering specialist.
    6. Alimony, if it appears there is a property settlement involving business property (i.e., accounts receivable, inventory).

     

  3. 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.
  4. 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.
    1. You should not exclude substantial items from the checksheet to convert what might be an interview examination to a correspondence examination.
    2. Under centralized classification, returns selected with these criteria should be designated for the correspondence unit in the service center.
    3. 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 employment tax.
    4. 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.
    5. HARA returns from examination classes 530 and 532 may be selected for correspondence technique if they have only correspondence issues.
    6. 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.
    7. 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.

     

  5. 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.
    1. A classification checksheet will be attached to each return identified for an office examination.
    2. 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 law.
    3. 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.
    4. 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 be held.
    5. 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 necessary.
    6. 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 used).
    7. Business returns may be identified for office interviews.
    8. 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 correspondence examination.
    9. 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.

     

  6. 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.
    1. 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 employee’s return.
    2. Precontact analysis returns are shown separately on the Centralized Files & Scheduling PSP Inventory Report.

     

4.1.5.9.2  (05-19-1999)
Issue Identification

  1. 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.

4.1.5.9.3  (05-19-1999)
Itemized Deductions

  1. Important! Look first at overall potential based on the amount by which the itemized deductions exceed the standard deduction.
  2. 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).

4.1.5.9.4  (05-19-1999)
Exemptions

  1. Exemptions claimed by the noncustodial parent have proven to have high potential for adjustment.
  2. 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.

4.1.5.9.5  (05-19-1999)
Medical Expenses

  1. High medical expenses for large families, deceased taxpayers, or older taxpayers are usually not productive.

4.1.5.9.6  (05-19-1999)
Taxes

  1. Real Estate Taxes—Consider changes in address (i.e., W–2, 1040, 2119).

4.1.5.9.7  (05-19-1999)
Interest Expense

  1. Productive issues could come from payments to individuals, and closing costs on real estate transactions.
  2. Home mortgage interest usually is unproductive.

4.1.5.9.8  (05-19-1999)
Contributions

  1. Check to see if contributions exceed 50 percent of Adjusted Gross Income (AGI).
  2. Check large donations made to questionable miscellaneous charities.
  3. Check for payments which may represent tuition.
  4. Check for large donations of property, other than cash.

4.1.5.9.9  (05-19-1999)
Casualty or Theft Loss

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

4.1.5.9.10  (05-19-1999)
Miscellaneous Deductions

  1. Scrutinize large, unusual, or questionable items.

4.1.5.9.11  (05-19-1999)
Capital Transactions

  1. 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.
  2. Loss on the sale of rental property, recently converted from a personal residence, is usually productive.
  3. Current year installment sales and exchanges of property should be carefully scrutinized as taxpayers frequently make errors in computing the recognized gain.
  4. Check to see if the gain on a sale is large enough to require the alternative minimum tax computation.

4.1.5.9.12  (05-19-1999)
Pension and/or Annuity

  1. Check whether the taxpayer received a premature distribution from a pension/profit sharing plan.
  2. Check whether distribution qualifies as a lump sum distribution.

4.1.5.9.13  (05-19-1999)
Rental Properties

  1. Consider fair rental value.
  2. 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.
  3. Repairs may be capital improvements.
  4. Consider whether the cost of land is included in the basis.
  5. The rental of vacation/resort homes should be scrutinized.

4.1.5.9.14  (05-19-1999)
Unreported Income

  1. Is the income sufficient to support the exemptions claimed?
  2. Installment sale of property but no interest reported.
  3. Does the taxpayer show interest and real estate tax deductions for two residences but no rental income?
  4. If a taxpayer lists his/her occupation as waiter, cab driver, porter, beautician, etc., tip income is a productive issue.
  5. Are there substantial interest expenses with no apparent source of funds to repay the loans?
  6. 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)?

4.1.5.9.15  (05-19-1999)
Copy of Schedule K–1

  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.
  2. 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.

4.1.5.9.16  (05-19-1999)
Moving Expenses

  1. Review W–2’s for address and other compensation. Also, consider sale of residence.

4.1.5.9.17  (05-19-1999)
Employee Business Expenses

  1. Amounts should be reasonable when compared to the taxpayer’s occupation and income level.
  2. Avoid auto expenses as an issue where the standard mileage computation is used and the mileage shown does not appear excessive.
  3. 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).
  4. Expenses for clubs, yachts, airplanes, etc., must meet the facilities requirements of IRC 274 and therefore, are usually productive issues.

4.1.5.9.18  (05-19-1999)
Taxpayer’s Previous/Subsequent Year Return

  1. Determine whether the previous/subsequent year return should be inspected. If so, you must note the checksheet. Situations where inspection may be warranted are:
    1. Probable carryover adjustments (i.e., capital loss carryover, substantial depreciation changes).
    2. Items which, if disallowed in the selected year, may be allowable in the following year.

     

    Note:

    If Centralized 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.

     

4.1.5.9.19  (05-19-1999)
Business Individual Returns

  1. 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:
    1. 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.
    2. 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.

     

  2. Generally, business returns should be selected for Field Examination when the following conditions occur:
    • Voluminous records
    • Complex accounting method
    • Extensive time frame required to complete the examination
    • Advisability of on-site inspection of business
    • Inventories are substantial and material
    • 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)

     

  3. 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.
  4. Certain businesses would normally not be adaptable to Office Examination, such as contractors, manufacturers, auto dealers, and funeral parlors.
  5. 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.

4.1.5.9.20  (05-19-1999)
Net Profit

  1. Is the taxpayer engaged in the type of business or profession normally considered to be more profitable than reflected on the return?
  2. 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.
  3. Do the address, real estate taxes and/or mortgage interest indicate a higher standard of living than justified by the reported income?
  4. Does the return reveal large amounts of interest/dividend income not commensurate with current sources of income?

4.1.5.9.21  (05-19-1999)
Cost of Goods Sold

  1. Check for the possibility of withdrawal of items for personal use.
  2. Is the ending inventory inclusive of all costs, direct and indirect?

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