Section 4. Examination of Income

(1) The following IRM sections have been added to incorporate the provisions of Interim Guidance Memorandum SBSE-04-0915-0056, Interim Guidance on Access to Suspicious Activity Reports for Title 26 Civil Tax Purposes, which provides procedures for gaining access to suspicious activity reports.

Effect on Other Documents

This IRM supersedes IRM 4.10.4, Examination of Income, dated August 9, 2011. This IRM incorporates Interim Guidance Memorandum SBSE-04-0915-0056, Reissued Interim Guidance on Access to Suspicious Activity Report for Title 26 Civil Tax Purposes, issued September 18, 2015.

Audience

Effective Date

Karen A. Turner
Acting Director, Examination Field and Campus Policy, SE:S:E:HQ:EFCP
Small Business/Self-Employed Division

Overview

1. The purpose of this section is to provide guidance for the examination of income. It includes the minimum income probe requirements for all types of returns, in-depth examination techniques, and formal indirect methods. See IRM 4.10.4.3.5 , Minimum Income Probes: Delinquently Filed Returns and Nonfiled Returns, for instructions regarding income probes for nonfilers and delinquently filed returns.
2. An examination of income is conducted to determine whether taxable income has been accurately reported on the tax return. The steps taken in an examination are dependent on the facts and circumstances, and therefore, the audit strategy for completing the examination of income must remain dynamic. Consideration should be given to tax return information, responses to interview questions, the taxpayer’s books and records, and other financial information when completing an examination of income. As new information becomes available, the audit plan should be adjusted accordingly; examiners should use their judgment when determining the depth of the examination of income.
3. It is advisable to include a statement on the initial information document request (IDR) indicating that the examiner may request additional records as the examination progresses. This will help prevent any potential misunderstanding about the scope and depth of the examination of income.
4. Examinations of income for all business tax returns should incorporate industry-based audit techniques. The Audit Technique Guides are available in alphabetical order at http://www.irs.gov/Businesses/Small-Businesses--Self-Employed/Audit-Techniques-Guides-ATGs .

Scope of Section

1. This IRM applies to all examinations except correspondence examinations conducted by the Campus.
2. Occasionally an examiner will conduct the majority of an examination by correspondence nonetheless the minimum income probes apply.
3. Compliance Initiative Project cases are subject to the general rules for the examination of income.

Definitions

1. The following definitions are provided to clarify terms used within this IRM section. An understanding of these definitions is helpful to complete the examination of income.

"Nonbusiness" Returns

1. Individual tax returns with no attached business schedule(s); i.e., no Schedule C, Profit or Loss from Business (Sole Proprietorship) or Schedule F, Profit or Loss from Farming.
2. For office audit, individual returns which have attached business Schedule(s) C and/or Schedule(s) F, for which gross business receipts is NOT a classified issue.

"Business" Returns

1. All types of returns other than nonbusiness returns described in IRM 4.10.4.2.1 above.
2. For office audit, individual returns which have attached business Schedule(s) C and/or Schedule(s) F, for which gross business receipts is a classified issue.
3. An individual business return is an individual return that also includes a business activity, such as a Schedule C sole proprietorship, reflects financial activities of both living person(s) and/or an entity. For purposes of auditing an individual business return, the financial activities of the business entity and the individuals are audited simultaneously as one taxpayer.
4. Corporations and other business returns are considered separate legal entities from the owners of the business; i.e., the business entity and its owner file separate tax returns. However, since the business entity is controlled by the owners, it is subject to manipulation and the diverting of income or camouflaging of financial transactions. For purposes of auditing a business return, the audit will be expanded to include the tax returns of the related owner only if specific criteria are met. See IRM 4.10.4.3.4.3 . All of the steps for the minimum income probes of a business entity should include an evaluation of potential for diverting income or camouflaging transactions with related owners of the business.

Gross Receipts or Gross Income

1. The term "gross receipts" or gross income means the taxpayer's total or gross taxable receipts during the year from all sources. Gross receipts is not reduced by returned sales, allowances, cost of goods sold, basis, or expenses. Gross receipts includes, but is not limited to the following:

1. Gross sales of a trade or business;
2. Gross fees and commissions;
3. Gross wages, salaries, tips, and gratuities;
4. Gross dividends, interest, rents, royalties, pensions, and annuities;
5. Gross income from estates, trusts, and partnerships;
6. Gross proceeds from the sale of assets; and
7. Gross farm income.

Gross Business Receipts

1. The term "gross business receipts" means the gross receipts derived from a trade, business, farm, or profession. The distinction between "gross receipts" and "gross business receipts" is important when examining nonbusiness returns or business returns which also include nonbusiness income.

Cash-on-Hand

1. Generally, cash-on-hand is currency (not balances in bank accounts) associated with routine business practices and/or the need to complete cash transactions with customers.

Accumulated Funds

1. Accumulated funds is currency accumulated by the taxpayer, but not associated with routine business practices and/or transactions with customers. The funds may have been taxed in prior years, originate from nontaxable sources, or may represent taxable income in the year under audit.

Specific Item Method

1. The specific item method involves the use of direct evidence to determine the tax liability based on omitted income, overstated expenses, or both. For example, funds from known sources are tracked to deposits made to a taxpayer's bank account rather than analyzing bank deposits to identify unreported income from likely sources.
2. Direct evidence is evidence from which only one logical conclusion can be reached. Direct documentary evidence is generally regarded as having the greatest value; and, when possible, examiners should ask to see the original documents when there is reason to believe they exist. Documentary evidence should not be relied upon to the exclusion of facts established through oral testimony or other techniques, such as a tour of the business site.
3. The specific item method is appropriate when the taxpayer maintains books and records, adjustments are due to technical issues (such as timing or character of funds), or the potential sources of unreported income are limited (such as an insurance agent who underwrites for several companies).
4. The specific item method is not useful if the taxpayer's gross receipts are generated from numerous sources or in small amounts, such as a grocery store.
5. See IRM 4.10.7.3, Evaluating Evidence, for complete discussion.

Indirect Method

1. The indirect method involves the use of circumstantial evidence to determine the tax liability based on omitted income, overstated expenses, or both. Circumstantial evidence is evidence from which more than one logical conclusion can be reached. To support adjustments for additional taxable income, both the credibility of the evidence and the reasonableness of the conclusion must be evaluated before the determination of tax liability is made.
2. Analytical reviews and testing of the taxpayer's books and records, as required by the minimum income probes, may result in the identification of additional taxable income based on circumstantial evidence from which an inference can be made. The financial status analysis and bank account analysis are not prohibited by IRC 7602(e), Limitation on the Use of Financial Status Audit Techniques, simply because an adjustment to taxable income supported by indirect (circumstantial) evidence may be the result.

Example:

The minimum income probes for an individual business return include a bank account analysis. There is an identifiable potential source of additional taxable income. The records used for the analysis are the bank account statements, which are prepared by a third party, and are credible evidence. The characterization of excess funds as additional taxable income is reasonable because deposits of nontaxable funds are identified and eliminated. See IRM 4.10.4.3.3.7 , Bank Account Analysis (Individual Business Returns).

Formal Indirect Method

1. The formal indirect methods are audit techniques used to determine the tax liability based on the amount of unreported income.

1. IRM 4.10.4.6.3 , Source and Application of Funds Method
2. IRM 4.10.4.6.4 , Bank Deposit and Cash Expenditures Method
3. IRM 4.10.4.6.5 , Markup Method
4. IRM 4.10.4.6.6 , Unit and Volume Method
5. IRM 4.10.4.6.7 , Net Worth Method

1. Reliance on indirect evidence of income,
2. In-depth analysis of actual costs that requires the extensive collection of detailed information, and
3. Subject to IRC 7602(e), which states, "the Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income."

1. The taxpayer's books and records are missing, incomplete, or irregularities are identified; or
2. The financial status analysis indicates a material imbalance of cash flows after consideration of other adjustments identified during the examination.

See IRM 4.10.4.6.2 and IRM 4.10.4.3.3.1 .

Minimum Requirements For Examination of Income

1. All examiners will consider gross income during the examination of all income tax returns.
2. Minimum income probes will be completed regardless of the type of return filed by the taxpayer. The minimum income probes are designed as a set of analytical tests intended to determine whether the taxpayer accurately reported income. If the taxpayer is underreporting income, the probes should result in the identification of at least a portion of the understatement.

1. The minimum income probes vary depending upon the type of return (nonbusiness or business) and the method of the examination (office audit or field examination).
2. The minimum income probes are not subject to IRC 7602(e) governing the use of financial status audit techniques.
3. Internet use and e-commerce activities will be audited as part of the minimum income probes for all business returns. See IRM 4.10.4.3.7 for detailed discussion.
4. All minimum income probes will be completed regardless of whether or not the taxpayer maintains a double-entry set of books.

1. IRM 4.10.2.3.1, Large Unusual Questionable Items Defined, advises an LUQ item can be based on comparative size of the item, the absolute size of the item, inherent character of the item, evidence of intent to mislead, beneficial effect of manner in which the item was reported, relationship to other items, possible whipsaw effect on other taxpayers, automatic adjustments, and missing items.

Example:

An income whipsaw is when income is reported on a joint state return and the examiner cannot determine the appropriate income to reflect on the federal return for each spouse. The examiner should not automatically report the total income on both spouses returns. The examiner should first check the state tax return for information that would provide a basis for allocating the income reported. Second, the examiner should cross-reference the information on the state return with any other information that may be available, such as information returns (Forms W-2, 1099, etc.). If the examiner has sufficient information to determine the amount of income per spouse, the examiner can prepare a report. If the examiner does not have sufficient information to allocate income based on the steps taken above, the examiner should try to contact each spouse and attempt to obtain information on how much income should be reported for them prior to issuing a report. If the taxpayer(s) are non-responsive or uncooperative, the examiner can then treat this as a whipsaw issue and place the full income on each taxpayer’s return. The latter will be done only when the steps outlined above provide insufficient information on how to allocate income. For community property states, the examiners should refer to IRM 25.18.2, Income Reporting Considerations of Community Property. For whipsaw see IRM 4.10.13.5, Adjustments Between Correlative Taxpayers, (aka whipsaw issues).

Example:

When the federal / state matching program indicates a taxpayer has reported significantly less income on the federal return, the examiner can use the income reported on the state tax return to produce a federal tax examination report. It has been held that positions taken in a tax return signed by a taxpayer may be treated as admissions. See Waring v. Commissioner, 412 F.2d 800, 801 (3rd Cir. 1969); Lare v. Commissioner, 62 T.C. 739, 750 (1974); Kaltreider v. Commissioner, 28 T.C. 121, 125 -126(1957). As stated in Crigler v. Commissioner, T.C.M . 2003-93, a taxpayer "cannot . disavow . returns without cogent proof that they are incorrect." Evidence obtained through the taxpayer’s own admission on a state income tax return signed under penalties of perjury is as reliable as evidence from third parties, and perhaps more so if the taxpayer is unable to successfully refute the information contained in the state return. If the taxpayer establishes during the course of the examination that the state information is incorrect, the examiner will adjust their report accordingly.

1. Whether the NOLD was generated from the same business that gave rise to an adjustment for unreported income in the current year under examination.
2. Materiality of the current year adjustment to income,
3. Likelihood of erroneous reporting in prior years,
4. Materiality of the NOLD, and
5. Prior audit activity.