GAO Says IRS Needs More Financial Status Audit Guidance

What type of car do you drive? How much money is in your bank account? Let me know a little more about your credit card debt. These are the kinds of questions asked during an IRS financial status auditan audit the IRS uses to identify unreported income.

Congress had asked the General Accounting Office to determine how frequently financial status audit techniques were used, how they were applied, whether they were intrusive and burdensome for the taxpayer and, also, how the IRS measured its quality control. In a report to Congressman Bill Archer (R-Texas), chairman of the House Committee on Ways and Means, the GAO said financial status audits were useful in collecting unreported income but the IRS needed to provide its staff with guidance on when and to what extent to use such audits to ensure they are not overly intrusive.

Probing too soon

In 1992, the IRS estimated that the tax gapthe amount of tax taxpayers owe but have not paidwas $95.3 billion. Because of this, the IRS urged its auditors to consider a taxpayers financial status and to probe for unreported income, initiating a financial status audit program in 1994.

According to the GAO report, Tax Administration: More Criteria Needed on IRS Use of Financial Status Audit Techniques , by early 1995, the IRS was criticized for certain techniques used in its financial status audits. The AICPA, members of Congress and various other taxpayer groups argued that IRS auditors were asking financial status questions before and during the initial interview with the taxpayer without any evidence of underreported income, thus blurring the difference between probing for unreported income and a fraud investigation. (See Financial Status Audits: A Widespread Problem, JofA, May96, page 44.)

However, the GAO report found that the number of audits in which auditors were asking financial status audit questions before or during the initial interview had not increased drastically after the 1994 initiative. In fact, intrusive initial interview question were asked in fewer than 5% of the audits in 1995 and 1996. The GAO did find that as many as 83% of that periods financial status audits resulted in no adjustment of income. The report said the no-change rate was too high and the IRS needed to better monitor when and when not to use financial status questions.

More guidance for IRS staff

The GAO recognized it is the IRS auditors responsibility to determine how and when financial status audit techniques should be used, but it recommended that the IRS provide specific criteria to help an auditor judge when employing such techniques is appropriate. It also suggested that the IRS provide further guidance to its auditors based on its monitoring of the use of these audit techniques.

Copies of the report (GAO/GGD-98-38) are available from the GAO by phone at 202-512-6000 or through its Web page at www.gao.gov .

1998 Guidelines for Understatements

The IRS issued its 1998 guidelines for underpayment of tax on income tax returns, including a list of adequate disclosuresthat is, understated items on the return that do not require additional paperwork or attachments. Little has changed from the 1997 guidelines.

Preparers can be penalized up to 40% of the understated tax liability of an incorrect tax returnfor example, one in which a taxpayer understates income or overstates deductions to reduce the amount of the tax liability. IRS revenue procedure 96-58 provides guidance in determining when certain disclosures on a tax return are adequate and therefore are not cause for the 40% penalty for underpayment. For example, 1998 adequate disclosure for an individuals Schedule A, Itemized Deductions , includes certain medical and dental expenses, taxes, interest expenses, contributions and casualty and theft losses. Revenue procedure 96-58 also lists adequate disclosures for certain trade or business expenses, foreign tax items and items on Form 1120 Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return .

CPAs have to be very familiar with these guidelines to avoid stiff penalties, said Nancy H. Boozer, a member of the AICPA tax forms committee and a partner of Rogers & Laban in Columbia, South Carolina. We have to be sure we have documentation for these items on our clients returns, especially when the amounts are substantially different from the prior year.

Revenue procedure 96-58 applies to any return filed on 1997 tax forms for taxable years beginning in 1997 or for short taxable years beginning in 1998. For more information on the new guidelines, contact Marcia Rachy of the IRS at 202-622-6232.

Tax Briefs

Individual

A New Preparers Penalty

Earned Income Credit (EIC) Eligibility Checklist For use by income tax return preparers in preparing 1997 tax returns and claims for refund. Taxpayer may claim the EIC if all the following questions are answered yes .

Yes No 1. Do the taxpayer, spouse and qualifying child each have a Social Security number? 2. Is the taxpayers total taxable and nontaxable earned income at least $1 but less than $9,770 if the taxpayer does not have a qualifying child? $25,760 if the taxpayer has one qualifying child? $29,290 if the taxpayer has more than one qualifying child? 3. Is the taxpayers modified aggregate gross income less than $9,770 if the taxpayer does not have a qualifying child? $25,760 if the taxpayer has one qualifying child? $29,290 if the taxpayer has more than one qualifying child? 4. Is the taxpayers investment income $2,250 or less? 5. Is the taxpayers filing status one of the following: married filing jointly, head of household, qualifying widow(er), single? 6. If the taxpayer is a nonresident alien, is the filing status married filing jointly? (If the taxpayer is not a nonresident alien, answer yes ). 7. Answer yes if the taxpayer (and spouse if filing a joint return) is not a qualifying child of another person. 8. Answer yes if the taxpayer (and spouse if filing a joint return) is not filing form 2555 or form 2555-EZ to exclude from gross income any income earned in foreign countries or to deduct or exclude foreign housing amounts. STOP: If the taxpayer has a qualifying child, answer question 9 and skip 10. If the taxpayer does not have a qualifying child, skip 9 and answer 10. 9a. Does the child meet the age, relationship and residence tests for a qualifying child? See form 1040 instructions for line 56a. b. Answer yes if the qualifying child is also a qualifying child for one or more other persons and the taxpayers modified AGI is higher than each other persons. Answer yes if the child is a qualifying child only for the taxpayer. c. If the qualifying child is married, is the taxpayer claiming the child as a dependent? (If the qualifying child is not married, answer yes .) or 10a. Was the taxpayers main home (and the spouses if filing a joint return) in the United States for more than half the year? Military personnel on extended active duty outside the United States are considered to be living in the United States. b. Was the taxpayer (or spouse, if filing a joint return) at least age 25 but under 65 at the end of 1997? c. No one can claim the taxpayer (or spouse if filing a joint return) as a dependent on their return. If the taxpayer (and spouse filing a joint return) is not eligible to be a dependent on anyone elses return, answer yes . If the taxpayer (or spouse if filing a joint return) is eligible to be claimed as a dependent on someone elses return, answer no. PERSONS WITH A QUALIFYING CHILD: If the taxpayer answered yes to questions 1 through 9(a), (b) and (c), the taxpayer can claim the credit. Remember to fill out schedule EIC and attach it to the taxpayers form 1040 or 1040A. PERSONS WITHOUT A QUALIFYING CHILD: If the taxpayer answered yes to questions 1 through 8 and 10(a), (b) and (c), the taxpayer can claim the credit. IF THE TAXPAYER ANSWERED NO TO ANY QUESTION, THE TAXPAYER IS NOT ELIGIBLE FOR THE CREDIT.

The Taxpayer Relief Act of 1997 created a $100 penalty for return preparers who fail to comply with due-diligence requirements for determining a taxpayers eligibility for the earned income credit (EIC). The penalty is effective for tax years beginning after 1996.

Notice 97-65 sets forth the requirements paid preparers must meet or be liable for under IRC section 6695(g) for each 1997 return or refund claim involving the EIC.

In order to avoid the penalty, preparers must

1. Complete a checklist (see sidebar) or keep a paper or electronic file containing the information needed to complete the checklist (the alternate eligibility record). This information must be obtained from the taxpayer or be reasonably obtained by the preparer.
2. Either complete the EIC worksheet (included in the 1997 form 1040 instructions) or keep a detailed record of how they computed the EIC.
3. Not know, or have any reason to know, that any information they use in determining the taxpayers eligibility for, or in computing, the EIC is incorrect. If the information appears to be incorrect, inconsistent or incomplete, preparers must make reasonable inquiries.
4. Retain the above information for approximately three years after the date the return was presented to the taxpayer for signature. Preparers may keep these documents on magnetic media or in an electronic storage media system.

Observation. If preparers do not meet these requirements, they may still avoid the penalty if they demonstrate to the satisfaction of the IRS that their normal office procedures are reasonably designed and routinely followed to ensure compliance with the 1997 due-diligence requirements and that any failure to meet the requirements is an isolated and inadvertent case.

Michael Lynch, CPA, Esq., associate professor of accounting at Bryant College, Smithfield, Rhode Island .

Business/Industry

Internal-Use Software and the Research Credit

Taxpayers who claim the incremental research credit, particularly for internal-use software, must meet a new discovery test. In United Stationers, Inc. v. United States (no. 92 C 6065, N.D. Ill., October 17, 1997), an office products wholesaler was denied the research credit for internal-use software in part because its projects did not discover any technological information, venture into new fields or develop a new realm of computer science.

United Stationers had developed the software to automate certain business operations, including document management, order processing and invoicing, marketing and inventory control. The court considered whether

• United Stationers undertook the software projects to discover information that was technological in nature.
• Substantially all the research activities constituted elements of a process of experimentation.
• The projects involved internal- use software.
• The software was innovative.
• The projects involved significant economic risk.

Judge Norgle, emphasizing the discovery element of the technology test, concluded there was no evidence United Stationers had discovered any information of a technological nature or even intended to expand or refine existing principles of computer science. According to Norgle, United Stationers had merely applied, modified and, at most, built upon preexisting technological information. Further, he said the projects lacked an essential element of an experimental processsome degree of technological uncertainty at the outset about whether the programs would workas contrasted with whether they would produce the anticipated economic benefits.

The judge also concluded United Stationers developed the software primarily for its own use. Although he considered the software innovative, Norgle held the projects did not involve the necessary economic risk to claim the creditbased on internal technological risks, not the amount of money United Stationers had devoted to the project.

Observation. The decision will influence the outcome of many research credit claims currently before the IRS and may create more hurdles taxpayers must overcome in supporting their claims. Further, companies that implement integrated manufacturing and other enterprisewide computer systems believe some of the costs of those systems, particularly when they entail process reengineering, should qualify for a research credit. The IRS, however, is expected to actively challenge such claims, taking full advantage of the United Stationers decision.

Taxpayers should distinguish their software development from the mere adaptation that the court seemed to find in United Stationers and be able to demonstrate technical as well as economic risk. Some may be able to establish that their internal-use software is part of a process that is considered qualified research. Others may need to establish that the software development ventured into an uncertain field or provided technology to use computers in a manner that was never before available.

Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia .

Corporate

Demutualization and Tax Deductions

UNUM Corp. is the product of a demutualizationwhen a mutually owned institution converts to a stockholder-owned company. UNUM was set up to be the owner of the stock of a new company (UNUM Life Insurance Co.) formed as a result of a conversion by Union Mutual, a mutual insurance company owned by its policyholders. Eligible policyholders of Union Mutual transferred their ownership interests to UNUM in exchange for stock and cash. UNUM, in turn, exchanged that ownership interest for shares of the new stock insurer (UNUM Life Insurance Co.) and also sold shares to the public. UNUM sought to deduct over $650 million for the cash and stock distributed to eligible policyholders, arguing that it constituted policyholder dividends under IRC section 808. The IRS challenged the deduction and the case wound up in court.

UNUM argued that the term policyholder dividend includes any distribution that fits literally within the language of section 808 (b)(1). Indeed, UNUMs payout could be construed as an amount paid or credited where the amount is not fixed in the contract but depends on the experience of the company or the discretion of management.

However, the First Circuit Court of Appeals rejected this literal interpretation and concluded that the intention of section 808(a) also must be satisfied. This section says that the term policyholder dividend means any dividend or similar distribution to policyholders in their capacity as such also must be satisfied.

On this basis, the court concluded the distributions were not deductible policyholder dividends because fundamentally they were not dividends.

Observation. A dividend is a unilateral distribution by a corporation to its owners, which leaves intact the owners equity interests in the corporation. Here, the distributions were made in exchange for membership interests in the former mutual company; those who received cash had their equity interests extinguished while those who received stock had their equity interests converted from one form to another. Thus, because the distributions did not possess the essential characteristics of a dividend, they were not policyholder dividends. This finding dramatically affects the economics of demutualization.

Robert Willens, CPA, managing director at Lehman Brothers, New York City .

Line Items

• Canteen Profits The IRS ruled that a veterans post, which operated a public restaurant, a public bar and gambling activities, has lost its tax-exempt status under IRC section 501 (c)(19). The post failed to keep adequate records separating member and nonmember transactions, and it was unable to show it was not operating a business for profit. (TAM 9747003).
• FICA Furor In 1992, a taxpayer was awarded $43,000 in back pay for work performed between October 1, 1978, and September 9, 1991. FICA taxes were withheld from the $43,000 award after a district court ruled that the back-pay award is subject to the FICA tax in the year the award is paid, not when it was earned. ( Dorothy A. Mazor v. Commissioner , DNY 11-14-97).
• Terms of Inurement The Tax Court retroactively revoked the exemption of a tax-exempt organization because of the contract it had with its professional fundraiser. Before 1984, the organization was supported by membership dues. In June 1984, it signed an exclusive five-year contract giving a professional fundraiser substantial control over its finances and direct-mail campaigns. The IRS said that because of the contract, the shareholder or individual benefited from the organizations net earnings. The organization unsuccessfully argued that the inurement doctrine applied only to insiders and not to third parties hired to perform services. According to the court, third parties now are insiders under the rules prohibiting private inurement. ( United Cancer Council, Inc. v. Commissioner , (109 T.C. no. 17, 1997).
• A Certain Magnetism Notice 97-77 provides guidance to partnerships with more than 100 partners on the requirements for filing partnership tax returns on magnetic media. However, mandatory magnetic media requirements will not apply to partnership tax years beginning before January 1, 1998.
• Lost in the Mail The IRS announced that nearly 100,000 taxpayers have yet to receive their 1996 refund checks, which total $62.6 million. The checks were returned to the IRS by the U.S. Postal Service marked undeliverable. Taxpayers who are missing refunds should call the IRS at 800-829-1040. To avoid this problem in the future, remember to fill out Form 8822 Change of Address when moving, or elect to have your refund deposited electronically into your bank account.
  
  

  Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.