- 4.75.11.6 Examination Techniques
- 4.75.11.7 Income Analysis
- 4.75.11.8 Disbursement Analysis
- 4.75.11.9 Balance Sheet Analysis
- Exhibit 4.75.11-1 Form 5773
- Exhibit 4.75.11-2 Sample Workpaper
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Following the initial interview, the examiner should ask for a tour of the facilities. The authority for conducting tours can be found in Treas. Reg. § 301.7605-1(d)(3)(iii).
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Generally, the principal location, and any locations acquired during the period under examination, should be visited. However, consideration should be given to the cost effectiveness and practicality of conducting the tour when appropriate alternatives are available.
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Tours should be conducted with knowledgeable individuals.
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The examiner should plan to address large, unusual, or questionable items identified during the pre-contact analysis or interviews.
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During the tour, the examiner should determine utilization of the organization's facility by others. The following situations if identified may require further documentation:
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Space used by other entities,
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Space used by officers or other individuals for their own personal or business use, and
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Space used for other than exempt purposes, such as a food service facility open to the public.
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Examiners should schedule and conduct tours in a manner that minimizes disruptions to the organization's operations/activities.
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An examination of books and records will establish whether an organization is both organized and operated for tax exempt purposes and what related returns have been or need to be filed by the organization.
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The examiner should review the books and records to:
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Substantiate and expand information about the organization's activities,
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Verify the accuracy of the return, and
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Verify that all appropriate returns have been filed and taxes paid.
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The following books and other records should be reviewed when appropriate:
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Governing instruments and amendments to obtain a general overview of the structure and purposes of the organization under examination.
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Organization's determination letter and application
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Minutes
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Publications (e.g. newsletters, pamphlets, brochures, etc.)
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Operating manuals
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Financial records (chart of accounts, general ledger, financial statements, other supporting documentation)
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Other Federal returns filed
Note:
These records provide important information on the organization's activities and should be adequately reviewed. Additionally, the examiner should test the organization's books, as appropriate, to ensure their reliability.
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Other records that may be reviewed as necessary are:
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Leases
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Correspondence files
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The examiner should review the organization's governing instruments to identify the following:
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Any amendments or changes that would jeopardize the organization's exempt status;
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Any committees with special responsibilities;
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Who controls the organization, both ultimately and in day-to-day operations; and
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Duties of officers, especially noting which officials are authorized to disburse funds and make decisions affecting the operations of the organization.
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The examiner should secure copies of amendments, including name changes, which the organization has not previously sent to the Service. These items need to be forwarded to the Cincinnati Records Unit to update the Determination file.
Exception:
If the organizing documents are not available after reasonable attempts are made to secure them and there is no indication of improper activities by the organization, the examiner can close the case without reviewing the organizing documents.
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The examiner should review minutes for the year under examination, prior years and subsequent years. At a minimum, coverage should include at least the year before and the year after the return under examination. The examiner will expand the review as circumstances warrant.
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The examiner should appropriately consider discussions about the following:
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Proposed activities, which may violate exempt purposes or constitute unrelated trade or businesses;
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Transactions which may serve the private interests of the trustees, directors, officers or private individuals; and
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Transactions with related entities.
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The examiner should review the minutes of any committees.
Note:
Committees are often identified in the bylaws or other governing instruments.
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The examiner should consider all attachments, exhibits, and reports as part of the minutes. If they are not provided with the minute book, they should be requested as an integral part of the minutes. This would also include correspondence referred to in the minutes.
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The Examiner will review newsletters, pamphlets, brochures, magazines, annual reports, and similar items and determine whether the publication:
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Furthers the exempt purpose of the organization.
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Contains advertising.
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Includes indications of legislative or political activity.
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The examiner should review the organization's website. Links to other websites may be indicative of advertising, for-profit joint ventures, other sources of unrelated business income, or inurement.
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The examiner should review the operating manuals, instruction booklets and any other printed material the organization may have regarding its operations.
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The examiner should consider reviewing questionable leases and other contracts, particularly those with officers or other related parties. He/she should determine whether private individuals are receiving any form of inurement or whether the organization has executed any agreements not in furtherance of its exempt purpose.
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The examiner should review copies of mortgages, contracts, agreements, etc. to determine if payments represent fair rental value and whether the agreements are at arm's length.
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Examiners should consider reviewing correspondence files. They usually fall into four categories:
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Letters soliciting funds that identify the nature of projects to be financed or supported;
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Correspondence relating to use of funds which identifies the type of organizations or activities being supported;
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General correspondence which identifies other activities carried on for or on behalf of the organization or related parties; and
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Correspondence with the Internal Revenue Service
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Examiners should request current correspondence the organization has had with the Service. He/she should take appropriate actions to help resolve any outstanding notices or other problems the taxpayer may be having with the Service.
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A review of the financial information generally reveals important information about the organization's activities. Additionally it verifies that the information reported on the tax return is correct.
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Examiners should consider the following procedures:
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Reconciling the books to the return
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Comparing prior and subsequent year income, expenses, assets, and liabilities
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Reviewing chart of accounts
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Reviewing year-end trial balance
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Reviewing auditor's report
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Reviewing audited financial statements and management reports
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Analyzing income and expenses
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Analyzing the balance sheet
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Ensuring an accurate return is filed
Note:
When a taxpayer submits unorganized records, the burden is on the taxpayer to organize them and prepare summaries and reconciliations.
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The term tax reconciliation workpapers means workpapers used in assembling and compiling financial data preparatory to placing it on a return. Typically these include the final trial balance after adjusting entries and can be used to trace financial information to the return.
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The term audit workpapers means workpapers retained by the independent accountant as to the procedures followed, the tests performed, the information obtained, and the conclusions reached pertinent to his/her examination. Workpapers may include work programs, analyses, memorandums, letters of confirmation and representation, abstracts of organization/plan documents, and schedules or commentaries prepared or obtained by the auditor. These workpapers provide an important support for the independent certified public accountant's opinion as to the fairness of the presentation of the financial statements, in conformity with generally accepted accounting principles and demonstrate compliance with the generally accepted auditing standards.
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The examiner should reconcile the return to the organization's books. This is necessary to ensure all transactions reported on the return have been recorded in the books.
Note:
If the tax return cannot be reconciled to the organization's books and records, this is a very good indication that internal controls may be inadequate or that proper accounting procedures are not being used.
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The return reconciliation workpapers should be reviewed. These generally consist of year-end trial balances after any adjusting (and consolidating, if applicable) entries.
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The examiner should review the adjusting journal entries, as they often can be important indicators of unusual transactions or expenditures.
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The examiner should identify and explain any material differences between the books and return.
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The examiner should compare the year under examination with prior and subsequent year income and expense statements to identify any large or questionable differences.
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The examiner should also review budget reports prepared by the organization. Large variances between actual and budgeted amounts may indicate diversion of funds or other problems requiring further analysis.
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The examiner should review the chart of accounts for unusual accounts or accounts that should appear but are absent;
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The chart of accounts also assists the examiner in the review of the general ledger.
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The examiner should review audit reports (both external and internal), as well as, the management letter from the exempt organization's CPA. The latter report provides useful information on internal controls and the organization's accounting procedures.
Caution:
Although the examiner may request the management letter, the taxpayer does not, by law, have to provide it.
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The organization's annual report should also be reviewed. This report may be issued to management, the public, and/or members. It usually discusses major accomplishments for the year and what is planned for the future.
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The examiner should consider reviewing reports to or prepared by other regulatory groups, such as the Department of Health and Human Services or the Department of Education.
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The examiner should always request and review the accountant's tax reconciliation workpapers. They provide a good starting point for reconciling the return to the books.
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Tax reconciliation workpapers, unlike audit workpapers, should be requested at the beginning of an examination. There is a need for these workpapers since they include the final balance tying the return to the general ledger and other analyses necessary to complete the return. Ordinarily tax reconciliation workpapers are prepared and provided by the taxpayer. However, if these workpapers are unavailable from the taxpayer, access should be sought from the accountant.
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In unusual circumstances, the examiner may request access to the audit workpapers. Accountant's audit workpapers should normally be used only when such factual data cannot be obtained from the taxpayer's records and then only as a collateral source for factual data.
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The examiner should limit any requests for audit workpapers to only those portions material and relevant to the examination. Whether an item is considered to be material is based on the examiner's judgment and an evaluation of the facts and circumstances in the case.
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The examiner should review the chart of accounts for unusual accounts or accounts that should appear but are absent, etc.
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The chart of accounts also assists the examiner in the review of the general ledger.
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It is generally necessary to identify certain accounts for further analysis to determine the source of the revenue or expenditures. An organization's utilization of its resources and expenditures are important indicators of an organization's programs and activities.
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The examiner should look for any unusual or nonrecurring items. Items may be unusual by amount, source or nature. Examples include:
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Unusual in amount - amounts which are much larger or smaller than typical entries to an account
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Unusual by source - Source, as used here, means the journals from which the account was posted, as indicated in the folio column. There is a normal source pattern for most postings and any deviations from the norm should be investigated. such as a payroll entry in the office supplies account.
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Unusual by nature - such as credit entries in accounts usually containing only debits or, accounts which exist at the beginning of the year but do not exist at the end.
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In reviewing accounts, the examiner should perform the following audit steps:
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Review year-end adjusting trial balance or similar summary of year-end general ledger account balances and select large unusual or questionable accounts for further analysis.
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Review detail transactions in general ledger for selected accounts.
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Select sample of detailed transactions as warranted and trace to journals or other supporting documentation.
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Discuss those items needing additional explanation with the organization.
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Request any additional documentation, e.g., sales contracts and mortgage documents, which may be necessary to adequately determine the impact of a particular transaction on the exempt organization's exempt status or tax liability.
Note:
The examiner should use his/her judgment in deciding which accounts, if any to select for further analysis.
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The process of examining the taxpayer’s books and records can be substantially enhanced and improved through the appropriate use of sampling techniques.
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There are two basic types of sampling, judgment and statistical, as discussed in the following sections.
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judgment sampling requires examiners to use professional judgment in performing the sampling procedure and in evaluating the results of the sample.
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One type of judgment sampling is block sampling.
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Block sampling may use groups of continuous items selected from an account balance or class of transactions.
Example:
An examiner selects one month of travel expenses to reach a conclusion about the travel expenses for the entire year.
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Block sampling may include selecting all items in a selected numerical or alphabetical sequence.
Example:
Gross Receipts might be sampled by selecting the months of January, September and December.
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Another type of judgment sampling is dollar limitation sampling or cut-off sampling.
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Dollar limitation sampling is a method, which selects a minimum dollar amount and creates a sample by selecting all items exceeding that dollar amount.
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This type of sampling prevents the examiner from wasting time examining small, insignificant amounts.
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Statistical sampling is a procedure used to choose a portion of the whole to make a statement about the entire body of information.
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Using statistical sampling, there is no way for the person who is sampling to impose their judgment on the selection process.
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Examiners should generally seek assistance before performing a statistical sampling application. Examiners should discuss the facts and circumstances with their manager and determine if a request for a Computer Audit Specialist (CAS) is necessary. Refer to IRM 4.47 for instructions on requesting CAS assistance.
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IRC § 7491(b) places the burden of proof on the Service in any court proceeding when the Service reconstructs any item of the taxpayer's income using solely statistical information on unrelated taxpayers. This is true whether the taxpayer does or does not cooperate and provides evidence or otherwise meets the requirements of IRC § 7491(a).
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The examination should include a review of the organization's income to determine the size, extent and nature of income.
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The purposes for analyzing income are to determine whether the income:
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Supports the organization's exempt purpose,
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Is from related parties and may result in inurement if the transactions are not at arms-length,
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Is from an unrelated trade or business, and/or
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Is properly classified for purposes of the private foundation public support tests.
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The examiner should select from the trial balance large, unusual, or questionable income accounts for further analysis. In addition, he/she should select those accounts, which may be sources of unrelated business income or result in potential inurement. Consider analyzing the following:
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Contributions/fund-raising activities
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Miscellaneous or other income accounts
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Program service revenue or other sources reported on the return identified during pre-audit
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Sales of assets
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Rental income
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In the case of IRC § 501(c)(3) organizations, the examiner must also determine whether the required support tests of IRC § 509(a) have been met to confirm an organization's continued exclusion from private foundation status.
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The examiner should identify fund-raising solicitations and ensure the organization has complied with all notification and/or disclosure requirements.
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The examiner should review disbursements to determine whether expenditures are made in accordance with the organization's stated exempt purposes.
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The purposes for analyzing disbursements are to:
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Determine whether expenses are in furtherance of exempt purposes,
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Identify potential inurement,
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Identify political and/or legislative expenditures,
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Identify additional tax liabilities,
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Determine other filing requirements, and
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Determine proper allocation of expenses for unrelated business income tax purposes.
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To detect possible inurement of income or serving of private interest, the examiner should identify the board of trustees, directors, officers, and key members of the organization's staff. Any business relationships or other dealings with these individuals should be carefully analyzed to determine if they provide inappropriate benefits.
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The examiner should determine the reasonableness of total compensation paid or accrued to principal officers. He/she should take into consideration any compensation claimed under a heading other than officers' salaries such as contributions to pension plans, payments of personal expenses, year-end bonuses, use of company car etc.
Note:
The examiner should be alert to multiple entity situations in which compensation is split between two or more related corporations making the aggregate amount paid excessive.
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The examiner should review the following accounts, as they may disclose lobbying activity
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Advertising
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Printing
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Promotion
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Outside services
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Legal and professional fees
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Miscellaneous expenses
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In the case of examinations involving membership organizations other than IRC 501(c)(3) organizations, the examiner should review the following aspects of an organization's lobbying activities:
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The existence and extent of its involvement in "grassroots" lobbying, or lobbying in support of, or opposition to legislation not directly connected with the trade or business of its members.
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Whether such activities were financed from dues and other general funds, or by special assessments of organization members.
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Whether part or all of the dues or special assessments for the years involved were or were not properly deductible by the member in accordance with section 162(e)(2).
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The examiner should review contract labor, repairs and maintenance, legal, consulting, and similar accounts for potential Form 1099 filing requirements. The following should be considered:
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Payments to individuals, e.g., prizes and fees, that may result in a discrepancy adjustment
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Additional compensation in the form of expense accounts
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The examiner should analyze travel and other expense allowances. If the organization does not require the employee to file an expense account, the payments should be included in the gross income of the recipient.
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Refer to IRM 4.75.12 Required Filing Checks for additional information on required package audit procedures.
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In cases where unrelated business income is identified, the examiner is responsible for ensuring:
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Expenses are allocated on a reasonable basis
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The deductibility of any losses
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An organization is not required to use any specific allocation method. Rather, the only requirement is that the method reasonably approximate the costs incurred to generate the unrelated income.
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See IRM 4.76.16, Social and Recreational Clubs - IRC § 501(c)(7), for a detailed discussion and examples of the allocation of expenses in situations involving the dual use of facilities.
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The examiner should review and comment on any unusual balance sheet items.
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The purposes for analyzing the balance sheet include:
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Identifying potential inurement, private benefit, or excess benefit transactions
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Identifying assets generating unrelated business income
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The examiner should analyze the changes in net assets/fund balances and in net worth and reconcile any increases or decreases with the income and expense statements.
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In reviewing assets the examiner should:
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Identify and analyze receivables with officers, directors, or other persons in a position of control to determine whether the transactions serve private interests.
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Additionally, the lack of intent to fulfill the obligations on the part of an officer or director could have income tax consequences.
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Look for automobiles, houses and other assets that could be used by individuals in control.
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Look for rental property or property used in an unrelated trade or business.
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Look for investments that may be used to generate unrelated business income.
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Determine whether any assets are being used for personal purposes. This may constitute inurement or be taxable income to the user.
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Analyze any dispositions for possible inurement to officials.
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Identify any loans that became delinquent or foreclosed during the years under examination.
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Identify receivables written off to determine if they were from an official. This can also be, in effect, a reimbursement to the official for an illegal payment made on behalf of the organization.
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The examiner should determine if an exempt organization is liable for certain taxes and if so, determine the correct amount relating to:
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Unrelated business taxable income, IRC §§ 511-514
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Transactions by private foundations, IRC §§ 4940-4953
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Lobbying activities, IRC §§ 4911-4912
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Political activities, IRC §§ 527(f) and 4955
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Excess benefit transactions, IRC § 4958
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Gaming activities, IRC § 4401
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Proxy Tax on Lobbying and Political Expenditures, IRC §6033(e)(2)(A)
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The examiner is responsible for ensuring the organization has filed a complete and accurate return.
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Because the Forms 990 and 990-PF are open for public inspection, it is important that the information be complete and correct.
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Any schedules or other information omitted from the originally filed return should be secured by the examiner and attached to the return.
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Information commonly omitted from the Form 990 are as follows:
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Schedules, particularly, asset schedules
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Program service accomplishments
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Complete list of the names and addresses of all officers, directors and trustees
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Answers to all applicable questions
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The primary responsibility for asserting penalties rests with the examiner.
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The workpapers should fully document the consideration, development, and assertion or non-assertion, of all applicable penalties. Examiners should include the following information in the case file
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The facts surrounding the issue
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Applicable law
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Application of the facts to the law
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Audit conclusion
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Taxpayer's position
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The examiner should solicit explanations from the taxpayer for any delinquencies subject to the assessment of penalties.
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IRC § 6751 requires the group manager to approve the penalty assertion in writing before the examiner discusses it with the taxpayer or representative. The manager must sign and date the Case Chronology Record and indicate the decision reached. The following penalties do not require managerial approval:
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IRC Section 6651, Failure to File or Failure to Pay, except where fraud is involved,
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IRC Section 6654, Failure to Pay Estimated Tax for Individuals,
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IRC Section 6655, Failure to Pay Estimated for Corporations, and
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Any other penalties automatically calculated through electronic means.
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IRC § 7491(c) states that the Service now has the burden of proof in a court proceeding when the issue is a(n):
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Penalty,
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Addition to tax, or additional amount imposed by the Code.
Note:
IRC § 7491(c) applies only to individuals.
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The Service must first present evidence that a penalty, addition to tax, or additional amount is appropriately applied to the taxpayer. It is then the taxpayer's responsibility to present evidence of reasonable cause, substantial authority, or other similar defense in showing that the amount should not be asserted. See IRM 20, Penalties and Interest.
Example:
If a delinquency penalty is asserted under IRC § 6651, the Service would meet its burden of proof by showing the filing date was after the due date for the tax return, and that there was no evidence the taxpayer filed for an extension.
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The examiner must properly identify and address potential "badges of fraud".
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When initial badges of fraud are uncovered, examiners should initiate a discussion with their manager, and develop an action plan as soon as possible to document firm indications of fraud. The plan should be a joint effort of the examiner, manager, and when needed, the Fraud Coordinator.
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The examiner should resolve any discrepancies between the Exempt Organizations/Business Master File (EO/BMF) and the information developed during the examination. He/she should prepare a Form 2363-A Request for IDRS Input for BMF/EO Entity Change to update the Master File, if necessary.
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The examiner should ensure the organization is complying with the disclosure and notification requirements of IRC § 6104 and IRC § 6113.
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IRC § 6104, among other things, sets forth certain requirements for the disclosure of various returns, applications, etc. of organizations exempt under 501(a) or 527 to the public.
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IRC § 6113 provides certain non-IRC § 501(c)(3) organizations to disclose in fund-raising solicitations that contributions are nondeductible.
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The examiner should discuss the disclosure and/or notification requirements and ensure the organization has met its responsibility. Any violations noted in the minutes, correspondence or through interviews should be reviewed and a determination made as to the applicability of any penalties.
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Issues identified by the examiner should be developed to the point the pertinent facts or data gathered for the identified issues were not overdeveloped or underdeveloped.
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The examiner should request additional information for any areas needing further clarification. See IRM 4.75.13, Issue Development.
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The examiner may find it necessary during the examination to secure additional records, documents, or other clarifying evidence. He/she should generally prepare a Form 4564, Information Document Request, advising the taxpayer of the information needed.
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The examiner should only request relevant information necessary to resolve the issue(s) or areas under consideration. This decreases the burden on the taxpayer.
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A properly completed information document request is:
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Clear, concise and legible
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Dated
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Includes a due date for the information requested
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Indicates the manner in which the taxpayer will return the information, e.g., subsequent interview/appointment, mailed in, or picked up
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In some instances during an examination an examiner may request additional information from the taxpayer to be provided within a certain timeframe (10, 20, 30 days, etc). If the taxpayer does not provide the information within the specified time, the examiner should, attempt to contact the taxpayer by telephone, if feasible. If the taxpayer cannot be reached by telephone, the examiner should send another document request by mail. This request should also include a specific date for the information to be supplied to the examiner.
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A sufficient amount of time should be allowed the taxpayer to respond to the request, but the examiner should always be aware of statute and audit cycle considerations. However, if after two attempts at obtaining the information requested the taxpayer does not respond, the examiner should obtain his/her group manager's assistance in obtaining the requested information.
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The examiner and group manager should schedule a meeting that includes the taxpayer, examiner, and group manager in order to ascertain if or will be forthcoming. If the taxpayer still is not cooperative, the group manager should consult Area Counsel for advice on the issuance of a summons.