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Part 4. Examining Process

Chapter 1. Planning and Special Programs

Section 5. Classification and Case Building

4.1.5  Classification and Case Building

4.1.5.1  (10-24-2006)
Overview

  1. This chapter deals with classification of returns and case building for classification.

  2. 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.

  3. Case building is the process of assembling available taxpayer specific research to identify possible compliance issues.

4.1.5.1.1  (10-24-2006)
Classification

  1. Classification should be conducted by an experienced examiner who has received appropriate tax law training. Examiners with Examination Specialization expertise may be used to classify business returns. DIF ordered returns should be classified at the campus.

  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 or a tax compliance officer (TCO). For revenue agent or tax compliance officer, 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.

  5. Returns should be classified by examiners possessing experience commensurate with the type of return and activity code they are classifying.

  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 compliance officers (including traveling TCOs) are not available in the geographic location of the taxpayer or if the returns are needed for training.

  7. National Office Examination Classification Guidelines provide guidance to enable greater classification consistency nationwide and to select returns for examination with issues that are material in scope.

  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 international 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. ADP and IDRS Information ( Document 6209)

    2. Examination Division Reporting System Codes Booklet, Document 6036.

    3. Uniform Issues Code List

    4. Area Classification Instructions

    5. The National Office Examination Classification Guidelines

4.1.5.1.2  (10-24-2006)
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 NRP 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.

4.1.5.1.3  (10-24-2006)
Sorting of Classified Returns

  1. It is important for the Area PSP to have frequent discussions with the campus Manager of Centralized Files and Scheduling to keep abreast of the return orders and issues dealing with the Area inventory.

  2. Prior to the classification detail, Centralized Files will sort the returns for the Area to be classified by the oldest returns in status 06 first.

  3. PSP must classify the oldest returns in status 06 first in order to minimize the amount of inventory Central Files holds in storage at the campus awaiting classification.

  4. 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 pre-contact analysis.

    3. Returns accepted as filed. Returns not selected for examination will be appropriately stamped.

    4. 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 (ATAT, 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 Area instructions.

  5. Classifiers will determine whether individual returns will be examined by revenue agents (RA) or tax compliance officers (TCO). Guidelines are provided in this handbook to determine the type and scope of examinations for individual returns.

  6. The following table can be used as a guideline for judging the complexity of the returns. These guidelines should be considered only as recommendations. The designation of selected cases as " Office" or"Field" is ultimately a judgment call to be made by the classifier.

    ISSUE OFFICE OFFICE TCO GS-11 FIELD
    All 1120, 1120S 1120F, 1041, 1065, or other BMF returns     X
    Forms 1120 that meet the following criteria:

    • Form 1120

    • Assets < $250K

    • No balance sheet issues

    • No priority issues

    • No Acquisitions, mergers, reorganization

    • No Recapitalizations, liquidations

    • No Stock redemptions

    • No IRC 351 Stock transfers

    • No Final Returns

    Issues to be considered:

    • Bad Debt Deduction

    • Other Deductions – potential personal expenses

    • Form 4797 – potential related party losses

    		   X  
    Returns with Schedule C/F Gross Receipts and/or Cost of Goods Sold >$250,000 or < $750,000 if the return has multiple Schedule C/Fs (when gross receipts are an issue)   X X
    Returns with Schedule C/F Gross Receipts and/or Cost of Goods Sold <$250,000 if the return has multiple Schedule C/Fs (when gross receipts are an issue) X    
    DIF Gross Receipts < $750,000, UIDIF Gross Receipts < $750,000, HINF Gross Receipts < $750,000   X X
    Significant business activity at a place other than the taxpayer’s residence, especially if there are employees     X
    Schedule C/F returns with unusual accounting methods, complex issues and/or need for a significant amount of accounting/auditing skills     X
    Returns with substantial and/or questionable losses from S-Corps or Partnerships (TCO Grade 11 if other return criteria is met)     X
    Returns with significant income or losses from related entities     X
    Returns with simple Schedule C , E, or F, but substantial expenses/losses from interest or depreciation and little or no income in the following activities:

    • Equipment Leasing

    • Real Estate

    • Research and Development

    • Coal/Minerals

    • Farming/Cattle

    		     X
    Issues requiring on-site inspection of records or assets (e.g., substantial casualty losses, embezzlement losses, etc.)     X
    Individuals receiving wages from closely held C corporations and claiming employee business expenses/Schedule C expenses   X X
    Activity codes should be selected to closely fit the audit plan. Gross receipts as a classified issued is < $250K X    
    Activity codes should be selected to closely fit the audit plan. Gross receipts as a classified issue is between $250K and $750K   X  
    Schedule C/F with only non-gross receipts issues classified and total gross receipts are < $500K X    

4.1.5.1.4  (10-24-2006)
Area Classification Instructions

  1. Each Area should prepare Area specific classification instructions covering the following topics:

    1. Local issues

    2. Questionable practitioners

    3. Criteria for determining whether individual returns should be examined by tax compliance officers or revenue agents

    4. Training return guidelines

4.1.5.1.5  (10-24-2006)
Review of Classification

  1. PSP Territory 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 Territory 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.

4.1.5.1.5.1  (10-24-2006)
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. All returns will be manually classified by experienced examiners to select returns that contain significant issues.

  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 compliance officer , 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. Where possible, returns should be classified by or subject matter experts.

  6. All returns will be identified for assignment to a revenue agent, or tax compliance officer based on the complexity of the issues involved and the degree of accounting and auditing skills required to conduct a quality examination.

  7. During the classification process, the scope of the examination will be determined for all office examination returns.

  8. Financial status must be considered on all returns. Remember, SB/SE taxpayers are responsible for two thirds of the tax gap and two thirds of that amount is attributable to unreported income. The classifier must consider this if it appears that the taxpayer has insufficient income for the lifestyle indicated on the return. Consider family size and personal living expenses in relationship to the income stated on the return.

  9. Under RRA ’98, the likelihood of unreported income must be established before an indirect method can be used.

4.1.5.1.5.1.1  (10-24-2006)
Materiality-Significance of the Issue

  1. Classifiers should compare the potential benefits to be derived from examining a return to the resources required to perform the examination. Although you may identify some potentially good issues on the return, if they would not yield a significant adjustment, the return should be accepted as filed.

  2. 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.

    6. Permanency of the potential adjustment (a permanent adjustment is more material than one that will reverse itself in subsequent years)

    7. Timing adjustments (the longer the deferral/acceleration period, the more material the item)

4.1.5.1.5.1.2  (10-24-2006)
Fraud Potential Consideration During Classification

  1. Classifiers should be alert if it appears there are indications of fraud on the returns being classified:

    1. Refund schemes and abusive tax avoidance transactions.

    2. Typed, handwritten, or altered W–2 Forms showing a large business corporation or government agency could indicate a potential fraudulent refund scheme. Large corporations or government agencies normally would use computer generated W–2 Forms.

  2. See the LEM and the Fraud Handbook for specific criteria on fraud.

4.1.5.1.5.2  (10-24-2006)
Review of Performance

  1. A manager will conduct reviews of each classifier. This requirement may be waived if the classifier is a subject matter expert. 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 of 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, are properly completed and should not be limited to single issues for tax compliance officer returns because of the high no-change rate associated with single issue examinations

    4. Returns are properly selected for Office and Field Examination

    5. The potential tax change is sufficient to warrant selection, especially on returns with a negative taxable income

    6. Classifiers are maintaining a high level of technical proficiency, exercising good judgment in accepting and selecting returns, and effectively utilizing their time

    7. 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 Territory Manager. A copy of Form 5126will 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 Territory Manager or Chief, Classification Section, the PSP Territory Manager will be responsible for orientation of the manager regarding classification objectives, instructions to classifiers, quality review procedures and the documentation to be maintained. The PSP Territory 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 Territory Manager must maintain open communication with the Chief, Classification Section.

  5. These procedures are applicable to examiners who classify returns in the Area office and at the Campus. Note: quality review of classification should take place regardless of whether classification is done at the campus or the Area office.

4.1.5.1.6  (10-24-2006)
Classification Details

  1. PSP Territory Manager will consult with Campus Classification to determine the volume of returns for classification and the average number of returns classified per staff day. In addition, 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.

4.1.5.1.7  (10-24-2006)
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 Territory Managers and Campus 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, NAICS 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. MACS will be migrating to the Compliance Data Environment in FY 06. This is a web-based network system with central data repository that supports workload identification, case building, on-line classification and delivery process.

4.1.5.1.7.1  (10-24-2006)
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.

4.1.5.1.8  (10-24-2006)
Form 5546—Examination Return Charge-Out

  1. Before classifying a return, Form 5546should be reviewed for information.

  2. The following items on Form 5546, Examination Return Charge-Out See Exhibit 4.1.5-1. , 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., Modernized E-File return, employee return, collectibility indicators.

    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 Form 1040and Form 1040A.

    5. Collectibility Indicators— see the text dealing with collectibility indicators, 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

    • AIMS Assignee Codes

    • Status Codes—Area Office and Appeals

    • Status Codes—Campus

    • Project Codes

    • Push Codes and Special Handling Message Codes

4.1.5.1.9  (10-24-2006)
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.

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

  2. Revenue Agent Classification Checksheet, Form 10264is a comprehensive form that can be used for all types of Field Examination returns.

  3. The purpose of the checksheet is to:

    1. Set the scope for office examination cases by identifying significant items.

    2. Indicate if the examination should be conducted by interview or require a pre-contact analysis. At this time, all office examinations are pre-contact.

    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 returns.

  4. The checksheet will be stapled to the return

  5. Classifiers should provide comments to assist the examiner regarding the items questioned. This information should be provided in the Remarks section.

4.1.5.1.9.1  (10-24-2006)
Instructions for Preparation of Examination Classification Checksheet (Form 6754 11-2004)

  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.

4.1.5.1.9.2  (10-24-2006)
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. 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, Pre-contact Analysis or Field Examination. All office examination returns will be identified as pre-contact per Examination Re-engineering unless you receive instructions from PSP to classify training returns.

    3. Block C—Special Inventory — One of the items may be marked, if they apply in See Figure 4.1.5-1.

      Figure 4.1.5-1

      BOX # TITLE USE
      Box 5 Extended Time Slot For returns with issues that will require additional interview time. The major determination for this level is judgment. Once the return is classified, decide if the examination can be completed in two hours. (This will assist the manager when assigning cases.) These are generally returns with Gross Receipts classified or more complex issues.
      Box 6,7, or 8 Trainee Level Generally training returns are not classified during details, however, if it is warranted PSP will provide the guidelines to determine the appropriate training level.
      Box 9 GS-11 TCO/Local Option This option will be used to designate Grade 11 work. By checking this box for GS-11 work, the Area will be able to order GS-11 returns using the command CSORD.

    4. Block D—Priority Number 4 is the only number currently in use. It is 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 an interview to resolve the IRMF/IRP discrepancy and meets the criteria specified in the LEM.

    5. Block E, F and G are not completed by the Area classifiers.

  3. Issue Numbers (Block H) 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. Below is additional information for completing issue numbers:

    1. Number 10, IRMF—Blue 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.

  4. The Remarks section should be used for any comments, explanations or observations 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.

    1. This may include comments about the Schedule C/E/F.

    2. Examples are: "Income does not appear to support standard of living" , "appears to be bogus/false Schedule C" , "personal expenses being deducted" , "questionable preparer" .

  5. Block I, classifiers Standard Employee Identifier (SEID)

  6. Block J, Enter the date.

  7. Block K, Classification Reviewer's SEID will be shown on all classified returns that are reviewed.

  8. Block L, Date Reviewed.

4.1.5.1.9.3  (10-24-2006)
Special Instructions—Non-Business Returns

  1. In non-business TPI 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 compliance officer examining the return.

  4. For Office Examination returns, you should select only those issues that warrant examination. Limit the number of issues to the "vital few" , only 3 or 4.

    1. Do not select more issues than appear questionable; the examiner may expand the scope, if necessary, beyond the initial classification.

    2. If more than 4 issues appear questionable, approval from the classification manager is required prior to the final classification of the return.

    3. The manager will provide their Standard Employee Identifier (SEID) in Block K of Form 6754.

4.1.5.1.9.4  (10-24-2006)
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, 537, and 542; Schedule F, Activity Code 543.

  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."

  3. The classification of gross receipts should not be automatic. Gross receipts should not be classified on those returns where the potential for unreported income is not substantial.

  4. If you classify gross receipts, remember to classify cost of goods sold if there is a deduction on the return. Gross receipts do not need to be classified if cost of goods sold is an issue, unless it is warranted.

  5. the classification of gross receipts for grade 9 TCO should primarily focus on Schedule C where the primary income of the taxpayer(s) is not generated from the schedule C or, Schedule Cs where there would be few transactions resulting in a small number of documents to verify the gross receipts. These should generally be able to be obtained from 3rd parties. For example, the receipt of 1099’s by truckers or insurance sales.

  6. The classification of gross receipts for more complex businesses with gross receipts less than $750,000 should generally be assigned to grade 11 TCOs

  7. Make sure you are aware of the taxable income on the return. Judgment must be used to determine if a net operating loss (NOL) carry back or carry forward should be examined. There are instances where the current year NOL as well as the NOL carry forward is not accurate and therefore should be selected as an issue. If the loss cannot be substantiated, it can be disallowed.

4.1.5.1.10  (10-24-2006)
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.

  3. IRMF Transcripts are generated on DIF IMF returns ordered after cycle 26.

4.1.5.1.10.1  (10-24-2006)
Classifying Returns with IRMF Transcripts by Tax Compliance Officers 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). Number 4 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. 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.

4.1.5.1.10.2  (10-24-2006)
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.

4.1.5.1.10.3  (10-24-2006)
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 BMF CTR Transcripts and related returns. The classifier should refer to criteria specified in the LEM for further classification instructions.

4.1.5.1.11  (10-24-2006)
Identifying Issues on Individual Returns

  1. Returns containing office examination type issues will be selected and assigned to tax compliance officers 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 compliance officers 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.

  2. The goal of the classification guidelines is to achieve greater efficiency in the way we classify and conduct examinations. Please be specific in the selection of issues. Do not select "all" expenses or "other" expenses – BE SPECIFIC.

  3. Questionable business schedules will be identified during the classification process. As noted in See IRM 4.1.5.1.9.3. above, we have designed a process requiring managerial concurrence to allow for selection of "all expenses" on these returns when this is appropriate.

  4. When a Schedule C, E, or F does not appear to be a legitimate business (bogus) or you have a questionable preparer (QP) known to inflate expenses, understate income, or include fictitious schedules; classify the appropriate income or appropriate expenses and notate in the "Remarks" section either "Is this a legitimate business?" or " QP" . Managerial or reviewer concurrence must be obtained. The manager/reviewer will provide their SEID and date in Blocks K and L of Form 6754.

  5. When a Schedule C, E, or F does not appear to be a business engaged in for profit (hobby loss), the examination should focus on whether this is an income producing business. Gross Receipts and all expenses should generally not be classified.

  6. If a potential questionable preparer is identified, these returns should be given to the PSP Manager assigned to the detail to contact the Area Return Preparer Coordinator. The Coordinator will make a decision concerning any further consideration of potential Program Action against the preparer.

4.1.5.1.11.1  (10-24-2006)
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 compliance officer. In making this determination, you must give consideration to the type(s) of issue(s) identified for examination.

  2. Below are examples of items which generally cause the return to be identified for field examination:

    1. Issues which require on-site 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. Tax Compliance Officer 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 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. Business returns may be identified for office interviews.

4.1.5.1.11.1.1  (10-24-2006)
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, the classifier should be as specific as possible.

4.1.5.1.11.1.2  (10-24-2006)
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).

4.1.5.1.11.1.3  (10-24-2006)
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.

4.1.5.1.11.1.4  (10-24-2006)
Medical Expenses

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

4.1.5.1.11.1.5  (10-24-2006)
Taxes

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

4.1.5.1.11.1.6  (10-24-2006)
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 and should not be questioned unless the IRMF or IRP transcript indicates a material discrepancy.

4.1.5.1.11.1.7  (10-24-2006)
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 dollar non-cash contributions.

4.1.5.1.11.1.8  (10-24-2006)
Casualty or Theft Loss

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

4.1.5.1.11.1.9  (10-24-2006)
Miscellaneous Deductions

  1. Scrutinize large, unusual, or questionable items.

4.1.5.1.11.1.10  (10-24-2006)
Capital Transactions

  1. Gains on sales of rental and other depreciable property, where the taxpayer has been using an accelerated method of depreciation 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.

4.1.5.1.11.1.11  (10-24-2006)
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.

4.1.5.1.11.1.12  (10-24-2006)
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.

4.1.5.1.11.1.13  (10-24-2006)
Unreported Income

  1. Is the income sufficient to support the exemptions claimed?

  2. Installment sale of property but no interest reported.

  3. If a taxpayer lists his/her occupation as waiter, cab driver, porter, beautician, etc., tip income is a productive issue.

  4. Are there substantial interest expenses with no apparent source of funds to repay the loans?

  5. 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 Form W–2 for that occupation)?


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