Examination of Returns

Your return may be examined for a variety of reasons, and the examination may take place in any one of several ways. After the examination, if any changes to your tax are proposed, you can either agree with those changes and pay any additional tax, or you can disagree with the changes and appeal the decision.

Examination selection criteria. Your tax return can be selected for examination on the basis of computer scoring. A computer program called the Discriminant Function System (DiF) assigns a numeric score to each individual and some corporate tax returns after they have been processed. If your tax return is selected from DiF, it has received a high score. This means that there is a high potential for an examination of your return to result in change to your income tax liability.

Your return can also be selected for examination on the basis of information received from third-party documentation, such as Forms 1099 and W-2, that does not match the information reported on the tax return. Or, your return can be selected to address both the questionable treatment of an item and to study the behavior of similar taxpayers (a market segment) in handling a tax issue.

In addition, your return can be selected as a result of information received from other sources on potential noncompliance with the tax laws or inaccurate filing. This information can come from a number of sources, including the media, public records, or possibly informants. The information is evaluated for reliability and accuracy before it is used as the basis of an examination or investigation.

Notice of IRS contact of third parties. The IRS must give you reasonable notice before contacting other persons, that in examining or collecting your tax liability the IRS may contact third parties such as your neighbors, banks, employers, or employees. The IRS must also give you notice of specific contacts by providing you with a record of persons contacted on both a periodic basis and upon your request.

This provision does not apply:

If Your Return Is Examined

Some examinations are handled entirely by mail. Examinations not handled by mail can take place in your home, your place of business, an Internal Revenue office, or the office of your attorney, accountant, or enrolled agent. If the time, place, or method is not convenient for you, the examiner will try to work out something more suitable. However, the IRS makes the final determination of when, where, and how the examination will take place.

Throughout the examination, you can act on your own behalf or have someone represent you or accompany you. If you filed a joint return, either you or your spouse, or both, can meet with the IRS. You can have someone represent or accompany you. This person can be any federally authorized practitioner, including an attorney, a certified public accountant, an enrolled agent (a person enrolled to practice before the IRS), an enrolled actuary, or the person who prepared the return and signed it as the preparer.

If you want someone to represent you in your absence, you must furnish that representative with written authorization. Make the authorization on Form 2848 or any other properly written authorization. If you want to consult an attorney, a certified public accountant, an enrolled agent, or any other person permitted to represent a taxpayer during an interview for examining a tax return or collecting tax, IRS will suspend the interview and reschedule it. IRS cannot suspend the interview if you are there because of an administrative summons.

Paid preparer authorization. If you checked the box in the signature area of your Form 1040 to authorize the IRS to discuss your tax return with your paid preparer, this authorization does not replace Form 2848. The box you checked on Form 1040 only authorizes the preparer to receive information about the processing of your return and the status of your refund during the period your return is being processed. For more information, see the instructions for Form 1040.

Confidentiality privilege. Generally, the same confidentiality protection that you have with an attorney also applies to certain communications that you have with federally authorized practitioners.

This confidentiality protection cannot be used by you in any administrative or court proceeding with an agency other than the IRS.

Confidential communications are those that:

• Advise you on tax matters within the scope of the practitioner's authority to practice before the IRS,
• Would be confidential between an attorney and you, and
• Relate to noncriminal tax matters before the IRS, or
• Relate to noncriminal tax proceedings brought in federal court by or against the United States.

The confidentiality privilege does not apply to any written communication that:

• Takes place between a federally authorized practitioner and a corporate director, shareholder, officer, employee, agent, or representative, and
• Promotes the corporation's participation in a tax shelter.

A tax shelter is any entity, plan, arrangement, or transaction, a significant purpose of which is the avoidance or evasion of income tax.

Tape recordings. You can make an audio recording of the examination interview. Your request to record the interview should be made in writing. You must notify the examiner 10 days in advance and bring your own recording equipment. The IRS also can record an examination. If the IRS initiates the recording, you must be notified 10 days in advance and you can get a copy of the recording at your expense.

Transfers to another district. Generally, your return is examined in the IRS district where you live. But if your return can be examined more quickly and conveniently in another district, such as where your books and records are located, you can ask to have the case transferred to that district.

Repeat examinations. The IRS tries to avoid repeat examinations of the same items, but sometimes this happens. If your tax return was examined for the same items in either of the 2 previous years and no change was proposed to your tax liability, please contact the IRS as soon as possible to see if the examination should be discontinued.

The Examination

An examination usually begins when you are notified that your return has been selected. The IRS will tell you which records you will need. If you gather your records before the examination, it can be completed with the least effort.

Any proposed changes to your return will be explained to you or your authorized representative. It is important that you understand the reasons for any proposed changes. You should not hesitate to ask about anything that is unclear to you.

The IRS must follow the tax laws set forth by Congress in the Internal Revenue Code. The IRS also follows Treasury Regulations, other rules, and procedures that were written to administer the tax laws. The IRS also follows court decisions. However, the IRS can lose cases that involve taxpayers with the same issue and still apply its interpretation of the law to your situation.

Most taxpayers agree to changes proposed by examiners, and the examinations are closed at this level. If you do not agree, you can appeal any proposed change by following the procedures provided to you by the IRS. A more complete discussion of appeal rights is found later.

If You Agree

If you agree with the proposed changes, you can sign an agreement form and pay any additional tax you may owe. You must pay interest on any additional tax. If you pay when you sign the agreement, the interest is generally figured from the due date of your return to the date of your payment.

If you do not pay the additional tax when you sign the agreement, you will receive a bill that includes interest. If you pay the amount due within 10 business days of the billing date, you will not have to pay more interest or penalties. This period is extended to 21 calendar days if the amount due is less than $100,000.

If you are due a refund, you will receive it sooner if you sign the agreement form. You will be paid interest on the refund.

If the IRS accepts your tax return as filed, you will receive a letter in a few weeks stating that the examiner proposed no changes to your return. You should keep this letter with your tax records.

If You Do Not Agree

If you do not agree with the proposed changes, the examiner will explain your appeal rights. If your examination takes place in an IRS office, you can request an immediate meeting with the examiner's supervisor to explain your position. If an agreement is reached, your case will be closed.

If you cannot reach an agreement with the supervisor at this meeting, or if the examination took place outside of an IRS office, the examiner will write up your case explaining your position and the IRS' position. The examiner will forward your case to the district office for processing.

Within a few weeks after your closing conference with the examiner and/or supervisor, you will receive a package with:

• A letter (known as a 30-day letter) notifying you of your right to appeal the proposed changes within 30 days,
• A copy of the examination report explaining the examiner's proposed changes,
• An agreement or waiver form, and
• A copy of Publication 5.

You generally have 30 days from the date of the 30-day letter to tell the IRS whether you will accept or appeal the proposed changes. The letter will explain what steps you should take, depending on which action you choose. Be sure to follow the instructions carefully. Appeal Rights are explained later.

If you do not respond to the 30-day letter, or if you later do not reach an agreement with an Appeals officer, the IRS will send you a 90-day letter, which is also known as a notice of deficiency.

You will have 90 days (150 days if it is addressed to you outside the United States) from the date of this notice to file a petition with the Tax Court. Filing a petition with the Tax Court is discussed later under Appeals to the Courts and Tax Court.

The notice will show the 90th (and 150th) day by which you must file your petition with the Tax Court.

Suspension of interest and penalties. Generally, the IRS has 3 years from the date you filed your return (or the date the return was due, if later) to assess any additional tax. However, interest and certain penalties will be suspended if the IRS does not mail a notice to you, stating your liability and the basis for that liability, within an 18-month period beginning on the later of:

• The date on which you timely filed your tax return, or
• The due date (without extensions) of your tax return.

If the IRS mails a notice stating your liability and the basis for that liability after the 18-month period, interest and certain penalties applicable to the suspension period will be suspended.

Note. The suspension only applies to timely filers of individual income tax returns for tax years ending after July 22, 1998. Also, for tax years beginning after 2003, the suspension period will apply if the IRS does not mail the notice stating your liability and the basis for that liability within a 1-year period (rather than 18 months).

The suspension period begins the day after the close of the 18-month period and ends 21 days after the IRS mails a notice to you stating your liability and the basis for that liability. Also, the suspension period applies separately to each notice stating your liability and the basis for that liability received by you.

The suspension does not apply to a:

If you later agree. If you agree with the examiner's changes after receiving the examination report or the 30-day letter, sign and return either the examination report or the waiver. Keep a copy for your records. You can pay any additional amount you owe without waiting for a bill. Include interest on the additional tax at the applicable rate. This interest rate is usually for the period from the due date of the return to the date of payment. The examiner can tell you the interest rate(s) or help you figure the amount.

You must pay interest on penalties and on additional tax for failing to file returns, for overstating valuations, for understating valuations on estate and gift tax returns, and for substantially understating tax liability. Interest is generally figured from the date (including extensions) the tax return is required to be filed to the date you pay the penalty and/or additional tax.

If you pay the amount due within 10 business days after the date of notice and demand for immediate payment, you will not have to pay any additional penalties and interest. This period is extended to 21 calendar days if the amount due is less than $100,000.

How To Stop Interest From Accruing

If you think that you will owe additional tax at the end of the examination, you can stop the further accrual of interest on the amount you think you will owe. You can do this by sending money to the IRS to cover all or part of the amount you think you will owe. Interest will stop accruing on any part of the amount you cover when the IRS receives your money.

You can send an amount either in the form of a deposit (cash bond) or as a payment of tax. Both a deposit and a payment stop any further accrual of interest. However, making a deposit or payment of tax will stop the accrual of interest on only the amount you sent. Because of compounding rules, interest will accrue on accrued interest, even if you have paid the underlying tax.

To stop the accrual of interest on both tax and interest, you must make a deposit or payment for both the tax and interest that has accrued as of the date of deposit or payment.

Payment or Deposit

Deposits differ from payments in two ways:

1. You can have all or part of your deposit returned to you without filing for a refund. However, if you request and receive your deposit and the IRS later assesses a deficiency for that period and type of tax, interest will be figured as if the funds were never on deposit. Also, your deposit will not be returned if one of the following situations applies:
   1. The IRS assesses a tax liability.
   2. The IRS determines, that by returning the deposit, it may not be able to collect a future deficiency.
   3. The IRS determines that the deposit should be applied against another tax liability.
2. Deposits do not earn interest. No interest will be included when a deposit is returned to you.

Notice not mailed. If you send money before the IRS mails you a notice of deficiency, you can ask the IRS to treat it as a deposit. You must make your request in writing.

If, after being notified of a proposed liability but before the IRS mails you a notice of deficiency, you send an amount large enough to cover the proposed liability, it will be considered a payment unless you request in writing that it be treated as a deposit.

If the amount you send is at least as much as the proposed liability and you do not request that it be treated as a deposit, the IRS will not send you a notice of deficiency. If you do not receive a notice of deficiency, you cannot take your case to the Tax Court. See Tax Court, later.

Notice mailed. If, after the IRS mails the notice of deficiency, you send money without written instructions, it will be treated as a payment. You will still be able to petition the Tax Court.

If you send money after receiving a notice of deficiency and you have specified in writing that it is a "deposit in the nature of a cash bond," the IRS will treat it as a deposit if you send it before either:

• The close of the 90-day or 150-day period for filing a petition with the Tax Court to appeal the deficiency, or
• The date the Tax Court decision is final, if you have filed a petition.

Using a Deposit To Pay the Tax

If you agree with the examiner's proposed changes after the examination, your deposit will be applied against any amount you may owe. The IRS will not mail you a notice of deficiency and you will not have the right to take your case to the Tax Court.

If you do not agree to the full amount of the deficiency after the examination, the IRS will mail you a notice of deficiency. Your deposit will be applied against the proposed deficiency unless you write to the IRS before the end of the 90-day or 150-day period stating that you still want the money to be treated as a deposit. You will still have the right to take your case to the Tax Court. See If You Do Not Agree, discussed earlier.

Installment Agreement Request

You can request a monthly installment plan if you cannot pay the full amount you owe. To be valid, your request must be approved by the IRS. However, if you owe $10,000 or less in tax and you meet certain other criteria, the IRS must accept your request.

Before you request an installment agreement, you should consider other less costly alternatives, such as a bank loan. You will be charged interest on the amount you owe and you may be charged a late payment penalty on any installment not paid by its due date. There is also a $43 fee if your installment agreement is approved.

For more information about installment agreements, visit the IRS web site at www.irs.gov/ind_info/ coll_stds/collect.html or see Form 9465, Installment Agreement Request.

Interest Netting

If you owe interest to the IRS on an underpayment for the same period the IRS owes you interest on an overpayment, you will be charged interest on the amount of the underpayment (up to the amount of the overpayment) at the overpayment interest rate. As a result, the net rate is zero for that period.

Abatement of Interest Due to Error or Delay by the IRS

The IRS may abate (reduce) the amount of interest you owe if the interest is due to an unreasonable error or delay by an IRS officer or employee performing a ministerial or managerial act (discussed later). Only the amount of interest on income, estate, gift, generation-skipping, and certain excise taxes can be reduced.

Note. Interest due to an error or delay in performing a managerial act can be reduced only if it accrued with respect to a deficiency or payment for a tax year beginning after July 30, 1996.

The amount of interest will not be reduced if you or anyone related to you contributed significantly to the error or delay. Also, the interest will be reduced only if the error or delay happened after the IRS contacted you in writing about the deficiency or payment on which the interest is based. An audit notification letter is such a contact.

The IRS cannot reduce the amount of interest due to a general administrative decision, such as a decision on how to organize the processing of tax returns.

Ministerial act. This is a procedural or mechanical act, not involving the exercise of judgment or discretion, during the processing of a case after all prerequisites (for example, conferences and review by supervisors) have taken place. A decision concerning the proper application of federal tax law (or other federal or state law) is not a ministerial act.

Example 1. You move from one state to another before the IRS selects your tax return for examination. A letter stating that your return has been selected is sent to your old address and then forwarded to your new address. When you get the letter, you respond with a request that the examination be transferred to the district office closest to your new address. The examination group manager approves your request. After your request has been approved, the transfer is a ministerial act. The IRS can reduce the interest because of any unreasonable delay in transferring the case.

Example 2. An examination of your return reveals tax due for which a notice of deficiency (90-day letter) will be issued. After you and the IRS discuss the issues, the notice is prepared and reviewed. After the review process, issuing the notice of deficiency is a ministerial act. If there is an unreasonable delay in sending the notice of deficiency to you, the IRS can reduce the interest resulting from the delay.

Managerial act. This is an administrative act during the processing of a case that involves the loss of records or the exercise of judgment or discretion concerning the management of personnel. A decision concerning the proper application of federal tax law (or other federal or state law) is not a managerial act.

Example. A revenue agent is examining your tax return. During the middle of the examination, the agent is sent to an extended training course. The agent's supervisor decides not to reassign your case, so the work is unreasonably delayed until the agent returns. Interest from the unreasonable delay can be abated since both the decision to send the agent to the training class and not to reassign the case are managerial acts.

How to request abatement of interest. You request an abatement (reduction) of interest on Form 843. You should file the claim with the IRS service center where you filed the tax return that was affected by the error or delay. If you do not remember the service center where you filed that tax return, send your claim to the service center where you filed your last tax return.

If you have already paid the interest and you would like a credit or refund of interest paid, you must file Form 843 within 3 years from the date you filed your original return or 2 years from the date you paid the interest, whichever is later. If you have not paid any of the interest, these time limitations for filing Form 843 do not apply.

Generally, you should file a separate Form 843 for each tax period and each type of tax. However, complete only one Form 843 if the interest is from an IRS error or delay that affected your tax for more than one tax period or for more than one type of tax (for example, where two or more tax years were being examined). You do not have to figure the dollar amounts of interest that you want lowered.

If your request for abatement of interest is denied, you can appeal the decision to the IRS Appeals Office.

Failure to abate interest may be reviewable by Tax Court. The Tax Court can review the IRS' refusal to abate (reduce) interest when all of the following requirements are met.

1. You have filed a request for abatement of interest (Form 843) with the IRS.
2. The IRS has not denied your request for abatement before July 31, 1996.
3. The IRS has mailed you a notice of final determination or a notice of disallowance.
4. You have filed a petition for review of failure to abate interest under Code section 6404 with the Tax Court within 180 days of the mailing of the notice of final determination or the notice of disallowance.

You must also meet the following requirements.

1. For individual and estate taxpayers -- your net worth must not exceed $2 million as of the filing date of your petition for review. For this purpose, individuals filing a joint return shall be treated as separate individuals.
2. For charities and certain cooperatives -- you must not have more than 500 employees as of the filing date of your petition for review.
3. For all other taxpayers -- your net worth must not exceed $7 million, and you must not have more than 500 employees as of the filing date of your petition for review.

Abatement of Interest for Individuals in Disaster Areas

If you live in an area declared a disaster area by the President after 1996, the IRS will abate interest on income tax for the length of any extension period granted for filing income tax returns and paying income tax.

If you were granted an extension, but were charged interest on income tax owed during the declared disaster period, the IRS can retroactively abate your interest. To the extent possible the IRS can do the following.

• Make appropriate adjustments to your account.
• Notify you when the adjustments are made.
• Refund any interest paid by you where appropriate.

For more information on disaster area losses, see Disaster Area Losses in Publication 547, Casualties, Disasters, and Thefts.

Offer in Compromise

In certain circumstances, the IRS will allow you to pay less than the full amount you owe. If you think you may qualify, you should submit your offer by filing Form 656, Offer in Compromise. The IRS may accept your offer for any of the following reasons.

• There is doubt about the amount you owe (or whether you owe it).
• There is doubt as to whether you can pay the amount you owe based on your financial situation.
• An economic hardship would result if you had to pay the full amount owed.
• Regardless of your financial circumstances, payment of the full amount owed would harm voluntary compliance by you or other taxpayers.

If your offer is rejected, you have 30 days to ask the Appeals Office of the IRS to reconsider your offer.

Generally, if you submit an Offer in Compromise, the IRS will delay certain collection activities. The IRS usually will not levy (take) your property to settle your tax bill during the following periods.

• While your Offer in Compromise is being evaluated by the IRS.
• For 30 days immediately after the offer is rejected.
• During any period that your timely-filed appeal is being considered by Appeals.

Also, if the IRS rejects your original offer and you submit a revised offer within 30 days of the rejection, the IRS generally will not levy your property while it considers your revised offer.

For more information about submitting an offer in compromise, see Form 656.

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