Tax Examination and Appeals Series Determination of Tax Liability

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This is the second article in a series of articles on tax examination and appeals.  The goal of the series is to provide an overview of tax examinations and appeals, provide an overview of what happens at each stage of tax examinations and appeals, and provide tips on how to handle each stage. [Read the first article of this series here]

IRS examinations and appeals are part of an overall system of federal tax liability determination that includes the taxpayer, the Internal Revenue Service (“IRS”), the US Tax Court, the Tax Division of the Department of Justice, the Joint Committee on Taxation, federal district courts, and the US Court of Federal claims, federal courts of appeal, and the US Supreme Court.

  • Processing of Tax Returns

Tax returns filed with the IRS are processed at the IRS campuses where, after computational and other information checks are performed, a determination is made as to whether any further examination of the tax return is required.  In most cases, the taxpayer’s self-assessment of his or her tax liability is accepted by the IRS and becomes the final tax liability determination.

The processing of tax returns has become increasingly automated over the past decades under the IRS Automated Data Processing (“ADP”) system.  In addition, AIMS, the Audit Information Management System, is a computer system used by Examination, LB&I, SB/SE, W&I, Appeals, and TE/GE divisions to control tax returns, input assessments and adjustments to tax returns, and provide management reports.

The IRS operates various types of automated programs for processing tax returns.  For example, the Automated Underreporter Program (“AUR”) matches information documents received from third parties against tax returns, identifies where there is a mismatch, and send out computer-generated letters to taxpayers notifying them that the IRS will assess additional tax unless the taxpayer comes forward with information demonstrating that the additional tax is not in fact due.  Another example is the Automated Substitute for Return (“ASFR”) program, which operates when the computerized document matching programs cannot find a taxpayer’s tax return to match with the information received from third parties.  Another example is the Automated Correspondence Exam (“ACE”) program, under which a number of issues that arise from the computerized processing of tax returns result in computer-generated notices to taxpayers, with little or no involvement by IRS personnel until a reply is received from the taxpayer.  

  • Amended Tax Returns

Amended tax returns can be filed to correct original erroneous tax returns.  The general administrative practice is to recognize amended tax returns which correct clear errors or plain mistakes in the original tax returns.  The treatment of an amended tax return is a matter of internal agency discretion. The IRS’s refusal to accept amended tax returns is subject to judicial review for abuse of discretion.

Comment:  The question arises whether a taxpayer must file an amended tax return to correct errors.  There appears to be no legal requirement in the Internal Revenue Code (“IRC”) to do so, i.e., the basic command in most cases is that a taxpayer should file an amended tax return.  However, a taxpayer may be liable for penalties for understatements of tax and negligence under IRC § 6662 if the error is not corrected.  Also, given the manner in which carry forwards of certain items like depreciation, excess capital losses, and suspended passive activity losses, etc., generally impact future tax returns, an error in one year that is not corrected may be compounded into future years, at which point the taxpayer’s knowledge in preparing the current year tax return based on the prior year’s erroneous information can be problematic given the duty to file a true and accurate tax return.  For many similar reasons, a tax return preparer should advise a taxpayer that an amended tax return should be filed when an error is discovered.

  • Examination of Tax returns

Once tax returns are selected for examination, the examination may be conducted as a computer-generated correspondence examination, from one of the IRS campuses, or, in more complex cases, by examination at the area office level.  

  • Agreement on Examination

If the IRS examiner determines that the tax liability shown on the tax return is correct, the examination is terminated, and the tax liability shown on the taxpayer’s tax return becomes the final IRS determination.  If the examination makes an initial determination that the taxpayer has not correctly determined his or her tax liability and that additional tax is due, such determination becomes a final determination of tax liability if the taxpayer agrees with, or chooses not to contest, the IRS determination.  

  • Disagreement on Examination

Asset Protection Strategies for clientsA case not agreed upon in examination will generally be subject of a group manager conference before submission to appeals to try to resolve factual issues.  Fast track mediation – collection is a process designed to resolve SB/SE and other disputes quickly, and fast track settlement is a similar process designed to reach settlement of an entire LB&I issue or other matter.

If the taxpayer continues to disagree with the initial examination of tax liability made by examination and it is not resolved by the initiatives described above (i.e., there is a proposed deficiency), the taxpayer may, but is not required to, pursue an administrative appeal.  Appeals are handled by IRS appeals offices, which generally make the final administrative determination of a taxpayer’s tax liability.

  • Disagreement on Examination – No Appeal

If a taxpayer does not pursue an administrative appeal, the taxpayer may file a petition with the Tax Court seeking a redetermination of the proposed deficiency.  In such cases, appeals may consider settlement of the case for a limited period of time after the petition is filed, provided it has not previously considered the case.  If a taxpayer reaches an agreement with appeals, the settlement is effected by stipulation of agreed deficiency or overpayment filed with the Tax Court and so ordered by the court.  If the taxpayer is unable to reach a settlement with appeals during the time allowed, appeals consideration will stop and the Tax Court case will proceed.