4.10.3. Examination Techniques

(1) This IRM provides an overview of the examination techniques examiners should understand and apply in the performance of their duties.

(1) By law, the IRS has the authority to conduct examinations under Title 26, Internal Revenue Code, Subtitle F – Procedure and Administration, Chapter 78, Discovery of Liability and Enforcement of Title, Subchapter A, Examination and Inspection, which includes, but is not limited to, the following Internal Revenue Code (IRC) sections:

• IRC 7521, Procedures involving taxpayer interviews

• IRC 7602, Examination of books and records

• IRC 7605, Time and place of examination

(1) The Director, Examination Headquarters, is the executive responsible for providing policy and guidance for SB/SE Examination employees and ensuring consistent application of policy, procedures and tax law to effect tax administration while protecting taxpayers’ rights. See IRM 1.1.16.5.5, Examination Headquarters, for additional information.

(2) The Director, Examination Field and Campus Policy, reports to the Director, Examination Headquarters, and is responsible for the delivery of policy and guidance that impacts the field examination process. See IRM 1.1.16.5.5.1, Examination Field and Campus Policy, for additional information.

(3) Field Examination General Processes (FEGP), which is under the Director, Examination Field and Campus Policy, is the group responsible for providing policy and procedural guidance on standard examination processes to field employees. See IRM 1.1.16.5.5.1.1, Field Examination General Processes, for additional information.

(4) All examiners must perform their professional responsibilities in a way that supports the IRS Mission. This requires examiners to provide top quality service and to apply the law with integrity and fairness to all.

(5) Income tax examiners and their managers should thoroughly acquaint themselves with the examination procedures and information contained in this IRM, as well as other resources, such as those listed in, IRM 4.10.3.1.5, Related Resources, below.

(1) The following table lists acronyms and their definitions used throughout this IRM:

(1) Examiners will use various IRMs for additional guidance and information examiners including, but not limited to:

• IRM 4.10.2, Pre-Contact Responsibilities

• IRM 4.10.4, Examination of Income

• IRM 4.10.7, Issue Resolution

• IRM 4.10.8, Report Writing

• IRM 4.10.9, Workpaper System and Case File Assembly

• IRM 4.10.20, Requesting Audit, Tax Accrual or Tax Reconciliation Workpapers

• IRM 4.11.6, Changes in Accounting Methods

• IRM 4.11.57, Third-Party Contacts

• IRM 4.46, LB&I Examination Process (LB&I only)

(2) The examples linked below contain additional information:

• Example - Reconciliation of Current Year Retained Earnings

• Example - Reconciliation of Income and Analysis of Unappropriated Retained Earnings

• Example - Reconciling Taxable Bank Deposits

(1) The goal of an examination is to determine the "substantially correct" tax liability. The 80/20 concept is" value-added "decision making that weighs the impact of our decisions (potential results) with the investment of additional case time (cost) and is applicable throughout the audit to evaluate and determine the scope of the examination. See IRM 4.10.2.7.1.1, Risk Analysis, for further discussion of the 80/20 concept.

(2) The examiner must consider the facts and circumstances, evaluation of internal controls (in business examinations) and use professional judgment to determine whether the scope should be expanded or contracted.

(3) Examiners must document the reasons for expanding and contracting the examination on Lead Sheet 100-2 or a supporting workpaper indexed to Lead Sheet 100-2, or Form 9984.

(1) The mid-audit decision point or mid-cycle risk analysis (LB&I only) or 50 percent rule refers to performing a risk-based analysis of the examination at its mid-point.

(2) The mid-point of the examination can be determined based on the number of issues classified/identified or the number of hours expended.

(3) At the mid-point of the examination, the examiner should determine whether the remaining classified/identified issues should be examined. This decision should be based on the facts and circumstances, evaluation of internal controls (in business examinations) and the examiner’s judgment. For example, the resulting additional tax is not expected to be material, or the time to develop additional issues is not justified, based on the potential for additional tax.

(4) Examiners are expected to use their professional judgment to determine if it is in the government’s best interest to continue the examination. If it is not in the government’s best interest to continue the examination, the examiner must document this determination. See IRM 4.10.3.3.1 for additional guidance. LB&I examiners should reference IRM 4.46.3.3.6, Documenting the Risk Analysis, for additional guidance.

(1) Examiners may conduct interviews during any phase of the examination including pre-contact, initial appointment, review of books and records, fact finding, issue resolution, report writing, and closing. The initial interview is typically the most in-depth interview, however subsequent interviews, and interviews of third parties can be equally important. Further, conducting a thorough interview during the closing phase of the examination (i.e., at the closing conference) will often help the examiner resolve the case more efficiently. See the following for additional guidance:

• IRM 4.10.3.4.1.1, Initial Interviews

• IRM 4.10.3.4.1.2, Subsequent Interviews

• IRM 4.10.3.4.1.3, Third-Party Interviews

• IRM 4.10.3.4.1.4, Closing Interviews (Conferences)

(1) Timing — Proper timing of the interview is essential in obtaining information that is material in resolving a case.

(2) Review Available Information — Prior to any interview, the examiner should review all available information relating to the case. Such information may then be divided into three general categories:

1. Information that can be documented, and need not be discussed;

2. Information that may be documented, but needs to be discussed (i.e., requires further clarification or collaboration); and

3. Information that must be developed by testimony.

(3) Prepare Outline — Before the interview, the examiner should determine the goal of or purpose for questioning the taxpayer or witness. The topics that will enable the examiner to accomplish this goal should be outlined in detail, depending on the examiner’s experience and the complexity of the case. The outline should contain only information that is relevant and material, including hearsay (see IRM 4.10.7.3.5, Hearsay). Extraneous matters should be excluded because they may be confusing and adversely affect the development of relevant topics. Important topics should be set off or underscored and related topics listed in their proper sequence. Specific questions tend to reduce the flexibility of the examiner and should be kept to a minimum. The outline should include the following:

1. Identification of the taxpayer or witness;

2. Purpose of the interview;

3. Identification of topics to be addressed; and

4. Reference to pertinent documents or exhibits that will be shared during the interview.

(4) A separate interview file may be utilized for purposes of conducting an interview. This file should contain only data or information arranged in the order it is to be discussed or covered in the interview.

(1) Interviews should always be held with the person(s) having the most knowledge concerning the total financial picture and history of the person or entity being examined. Generally, that person(s) is the taxpayer for individual/Form 1040 examinations.

(2) IRC 7521(c) states that an examiner cannot require a taxpayer who has obtained representation to accompany the representative to an examination interview (absent an administrative summons). However, the taxpayer’s voluntary presence at the interview can be requested through the representative as a means to expedite the examination process.

(1) The time and place of interviews will be set by the Secretary if they are reasonably scheduled. This authority is provided in IRC 7605(a), Time and place, and the related regulations at 26 CFR 301.7605-1, Time and place of examination. In general, the IRS will determine if an office or field examination is to be performed.

(2) Generally, the initial interview should be held as soon as possible after opening a case with every effort made to hold the initial appointment within 20-35 calendar days. See IRM 4.10.2.9, Scheduling the Appointment: Overview.

(3) Office examinations will be conducted at the IRS office closest to the location of the taxpayer. See IRM 4.10.2.9.2, Place and Time of Examination for additional information.

(4) Field examinations should be conducted at the taxpayer's residence, place of business, or where the taxpayer’s original books and records are maintained. In the case of a sole proprietorship or business entity, this will usually be the taxpayer's principal place of business. See IRM 4.10.2.9.2, Place and Time of Examination, for additional guidance.

(5) An exception to the rule for field examinations would be for some frivolous filers/nonfilers. Group managers should consider the potential hazards to the personal safety of examiners examining these returns. Meetings between the examiner and the non-compliant taxpayer should be held, where practical, in a government facility. The group manager may make other arrangements to facilitate the examination when it would not compromise the safety of the examiner.

(1) It is important to create an environment where the taxpayer feels comfortable. Examiners should maintain a friendly and professional demeanor. Suggestions for establishing rapport include:

1. Examiners should introduce themselves.

2. Examiners should explain what will happen during the examination.

3. Examiners should be prepared to explain return selection procedures, rights to representation, and appeal rights. See Pub 3498, The Examination Process.

4. Examiners should recognize that an IRS audit is often a once-in-a lifetime experience for the taxpayer, and therefore the taxpayer may be tense or nervous.

5. Examiners should exhibit openness, honesty and integrity and be calm and objective.

6. Examiners should listen carefully to all details, be receptive to all information volunteered, regardless of its nature, and be patient and persistent in extracting the facts necessary to achieve the goals of the interview.

(1) Interviews provide information not available from other sources. A properly planned and executed interview will provide an understanding of the taxpayer's financial history, business operations, and accounting records.

(2) The case file should reflect in-depth planned interviews throughout the examination. Sufficient questions should be asked to gain a clear understanding of the taxpayer, as well as the operations of the taxpayer.

(3) The elements of an adequately documented interview include, but are not limited to:

1. Items specific to the taxpayer such as the type of return and relevant facts and circumstances.

2. Sufficient depth to give a clear understanding of the nature of the taxpayer's financial history, business history, and day-to-day operations.

3. Explanations of large, unusual or questionable (LUQ) items and whether such explanations resolve the potential issues.

4. Description of books and records maintained and their availability.

5. Description of financial status or overall assessment of return validity, when appropriate.

6. Complete explanation of the taxpayer's accounting system and accounting methods, including any changes when appropriate. This may also include an explanation of the accounting method used for tax, if different from book accounting, and any adjustments that were made.

7. Explanation of the taxpayer's internal controls as discussed in IRM 4.10.3.6 below, Evaluating the Taxpayer’s Internal Controls.

8. Additional items addressed (as warranted).

(4) Examiners should inquire about the return preparer including, but not limited to:

1. Was the return prepared for compensation?

2. What information or documents did the T/P provide to the preparer?

3. Did the preparer sign the return and include the appropriate identification number(s)?

4. Did taxpayer receive a copy of the return?

5. Did preparer negotiate the refund?

(5) Case files may be reviewed by many individuals after closing from the examiner, especially if the examination is unagreed. This includes the examiner, who may need to provide testimony during litigation. The interview(s) should be documented in sufficient detail that no unanswered questions remain.

(6) It is important for the examiner to ask appropriate follow-up questions and properly document the interview without hindering the flow of information. Examiners should:

1. Take brief notes during the interview for significant responses to questions and note those areas that need additional development. It is not advisable to take extensive notes during the interview as it can be distracting and hinder the flow of the interview.

2. Prepare a memorandum of interview (MOI) immediately following the meeting or shortly thereafter, fully documenting the statements and replies made by the taxpayer. The MOI and the handwritten interview notes will serve to document statements made by the taxpayer, refute subsequent contradictory statements, and support examination positions taken.

(7) As an alternative, questionnaires may be used to record taxpayer responses instead of a memorandum. If an interview questionnaire is used, the examiner should ask follow-up questions as needed. The original questions and responses should be included in the case file.

(8) Use of Lead Sheets in RGS — RGS contains various lead sheets for use by SB/SE Examination.

1. Tax Compliance Officers — SB/SE tax compliance officers (TCO) are required to use the following lead sheets.

Title of Lead Sheet	When Used:
Lead Sheet 100-3, TCO Initial Discussion	Pre-contact or Interview
Lead Sheet 400, Initial Interview Questions and Notes	Interview
Lead Sheet 400, Initial Interview Questions and Notes - Business Supplement	Interview

2. Revenue Agents — SB/SE revenue agents use Lead Sheet 400, Initial Interview Questions and Notes.

(1) IRC 7521(a) provides that taxpayers and IRS employees may audio record an "in-person" interview, provided that advance notice is given to the other party.

(1) The mutual commitment date (MCD) is a tool used by SB/SE revenue agents to promote cooperation and the timely submission and review of records, resulting in a more efficient examination.

(2) The MCD is the date the parties agree the SB/SE revenue agent will issue the audit report (generally the closing conference date) and should be established with the input of the taxpayer and/or representative at the end of the first appointment. If the initial appointment is scheduled for multiple days, then the MCD should be established at the end of the last day.

(3) The MCD process establishes mutual responsibilities such as:

1. Identifying and discussing potential areas of examination (including issues raised by the taxpayer);

2. Requesting, providing and reviewing pertinent information necessary to determine the deductibility of an expense or inclusion of an income item;

3. Applying relevant tax law, including the Internal Revenue Code, the Treasury Regulations, court cases, etc., required to make a correct determination;

4. Keeping all parties advised of unavoidable delays;

5. Addressing all parties’ questions and concerns raised during the audit; and

6. Keeping all parties fully informed about the adjustments being proposed, and the progress of the audit.

(4) The MCD should be reasonable and attainable. The following factors should be considered when determining the MCD:

1. Number of anticipated additional visits;

2. Days needed between visits to get information properly prepared; and

3. Availability of records.

(5) SB/SE revenue agents must:

1. Document the MCD on Lead Sheet 100-2, Revenue Agent Audit Plan;

2. Discuss the MCD with the group manager during the GMCM and ensure the discussion is documented on Lead Sheet 100-4, Group Manager Concurrence Meeting; and

3. Promptly notify the group manager if a taxpayer and/or representative declines to establish a MCD or fails to cooperate. If this occurs, the group manager should contact the taxpayer and/or representative to discuss expectations and responsibilities of the IRS and taxpayer or representative during the course of the examination. Based on the results of the discussion, the group manager and examiner will establish and document an estimated completion date (ECD).

(6) Both the MCD and ECD may be extended if:

1. The examination is expanded to new issues;

2. The examination is expanded to pick up prior, subsequent, or related returns;

3. New information is discovered;

4. The taxpayer and/or representative become uncooperative; or

5. Unforeseen circumstances arise.

(7) An extension of the MCD must be communicated to the taxpayer/representative. If the MCD is extended more than 30 calendar days, the revenue agent must also notify the group manager and discuss the reasons for the extension. The revenue agent must document the discussions with the taxpayer/representative and group manager on Lead Sheet 100-2, a workpaper, or Form 9984.

(8) Whether or not the taxpayer or representative agrees to establish a MCD, in the event a taxpayer and/or representative fails to work with the IRS in a collaborative manner, the revenue agent will be expected to use the full extent of the authority allowed by the Internal Revenue Code to obtain the information necessary for an effective examination, make an appropriate determination, and conclude the examination in a timely manner.

(9) Pertinent case actions and related discussions concerning the MCD/ECD should be documented on Lead Sheet 100-2, a workpaper, or Form 9984.

(1) The GMCM is an opportunity for the group manager and SB/SE revenue agent to discuss the scope and depth of the examination, as well as the MCD. Group manager involvement in the early stages of an examination results in fewer delays, increased efficiency and higher quality cases.

(2) The GMCM should occur no later than 30 business days after completion of the initial appointment or 60 business days after the case is updated to Status 12, Started, in the Examination Returns Control System (ERCS), whichever is first.

(3) The revenue agent should schedule the GMCM meeting as soon as the date of the initial appointment is scheduled.

(4) GS-12 revenue agents and below are required to use the GMCM.

(5) GS-13 revenue agents are encouraged to utilize a GMCM to provide updates on cases and obtain guidance from managers.

(6) At a minimum, the revenue agent should be prepared to discuss audit issues, accomplishments, concerns and barriers including:

1. Case overview;

2. Initial appointment and MCD;

3. Books and records;

4. Minimum income probes;

5. Required filing checks;

6. Risk analysis, scope and depth;

7. Planned actions; and

8. Managerial involvement.

(7) The GMCM is documented on Lead Sheet 100-4, Group Manager Concurrence Meeting and Managerial Involvement.

(1) 26 CFR 301.7605–1(d)(3)(iii) states: "Regardless of where an examination takes place, the IRS may visit the taxpayer’s place of business or residence to establish facts that can only be ascertained by direct visit, such as inventory or asset verification. The IRS generally will visit for these purposes on a normal workday of the IRS during the IRS’ normal duty hours."

(1) Tours of business sites should be conducted during examinations of all business entities. 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 should be considered.

(2) Tours should be conducted after the initial interview and early in the examination process. This clarifies what was said during the interview and provides a frame of reference when interpreting information in the books and records. This assists examiners to correctly determine the scope and depth of the examination and avoid unnecessary audit steps.

(3) Tours should be conducted with knowledgeable individuals. Taxpayers, or their representatives, can often explain business practices that appear unusual to the examiner.

(4) Tours should be planned to address large, unusual, or questionable items identified during the pre-contact analysis or interviews.

(5) Design the tour to fit the type of business. The Audit Technique Guides (ATGs) include descriptions of business operations which can help determine what examiners should expect to see. The ATGs are available at: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Audit-Techniques-Guides-ATGs.

(6) Tours should not disrupt business operations or interfere with the taxpayer’s interactions with customers.

(1) Observe and be alert to the physical surroundings. Confirm that assets identified on the tax return (and identified as having audit potential during the pre-contact analysis) are physically present and identify assets that are physically present but are not represented on the return.

(2) Ask questions to confirm understanding of what is observed and avoid confusion.

(3) Trace common business transactions through the system. Look for discrepancies between what the transactions "should" look like and what actually happens. Look for weaknesses in the internal controls such as a lack of separation of duties. This will help determine what degree of reliance can be placed on the books and records and what audit steps will be needed.

(1) The following examples emphasize how tours of business sites can assist examiners to determine the correct scope and depth of examinations, identify significant issues, and avoid unnecessary and time consuming procedures.

1. Example 1 – An examination of an auto dealership was conducted at the representative’s office due to limited space at the business site. During the tour of the business, the examiner asked what was on the second floor above the work area and the POA stated that some obsolete parts were kept there. The examiner asked to look and found a well-stocked inventory of parts used for repairs. The inventory, as represented on the return, included only the vehicles held for sale and not the parts used to complete repairs.

2. Example 2 – During the tour of a pharmacy, the examiner noticed that a large billboard was mounted on the roof of the building. It was determined that the income from the rental of the billboard was omitted from the tax return.

3. Example 3 – Touring a new building included questions about a demolition loss claimed on the return. The examiner determined that the expense was for the demolition of the old building on the site of the new facility and was not properly accounted for on the tax return.

4. Example 4 – During the tour of an auto repair shop, an examiner observed a new computerized alignment rack, an air conditioning evacuation and charging station, two brake lathes, and an elaborate engine analyzer. The depth of the examination into depreciation was minimized because the examiner was able to inspect and observe many of the assets listed on the depreciation schedule.

(1) An examiner may consider inspecting the taxpayer’s residence. Due to privacy issues and the intrusiveness of such inspections, their use should be limited. The purpose of inspecting the taxpayer’s residence includes (but is not limited to):

1. Determining the validity of deductions for an office or business located in the residence.

2. Determining the taxpayer’s financial status.

(1) Examiners should document that a tour or inspection was completed and describe the results, including observations and resolution of any questions. The tour of the business site or inspection of the taxpayer’s residence should also be noted on the activity record.

(2) If a tour of the taxpayer’s business facilities is not conducted, the reason(s) should be documented in the workpapers.

(1) An evaluation of a taxpayer’s internal controls is necessary to determine the reliability of the books and records.

(2) It is essential to evaluate internal controls to determine the appropriate audit techniques to be used during the examination.

(3) The evaluation of internal controls gives examiners the opportunity to identify high risk accounts and eliminate verification of accounts that have little or no tax consequence.

(4) An evaluation of internal controls is used to determine the scope of an audit and the extent of audit procedures to be used.

(5) An evaluation of internal controls is used to assess the level of control risk and establish the depth of the examination. "Control risk" is defined as the risk that a material misstatement could occur, and it will not be prevented or detected on a timely basis by the business’s internal control structure, policies or procedures.

(1) Internal Controls are defined as the "taxpayer’s policies and procedures to identify, measure and safeguard business operations and avoid material misstatements of financial information."

(2) Examiners should obtain an understanding of three key elements of the taxpayer’s business:

1. The control environment;

2. The accounting system; and

3. The control procedures.

(1) The evaluation of internal controls can be described as an analysis completed by the examiner to understand and document the entire business operation. The key steps of the evaluation process are:

1. Understanding the control environment;

2. Understanding the accounting system; and

3. Understanding the control procedures.

(2) Each of these steps is discussed in the following subsections. To add clarity, a flowchart of the process of evaluating internal controls is included as Exhibit 4.10.3-1, Analysis of Taxpayer’s Internal Controls. The flowchart identifies the minimum steps to be taken by the examiner to understand and document the entire business operation.

(3) While the flowchart appears to be a linear process, the evaluative process is not linear and the steps illustrated need not be followed in the order shown in the exhibit.

(1) Not all businesses are susceptible to the same level of control risk. In some businesses, internal controls are required by third parties (such as when a franchise is involved). Moreover, internal controls for businesses within the same industry may vary significantly.

(1) An examination of a taxpayer cannot be undertaken without an overview of the entire operation. An in-depth review of taxpayers’ financial status can only be accomplished through an evaluation and documentation of internal controls, including the control environment, the accounting system and the control procedures.

(1) Once these steps are completed, the examiner can decide if the books and records adequately reflect business operations. Examiners should utilize the 80/20 concept to determine whether the scope of the examination should be revised and select the appropriate depth and method of examining income and other issues based on the evaluation of internal control. See IRM 4.10.3.3.1, The 80/20 Concept, for additional guidance.

(1) The first step is to determine what books and records are available for examination.

(2) If applicable, read the audited and certified financial statements, including the notes, for unusual comments and potential audit issues.

(3) Taxpayers may present receipts and cancelled checks as verification for items on the return. A business may use a single-entry system with daily, weekly, or monthly entries and total, or a double-entry system. The routine bookkeeping may be accomplished through computerized or manual means.

(4) If the taxpayer is under a record retention agreement with the IRS, they must maintain magnetic tapes, disks, or other machine sensible data or media used for recording, consolidating, and summarizing accounting transactions and records within the taxpayer’s processing system. See Rev. Proc. 98-25, 1998-1 C.B. 689, for further information on Record Retention Agreements.

(1) The second step is to have the taxpayer explain the books and records. The accounting and recordkeeping system should be explained by the person most knowledgeable of the system. The appropriate person may be the taxpayer, an employee of the taxpayer, or the taxpayer’s representative. The key is that the person must have knowledge of the taxpayer’s accounting system.

(2) The taxpayer’s explanation of the books and records should include:

1. Explaining the flow of transactions or entries from the initial transaction, through all book entries and reconciliations to the tax return.

2. Tracing specific income, expense, and, if applicable, balance sheet items through the accounting system (an accounting system includes all books of entry and all reconciliations).

3. If applicable, tracing the flow of purchases and inventory through to Cost of Goods Sold.

(1) The third step is to determine the taxpayer’s accounting period. "Annual Accounting Period" means the annual period regularly used by the taxpayer to compute income and maintain books and records. (See IRC 441(c)), Annual accounting period.

(2) The term "taxable year" means:

1. The taxpayer’s annual accounting period, if it is a calendar year or a fiscal year; or

2. The period for which the return is made, if a return is made for a period of less than 12 months.

3. See IRC 441(b), Taxable year, for other taxable years.

(3) A tax year is adopted when a tax return for the taxpayer is filed by the due date of the taxpayer’s first taxable year. Examples:

1. A new corporate taxpayer, with a fiscal year ending August 30, has until November 15 of that same year to file its first tax return, to adopt this taxable year.

2. A new individual taxpayer, with a calendar year, has until April 15 of the subsequent year to file his/her first tax return, to adopt this taxable year.

3. A new corporate taxpayer, with a calendar year, has until March 15 of the subsequent year to file its first tax return, to adopt this taxable year.

(4) Allowable annual accounting periods include:

1. Calendar year, ending December 31 — A calendar year is required if the taxpayer does not keep books, does not have an annual accounting period, or has an annual accounting period that does not qualify as a fiscal year.

2. Fiscal year, ending on the last day of a month other than December.

   Note: If the taxpayer intends to choose a fiscal year, adequate books of account must be established before the end of the first annual accounting period.

3. 52–53 week period.

(5) A short tax year is one of less than 12 months. The following two situations can result in a short tax year:

1. When a taxable entity is not in existence for an entire tax year. Income, expenses, and tax are computed solely for the period of time the entity is in existence.

2. When an existing taxable entity changes or is required to change its annual accounting period. In this case, income, expenses, and tax must be annualized.

   Example: A corporation files a tax return because of a change in accounting period for the 6-month short tax period ending June 30. The corporation has taxable income of $40,000 during the short tax year. Its annualized income is $80,000 ($40,000 x ¹²⁄₆). Its total tax (as annualized) is $15,450. The tax for the short year is $7,725 ($15,450 x ⁶⁄₁₂).

(6) Generally, partnerships, S corporations, and personal service corporations must use a calendar year unless:

1. A business purpose is established for another tax year, or

2. An IRC 444 election is made.

(7) In general, the taxpayer must obtain the consent of the Commissioner to change the annual accounting period. (See 26 CFR 1.442-1(a)). The guidelines for obtaining this consent are contained in Rev. Proc. 2002-39, Rev. Proc. 2003-62, Rev. Proc. 2006-45, Rev. Proc. 2006-46, Rev. Proc. 2007-64 and Rev. Proc. 2018-17. Please note that each of these Revenue Procedures have been clarified and/or modified on numerous occasions and an electronic research request (e.g., Westlaw ) should be made to identify current guidance.

(8) 26 CFR 1.442-1(c), Special rule for change of annual accounting period by subsidiary corporation, provides a special rule for qualifying subsidiary corporations to change their annual accounting period without the prior approval of the Commissioner.

(1) The fourth step is determining the taxpayer’s method of accounting. An accounting method is a system for stating income, expenses, assets, liabilities, and financial position. Taxable income must be computed not only based on a fixed accounting period, but also in accordance with a method of accounting regularly employed in keeping the taxpayer’s books.

(2) An accounting method is selected when the first tax return is filed.

(3) IRC 446(c), Permissible methods, states a taxpayer may compute taxable income under any of the following methods of accounting:

1. The cash receipts and disbursements method;

2. An accrual method;

3. Any other method permitted by this section, or any combination of the foregoing methods permitted under regulations prescribed by the Secretary (hybrid methods).

(4) There are specific methods of accounting for income and expense items, which include, but are not limited to:

1. Depreciation (IRC 167, Depreciation, and IRC 168, Accelerated cost recovery system).

2. Amortization (IRC 169, Amortization of pollution control facilities, IRC 178, Amortization of cost of acquiring a lease, IRC 194, Treatment of reforestation expenditures, and IRC 197, Amortization of goodwill and certain other intangibles).

3. Depletion (IRC 611, Allowance of deduction for depletion, IRC 612, Basis for cost depletion, IRC 613, Percentage depletion, and IRC 613A, Limitations on percentage depletion in case of oil and gas wells).

4. Deduction for Bad Debts (IRC 166, Bad debts, and IRC 582, Bad debts, losses, and gains with respect to securities held by financial institutions).

5. Installment Sales (IRC 453, Installment method, and IRC 453B, Gain or loss on disposition of installment obligations).

6. Long Term Contracts (IRC 460, Special rules for long-term contracts).

(5) A taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.

(6) A reasonable (hybrid) method may be used, subject to the following restrictions:

1. If inventories are present, the accrual method must be used for purchases and sales.

2. If the cash method is used to compute income, the cash method must be used to compute expenses.

3. If the accrual method is used for reporting expenses, the entire accounting method must be accrual.

(7) If the taxpayer selects an erroneous accounting method when the first return is filed, it can be corrected by filing an amended return before the filing of the next year’s return. All other accounting method changes can only be done with the permission of the Commissioner. See paragraph (9) below.

(8) The IRS can prescribe a method of accounting that will "clearly reflect income" if, in the IRS’ opinion, the taxpayer’s method does not clearly reflect income. See IRM 4.11.6.2(2) through (4), General Principles for Changes in Accounting Methods. The Commissioner has broad discretion in selecting a method of accounting that the Commissioner believes properly reflects the income of a taxpayer once the Commissioner has determined that the taxpayer's method of accounting does not clearly reflect income. See Rev. Proc. 2002-18

(9) Taxpayers may obtain the consent of the Commissioner to voluntarily change their method of accounting. In addition, an examiner may require a taxpayer to change from an improper method of accounting to a proper one. The IRS has issued a series of revenue procedures to provide guidance and procedures for changes in method of accounting, whether voluntary or involuntary. Examiners must ensure that they are familiar with the applicable guidance in effect for the tax year under examination. See Methods of Accounting and Timing Practice Network for additional guidance.

(10) For additional details concerning change in accounting method, please refer to IRM 4.10.13.7, Change in Accounting Method. Additionally, examiners are encouraged to consult with the Change in Accounting Method (CAM) Technical Advisor for additional assistance. For additional information regarding changes in accounting methods refer to IRM 4.11.6, Examining Officers Guide (EOG), Changes in Accounting Methods, and Corporate/Business Issues & Credits Knowledge Base.

(1) The fifth step is determining the depth of the examination of the taxpayer’s books and records.

(2) Factors that should be considered when determining the depth include:

1. Type of Records — taxpayers use a variety of bookkeeping methods and maintain different types of records.

2. Volume of Records — voluminous records may be encountered when auditing larger taxpayers or when the taxpayer’s records are unorganized.

   Note: When a taxpayer submits unorganized records, the burden is on the taxpayer to organize them and prepare summaries and reconciliations. This can be done with or without the examiner’s presence.

(3) The depth of the examination of the taxpayer’s books and records should be established after:

1. Interviewing the taxpayer;

2. Touring the business site (if applicable); and

3. Evaluating the taxpayer’s internal controls.

(4) The depth may be expanded or contracted as the examination progresses, if warranted.

(5) The depth of the examination of the taxpayer’s books and records can be limited to the verification of specific items. This is appropriate for Office Audit examinations of wage earners and small Schedule C’s (where gross receipts have not been classified as an audit issue).

(6) The depth of the examination of the taxpayer’s books and records should include sampling techniques when there are voluminous records. This is an effective use of time in situations when it is impossible to review all records.

(7) Mechanical verification of particular accounts or journals should be kept to a minimum. If the degree of error is substantial, the taxpayer should be asked to make suitable verification and correction before the examination proceeds. Mechanical verification of the taxpayer’s books and records should be more extensive when indications of fraud are present.

(8) Taxpayers are required by law to maintain accounting records in sufficient detail to enable the preparation of an accurate tax return (See IRC 6001). The appearance of the records is not important if the accuracy and orderliness are not affected.

(9) If the taxpayer’s records are lost, destroyed, or are not available due to circumstances beyond the taxpayer’s control, examiners may allow the taxpayer to present reconstructed records. The reconstructed records should be reviewed to determine the amounts are ordinary and necessary to the business activity.

(10) When records are incomplete, nonexistent, or suspect, the examiner should document Form 9984, Examining Officer’s Activity Record, with all attempts to obtain the taxpayer’s records and the group manager should be informed so delays can be kept to a minimum.

(1) The sixth step is reconciling the taxpayer’s books and records to the tax return. The reconciliation traces the process the taxpayer used to prepare the return from the books and records.

(2) The records used for this reconciliation are:

1. Taxpayer and/or accountant summaries, reconciliations, and account grouping papers — These will show the grouping of book accounts to the respective line items on the tax return.

2. Profit and loss statement — The profit and loss statement is a financial report of an entity’s revenues and expenses for the accounting period. The report summarizes the net income or net loss for the period. The report is sometimes referred to as a "P&L", income statement, or statement of operations.

3. Compilations, audited and certified financial statements.

4. Trial balance sheets — The trial balance is the listing of all accounts in the general ledger and their balances. A trial balance may be prepared at any time.

5. Adjusted trial balance — A trial balance taken immediately after all year-end adjusting entries have been posted is called an adjusted trial balance. The adjusted trial balance is used to prepare financial statements. The balance taken immediately after closing entries have been posted is called a post-closing trial balance. Schedule M adjustments are calculated next, and then the tax return is prepared.

6. Adjusting journal entries — Normally a taxpayer will need to correct, adjust or reclassify some original book entries by making adjusting journal entries. The adjusting journal entries are often recommended by persons conducting the year-end audit for financial reporting purposes.

7. Tax reconciliation workpapers — The trial balances and adjusting (and consolidating, if applicable) entries are usually included in what the taxpayer may call the "tax reconciliation workpapers" or "grouping papers". The tax reconciliation workpapers are requested at the beginning of an examination. These workpapers include the final balance which ties the tax return to the general ledger and other analyses necessary to complete the return. See IRM 4.10.20.2, Service Policy for Requesting Tax Reconciliation Workpapers, for additional information.

8. Audit or tax accrual workpapers — In unusual circumstances, the IRS may request audit or tax accrual workpapers but only when such factual data cannot be obtained from the taxpayer’s records or from available third parties. See IRM 4.10.20.3.1, Unusual Circumstances Standard, and IRM 4.10.20.3.2, Requests for Tax Accrual Workpapers Involving Listed Transactions, and IRM 4.10.20.4, Procedure for Requesting Audit and/or Tax Accrual Workpapers, for additional information.

(3) The following audit techniques should be used to reconcile the taxpayer's books and records to the tax return:

1. Reconcile the profit or loss shown on the return to the taxpayer’s books.

2. Compare prior and subsequent years P&L statements. Identify significant changes and adjust the scope/depth of the examination as needed.

3. Review the adjusted trial balance, including the adjusting entries and explanations.

4. Compare the current year’s trial balance to the prior and subsequent year’s balance. Note significant variations for further inquiry.

5. Review the adjusting journal entries. Analyze the adjusting journal entries to verify the corrections or reclassifications are proper. Confirm the taxpayer’s explanations depict the true effect of the adjustments.

(1) Schedule M–1 is a critical schedule for identifying potential tax issues resulting from both temporary and permanent differences between financial and tax accounting.

(2) For a C corporation, Schedule M–1 is the reconciliation between net income per the books and taxable income before the net operating loss deduction, dividends received, and the special deductions per Schedule C.

(3) For S corporations and partnerships, Schedule M–1 is the reconciliation of net income per the books to the net income per Schedule K after taking into consideration all the separately stated income and expense items.

(4) Since the Schedule M–1 for C corporations is slightly different than the Schedules M–1 for S corporations and partnerships, the audit techniques vary slightly as addressed in the following subsections.

(1) Form 1120, Schedule M–2, Analysis of Unappropriated Retained Earnings per Books, reflects changes in the retained earnings account per books during the year.

(2) Form 1120S, Schedule M–2, Analysis of Accumulated Adjustments Account, Shareholders’ Undistributed Taxable Income Previously Taxed, Accumulated Earnings and Profits, and Other Adjustments Account, reflects the following:

1. Accumulated Adjustments Account – Reflects the accumulated undistributed net income of the corporation for the corporation's post-1982 S corporation years. S corporations with accumulated earnings and profits must maintain the AAA to determine the tax effect of distributions made in each year.

2. Shareholders' Undistributed Taxable Income Previously Taxed – Reflects pre-1983 income that has been taxed on the shareholder's return, but has not been distributed to the shareholder. The PTI is decreased by the S corporation losses accumulated prior to 1983.

3. Accumulated Earnings and Profit – Reflects the earning and profits from when the entity was a C corporation or the earnings and profits from an acquired C corporation.

4. Other Adjustments Account – Reflects S corporation tax exempt income and/or expenses related to tax exempt income.

(3) Form 1065, Schedule M–2, Analysis of Partners' Capital Accounts, reflects changes to the partners’ capital accounts during the year.

(1) The purpose of the Schedule M–3 is to provide increased transparency and disclosure of the differences between financial statement income and tax return income. The information required on Schedule M-3 will vary, based on the return type (e.g., Form 1120, Form 1120-S, Form 1065). The information required on Schedule M–3 provides examiners with data needed to perform more efficient risk analysis and improved audit selection capability. See IRM 4.46.3.3.5.3, Analyzing Schedules M-2 and M-3, for additional guidance.

(1) Review the year-end bank account reconciliations prepared by the taxpayer to determine how much audit work is required.

(2) If the bank accounts reconcile back to the books, then all transactions are probably recorded somewhere in the records. The transactions should be tested for proper recordation.

(3) If reconciliations do not exist or the bank accounts do not reconcile to the books, additional audit procedures are necessary.

(4) Reviewing the bank reconciliations involves the following steps:

1. Trace the ending balance to the general ledger.

2. Review any outstanding checks and investigate their status.

3. Review outstanding deposits and determine if all are included in the reconciliation.

4. Trace total deposits and disbursements per the reconciliation to the general ledger account entries.

(1) Review the monthly bank statements to:

1. Gain an understanding of the frequency and typical amounts of deposits.

2. Determine the average amount and volume of checks written.

3. Establish the interaction between accounts.

4. Compare the total deposits to the gross income of the taxpayer by considering non-taxable deposit sources such as loans, checks to cash, transfers between accounts, gifts and inheritances, and insurance proceeds and by identifying large, unusual, questionable (LUQ) deposits and withdrawals which warrant further audit action. Keep in mind that this is not a bank deposit indirect method of determining income, which is only appropriate for cash method taxpayers or taxpayers who have inadequate books and records.

5. Trace these LUQ items through the ledger to determine their source and book treatment.

6. Interview the appropriate person to determine the treatment of LUQ items.

(1) The purpose of the bank deposit analysis is to determine the source of the deposits. An analysis is time consuming, and in many instances, inappropriate, as in the case of a large corporation with a double entry accounting system. Therefore, the examiner must use judgment as to the extent and degree of this analysis.

(2) For testing the reporting of income, trace specific items of income from the source document through to the general ledger to determine whether all income transactions are reported properly and to detect unreported or improperly recorded items. A review of two or three months’ transactions postings should be sufficient.

(3) LUQ deposits deserve attention. Information from the initial interview should help determine what is LUQ.

(4) Some examples of LUQ deposits include:

1. A large deposit when the normal is small;

2. Even dollar amounts when most are not even;

3. Cash deposit(s) by a non-cash business;

4. Regular monthly deposits from unidentified source(s) (possible sources include unreported rental or installment sale income, and repayment of loans without reporting appropriate interest income); and

5. Any other deviations from a regular deposit pattern.

(1) A useful audit procedure for small to medium-size taxpayers who deposit the majority of their gross receipts into a bank account is the reconciliation of bank deposits to gross receipts reported on the tax return.

(2) Non-taxable sources of income are critical to this computation and should be identified first.

(3) If the deposit analysis shows no material discrepancy between deposits and gross receipts, then a testing of income transactions may be all that is needed to determine whether all receipts were deposited.

(4) If the deposit analysis shows a discrepancy between deposits and gross receipts, the audit steps are expanded to determine the cause of the discrepancy. See IRM 4.10.4.4.1, Material Understatements and Managerial Involvement, and IRM 4.10.4.5, In-Depth Examinations of Income, for additional guidance.

(5) See Example - Reconciling Taxable Bank Deposits for an example.

(1) A check and EFT analysis is conducted as a:

1. Means of verifying the expenses and deductions claimed on the return.

2. Source of information to determine the total disbursements, including nondeductible expenditures.

(2) A detailed analysis is time consuming and only necessary when there are inadequate records or when a potential for unreported income is present.

(3) If a review of disbursements is necessary, a quick scan of the cash disbursements journal can be made. Look for LUQ items and follow up as necessary.

(4) Checks and EFTs should be analyzed to identify:

1. Possible undisclosed income;

2. Possible investments;

3. Possible expenditures; and

4. Check endorsements.

(5) When there are inadequate records or when the possibility of unreported income is present, an indirect method of determining income is indicated. IRM 4.10.4.6, Formal Indirect Methods of Determining Income, contains guidelines and computational instructions for indirect methods.

(1) A balance sheet, or statement of financial position, presents the financial position of a business entity on a specific date. The balance sheet provides a summary of the following elements:

1. Assets — the financial resources the entity owns, future benefits obtained or controlled by the entity as result of past transactions or events.

2. Liabilities — the debts the entity owes, the sacrifice of economic benefit, obligations to transfer assets or provide services to other entities.

3. Equity — the remaining interest in the assets of the entity after deducting its liabilities. The equity represents the ownership interest.

(2) A balance sheet is a detailed expression of the equation:
Assets = Liabilities + Equity

(3) Exhibit 4.10.3-2, Double Entry Accounting Recording Procedures, demonstrates how transactions are posted to balance sheet and income statement accounts.

(1) The first step when analyzing a balance sheet is to determine whether the taxpayer’s balance sheet is tax or book based.

(2) If the balance sheet is tax based, account balances are calculated based on the tax treatment of various income and expense items, as opposed to the book treatment of these items.

(3) In most instances where the balance sheet is tax based, the net income per the books will not agree to Schedule M–1, line 1 or M–3, line 11, per the tax return. This means that all Schedule M–1 or M–3 adjustments have not been disclosed. For example, balances on the tax return balance sheet do not agree to balances per books. Small differences may be the result of different account groupings for book and tax purposes.

(4) Use the following audit steps if the balance sheet is tax based:

1. Verify net income per books agrees to net income per Schedule M–1, line 1, or M–3, line 11. If it does not reconcile, obtain a schedule from the taxpayer reconciling the net income per the books to net income per Schedule M–1, line 1, or M–3, line 11.

2. Verify total assets and retained earnings per tax return balance sheet agrees to total assets and retained earnings per books. Any differences should be analyzed.

3. Determine if the taxpayer’s accounting method clearly reflects income pursuant to IRC 446(c), Permissible methods.

(1) The second step when analyzing a balance sheet is to identify accounts for in-depth analysis. See IRM 4.10.2.3.1, Large Unusual or Questionable (LUQ) Items Defined.

(2) The analysis will include review of the books and records and consideration of:

1. Accounts with unusual titles;

2. Unusual entries within accounts;

3. Accounts with large numbers of adjusting journal entries; and

4. Accounts with large dollar amount entries in one month versus other months.

(1) The third step of a balance sheet analysis is the in-depth analysis of the balance sheet accounts selected in Step 2.

(2) The following subsections present specific techniques for analyzing individual balance sheet items. See Exhibit 4.10.3-3, Balance Sheet Examination Techniques, for additional information.

(1) When inventories are a material income producing factor, the gross profit test serves as an indicator of the reasonableness of gross receipts, inventories, purchases, and business net profit represented on the tax return.

(2) The term, "gross profit ratio" refers to the ratio: Gross Profit Realized on Sales divided by Gross Receipts from the Sales.

(3) It is the difference, or "margin", between the cost of sales and gross receipts expressed as a percentage of sales.

(4) The margin is always computed based on the selling price.

1. The gross profit would be 40 cents; ($1.60 – $1.20).

2. The gross profit ratio or "margin" would be 25 percent; ($1.60-$1.20/$1.60).

(5) A related computation, "markup", can be computed as either a percentage of cost or of selling price. Although many consider markup as a percentage of the selling price, computing the markup on the cost price is easier and less confusing to be used to compute the markup on the cost of goods and determine the correct sales.

(6) Exhibit 4.10.3-4, Markup Table, shows what the markup on cost must be to give the desired margin for common cases. To use this table, find the margin or gross profit percentage in the left column. Multiply the cost of the article by the corresponding percentage in the right or markup column. The result, added to the cost, gives the correct selling price.

(7) When the markup is computed based on the selling price, a different markup percentage must be used than when computing the markup on the cost price.

1. The markup of 25 percent of the cost ($1.20) equals 30 cents. Add 30 cents to the cost, and the selling price is $1.50 with a margin of 30 cents, or 20 percent gross profit margin.

2. If a 25 percent margin is needed, then the percentage that will yield the desired margin when applied to the cost price must first be determined.

3. From Exhibit 4.10.3-4, Markup Table, it can be determined that a 25 percent margin is equivalent to a 33.3 percent markup on cost.

4. Multiplying 33.3 percent times the cost ($1.20) equals 40 cents. Adding 40 cents to the cost price gives a selling price of $1.60, and a margin of 40 cents, or 25 percent .

5. A markup on cost of 25 percent gives a selling price of $1.50. If it were necessary to have a margin of 25 percent to cover the costs of operations and net profit, the taxpayer would be losing money by pricing merchandise on the basis of a 25 percent markup on cost. To realize a 25 percent margin, the taxpayer would need to use a 33.3 percent markup on the cost price.

(8) The following example illustrates the application of the gross profit ratio as a percentage of sales:

1. The gross profit margin ratio is 20 percent. That is, 20 percent of $50,000 sales gives the margin of $10,000.

2. From the markup table it is determined that a 20 percent gross profit ratio (margin) requires a 25 percent markup based on cost. The cost of sales in the amount of $40,000 must be increased by 25 percent or $10,000, to give the $50,000 gross sales.

(9) A change in the gross sales, in the example above, results in a change in the gross profit ratio and the markup:

1. There has been an increase in gross sales of $10,000 ($50,000 to $60,000) or a 20 percent increase in gross sales. This results in a gross profit ratio of 33.3 percent. The markup (on cost) formerly is now 50 percent.

(10) After the ratio for the business under examination has been determined:

1. Compare it with the prior years’ ratios for the same taxpayer, and

2. Compare it with the ratios of similar businesses. In making the comparison, remember that the ratio will vary according to the size, sales volume and location.

(11) If the comparison indicates that there is a probable error in the reported gross profit amount, consider the reasons listed in items (12), (13), and (14) below, as possible reasons for the error.

(12) Possible errors in reporting "Gross Receipts":

1. Inclusion of costs not subject to the gross profit ratio, i.e., rents, interest, dividends, etc.;

2. All accounts receivable were not reported when accrual basis accounting was used;

3. All collected accounts receivable were not reported when the cash basis of accounting was used;

4. Income constructively received was not reported;

5. Installment sales were incorrectly reported;

6. Sale of ending inventory was not included in gross receipts when the business was sold;

7. Theft of inventory; or

8. Unreported gross receipts from bartering.

(13) Possible errors in reporting "Inventory":

1. Inventory improperly valued or incorrect amount carried over from the prior year;

2. Figures are estimates;

3. Inventories are not used, even though inventory is a material income producing factor; or

4. Ending inventory is understated.

(14) Possible errors in reporting "Purchases":

1. Included costs are not properly a part of the cost of sales;

2. Personal withdrawals are not properly accounted for;

3. Purchases are not reduced for returned merchandise; or

4. Purchase discounts are not properly reflected.

(1) Judgment sampling requires examiners to use professional judgment in performing the sampling procedure and in evaluating the results of the sample.

(2) One type of judgment sampling is block sampling.

1. 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 expense to reach a conclusion about travel expense for the entire year.

2. Block sampling may include selecting all items in a selected numerical or alphabetical sequence.

   Example: Gross Receipts is sampled by selecting customers with names beginning with certain letters such A, B, or C or by selecting the months of January, September and December.

(3) Another type of judgment sampling is dollar limitation sampling (cut-off sampling).

1. Dollar limitation sampling is a method which selects a minimum dollar amount and creates a sample by selecting all items exceeding that dollar amount.

2. This type of sampling prevents the examiner from wasting time examining small, insignificant amounts.

3. This method is often combined with block sampling.

(1) Statistical sampling is a procedure used to choose a portion of the whole to make a statement about the entire population.

(2) Other terms applied to statistical sampling include probability sampling and random sampling. See Rev. Proc. 2011-42 and IRM 4.47.3, Statistical Sampling Auditing Techniques for more information.

(3) Using statistical sampling, there is no way for the person who is sampling to impose their judgement on the selection process.

(4) Examiners will discuss the facts and circumstances of the case with their manager and determine if a request for a computer audit specialist (CAS) is necessary. If a statistical sample is warranted, CAS assistance must be requested. Refer to IRM 4.10.2.7.5, Specialist Referrals, for instructions to request CAS assistance. Also refer to IRM 4.47.1, Computer Audit Specialist Program (CAS).

(1) Double-entry recordkeeping is a system which is based on the "accounting equation":
Assets = Liabilities + Capital

(2) Every net increase or decrease in assets is accompanied by a corresponding increase or decrease in either liabilities or capital.

(3) Each transaction is recorded as a debit entry in one account and a credit entry in another. Therefore, a properly maintained set of double-entry books is always in balance.

(4) The double-entry system is comprised of journals and ledgers.

(5) See Exhibit 4.10.3-5, Flow of Accounting Transactions, for a flowchart of accounting transactions in double entry accounting systems.

(1) The single-entry system of recordkeeping does not include equal debits and credits to the balance sheet and income statement accounts. A single-entry accounting system is not self-balancing. Mathematical errors in the account totals are thus common. Reconciliation of the books and records to the return is an important audit step.

(2) A single-entry system may consist only of transactions posted in a notebook, daybook, or journal. However, it may include a complete set of journals and a ledger providing accounts for all important items.

(3) A single-entry system for a small business might include a business checkbook, check disbursements journal or register, daily/monthly summaries of cash receipts, a depreciation schedule, employee wages records, and ledgers showing debtor and creditor balances.

(4) See Exhibit 4.10.3-5, Flow of Accounting Transactions, for a flowchart of accounting transactions in single entry accounting systems.

(1) The voucher system is a recordkeeping system which uses a voucher register for recording expenditures that are to be paid for by check. The voucher register is similar to and replaces the purchases journal. The following steps are performed when this system is used:

1. Each invoice (or group of invoices) which is paid by one check is entered in the voucher register on a single line.

2. An identifying number is placed on both the voucher and the register.

3. The voucher is placed in an unpaid voucher file until it is paid.

4. When paid, the check number is placed in an appropriate box on the same line as the original entry in the voucher register.

5. Postings are made periodically to appropriate cost or expense accounts (debits) and accounts payable (credits).

(2) Accounts Payable is the total of the items in the voucher register not having check numbers and invoices not posted in the register.

(1) A cost accounting system is a double entry system designed to show the cost of:

1. Each completed job;

2. Each completed process;

3. Each completed product,; and

4. Work in process.

(2) Cost systems are used primarily by manufacturers and fabricators. They are also used by some smaller businesses, such as automobile dealers.

(3) There are three types of cost accounting systems in general use:

1. Job cost — used when goods are manufactured on specific orders only. Costs are accumulated on a departmental basis for each order or job.

2. Process cost — used when goods are manufactured continuously or in bulk and it is not desirable to distinguish between orders. Costs and quantities processed are determined by department and the average costs per unit are determined. The accumulated costs are transferred from department to department and inventories of work-in-process are valued on the basis of the accumulated costs.

3. Standard cost — sometimes used in conjunction with either job or process cost systems. Standard costs are the costs that are expected to be achieved in a particular production process under normal conditions. These costs are based on estimates and are used by management to determine how much a product should cost (standard), how much a product does cost (actual), and the causes of any difference (variance) between the two.

(4) Cost accounting systems include the following ledgers with related general ledger control accounts. Each of these accounts is debited for all additions and is credited for all deductions.

1. Work-in-process — journal entries are made, charging (debiting) work-in-process for material put in process, labor expended, and overhead applied to production.

2. Materials — journal entries are made, charging work-in-process for materials put in process. If materials are allocated between direct and indirect costs, the indirect portion is charged to Factory Overhead.

3. Payroll — journal entries are made, charging work-in-process for labor expended in manufacturing. If labor is allocated between direct and indirect costs, the indirect portion is charged to Factory Overhead.

4. Factory overhead — overhead expenses incurred are initially recorded as debits to the Factory Overhead account. Journal entries are then made, charging work-in-process for overhead applied to production. The overhead applied is an estimate based on experience. At year-end, the variance between the overhead applied and the actual overhead is closed to the income summary account.

5. Finished goods — cost of goods or jobs completed during the month is removed from the work-in-process account and recorded in Finished Goods.

   Note: Some cost systems do not use a finished goods account. In that situation, the cost of goods or jobs completed is recorded in the Cost of Goods Sold account.

6. Cost of goods sold — At year-end, the cost of finished products or jobs sold is removed from Finished Goods and charged to Cost of Goods Sold.

(5) Taxpayers using standard cost systems sometimes maintain a separate variance account. The variance is the difference between actual and standard costs. At year-end, the variance accounts are usually closed to the income summary account. If any of the products manufactured are still on hand, the variances should be allocated between the work-in-process, Finished Goods, and Cost of Goods Sold accounts. This year-end allocation is necessary to convert these account balances from standard cost to actual cost.

(1) Rev. Proc. 98-25 , 1998-1 C.B. 689, provides requirements for taxpayers maintaining accounting records within Automatic Data Processing (ADP) systems. Per this revenue procedure, ADP systems include all accounting systems that process information "by other than manual methods."

(2) Taxpayers who use computerized systems for recordkeeping must:

1. Be able to produce legible records from the systems to provide the information needed to determine their correct tax liability.

2. Keep all machine-sensible records and a complete description of the computerized portion of their accounting systems.

(3) The computer systems used by small businesses are usually less complex, consisting of microcomputers and purchased software packages which may be designed for their industry. In these situations, the examiner does not need specialized computer skills or knowledge to conduct the examination. The examiner should learn how the taxpayer’s computer is used, while obtaining an understanding of the accounting system.

(4) For examinations involving computerized accounting systems, the examiner should consider requesting the assistance of a computer audit specialist (CAS). See IRM 4.10.2.7.5.1, Specialist Referral System (SRS) - Online Referrals.

(5) Examiners must request the assistance of a CAS:

1. When Form 5546, Examination Return Charge-Out Sheet, states "Record Retention Agreement on File."

2. For all examinations of corporations with an activity code of 219 or above where the taxpayer has a computerized accounting system.

(1) There are many different types of manually prepared recordkeeping systems. Some are simple single-entry systems and others are sophisticated multi-journal, double-entry systems.

(1) The general journal is used to record all transactions for which special journals have not been provided.

(2) Usually, the general journal has only a single pair of columns for the recording of debit and credit entries, but many variations of this basic design can be found. A third column may be included for entries to subsidiary ledgers, or various multi-column forms may be used.

(3) Entries can include:

1. Routine monthly accruals;

2. Standard journal entries (computations made the same way each month, on standardized journal entry forms);

3. Reversals; and

4. Correcting Entries.

   Note: Not all entries necessarily flow through to the tax return.

(4) Some companies maintain a system of journal vouchers. These are serially numbered documents, each containing a single, general journal entry, with full supporting details. In many cases the transaction numbering system used will indicate the source and type of each entry.

(5) Vouchers may be used in lieu of a general journal or a general journal, in traditional form, may be prepared from the journal vouchers.

(6) Companies having electronic data processing equipment generally enter journal vouchers to serve as one of the transaction sources for printouts of the ledger and the trial balance.

(7) Audit techniques for verifying journal entries include determining:

1. That entries in the general journal were posted from authentic sources.

2. That entries in the journal are properly supported by tracing a sample of journal entries back into the source documents. Sampling techniques may reveal transactions that are not supported, and possibly, not valid.

3. Unusual entries by scanning.

4. Material differences from prior and subsequent years.

(1) A special journal is used to group similar types of transactions, such as all sales of merchandise on account, or all cash receipts. The types of special journals used depends largely on the types of transactions that occur frequently in its business.

(2) In each special journal, all transactions result in debits and credits to the same accounts.

(3) If the transaction cannot be recorded in a special journal, it is recorded in the general journal.

(1) The sales journal is a special journal designed to record only credit sales.

1. Each sale is debited to Accounts Receivable and credited to Sales.

2. Sales invoices are prepared for each sale.

3. A copy of the sales invoice is used to make an entry in the sales journal.

4. The sales journal entry usually includes the date, the customer’s name, an invoice number, the amount of the sales, and possibly the credit terms.

(2) Cash sales are entered in the cash receipts journal.

(3) The nature of a taxpayer’s business will determine whether other entries are included in the sales journal. An example is a retailer required to collect sales tax from its customers. In this case, an additional column in the sales journal is needed to record the necessary credit to Sales Tax Payable.

(4) Sales returns and allowances are frequently accounted for in the back of the sales journal. The daily activity is posted to the individual customers’ accounts in the Accounts Receivable subsidiary ledger. The returns and allowances are totaled periodically (usually monthly) and are posted to the sales returns and allowances (debit) and control accounts receivable (credit) accounts in the general ledger.

(1) The purchases journal is a special journal designed to record all purchases on credit, including merchandise for resale or materials/supplies for incorporation into a finished product.

1. Each purchase is debited to purchases and credited to accounts payable.

2. Purchase invoices are prepared for each purchase.

3. A copy of the purchase invoice is used to make an entry in the purchases journal.

4. The purchases journal entry usually includes the date, the supplier’s name, the invoice number, the amount of the purchase, and possibly the credit terms.

(2) Cash purchases are recorded in the cash disbursements journal.

(3) The nature of a taxpayer’s business will determine whether other entries are included in the purchases journal. An example of this would be other expenses often bought on credit (e.g., Freight In, Supplies, etc.). In this case, an additional column in the purchases journal is needed to record the necessary debit to the appropriate expense account.

(4) Purchase returns and allowances are frequently accounted for in the same purchases journal. The daily activity is posted to the individual suppliers’ accounts in the Accounts Payable (subsidiary) ledger. The returns and allowances are totaled periodically (usually monthly) and are posted to the control accounts payable (debit) and the purchase returns and allowances (credit) accounts in the general ledger.

(1) The cash receipts journal is a special journal designed to handle all transactions involving receipts of cash.

(2) Unlike other special journals in which all transactions result in debits and credits to the same accounts, all transactions in the cash receipts journal result in debits to Cash, but require a variety of credit entries.

(3) Examples of transactions recorded in the cash receipts journal include cash sales, cash received from credit customers in payment of their accounts, or cash from other sources (such as a loan).

(4) The journal entry usually includes the date, the amount received, the payor, and the account credited with the cash receipt.

(5) In practice, almost all companies that sell to customers on credit keep an individual accounts receivable record for each customer in an Accounts Receivable (subsidiary) Ledger. The individual customer’s accounts are credited daily as receipts of cash occur.

(6) The cash receipts journal is totaled periodically and posted to the cash (debit) control accounts receivable (credit), cash sales (credit), and other (credit) accounts in the general ledger.

(7) The nature of a taxpayer’s business will determine the type and complexity of its cash receipts journal. It could be integrated with the cash disbursements in a checkbook or combined cash journal. Many taxpayers simply use bank records as a cash receipts journal. The bank statements or deposit slips are totaled and used for sales or gross receipts on the return. In this situation, failing to include non-deposited cash in gross receipts is a potential for an adjustment.

(1) The cash disbursements journal is a special journal designed to handle all transactions involving payments of cash.

(2) Unlike other special journals in which all transactions result in debits and credits to the same accounts, all transactions in the cash disbursements journal result in credits to Cash, but require a variety of debit entries.

(3) Examples of transactions recorded in the cash disbursements journal include cash purchases, payments of obligations, resulting from earlier purchases on credit, or other cash payments.

(4) The journal entry usually includes the date, the amount paid, the payee, and the account charged with the disbursement for each check.

(5) In practice, almost all companies that purchase from suppliers on credit keep a separate accounts payable record for each supplier in an Accounts Payable (subsidiary) Ledger. The individual supplier’s accounts are debited daily as payments of cash occur.

(6) The cash disbursements journal is totaled periodically and is posted to the control accounts payable (debit), cash purchases (debit), other (debit) accounts, and cash (credit) in the general ledger.

(7) The nature of a taxpayer’s business will determine the type and complexity of its cash disbursements journal. It could be integrated with the cash receipts in a checkbook or combined cash journal. Many taxpayers simply use bank records, check stubs, or a check register as a cash disbursements journal. The bank statements or checks are totaled and used for various expense accounts.

(1) The payroll register is a special journal which includes a detailed listing of the company’s total payroll for each payday.

(2) The payroll register generally includes the name of the employee, hours worked, earnings, deductions, and net pay.

(3) The payroll register is totaled each payday to record the payroll journal entry, usually in the general journal.

(4) The journal entry results in a debit to the Salary Expense accounts, credits to Federal Insurance Contributions Act (FICA) Tax Payable, Federal Income Tax Payable, and Other Payables (e.g., medical insurance, union dues, etc.) deducted from the employees’ earnings, and a credit to Salaries Payable for the net amounts due the employees.

(5) The nature and size of the taxpayer’s business will determine how the net amounts due the employee will be paid. Many companies use a separate payroll bank account against which payroll checks are drawn. Under this system, a check must first be drawn from a regular checking account for the net earnings due to employees and deposited into the payroll account.

(6) Besides the FICA Tax and Federal Income Tax deducted from the employees’ earnings discussed above, the employer must also pay FICA Tax equal to the amount paid by the employee, Federal Unemployment Insurance Tax (FUTA), and State Unemployment Insurance Tax Act (SUTA). These three taxes on salaries paid by the employer are considered operating expenses. The journal entry results in a debit to Payroll Tax Expense and credits to FICA Tax Payable, FUTA Payable, and SUTA Payable.

(7) The FICA Taxes (both employees’ and employer’s shares) and the Federal Income Tax Withheld from the employees’ earnings are reported on the Form 941, Employer's Quarterly Federal Tax Return, and must be paid at least quarterly. Depending on the liability, payments may be required monthly or more frequently. The FUTA Taxes are reported on the Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, and must be paid at least yearly. Depending on the liability, payments may be required quarterly. The SUTA Taxes are reported on various state forms and payment dates among the states vary. Other payroll deductions (e.g., medical insurance, union dues, etc.) must be paid according to the contracts or agreements involved.

(1) The general ledger is used to accumulate and classify the transaction data posted from the journals.

(2) The general ledger is self-balancing and has an account for every balance sheet and profit and loss statement item.

(3) Periodic postings are made to these accounts. At the end of each accounting period:

1. Proper adjustments are made to the accounts through the general journal.

2. A balance sheet and profit and loss statement are prepared from the open accounts.

3. Income and expense accounts are then closed.

4. The net balances are transferred to the capital account.

(4) Some businesses include details of all entries in the general ledger, in effect combining the ledger and journal into one document. Others show only net debits and credits for each month, with the specifics recorded elsewhere.

(5) The mathematical accuracy of the account balances is tested by verifying the footings of some or all of the ledger accounts. Audit techniques include:

1. The general ledger is scanned for entries that are unusual in amount, source, or nature. All significant entries are analyzed.

2. Compare some or all of the account balances and entries recorded for the year under examination with the previous and/or subsequent year. This is an important task and can determine the depth and scope of your audit.

3. Verify that entries in the general ledger were posted from authentic sources because the return is drawn from the general ledger balances. These balances can be falsified through the recording of unsupported debits or credits in the general ledger. Trace a sample of ledger entries back to the journals. Sampling techniques can reveal unsupported entries.

4. Trace a sample of entries from the journal into the general ledger. An omitted transaction can be detected only by tracing from the source documents or the journals to the ledgers.

5. Some errors, such as transposition errors in entering transactions and postings to the wrong account, may be discovered by tracing in either direction.

(1) A subsidiary ledger contains the detail of a large general ledger account (i.e., accounts receivable detail). A taxpayer will maintain a controlling account in the general ledger that summarizes the totals in the subsidiary ledger.

(2) Subsidiary ledgers are not self-balancing.

(3) Subsidiary ledgers may be established for accounts such as:

1. Accounts Receivable

2. Accounts Payable

3. Inventory

4. Selling Expenses

5. Property, Plant, and Equipment

6. Investments

7. General Expenses

(4) The general ledger control account balance must equal the composite balance of the individual accounts in the subsidiary ledger.

(5) The Accounts Receivable Ledger is a subsidiary ledger containing a chronological record of customer transactions. The customers’ accounts are usually filed in alphabetical order in the Accounts Receivable Ledger.

1. Most taxpayers that sell to customers on credit keep an individual accounts receivable record for each customer. Including all of these accounts in the general ledger, with all other accounts, would be cumbersome. Credit sales are recorded as debits to the appropriate customer’s account and payments received from customers are recorded as credits to the accounts.

2. When a taxpayer puts its individual customers’ accounts in an Accounts Receivable Ledger, there is still a need for an Accounts Receivable account in the general ledger to maintain its balance and to control the subsidiary ledger. It is a controlling account in that its balance should equal the total of the individual account balances in the subsidiary ledger. This is true because there must be postings to the individual subsidiary customer accounts every day and to the controlling account, in total, each month.

3. The single controlling account in the general ledger takes the place of all the individual accounts in the subsidiary ledger and the trial balance can be prepared using only the general ledger accounts.

(6) The Accounts Payable Ledger is a subsidiary ledger containing a chronological record of supplier transactions. The suppliers’ accounts are usually filed in alphabetical order.

1. Most taxpayers that purchase from suppliers on credit keep a separate accounts payable record for each supplier. Including all of these accounts in the general ledger, with all other accounts, would be cumbersome.

2. Purchases of goods and services on account are recorded as credits to the appropriate supplier’s account and payments to the suppliers are recorded as debits to the accounts.

3. When a taxpayer puts its individual suppliers’ accounts in an Accounts Payable Ledger, there is still a need for an Accounts Payable account in the general ledger to maintain its balance and to control the subsidiary ledger. It is a controlling account, in that its balance should equal the total of the individual account balances in the subsidiary ledger. This is true because there must be postings to the individual subsidiary supplier accounts every day and to the controlling account, in total, each month.

4. The single controlling account in the general ledger takes the place of all the individual accounts in the subsidiary ledger and the trial balance can be prepared using only the general ledger accounts.

(1) Management will ensure that tax examiners and audit accounting aides conducting correspondence examinations:

1. Receive the appropriate training (minimum Revenue Agent/Tax Compliance Officer Unit 1 Technical Training and Revenue Agent/Tax Compliance Officer Unit 2 Technical Training).

2. Work only those cases suitable for their grade and experience level.

3. Issue the appropriate initial contact letter for correspondence examinations (See IRM 4.10.3.17.3).

(2) In conducting correspondence examinations, tax examiners and audit accounting aides will follow the same procedures as the tax compliance officers and revenue agents for ensuring that a quality audit is completed and they should always charge complete and accurate time to the cases examined.

(1) Returns that will be examined by correspondence from Discriminant Index Function (DIF) inventory should be screened and classified in accordance with regular screening and classification procedures (including the use of classification checksheets).

(2) Returns selected using the Compliance Data Environment (CDE) and other local source work identified for correspondence technique will be screened and classified in accordance with Planning and Special Programs (PSP) procedures.

(3) The examiner assigned to a correspondence case will review the classified issues and prepare the necessary initial contact letter.

(1) The following letters should be used to communicate with the taxpayer when conducting an examination via correspondence.

(2) Only nationally developed letters should be used to correspond with taxpayers, since they have been approved for content and clarity. Modification of national letters is not authorized. Letters should be generated using the Report Generation System (RGS), whenever possible.

(3) All letters will contain:

1. Examiner’s name;

2. Examiner’s identification number; and

3. Telephone contact number.

(1) Form 2848, Power of Attorney and Declaration of Representative, is used by a taxpayer to designate representatives to receive and answer notices, letters, and reports regarding their tax matters.

(2) When a taxpayer obtains representation, the examiner will ensure that the authorization, Form 2848 or a similar privately designed form, is properly executed. See IRM 4.11.55.2.6, Authorized Forms, and IRM 4.11.55.2.7, Receipt of POA or TIA Form, for additional guidance.

(3) Form 8821, Tax Information Authorization, is used by a taxpayer to authorize an individual, corporation, firm, organization, or partnership to inspect and/or receive confidential information in any office of the IRS for the type of tax and the years or periods listed on the form.

(4) Practice before the IRS is restricted to persons recognized or qualified under provisions of Treasury Department Circular No. 230, Regulations Governing Practice before the Internal Revenue Service. See IRM 4.11.55, Power of Attorney Rights and Responsibilities, for additional guidance.

(5) If the taxpayer's representative impedes or delays the examination by failing to promptly submit the taxpayer's records or information requested by the examiner, failing to keep scheduled appointments, or failing to return telephone calls and written correspondence, the examiner may initiate procedures to bypass the representative and deal directly with the taxpayer, as outlined in IRM 4.11.55.4, By-Pass of a Representative.

(1) Cases that require special processing will have a Form 3198, Special Handling Notice for Examination Case Processing, attached to the outside of the file folder. See IRM 4.10.9.9, Case File Assembly for Closing, to determine which forms should be placed on top of Form 3198.

(2) This form is used for:

1. Forwarding cases for mandatory quality review;

2. Identifying cases subject to backup withholding;

3. Identifying that taxpayer extension to file is invalid (annotate with "Extension is Invalid, reverse TC 460");

4. Correcting the taxpayer's address of record; and

5. Identifying any other special handling requirement.

(1) Every case conducted by correspondence must contain workpapers that document and support the examination process and results. The depth, scope, and quality of the examination should not be compromised because the examination is being conducted by correspondence rather than by interview.

(2) Workpapers are the written records kept by the examiner which provide the principal support for the examiner's report and document the procedures applied, tests performed, information obtained, and the conclusions reached in the examination. They should include all the information necessary to conduct the examination and support the audit results.

(3) Supporting workpapers are used to document the audit trail. Types of documents which support the examiner's conclusion include, but are not limited to:

1. Records documenting a sample of specific expenditures verified and the conclusions reached.

2. A list of questions or items raised during the examination and the conclusions reached.

3. Photocopies of relevant documents secured from the taxpayer during the examination.

4. Documents from computer sources such as IRP or CFOL.

5. Pro forma audit aids and case law (i.e., IRC, regulations, court cases, revenue rulings, etc.) supporting positions taken.

6. Correspondence from the taxpayer.

(4) IRM 4.10.9.7, Workpapers, provides guidelines for the development of workpaper content and organization. These guidelines are provided to promote quality and consistency in workpapers and should be used when conducting correspondence examinations. LB&I examiners should refer to IRM 4.46.6, Workpapers and Report Resources, for additional guidance.

(1) IRM 4.10.8, Report Writing, includes guidelines for the preparation of audit findings (reports), in terms of content and format and provides instructions for critical case closing requirements.

(2) When conducting examinations by correspondence, the examiner will observe the appropriate procedures and response times for each letter and report as outlined in IRM 4.10.8, Report Writing. Under no circumstances should these time frames or requirements be modified.

(3) The examiner will ensure the taxpayer has received and understands the right to appeal, as well as other rights as outlined in IRM 4.10.1.2, Taxpayer Rights.

(1) The IRS is involved in an ongoing effort to develop, monitor and revise programs designed to assist taxpayers in complying with legal requirements and avoid penalties. As indicated in IRM 1.2.1.12.1, Policy Statement 20-1 (Formerly P–1–18), "the Service uses penalties to encourage voluntary compliance".

(2) It is the examiner’s responsibility to identify, document, and accurately calculate appropriate penalties. This responsibility remains the same even when examinations are conducted by correspondence. See IRM 4.10.6, Penalty Considerations, for additional guidance. Written supervisory approval is required for certain penalty determinations, see IRM 20.1.1.2.3, Approval Prerequisite to Penalty Assessments. IRC 6751(b), Approval of assessment, states certain penalties may not be assessed unless the initial determination of the assessment is personally approved, in writing, by the immediate supervisor of the person making the penalty determination. Supervisory approval is not required for:

• Failure to file or pay penalties under IRC 6651, Failure to file tax return or to pay tax,

• Estimated tax penalty under IRC 6654, Failure by individual to pay estimated income tax, or IRC 6655, Failure by corporation to pay estimated income tax,

• Any overstatement of the deduction provided in IRC 170(p) , Special rule for taxpayers who do not elect to itemize deductions, under IRC 6662(b)(9), Portion of underpayment to which section applies,

• Any disallowance of a deduction by reason of IRC 170(h)(7), Limitation on deduction for qualified conservation contributions made by pass-through entities, or

• Any other penalty automatically calculated through electronic means.

(3) The taxpayer must be provided the name of the penalty, the IRC section under which the penalty is imposed, and computation of penalty on each notice imposing the penalty. An examination report is considered a notice for imposing a penalty if the penalty is proposed on the report.

(1) If a taxpayer requests a face-to-face interview, the request should be honored. The case should be referred to the Group Manager for reassignment, if necessary.

(2) There may be other instances in which a face-to-face interview would be required. Examples of these situations include:

1. The issue becomes too complex for correspondence. The examiner should discuss the case with the group manager and arrange for reassignment, if necessary.

2. Fraud development is required. The development of fraud requires face-to-face contact. The case should be discussed with the group manager and reassigned, if necessary.

(1) In addition to preparing all necessary reports, lead sheets, workpapers and organizing the contents of the case file, examiners have other critical case closing requirements. These include:

1. Completion of Form 5344, Examination Closing Record. (See IRM 4.4.12, Examined Closings, Surveyed Claims and Partial Assessments, for additional guidance on completing Form 5344.)

2. Entry of data required for the Examination Operational Automation Database (EOAD).

(2) The examiner conducting a correspondence examination has the same responsibility for case closing procedures as examiners conducting interview cases. Refer to IRM 4.10.8, Report Writing, for Examiner Case Closing Requirements.

(1) The determination that a taxpayer has not maintained adequate books and records, or has not complied with a record retention agreement, is a matter of judgment and should be based on the facts of the individual case. Factors to be considered include, but are not limited to:

1. An alternative or indirect method was used to establish the amounts of gross income, deductions, credits, or other matters shown on the taxpayer’s return because the taxpayer’s records were not sufficient,

2. Prior history and present degree of noncompliance,

3. Indications of willful intent or evidence of refusal to keep adequate books and records,

4. Probability that the inadequacies in recordkeeping will result in significant underreporting of tax liabilities, or

5. Other evidence of harm to the Government.

(1) When an examiner determines the taxpayer has not maintained adequate books and records or has not complied with a record retention agreement the examiner will:

1. Charge all time for development of inadequate records issues to the case.

2. Fully develop the facts to explain how the taxpayer’s books and records are inadequate and what steps need to be taken to bring them into compliance with applicable statutes.

3. Document the nature of the inadequacies of the taxpayer’s records, group manager discussions, and basis for the conclusion reached.

4. Discuss the inadequacies with the group manager to determine if an inadequate records notice should be issued.

5. Contact a computer audit specialist if the case includes a record retention agreement.

(1) Generally, Letter 979, Inadequate Record Notice, requesting a follow-up statement of corrective action from the taxpayer within 6 months, will be used to notify the taxpayer.

(2) The designated contact identified on Letter 979 or Letter 978 should be the individual in PSP responsible for monitoring the taxpayer’s future compliance.

(3) The narrative on Letter 979 or Form 2807 must include the following:

1. The date the taxpayer was orally notified that the records were inadequate or not in compliance with a record retention agreement,

2. The tax year(s) examined,

3. A clear and concise statement specifying how the taxpayer’s records were inadequate or not in compliance with a record retention agreement.

   Note: Form 2807 should specify the books and records which will be maintained.

(4) Examiners will prepare a detailed Form 5346, Examination Information Report, following the form instructions. The "other" section should state that the package is documentation for an Inadequate Records Notice. The package should include:

1. Copies of pertinent workpapers,

2. Copy of the audit report,

3. Copy of Letter 978 or Letter 979,

4. Original Form 2807, if applicable.

(5) A copy of the completed Form 5346 should be included in the workpapers with other documentation of the issue.

(6) The original Form 5346 and documentation should be forwarded to PSP for suspense and follow-up action.

(1) Inadequate Records Notices should be served personally by examiners or sent by certified mail.

(2) The examiner will complete the record of service on Letter 978 and Letter 979 at the time of delivery or before it is sent certified mail. The record of service should also be completed on all retained copies.

(3) If sent by certified mail, the return receipt will constitute the record of service and will be attached to the copy of Letter 978 or Letter 979 retained in the case file.

(1) Letter 978 and Letter 979 serve as notification to taxpayers that their records are inadequate and execution of Form 2807 is not necessary to close the case. Whether or not the taxpayer signed Form 2807 will be noted on Letter 978.

(2) If the taxpayer does not execute Form 2807 and the case is unagreed, the taxpayer will be informed of the further opportunity to discuss the matter at an Appeals conference.

(1) Follow-up examinations will be conducted when appropriate. These examinations should be started with sufficient time to be completed within established audit cycles.

(2) The examiner will document consideration of the inadequate recordkeeping issue and state whether the taxpayer has corrected the inadequacies in the recordkeeping practices.

1. If the examiner concludes that the taxpayer is substantially complying with requirements to keep adequate records, the inadequate records notice information should be included in the case file when the examination is closed.

2. If the examiner concludes that the taxpayer is not substantially complying with requirements to keep adequate records, then consideration of additional enforcement measures, such as the assertion of penalties, is warranted.