IRS Audits and Statutory Protection

Overview

Much has been made of the provision in the “Inflation Reduction Act” that would allow the IRS to hire over 80,000 agents.  To an extent, this is necessary.  The IRS currently has 78,000 agents, but 50,000 of them are set to retire in the next few years.  Title I, Part 3, Sec. 10301 of H.R. 5376 is entitled, “Enhancement of Internal Revenue Service Resources.”  The provision allocates $3,181,500 to “taxpayer services,” $45,637,400,000 to “enforcement,” $25,326,400,000 to “operations support,” $4,750,700,000 to “Business Systems Modernization,” $15,000,000 for IRS to develop a report to the Congress within nine months of enactment of the law on the cost of developing and running a free direct efile tax return system; $403,000,000 to the Treasury Inspector General for Tax Administration; $104,533,803 to the Office of Tax Policy; $153,000,000 to the U.S. Tax Court; and $50,000,000 to the Treasury Department Offices for implementation.

It’s the enforcement funding that received much of the public’s attention.  The enforcement funding provision is by far the most funded provision and reads as follows:

“For necessary expenses for tax enforcement activities of the Internal Revenue Service to determine and collect owed taxes, to provide legal and litigation support, to conduct criminal investigations,… to provide digital asset monitoring and compliance activities, to enforce criminal statutes related to violations of internal revenue laws and other financial crimes….”

Clearly the emphasis of the Congressional funding is to ramp up taxpayer audits rather than improving IRS service.  Taxpayers preparing their own returns will certainly be targeted – that’s “low hanging fruit” for the IRS.  Also, small businesses will likely be in the crosshairs of the IRS as will any businesses that deal in cash.  It also appears the emphasis is intended to include cryptocurrency transactions. 

Experiencing a tax audit can be a traumatic experience.  Often, the level of trauma depends on the examining agent(s).  It can also depend on how aggressive the IRS National Office is on the issue under examination.  With the massive increase in funding, IRS can “afford” to be more aggressive. But, a question is that once an audit is completed can the IRS return to the same issue involving the same tax year and with the same taxpayer and get a “do-over”?  In other words, how many times can the IRS audit the same issue?  The increased funding will give the IRS the chance to do this.  But can it?

The ability of IRS to re-audit issues that have been examined and resolved – it’s the topic of today’s post.

Applicable Code Section

In 1921, the Congress enacted I.R.C. 7605(b) as a reaction to constituent complaints that the IRS was abusing its power by subjecting taxpayers to unnecessary audits.  See H.R. Rep. No. 67-350, at 16 (1921).  Based on the recorded legislative history, the purpose of the new Code section was to relieve taxpayers from “unnecessary annoyance” by the IRS.  See statement of Sen. Penrose at 61 Cong. Rec. 5855 (Sept. 28, 1921). 

I.R.C. §7605(b) states as follows:

“No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.”

Thus, the provision bars the IRS from conducting “unnecessary examination or investigations” and conducting more than a single investigation of a taxpayer’s “books of account” for a tax year.  But, if any investigation is legitimate, the courts generally don’t get in the way of the IRS.  Instead, the courts have tended to focus on the “unnecessary” language in the statute rather than the “single investigation” part of the provision.  See, e.g, United States v. Schwartz, 469 F.2d 977 (5th Cir. 1972); United States v. Kendrick, 518 F.2d 842 (7th Cir. 1975).  In addition, the provision has been interpreted so as to not prevent an IRS agent from “diligently exercising his statutory duty of collecting the revenues.”  Benjamin v. Comr., 66 T.C. 1084 (1976).  The public purpose of collecting revenues duly owed is of utmost importance to the courts, and the statutory provision is not to be read in such a broad manner as to defeat that purpose.  At least that’s how the U.S. Court of Appeals construed the statute in a 1963 case.  DeMasters v. Arend, 313 F.2d 79 (9th Cir. 1963).   

Recent Case

In 2020, the U.S. Tax Court addressed the application of I.R.C. §7605(b) in a case involving a surgeon (the petitioner) that inherited his mother’s IRA upon her death in 2013 – one that she had received upon her husband’s (the petitioner’s father) death.  In Essner v. Comr., T.C. Memo. 2020-23, the petitioner then took distributions from the IRA in 2014 and 2015.  He didn’t tell his return preparer that he had taken sizable distributions in either 2014 or 2015, and didn’t ask for guidance from the preparer on how to treat the distributions for tax purposes.  Even though he received a Form 1099-R for the distributions received in 2014 and 2015, he didn’t report them in income for either year.  The IRS Automated Underreporting (AUR) program, caught the discrepancy on the returns and generated a notice to the petitioner seeking more information and substantiation.  After a second notice, the petitioner responded in handwriting that he disagreed with having the distributions included in income.  While the AUR review was ongoing, the IRS sent the petitioner a letter in late 2016 informing him that his 2014 return had been selected for audit and requesting copies of his 2013 through 2015 returns.  The audit focused on various claimed expenses, but did not focus on the IRA distributions.  The examining agent was unaware of the AUR’s actions concerning the 2014 and 2015 returns.  The examining agent sent the petitioner a letter in early 2017 with proposed adjustments, later revising it upon receipt of additional information.  Neither letter mentioned the issue with the IRA distributions, and the petitioner sent a letter to the IRS agent requesting confirmation that his IRA distribution received in 2014 was not taxable.  17 days later, the petitioner filed a Tax Court petitioner challenging a notice of deficiency that the AUR had generated seven days before the examining agent’s original letter proposing adjustments to the 2014 return.  About seven months later the IRS issued a notice of deficiency to the petitioner asserting a $101,750 tax deficiency for the 2015 tax year and an accuracy-related penalty.  The petitioner filed another Tax Court petition concerning the 2015 tax year. 

At trial, the petitioner couldn’t establish that any portion of the distributions he received represented a return of his father’s original investment and the Tax Court sustained the IRS position that the distributions were fully taxable.  The petitioner also claimed that I.R.C. §7605(b) barred the IRS from assessing the proposed deficiency for 2014 because the concurrent review of the 2014 return by the AUR and the agent constituted a “second inspection” of his books and records for 2014.  The Tax Court, based on its prior decision in Digby v. Comr., 103 T.C. 441 (1994), framed the issue of whether the examination was unnecessary or unauthorized, and noted that the U.S. Supreme Court has explained that I.R.C. §7605 imposes “no severe restriction” on the power of the IRS to investigate taxpayers.  United States v. Powell, 379 U.S. 48 (1964).  The Tax Court noted that the AUR didn’t inspect the petitioner’s books, but merely based its review on third-party information returns – there was no “examination” of the 2014 return.  Accordingly, the Tax Court concluded that the AUR program’s matching of third-party-reported payment information against his already-filed 2014 return was not an “examination” of his records.  There was no violation of I.R.C. §7605(b).  The Tax Court also upheld the accuracy-related penalty.

Recent Chief Counsel Legal Advice

In 2021, the IRS Chief Counsel’s Office addressed the I.R.C. §7605(b) issue with respect to net operating loss (NOL) carrybacks.  This time the outcome was favorable for the taxpayer.  Under the facts of CCM 20202501F (May 7, 2020), the taxpayer was a hedge fund operator and a former investment banker that bought a vineyard.  The vineyard also included a house, guesthouse, caretaker’s house, and olive grove. The IRS conducted an audit resulting in the issuance of a Notice of Proposed Adjustment disallowing all expenses and depreciation deductions related to the vineyard for the prior tax years under audit. The IRS took the position that the vineyard was a hobby activity under I.R.C. §183 for those years.

On further review, the IRS Appeals Office determined that the taxpayer’s vineyard activity was not a hobby for those tax years based on its conclusion that all of the nine-factors contained in Treas. Reg. §1.183-2(b) were in the taxpayer’s favor and, as a result, the deductions and expenses claimed in those years were allowable which resulted in a net operating loss (NOL). The IRS again audited the taxpayer in a later year on the hobby activity issue.  Also at issue was whether the taxpayer could deduct an NOL carryforward originating from the tax years that had previously been audited and for which IRS Appeals had determined that the vineyard activity was not a hobby The taxpayer asserted that the second audit stemmed from previously audited tax years and violation I.R.C. §7605(b) as a repetitive audit. The IRS sought guidance from the IRS Chief Counsel’s Office (CCO).

The CCO noted that I.R.C. §7605 bars the IRS from conducting more than a single inspection of a taxpayer’s books of account for a tax year to prevent an “unnecessary” examination or “unnecessary annoyance.” As noted above, existing caselaw does not prevent the IRS from auditing a later year based on a taxpayer’s transactions that originated from records that had been part of a prior audit.  However, the CCO concluded the taxpayer’s situation was different. Here, the CCO noted, the taxpayer had been previously examined and prevailed at the IRS Appeals Office level. The losses allowed in the prior years under examination were properly carried forward, and IRS was disallowing the NOL carryforward on the second audit for the same reason that the IRS Appeals Office had previously considered and ruled in the petitioner’s favor. The CCO determined that this amounted to a “second examination” or “repetitive audit” that I.R.C. §7605 barred. Had the NOL carryforward been disallowed for a different reason, the CCO noted, a second examination would have been proper. 

Conclusion

Almost 100 years ago, the Congress determined that taxpayers needed protection against abuses from the IRS.  That determination manifested itself in I.R.C. §7605(b) which was enacted within the first ten years of the creation of the tax Code.  But, whether or not the IRS can get a “second-bite” at the audit apple is highly fact-dependent. 

With the increased funding, if it stays in place, will certainly lead to increased audits.  There is some statutory protection, however, against IRS audit abuse.