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IRS National Research Program Audits

Under the Reform and Restructuring Act of 1998, Congress required the IRS to conduct studies regarding noncompliance with U.S. tax laws by taxpayers. As such, in 2000, the IRS established the National Research Program (“NRP”) to gather information on reporting, payment, and filing compliance for various categories of taxes and different types of taxpayers. According to the IRS, the data collected from the NRP is used to determine key areas where its limited resources should be spent to reduce noncompliance. To acquire such information, the IRS conducts NRP audits that may be burdensome for many taxpayers.

The national research program examination process

An NRP audit begins with a random selection of tax returns. From the selected tax returns, the IRS compiles information to create a set of data that is representative of the type of taxpayer from which the returns were selected. The IRS subsequently utilizes these figures to identify potential issues that should be examined. The IRS also compiles various documents related to the selected tax return into a case file for the IRS examiner. The case file includes the original tax return, a report of three years of the selected taxpayer’s tax return data in a side-by-side format, IRS notices and other correspondence, and any tax return the selected taxpayer is responsible for filing.

Once a robust case file has been created, it is sent to an IRS classifier who reviews every item on the return and creates a list of issues that must be examined. In addition to the case file, a classifier may use any research tools and reference materials available to her. After reviewing a tax return, an IRS classifier will determine whether the return should be accepted as filed, accepted with adjustments, or audited further.

The examination phase of the NRP is essentially a more intrusive IRS audit. An IRS agent will be assigned to gather information and determine the accuracy of any item flagged by an IRS classifier. During and after the audit, IRS managers must review the record to assess the thoroughness of audit work, adequacy of supporting documents for conclusions, and technical correctness. Once a case is closed, the data is analyzed to determine the areas that are more likely to experience noncompliance.

tax return items most likely to be audited during a national research program examination

According to the IRS, the following items on Form 1040, U.S. Individual Income Tax Return, are generally examined during an NRP audit even when they match information reported by third parties:

  • Earned Income Credit;
  • Income reported on:
    • Schedule B, Interest and Ordinary Dividends;
    • Schedule C, Profit or Loss from Business (Sole Proprietorship);
    • Schedule D, Capital Gains and Losses;
    • Schedule E, Supplemental Income and Loss; and
    • Schedule F, Profit or Loss from Farming;
  • Items considered Large, Unusual or Questionable according to the following factors:
    • The comparative size of the item;
    • The absolute size of the item;
    • The inherent character of the item; and
    • Evidence of intend to mislead.
  • Head of Household Filing Status;
  • Net Operating Loss Deduction under Other Income; and
  • Foreign Tax Credit.

The following items on Form 1120S, U.S. Income Tax Return for an S Corporation, are mandatory items to be examined:

  • Income items;
  • At least one item, if any, on Form 1125-A, Cost of Goods Sold;
  • Total property distributions on Schedule K, Shareholders’ Pro Rata Share Items;
  • Total dividend distributions from earnings and profit on Schedule K; and
  • Other current liabilities and other liabilities on Schedule L, Balance Sheets per Books.

In addition, the following items have a high probability for error and more likely to be reviewed:

  • Cancellation of Debt Income;
  • Compensation of Officers;
  • Interest;
  • Fringe Benefits;
  • Excessive Net Passive Income Tax;
  • Form Schedule D (Built-In Gains);
  • Additional Taxes - LIFO Reserve Recapture Tax;
  • Section 179 Expense Deduction;
  • Charitable Contributions;
  • Non-Cash Distribution;
  • Disproportionate Distributions;
  • Buildings and Other Depreciable Assets;
  • Accumulated Depreciation;
  • Related Party Accruals;
  • Loans From Shareholders;
  • Reconciliation;
  • Final Returns;
  • Potentially Abusive Schemes;
  • Invalid Shareholders;
  • Reconciliation of K-1’s to Schedule K;
  • Losses and Deductions Claimed in Excess of Stock Debt Basis;
  • Passive Activity Losses and Material Participation; and
  • Corporate Level Limits.

The following items on Form 1120, U.S. Corporation Income Tax Return, are likely to be scrutinized:

  • Form 4562, Depreciation and Amortization;
  • All income items including Gross Receipts;
  • Like-Kind Exchanges;
  • Loans to Shareholders;
  • Loans from Shareholders;
  • Net Operating Losses;
  • Officer-Shareholder Compensation;
  • Related Party Transactions; and
  • Schedule M, Noncash Contributions.

With respect to Form 940, Employer’s Annual Federal Unemployment Tax Return, and other employment tax returns selected in an NRP audit, the following items should be addressed:

  • Form 1099 Filing Checks;
  • Back-up Withholding;
  • Fringe Benefits – Executive; and
  • Fringe Benefits – Non-executive.

For taxpayers, an NRP audit may be more intensive and detailed than a traditional audit. The tax attorneys at the Ben-Cohen Law Firm know this firsthand and understand how emotionally and financially taxing an audit can be on taxpayers. If you would like an experienced tax attorney to represent you during your IRS audit, please contact us at (310) 272-7600.

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