When the IRS’s Large and Mid-size Business (LMSB) Division issues an initial information document request (IDR) to a corporate taxpayer, one topic that corporate officers are often concerned about is the inspection of their individual income tax returns. The corporation’s accountant or representative is likely to be involved in discussions of this “compliance check” aspect of the corporate examination. A corporate officer may have questions such as:
- Can they do this?
- Does this mean I will be audited personally?
- What is the downside if we don’t cooperate?
- Why don’t they simply inspect the original return that I filed?
- I want to appear cooperative; what do I have to hide?
These are all very realistic and common questions.
A good place to begin the search for answers is Internal Revenue Manual (IRM) Section 18.104.22.168.7 (rev. 3/1/06). The manual instructs IRS examiners to verify that the corporate officers, key executives, and highly compensated employees have filed the required personal income tax returns. The Service should internally requisition the return it wants to inspect. Other internal IRS guidance (Corporate Executive Compliance FAQs) suggests that only if the return is not available to the requesting agent internally should a letter (Form 3996) be sent to the corporate officer requesting a copy for inspection purposes. In no event should a request for an officer’s return be made via the corporate taxpayer.
This latter directive is likely being followed by most LMSB agents, but it is interesting to note the frequency with which certain agents use Form 3996 initially without trying to obtain the document internally. If the IRS performs its inspection internally, the procedure will be invisible to the corporate officer unless a decision to examine the return is made. It may be that the decision to examine is not very common.
Although an inspection is not an examination, if the examining agent asks questions about certain entries on the officer’s Form 1040, U.S. Individual Income Tax Return, that will likely be considered an examination. If the agent insists that he or she is not examining the Form 1040, the question should (respectfully) not be answered. Of course, the inspection of the return could lead to an IRS decision to place that officer’s Form 1040 under examination. This is one of the consequences of the mandatory compliance check as part of the corporate examination.
Caution: The IRM indicates that the mandatory inspection procedure generally should be limited to “officer/ shareholder” returns for industry cases. The majority of LMSB corporate taxpayers are considered “industry cases” as compared with super-large, generally multinational corporations, which are considered “coordinated industry cases.” A fair number of U.S. corporations have officers who are not shareholders. For an industry case, the practitioner should point this out to the IRS examiner because the mandatory procedure may not apply.
Practitioners need to be aware that IRS practice in this area does not always match the procedure spelled out in the IRM. If the examining agent skips the internal approach and goes immediately to Form 3996, tax practitioners can expect more billable hours spent explaining the process to their clients.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. James Brennan is a principal in the IRS Practice and Procedure Group of Ernst & Young LLP in New York, NY. The editor and Mr. Brennan are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at email@example.com.