What Occurs During an Examination

There is no statutory or common law definition of the term “examination.” However, an examination, or audit, may be described as the systematic inspection of the books and records of a taxpayer for the purpose of making a determination of the correct tax liability.

Because government entities are generally exempt from federal income tax, our compliance efforts are generally focused on employment tax and information return reporting.

During examinations, FSLG Specialists search for errors or omissions on employment tax and information returns.  Examples of common adjustments include the following:

• The employer discontinued the reporting of wages for FICA tax purposes before the annual wage limitation was reached.
• Compensation taxed for Federal income tax withholding purposes but not for FICA and/or Medicare tax withholding.
• Employers did not report the wages of all employees.  Examples of common errors of this type include the wages of janitors, part-time or seasonal workers, etc.
• The amount of wages or income tax withheld was incorrectly reported.
• The employer did not report bonuses, vacation pay, or other payments that constitute additional wages for employment tax purposes.
• The employer did not report the fair market value of non-cash compensation.

In addition, the FSLG Specialist will:

• Verify that all appropriate returns were filed timely.  If not, filing deadlines and associated penalties will be discussed and assessed, and any delinquent returns will be secured. 
• Verify that all deposits were made timely.  If they were not, deposit requirements and failure to deposit penalties will be discussed.

Generally, a telephone call is used to contact the organization to schedule an appointment in the field for an employment tax interview.  The FSLG Specialist will contact an authorized individual.

An “authorized individual” is someone who has authority under the applicable state law to legally bind the entity.  Usually state law, the government entity's regulations, or its charter specifies who is "authorized" to engage in certain kinds of activities.  The mayor, city manager, school superintendent or comptroller/treasurer (or similar positions in other types of government entities) are other individuals who are most likely “authorized” by law to bind the organization.

During the telephone call with the authorized government official,  the FSLG Specialist will generally:

• Set an appointment for the opening interview that is mutually agreeable,
• Discuss the tax returns and periods under audit,
• Provide information about taxpayer rights and the examination process,
• Discuss power of attorney procedures,
• Discuss the format and availability of books and records,
• Provide general information about issues initially planned to be examined and inform the taxpayer that additional issues may be examined depending upon the information obtained during the examination.

The FSLG Specialist will then send the taxpayer an audit confirmation letter with Publication 1 (Your Rights as a Taxpayer), Notice 609 (Privacy Act Notice), and a Form 4564 (Information Document Request (IDR).

Sometimes the initial contact is made by an appointment letter.  This general occurs when the FSLG Specialist has difficulty locating a telephone number for an authorized individual.

The IDR will include requests for documents needed to support issues the FSLG plans to examine.  The IDR will list the specific information and documents the taxpayer should provide to the FSLG Specialist.  Although FSLG Specialists strive to phrase items in terms that are understandable to the taxpayer, sometimes terminology is unclear.  If you have a question about what is requested, you should contact the Specialist for clarification.

Items frequently requested include:

• Books and records such as general ledger, cash disbursements journal, accounts payable ledger, etc.
• Trial balance
• Financial statements
• Forms 940, 941 or 944, 945
• Forms W-2
• Forms 1099
• Employee handbooks
• Employer-provided fringe benefit packages
• Collective bargaining agreement and contracts, if any, with employees

Generally an IDR is sent with audit appointment letter, which will list the specific information and documents the taxpayer should have available at the initial appointment.  Another IDR may be issued to the taxpayer following the initial interview to request information and documents needed to support issues that were discussed during the initial interview but not available at that time.  Additional IDRs may be sent to the taxpayer until all compliance questions are resolved.  IDRs will always have a deadline for information to be received.  The date listed on the IDR should provide the organization a reasonable amount of time to gather and provide the information, generally between two and four weeks.  If this is not sufficient, the government entity should contact the FSLG Specialist to discuss a more reasonable date.

Examinations can be completed in a professional and timely manner when the IRS and Taxpayer/POA work cooperatively together.  Time is a valuable resource for both parties and open communication will provide the framework for timely completion of the examination.

The following are a sample of questions that might be asked during the opening interview:

• What criteria are used for each of the following categories of employees and on average how many employees are in each category:
  • Full-time
  • Part-time
  • Temporary
  • Seasonal
  • Other (be specific)
• Do all of the above categories of employees receive Form W-2?
• How do you file your Federal Forms W-2/W-3 and 1099/1096; i.e. manually, using magnetic media, electronically?
• For each year in question, how many Forms W-2 were filed with the Social Security Administration?
• For each year in question, how and what type of Forms 1099 were filed with the Internal Revenue Service?
• Is your payroll maintained internally or externally (if so, who is the provider)?
• If your payroll is maintained internally, is it a manual or machine sensible (computerized) system?
• Will you walk me through your payroll system and internal controls from the employee time records to the filing of Federal forms 941 and W-2?
• How are your disbursements and accounts payable records kept, manually or machine-sensitive (computerized)?
• Are completed (name, address, TIN, type of entity) and signed Forms W-9 secured from all contractors prior to the work being performed or prior to payment for services rendered?
• How do you determine who receives a Form 1099?
• Who determines and what criteria are used to determine whether a worker should be treated as an independent contractor or employee?
• Do you engage the services of former employees?  If so, are they treated as employees or independent contractors?
• Will you walk me through your disbursements and accounts payable systems and internal controls?
• What employee fringe benefits do you provide?
• What classes of employees receive what benefits?

Forms 1099 are reviewed to identify potential issues such as:

• Worker classification
• Backup withholding, and
• Additional wages

We review the organization’s employee handbooks, union contracts, and employment contracts to identify fringe benefits.  Then we must determine that all the fringe benefits (cash and non-cash), noted during the review have been:

• Properly excluded from employees’ income and not subject to Federal employment taxes, or,
• Properly included in employees’ income and subject to all appropriate federal employment taxes, or,
• Improperly excluded from employees’ income and not properly subject to all appropriate Federal employment taxes.

Those benefits that were “improperly excluded from the employee’s income and not properly subject to all appropriate Federal employment taxes” will be included in the proposed adjustment.

If we accept your return as filed, you will receive a letter stating that the examiner proposed no changes to your return.  You should keep this letter with your tax records.

If we don’t accept your return as filed, we will explain any proposed changes to you and your authorized representative.  It is important that you understand the reasons for any proposed changes; don’t hesitate to ask about anything that is unclear to you.

If you agree with a proposed increase to tax, you can sign an agreement form and pay any additional tax you may owe.  You must pay interest and applicable penalties on any additional balance due.  If you pay when you sign the agreement, interest is generally figured from the due date of your return to the date of your payment.

If you do not pay the additional tax and interest, you will receive a bill

If you are entitled to a refund, you will receive it sooner if you sign the agreement form at the end of the examination. You will also be paid interest on the refund.

If you do not agree with the proposed changes, the examiner will explain your appeal rights.  You may request an immediate meeting with the examiner’s supervisor to explain your situation.

If you cannot reach an agreement with the supervisor, the FSLG Specialist will prepare a report explaining your position and the IRS position.  The examiner will forward your case to the Area office for processing.

You will receive:

• A letter (known as a 30-day letter) notifying you of your rights to appeal the proposed changes within 30 days,
• A copy of the FSLG Specialist’s report explaining the proposed changes, and
• An agreement or a waiver form.

You generally have 30 days from the date of the 30-day letter to tell us whether you will accept the proposed changes or appeal them. The letter will explain what steps you should take, depending on what action you choose. Be sure to follow the instructions carefully. Appeal rights are explained in the Appeals Process article.

If you do not respond to the 30-day letter, or if you respond but do not reach an agreement with an appeals officer, we will send you a 90-day letter, also known as a Notice of Deficiency. This is a legal document that explains the proposed changes and the amount of the proposed tax increase. You will have 90 days (150 days if it is addressed to you outside the United States) from the date of this notice to file a petition with the Tax Court.  If you do not petition the Tax Court you will receive a bill for the amount due.

We try to examine tax returns as soon as possible after they are filed, but occasionally we may request that you extend the statute of limitations of your tax return.

A return’s statute of limitation generally limits the time we have to examine it and assess tax.  Assessments of tax must be made within 3 years after a return is due or filed, whichever is later. We can’t assess additional tax or make a refund or credit (unless you filed a timely claim) after the statute of limitations has expired.  Also, if you disagree with the results of the examination, you can’t appeal the items you disagree with unless sufficient time remains on the statute.  Because of these restrictions, if there isn’t much time remaining to examine your return, assess additional taxes, and/or exercise your appeal rights, you have the opportunity to extend the statute of limitations. This will allow you additional time to provide further documentation to support your position, request an appeal if you do not agree with our findings, or to claim a tax refund or credit. It also allows the Service time to complete the examination, make any additional assessment, if necessary, and provide sufficient time for processing.

A written agreement between you and the Service to extend the statutory period of a tax return is called a “consent.”

IRS generally utilizes Form SS-10 to extend the statute of limitations on employment tax returns. 

If the statute of limitations for your tax return is approaching, you may be asked to sign a consent.  You may:

1. Refuse to extend the statute of limitations;
2. Limit or restrict the consent to particular issues, or
3. Limit the extension to a particular period of time.

The consent will be sent or presented to you with a letter explaining this process and Publication 1035, Extending the Tax Assessment Period. For further information, refer to this publication.