4233-Tax Audit Guidelines-Partnerships, Estates, Trusts, and Corporations (1) This Handbook was prepared for all agents who make field examinations of income tax returns. It contains standards and techniques relating to the evaluation and disposition of assigned returns and the auditing and reporting on examined returns. (2) The Handbook has been developed for application and use in making quality audits. A quality audit is the examination of a taxpayer's books and records in sufficient depth to fully develop relevant facts concerning issues of Merit; ascertaining the true meaning of applicable tax laws; and correctly applying such laws to the relevant facts. The Audit Standards relate to the overall quality of performance, and the audit techniques are ways in which to meet these standards. (3) The Handbook was developed so that a reasonably uniform approach could be adopted for use by all agents. 100-lntroduction 110-Purpose The Tax Audit Guidelines for Partnership, Estates and Trusts, and Corporations have been prepared for all examiners who make field examinations of income tax returns. They contain techniques relating to the evaluation and disposition of assigned returns and the auditing and reporting on examined returns. This Handbook should be used in conjunction with IRM 4231, Tax Audit Guidelines for Internal Revenue Examiners, since many of the techniques in that Handbook are also applicable to Partnerships, Estates and Trusts, and Corporations. 120-Statement of Principles of Internal Revenue Tax Administration (1) The function of the Internal Revenue Service is to administer the Internal Revenue Code. It is the duty of the Service to correctly apply the laws enacted by Congress; to determine the reasonable meaning of various Code Provisions in light of the Congressional purpose in enacting them; and to perform this work in a fair and impartial manner, with neither a government nor a taxpayer point of view. (2) The mission of the Service is to encourage and achieve the highest possible degree of voluntary compliance with the tax laws and regulations and to conduct itself so as to warrant the highest degree of public confidence in its integrity and efficiency. (See policy statement P-1-1.) Examination supports the mission of the Service by encouraging the correct reporting by taxpayers of income, estate, gift, employment, and certain excise taxes. This is accomplished by: (a) Measuring the degree of voluntary compliance as reflected on filed returns; (b) Reducing noncompliance by identifying and allocating resources to those returns most in need of examination; and, (c) Conducting on a timely basis quality audits of each selected tax return to determine the correct tax liability. (3) The purpose of auditing a tax return is to determine the taxpayer's correct tax liability -- no more or no less. A quality audit is the examination of a taxpayer's books and records in sufficient depth to fully develop relevant facts concerning issues of merit; ascertaining the true meaning of applicable tax laws; and correctly applying such laws to the relevant facts. (4) One responsibility of Examination is to conduct on a timely basis quality audits of selected tax returns to determine the correct tax liability. Examination standards were developed as the level of achievement required for you to discharge this responsibility. Examination procedures necessary to achieve the standards are explained in the sections of the Manual indicated. Efforts have been made to define all standards as fully as possible; however, certain terms in the standards are intangible or subjective, and, as such, do not lend themselves to explicit definition. These include terms such as reasonable and professional judgment. Although the explanations have been written in a manner to show you the intended meaning of the terms, you must use your technical knowledge, training, and experience to correctly apply these concepts to the examination process. 200-Audit Techniques for Business Returns 210-Preliminary Work at Taxpayer's Office in Corporate and Partnership Examinations (1) The examination at the taxpayer's office may begin with miscellaneous records other than the actual ledgers and journals. Frequently, these records indicate items which the examiner should be alert for as the examination progresses. (For additional considerations on site of examination see IRM 4591.2 and regulation 301.7605-IT published in 1990-17 I.R.B. 11.) (2) The records and the type of information to be obtained are as follows. (a) Minute book-This corporate record should contain information on officers salaries, real estate leases and sales, construction contracts, law suits, patent applications, the issuance of new stock, the purchase of Treasury stock, and information relating to restricted stock options. As the examiner skims through the minute book, appropriate notes for future consideration should be made. 1 The review of the minute book should not be confined to the taxable year under examination. It is advisable to cover at least some of the period immediately before and after, if necessary, the minute books should be obtained that go all the way back to the inception of the business. 2 The correct name of the corporation should appear on the company charter which is usually kept in the minute book. This name is important when it becomes necessary to prepare a waiver to extend the statutory period of limitations. 3 Large corporations maintain minutes of the executive committee in addition to the minute book. (b) Partnership agreement-The provisions of this document should be noted. The distribution of income including partners salaries and interest on capital and other allowances which it may establish should be checked against the partnership return. (c) Audit report of independent auditors-This report should be read. Where two reports were issued, one in detail for management and the other a condensed one for investors, the former should be secured. Income and net worth per this report may differ from income and net worth per books due to the auditor's adjusting entries not reflected on the books. where this difference exists, these adjusting entries will be reconciling items between the books and the return. The auditor's workpapers usually explain these entries. They should be checked closely. Any qualifications or unusual comments in the auditor's report or certificates, such as expressions of opinion as to taxpayer's depreciation policy, adequacy of reserves, status of collectibility of receivables and the like, should be noted for consideration later when the items of income and expense are audited. (d) Auditor's workpapers-Audits, particularly of larger companies-may frequently be simplified if the examiner is given access to the auditor's workpapers. Judicious use of such records helps to reduce the time in examining the taxpayer's books. Examples of the types of analyses often found in such workpapers which may prove useful to the examiner are accounts receivable aging schedules, or repair analyses in which each expenditure over a certain amount is described. Guidelines for Requesting Accountants' Workpapers are contained in IRM 4024. (e) Retained copy file of income tax returns-Preceding and succeeding years' tax returns should be inspected. Items to observe are: 1 Significant ratio variations between other years and the current year; such as gross profit ratios or selling expenses to sales. Where they vary widely from the current year the examiner should make a note to determine the cause as the taxpayer's records are being examined. Balance sheet ratios or trends should also be observed. 2 Continuation in the year of examination of prior elections concerning bad debts, inventory valuation methods, depreciation. 3 Prior or subsequent year entries in the reconciliation schedules of retained earnings on a corporate return or of partners' capital accounts on a partnership return which affect the year under examination. 4 Retained copies of other prior years returns may be useful in certain cases, such as those requiring determination of the status of the retained earnings account, the basis of assets and depreciation allowed or allowable. (f) Stock transfer book-This book contains the names of present and past stockholders with the number of shares owned and the dates issued or cancelled. It is an essential record where questions of corporate control arise, such as those under IRC 267, 351, 542, and 1239. A general knowledge of the names of the large shareholders is also of value when checking the salary accounts. when the stock transfer book is not available, the record of dividend payments is an alternative source of similar information. (g) Statements and schedules filed with regulatory bodies-Companies in the public utility field are required to file certain data with regulatory agencies, such as the Interstate Commerce Commission, Civil Aeronautics Board, and State and local utility commissions. These schedules are detailed and can at times save the examiner considerable analytical work. Rules of accounting which public utility enterprises are required to adopt by regulatory commissions are not controlling for Federal income tax purposes. (h) SEC statements-Companies with public issued securities are required to file certain statements with the Securities and Exchange Commission (SEC). The statements filed at the time new securities are issued are extremely detailed about the past corporate history, ownership and operations. The annual SEC statements required from such companies are primarily the operating details of past years. Officers' dealings in stock of their own company must be reported to the SEC. (i) Financial statement for credit purposes-Financial statements furnished grantors of dealer franchises-Comparison of such statements with the tax return balance sheet and income schedule may reveal significant variations. For instance the reserve for bad debts on a balance sheet furnished a bank or a credit agency may be smaller than the reserve shown on the return balance sheet. This may indicate the reserve on the return is too high. (j) Appraisals-Engineers' and real estate dealers' appraisals are important in many cases, particularly in allocating real estate costs between land and building. In addition, art dealer appraisals may be useful in valuing works of art. 220-General Ledger 221-Examination Approach (1) The accounts contained in the general ledger will provide the examiner with an insight into the operations of the business. when pertinent, the chart of accounts should be requested from the taxpayer. If a private ledger is maintained, it should also be requested. (2) The examiner should leaf through the general ledger noting any unusual entries which may need an explanation. Since the individual items on the return are usually summaries of similar items on the books, the examiner should note the details of the items in the summaries. The majority of the questions noted will be answered later as the examiner goes through the various journals. Concerning questions which pertain to the general journal, some examiners prefer to obtain immediate answers. when this is done, both the ledger and the general journal must be at hand. Other than the mechanical clumsiness of this technique, it is as good a method as accumulating the questions and checking them out later. (3) As the examiner goes through the ledger unusual or nonrecurring items should be noted. Such items fall roughly into three classes. (a) Unusual in amount-The examiner should be alert for month-end entries of like amounts which represent large expense items which have been debited to a deferred account and spread over several months to avoid attracting attention. The total amount of an account may be unusual in amount because it appears to be too small. For example, where there is a small repair account total in a year under examination and the taxpayer had substantial fixed assets, the small repair total may be indicative of the practice of charging repairs to other accounts less likely to be checked. The manufacturing expense account is one potential alternative for such repair charges. (b) Unusual by source-Source as used here means the journals from which the account was posted, as indicated in the folio column. There is a normal source pattern for most postings. Repairs or advertising expenses are generally posted from the cash disbursement journal or the purchase journal; if the folio column indicates a cash receipts journal or general journal source it may warrant a further check. Entertainment expense items from the general journal more often than not represent officers' expense. Fixed asset credits from the cash book are unusual, if the assets were sold, a general journal entry is the normal way to eliminate the cost of the asset from the books. A cash book source suggests that the total selling price instead of the cost was credited to the account. These are a few of the possible source variations. The examiner should be alert for the many more items which may be encountered. (c) Unusual by nature-An entry in a ledger account may be unusual by nature as well as by an account itself. Some examples of unusual entries and accounts are: 1 Credit entries in accounts that usually contain only debits or vice versa. As an example a debit to a sales account could possibly be a bad debt write off. 2 Accounts which exist at the beginning of the year but do not exist at the end. For instance, the existence of a supplies inventory at the beginning of the year and no inventory at the end may indicate that the taxpayer had made an unauthorized change in the method of accounting. Conversely, the existence of an account at the end of the year, where none existed at the beginning, such as accrued wages, may indicate a similar unauthorized change. 3 A general ledger in which the nominal accounts are not closed out to the income summary account at the end of the year. where this situation exists, and the necessary information is not available from the auditor's workpapers, the examiner should trace the account to the tax return. This audit approach is advisable so that the examiner will uncover adjustments to the accounts which are not reflected by entries on the books. 222-Net Worth Section 222.1-Purpose and Scope of Examiner's Analysis (1) The principal purpose of an income tax examination is the verification of the taxable income shown on a particular tax return. That taxable income is the end product of the various items of income and expense on the return. Any one of these items may be an accumulation of from one to thousands of individual transactions. These individual transactions do not appear on the tax return. Accordingly, it becomes necessary to examine them in the place where they do appear and that is in the books. (2) Since the transactions are recorded on the books according to accounting principles rather than tax law, it is likely that there will be some differences between the net income on the books and the net income on the tax return. The examiner must isolate and reconcile these differences. (3) If a questionable item is noted in the taxpayer's books during the examination of an income or expense account, the examiner should analyze the reconciliation from net book income to net income per return to determine if the item was eliminated from the amount deducted on the tax return. (4) The net worth section is the starting point in determining the relationship of the books and the return. There are three elements in this section at the end of any given tax year. They are: (a) the net worth at the beginning of the year; (b) the operating income or loss of the current year; (c) the nonoperating transactions of the current year. (5) The examiner is primarily concerned with the second element. However, since the books and the returns may vary, the examination should not be confined only to the second element. Items which fall in the second element on the books may belong in either of the other two insofar as the tax return is concerned, and vice versa. The examiner must therefore check all three elements. (6) Having defined the scope and purpose of the net worth analysis and the income reconciliation, the manner in which they are to be accomplished is the next step. In some respects the manner varies depending on the entity involved. The corporate taxpayer will be considered first. 222.2-Corporations (1) The net worth section of a corporate balance sheet is composed of the capital and retained earnings accounts. The examiner of a corporate return will find that most taxpayers have completed Schedules M-1 and M-2 on the return which show a reconciliation of income per books with income per return and an analysis of unappropriated retained earnings and undivided profits per books. (See 232.4 of this Handbook). (2) Audit techniques include the following: (a) Analyze and reconcile the retained earnings accounts. Verify correctness of all items, both increases and decreases, appearing on the books or return. (b) Consider whether the retained earnings has been improperly accumulated beyond the reasonable needs of the business. 222.3-Partnerships (1) There is no great difference in principle between the net worth analysis of a corporation and a partnership. The same technique applies to both. (2) Schedule M. Reconciliation of Partners' Capital Accounts. Form 1065, is a rough equivalent of Schedule M-1. Reconciliation of Income per Books with Income per Return, and Schedule M-2. Analysis of Unappropriated Retained Earnings and Undivided Profits per Books, on the corporate return, Form 1120. (3) Schedule K shows total distributive partnership items. Schedule K-1 reflects each partner's share of income, deductions, or credits which are required to be set out separately by the partnership. The schedule provides for the segregation of IRC 1231 transactions. The examiner should remember that the decision on whether gain or loss on such assets is ordinary or capital should be deferred until transferred into the partners' individual returns. For each "at risk" activity, Schedule K-1 requires the entry of the partner's share of partnership liabilities for which the partner is personally liable. Examiners should be aware of "at risk" limitations of losses on certain tax shelter partnership investment-(see IRM 4236, Examination Tax Shelters Handbook.) Examiners should be alert for situations where taxpayers have claimed deductions for accrued interest on existing liabilities and foreclosure proceedings have subsequently occured. Verify that the taxpayer has included the difference between the liability per books and the liability which was relieved by the foreclosure as income. (4) Since Schedule M on the partnerhsip return is condensed, the examiner should first secure the taxpayer's workpapers showing how various items were grouped for the schedule. Once this breakdown is secured the examiner can reconcile the books with the return. The "per return" column can be prepared solely from Schedule M as allocated in the workpapers; and from Schedule D Sale or Exchange of Property, Form 4797, Supplemental Schedule of Gains and Losses; and Schedule K of the return. The "per books" column detail should be secured from the taxpayer and then checked against the books to see that they agree. (5) After the reconciliation has been made; the examiner should continue with the examination bearing in mind the effect the above reconciling items have on the transactions appearing in the books. For instance, if there is a $1,000.00 charge to charitable contributions, the examiner should remember that the $1,000.00 was not claimed on the tax return. If the examiner sees an additional $200.00 contribution to another organization the examiner would know that it was claimed on the return and should be adjusted. (6) The regulations under IRC 6050K require partnerships to file Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests) when a portion of any money or other property given to a selling partner in exchange for all or part of the partner's interest in the partnership is attributable to unrealized receivables or substantially appreciated inventory items (IRC section 751(a)), IRC 6050K is effective for sales or exchanges occurring after 12/31/84. During their examination of partnerships, examiners will verify that all required Form 8308's have been filed. If they have not been filed, the appropriate penalties for failure to file these forms will be imposed, unless reasonable cause is found to exist. Examiners will also give consideration to securing within the district affected partners' returns to determine if examination is warranted, and preparing information reports on out of district partners. 222.4-Sole Proprietorships (1) Businesses are sometimes conducted as sole proprietorships, in which case profits or losses are reported in Schedule C (or in the case of a farm, Schedule F) of an individual return. Since this schedule contains no balance sheet the net worth that is to be analyzed is the net worth account on the books including the proprietor's drawing account. All entries in these two accounts should be checked. They may contain items, other than the closing entry which should properly be included as income or expense for tax purposes. If there are, and the taxpayer has not included them, the examiner should make the necessary adjustment in the report. (2) If the closing entry per books does not agree with the income shown on Schedule C, the taxpayer should be asked to supply the reconciling detail. (3) After the reconciliation and verification is completed, the examiner should turn to the next phase of the examination. If income per books agree with the return the examiner should go through the books noting items that belong in the other return schedules or the schedule of itemized deductions. Contributions are an example. They are subject to percentage limitations, or to complete disallowance if the standard deduction is used. 230-Balance Sheet Approach to Examinations 231-Examination of Asset Accounts 231.1-Introduction (1) Thus far, this chapter has presented a series of suggestions on the technique of commencing the examination of a set of books and records. The initial phase includes a verification that the net income per books with appropriate reconciling adjustments, is actually reflected in the tax return under examination, whether it be a corporation, a partnership or a sole proprietorship. (2) Once this verification is completed, the examiner should turn attention primarily to the books and records, bearing in mind that there are some reconciling items which affect the net income per books. (3) The following subsections offer guides to the technique of examining the asset, liability, income, and expense accounts normally found in general ledgers. 231.2-Cash on Hand and in Bank (1) Review cash disbursements journal for a representative period. Note any missing check numbers, checks drawn to order of cash, bearer, etc.; large or unusual items, and determine propriety thereof through a comparison with vouchers, journal entries, etc. (a) In the case of a cash basis taxpayer, ascertain if checks were written and recorded which were issued after the close of the year under examination. (b) Give special consideration to checks issued for cashier's checks, sight drafts, etc., where the payee and nature are not clearly shown. (2) Obtain bank statements and cancelled checks for each bank account for one or more months, including the last month of the period under examination. (a) Compare deposits shown by bank statement against entries in cash receipt book. (b) Note year-end bank overdrafts in case of cash basis taxpayer. This may indicate expenses which are unallowable since funds were not available for payment. (c) Determine if any checks have remained outstanding for an unreasonable time. This may indicate improper or duplication of disbursements. Old outstanding checks possibly could be restored to income. (d) Determine whether voided checks have been properly handled. (e) For a test period, check endorsements to see if they are the same as payee, noting any endorsements by owner, or questionable endorsements. (3) Review cash receipts journal for items not identified with ordinary business sales, being alert to such items as sales of assets, prepaid income, income received under claim of right, etc. (4) If records appear unreliable or have not been subjected to a competent independent audit, tests of footings and postings should be made for a representative period. (5) Investigate entries in general ledger cash account. Look for unusual items which do not originate from cash receipts or disbursements journals. These entries may indicate unauthorized withdrawals or expenditures, sales of capital assets, omitted sales, undisclosed bank accounts, etc. (6) Test check some cash sales with cash book to ascertain if they have been correctly recorded. Also check cash sales made at the beginning and end of the period under examination to determine if year-end sales have been recorded in the proper accounting period. (7) Test check disbursements from petty cash to determine if there are any unallowable items included. (8) Scrutinize cash overages and shortages, being alert to irregularities which may have cleared through accounts. (9) Review cash on hand account to determine if there are any credit balances during the period under examination. This may indicate unrecorded receipts. 231.3-Notes and Accounts Receivable (1) Check entries in general ledger control accounts. Look for unusual items, especially those which do not originate from the sales or cash receipts journals. (2) Determine if subsidiary ledgers are in agreement with control accounts, and, if not, ascertain the reasons for any differences. (3) Note any credit balances in the general ledger or subsidiary accounts. This may indicate deposits or overpayments which could be considered as additional income or unrecorded sales. (4) Some credit sales invoices and postings should be test checked from the sales journal to the subsidiary and control account. (5) Determine whether accrued income on interest bearing notes or accounts has been included in income. (6) where taxpayer reflects an accrual method by subtracting beginning receivables and adding ending receivables to cash collected, consider checking the detailed listing of receivables at the beginning of the period to the cash receipts book. This may disclose diverting of funds, etc. Determine if beginning receivables used in the computation are the same as the ending receivables of the preceding year. (7) Insure that return conforms to books in terms of method of accounting. 231.4-Investments (1) Analyze sales and other credit entries with regard to the following: (a) gains or losses (basis, wash sales, interest included in sales price, etc.); (b) other (exchanges, write downs, write- offs, transactions with related taxpayers, or controlled foreign entities, etc.). (2) Review debit entries. Consider such items as: (a) Nontaxable securities acquired with borrowed funds. (b) Other acquisitions (transactions with related taxpayers, noncash acquisitions, creation, organization or reorganization of a foreign corporation, etc.) (3) Become familiar with the nature of investments, utilizing any records maintained by the taxpayer. Make necessary test checks to determine if related income has been properly reported (dividends, interest, etc.). (4) If shares of stock are held in a foreign corporation, determine whether it is a foreign personal holding company. 231.5-Depreciable Assets (1) Determine whether assets shown on the depreciation schedule, which have a prior year acquisition date, are the same as shown on the tax return for the immediate preceding period. If not, this would point up depreciation being taken on assets which have previously been expensed or fully depreciated, etc. (2) Review additions during the period. Test additions by reference to invoices, contracts, etc., giving consideration to the following. (a) Note items which appear to have originated from unusual sources such as appraisal increases, transfers, exchanges, etc., and determine propriety thereof Ascertain if prior earnings were adequate to cover acquisitions. (b) Determine if costs relating to the acquisition and installation of assets, leasehold improvements, etc., have been capitalized. (c) Ascertain if assets include items of a personal nature. (d) Where construction or any other work of a capital nature is performed with the taxpayer's own equipment, labor, etc., for its own use, be certain that the basis of such asset includes the proper elements of material, labor and overhead, including depreciation. (e) With regard to the basis of assets, consider such items as trade-ins, acquisitions from related taxpayers, allocations of cost between land and building, etc. Also consider whether the basis has been reduced by the appropriate amount of investment credit for periods after December 31, 1982. (3) Decreases in the asset accounts during the year should be noted. Gains or losses resulting therefrom should be verified. (a) Ascertain if taxpayer has transferred assets to a controlled domestic or foreign corporation for less than fair consideration. (4) Examiners should be alert for situations where deductions are being claimed by entities leasing property to tax-exempt entities. As a result of the Deficit Reduction Act of 1984, certain tax benefits otherwise available (depreciation, investment credit), have been greatly reduced for owners of property that is leased to tax-exempt entities. 231.6-Valuation Reserves (1) Review nature and source of all accounts and ascertain whether they are being used as a means of diverting or understating income, or claiming unallowable deductions. (2) Depreciation, Amortization, and Depletion Reserves-Determine whether any of these are contingent reserves. Check for reasonableness of any addition. 231.7-Intangible Assets (1) Verify correctness of deductions claimed, such as amortization, write downs, write-offs, royalties, etc. (2) Test check current additions to determine if the basis includes the proper elements of cost, such as legal fees, application fees, etc. (3) Determine if there have been any transactions with related taxpayers, or controlled foreign entities; if so, consider arms-length features. (4) Determine if income applicable to intangibles has been included in income. In this connection be aware that it is not necessary for an intangible to have a basis or to appear on the records (e.g. subleases, overriding royalties, franchises, etc.). (5) Analyze any transaction involving transfer of foreign rights to any foreign entity for an equity interest, or for nominal consideration. (6) Be alert to any situation or transaction which logically could have given rise to an intangible which may have been expensed through inventories, fixed assets, expenses, etc. (e.g. purchase of a going business-which could involve good will, covenant not to compete, etc.). 231.8-Prepaid Expenses and Deferred Charges Make check as to the nature and source of these assets, and the manner in which they are charged off to expense. Prepaid expenses are generally present in all businesses. The absence of such items should be considered, since a distortion of income may be involved. 231.9-Other Assets The nature and classification of other asset accounts should be considered to determine if they have a bearing on tax liability. 231.(10)-Exchange, Clearing or Suspense Account Determine nature and purpose of the account. Test check debit and credit entries, being aware of the possibility that such account may be used as a means for diverting sales, padding expenses, etc. 231.(11)-lRC 897-Disposition of Investment in United States Real Property (1) INTRODUCTION-Prior to the enactment of IRC 897, foreign persons could legitimately sell U.S. real property without paying any U.S. taxes. Although investment in U.S. real estate helped the U.S. economy, it was inequitable to U.S. persons and placed U.S. persons at a disadvantage in selling their real estate. Because of this inequity to U.S. persons, Congress passed the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) IRC 897, which taxes dispositions of U.S. real property interest by nonresident alien individuals and foreign corporations (including foreign partnerships, trusts, and estates). (2) BACKGROUND-It is helpful to understand the taxability of foreign persons on disposition of interests in U.S. real property before FIRPTA and the techniques used to avoid taxation. (a) Prior Law-There are two broad categories of income that are taxable to foreign persons. 1 Income effectively connected with the conduct of a trade or business in the U.S. This income is taxed at graduated rates and would include a capital gain from the sale or exchange of U.S. real estate associated with a U.S. trade or business. 2 Income which is U.S. source but not effectively connected with the U.S. trade or business. This income is taxed at a flat rate of 30% or a lower treaty rate. Capital gains that are not associated with the conduct of a trade or business would not fall within this category unless the individual taxpayer (nonresident alien) is physically present in the U.S. more than 182 days during the taxable year. (b) Techniques Used to Avoid Taxation (Prior to FIRPTA)-For the purposes of this section it is assumed that the capital gain would be taxable as effectively connected with the conduct of trade or business in the U.S. if steps were not taken to avoid the taxable event. These common techniques are: 1 Sale of stock of a Holding Company 2 Liquidate a Holding Company 3 Installment Sale 4 Like-Kind exchange (c) Sale of Stock of a Holding Company-A foreign person would transfer real property to a corporation and then on finding a buyer for the real property would sell the stock to the buyer. If the sale were not otherwise effectively connected to a trade or business, the transaction would be tax free. (d) Liquidate a Holding Company-Again, as in item (c) above, a foreign person would transfer real property to a corporation. Prior to selling the real property, the corporation would adopt a plan of liquidation and liquidate under 2JR:C 337 which provides for nonrecognition of gain. The subsequent capital gain resulting from the exchange of shares in the corporation for the assets would again be tax free to the foreign person. (e) Installment Sale-Upon the sale of real property, the foreign person would elect installment sale treatment under IRC 453. If the taxpayer was not effectively engaged in a U.S. trade or business in the later years when the proceeds were received and the gain was recognized, the gain would escape taxation. (f) Like-Kind Exchange-If the foreign person exchanged U.S. real property for real property outside the U.S., under IRC 1031 no gain would be recognized. Also, no taxable gain would be recognized later when the foreign person disposed of the non-U.S. real property. (g) After FIRPTA-In general, FIRPTA eliminated the simplest method of tax avoidance by deeming that a disposition of a real property interest is always considered to be effectively connected with a U.S. trade or business. This also ended the installment sale technique of avoiding tax on real property sales. (3) The other techniques for avoiding tax were somewhat more complex and therefore required extensive legislation to eliminate. (a) Sale of Stock of a Holding Company-The foreign person could still transfer real property to a domestic corporation without a taxable event taking place but the subsequent sale of stock of the domestic corporation would now be taxable. If the foreign person transferred real property to a foreign corporation, the transfer would be taxable at that time (IRC 897(j)). However, the subsequent sale of stock of the foreign corporation would not be taxable. A tax avoidance method still exists when a foreign corporation acquires real property, for then a foreign person could sell the stock of the foreign corporation without tax consequence. (b) Liquidate a Holding Company-Prior to selling the U.S. real property, a domestic corporation could still adopt a plan of liquidation and liquidate under IRC 337. However, the subsequent capital gain from the exchange of shares in the corporation for the assets would now be taxable to the foreign person. Foreign corporations cannot now take advantage of IRC 337 as it no longer applies to a sale or exchange of U.S. real property interests by foreign corporations (IRC 897(d)). (c) Like-Kind Exchange-A foreign person can now only exchange a U.S. real property interest for an interest which would be taxable upon later disposition for the nonrecognition provisions of IRC 1031 to apply. Therefore, a foreign person cannot escape taxation by exchanging a U.S. real property interest for a non-U. S. real property interest and then selling the non-U.S. real property interest (IRC 897(e)). (4) DEFINITIONS-IRC 897 contains several terms that are special to this statute. A clear understanding of these terms is essential to the proper interpretation and application of the provisions of IRC 897. Some of the terms are defined below: (a) Real Property Defined-The term real property includes three types of property: 1 Land and natural products of the land 2 Improvements to land 3 Personal property associated with the use of real property (b) United States Real Property Interest (USRPI) Defined 1 The term "United States real property interest" means an interest in real property located in the United States or the Virgin Islands or any interest, other than an interest solely as a creditor, in any domestic corporation that is a United States real property holding corporation. 2 Interest in U.S. real property includes a fee ownership, co-ownership or leasehold interest in real property, a time sharing interest in real property and a life estate, remainder or revisionary interest in such property. It also includes options to acquire such interests in real property. (c) United States Real Property Holding Corporations (USRPHC) 1 A USRPHC is a corporation whose USRPIs constitute 50 percent or more of the fair market value of the aggregate of its USPRPIs, its foreign real property and its trade or business assets. 2 USRPHC status is important for determining whether the disposition of an interest in a domestic corporation by a foreign person is taxable. 3 In the event that the domestic corporation is not a USRPHC and so notifies the foreign persons and the Service, then disposition of an ownership interest in the corporation does not constitute a disposition of a U.S. real property interest. The statement and supporting calculation that foreign persons are relying upon in concluding they do not have a U.S. taxable event will need to be examined to determine their validity. (5) TAXABLE DISPOSITIONS-IRC 897 is applicable to dispositions of U.S. real property interests after June 18, 1980, unless the nonresident alien individual or foreign corporation is protected by a tax treaty that allows more favorable treatment. Tax treaties currently in force will not be affected by IRC 897 until January 1, 1985, at which time, IRC 897 will override the treaty provisions. (6) IRC 897(i) ELECTION-A foreign corporation may make an election under IRC 897(i) and its regulations to be treated as a domestic corporation for purposes of IRC 897 and 6039C if: (a) The corporation owns a U.S. real property interest. (b) Under any treaty obligation of the United States the foreign corporation is entitled to nondiscriminatory treatment with respect to that interest. (c) The corporation submits the election in proper form in accordance with the regulations. After 5/5/88, foreign corporations had to qualify as USRPHC in order to make section 897(i) elections. See Reg. Section 1.897-8T(b). A foreign corporation that makes this election shall not be treated as a domestic corporation for purposes of any other provision of the Code or Regulations, except to the extent that it consents to such treatment as a condition to making the election. You may be assigned a return of a foreign corporation reporting income based on an election pursuant to IRC 897(i). Examiners should verify that the Office of the Assistant Commissioner (International) has approved the election. (d) See 233:(6) of LEM IV for audit criteria involving IRC 897(i) elections. (7) AUDIT TECHNIQUES-During examinations, the following minimum checks should be made: (a) Determine if the entity under examination has foreign ownership, either directly or indirectly; (b) Determine whether dispositions of interests in U.S. real property after June 18, 1980, involve foreign investors. An interest in U.S. real property includes direct or indirect ownership. Indirect ownership could include ownership of real property through a domestic corporation, partnership, trust or estate; (c) Determine if tax havens (e.g., Netherland Antilles) have been used as conduits by foreign investors to disguise purchases of U.S. real property through complex financing arrangements. 1 Foreign investors may form Nether!and Antilles corporations to make "participatory loans" with "equity kickers" to disguise foreign purchases in U.S. real property. A participatory loan obligates the borrower to repay the amount loaned, together with a fixed or stated interest, and as additional compensation, pay the lender a portion of gross profits, net profits, or cash flow. Examiners should be aware that interest contingent on the profits, cash flow, or receipts of borrower can convert a loan into an equity investment of the borrower. If the taxpayer has structured their investment in this manner, they may also be c!aiming that: a The "equity kicker" is deductible as interest expense; and, b That the foreign "lender" is exempt from the U.S. tax on the U.S. source "interest" of 30 percent rate by virtue of Article VIII of the U.S.-Netherland Tax Treaty as extended to the Netherlands Antilles. 2 Such investment arrangements would cause a taxable event under ~ IRC 897 upon disposition. Additionally, if examiners treat these participatory loans as equity investments in a domestic corporation: a "Interest payments" can be treated as corporate distributions, and to the extent out of current profits or accumulated earnings of the "borrower", the foreign lender would be subject to U.S. tax on a dividend; and, b The U.S. "borrower" will not be allowed an interest deduction. (e) Audit techniques are not limited to the above checks. This is a new area in which the Service is still gaining experience. Examiners should employ any other audit techniques that are applicable and should use their ingenuity in examining these issues. For detailed audit guidelines on Foreign Investment in U.S. Real Property (FIRPTA) see Section 5(10)0 of this handbook. (9) REFERRALS AND ASSISTANCE-The Office of the Assistant Commissioner (International) has jurisdiction over nonresident alien individua!s who have income from U.S. sources. If the case involves disposition of U.S. real property by non-resident alien individuals, a referral should be made to the Office of the Assistant Commissioner (International). Because of the involvement of foreign persons and entities using tax havens, examiners should remember that assistance from International examiners in the International Enforcement Program is available when necessary. (See IRM 42(10)3). 232-Examination of Liability Accounts 232.1-Current and Accrued Liabilities, Including Notes Payable (1) Note any debit balances in the general ledger or subsidiary accounts. This may indicate diversion of funds, etc. Also note accounts which have long overdue balances. This may indicate contested liabilities and liabilities which no longer exist such as unclaimed wages, unclaimed deposits, items set up twice, etc. (2) Review computation of year-end accruals with respect to their allowability as expenses or purchases. Also see that accruals set up at the end of the preceding year were either reversed in the current year or that the actual expenses were charged against them when paid. Be alert to large year-end items which have been shifted between years for the taxpayer's advantage. (3) Determine if subsidiary ledgers are in agreement with controls, and if not, ascertain the reasons for any differences. (4) Determine if accrued items payable to related taxpayers, were paid within the time limit prescribed. (5) Investigate entries in the general ledger control accounts. Look for unusual items, especially those which do not originate from the voucher register or cash disbursements journals. This may disclose unreported income, improper or overstated expense. (6) Examiners should be alert for situations where taxpayers have claimed deductions for accrued interest on existing liabilities and foreclosure proceedings have subsequently occurred. Verify the taxpayer has included the difference between the liability per the books and the liability which was relieved by the foreclosure as income. (7) Analyze any newly established liability to a controlled foreign corporation as it may represent a constructive dividend. (8) Note that the accrual of vacation pay is no longer allowed after the repeal of IRC Section 463 as of December3l, 1987. The reserve balance as of December3l, 1987 is to be spread over 4 years or less. The change of accruing vacation pay to not accruing vacation pay is considered a change initiated by the taxpayer, and such change shall be treated as having been made with the consent of the Secretary. 232.2-Officer's Salaries (1) Determine total compensation paid or accrued to principal officers, taking into consideration any compensation claimed under headings other than officers' salaries, such as manufacturing sa!aries, supervisory salaries, labor, etc., contributions to pension plans for the officers, payments of personal expenses, year-end or other bonuses, etc. (2) Determine if and to what extent each principal officer's compensation is unreasonable. (3) The examiner should take into account such factors as: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, and locally, character and amount of responsibility, time of year compensation is determined, relationship of stockholder-officer's compensation to stockholdings, whether alleged compensate is in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified emp!oyees for similar services, etc. (4) Be alert to closely held multiple corporation situations in which compensation may be split between two or more re!ated corporations, and which, in the aggregate, may be considered excessive to the offlcer-stockholder. (5) In closely held corporations, determine that accruals payable to controlling stockholders are paid within the prescribed time limit. (6) Determine if executives have received substantial bonuses under the guise that the proceeds would be used by the recipient to make significant political contributions. (7) Be alert to situations where a corporation has entered into an agreement under which key personnel or other "disqualified individuals" are to receive excessive compensation in the event that control or ownership of the corporation changes. Such payments, commonly referred to as "golden parachute payments", are non-deductible by the corporation and the recipient is subject to an excise tax on the amount of the excess parachute payment in addition to the income tax due. 232.3-Fixed Liabilities (1) Financing arrangements such as mortgages, certificates of indebtedness, etc. are areas in which substantial adjustments are quite often found. The examiner should become acquainted with pertinent details with regard to such financing arrangements and consider possible adjustment areas as follows: (a) legal, professional and other expenses of issuance; (b) refunding of debt; (c) transactions with related taxpayers and controlled foreign entities; (d) related expense accounts (interest and amortization). (2) Scrutinize any long term outstanding liability to a controlled foreign corporation as it may represent an equity interest rather than a creditor interest. (3) Ensure that long term obligations issued after December 31, 1982 are in registered form and are not subject to the exicse tax imposed under IRC 4701 (See IRM 4743). 232.4-Other Liabilities The nature and classification of other liability accounts should be considered to determine if they have any bearing on tax liability. 232.5-Capital Stock (1) Review all capital stock accounts-give adequate consideration to the following. (a) No changes during period-Even though no changes in the total outstanding stock appear on the balance sheet or in the general ledger control accounts, consideration shou!d be given to such features as: 1 Subchapter S Corporations. Is there a valid election, number and changes in stockho!ders, limitation on losses, etc. 2 Dealings in stock between shareholders. Check gains or losses to the individuals concerned where the corporation ultimately becomes involved in such transactions and consider the possibility of distributions being essentially equivalent to a taxable dividend. 3 Closely held companies should receive special consideration throughout the examination for such items as arms-length features, disguised dividends, etc. (b) New issues and additions during the period 1 Compare date obtained from the corporate minute book and charter with items recorded on books to determine if proper entries have been made. 2 Verify all credit entries. Give consideration to such features as: stock issued for services or properties, stock dividends, employee stock options, stock issued at less than fair market value, reorganizations, taxable and nontaxab!e exchanges, etc. 3 Determine if expenses relating to the issuance of stock have been properly handled (legal fees, registration fees, etc.). 4 Determine if documentary stamps have been acquired and properly affixed, and cost correctly refiected. 5 Determine during the examination of a recapitalization of the stock in a closely held company that the fair market value of the stock to be received by each exchanging shareholder is equal to the fair market value of the stock surrendered in the exchange. If there is a significant difference, the examiner should be alert to possible gift tax consequences. (c) Reductions and cancellations during the period 1 Compare data obtained from the corporate charter and minute book with items recorded on books to determine if proper entries have been made. 2 Verify all debt entries. Give consideration to such features as, partial or comp!ete redemptions, cancellations, or liquidations; write-offs; distributions essentially equivalent to dividends; etc. (d) Treasury stock If treasury stock transactions have occurred, consider such possibilities as acquisitions being essentially equivalent to dividends, etc. 232.6-Surplus (1) Analyze and reconcile the surplus accounts. Verify correctness of all items, both increases and decreases, appearing on the books or return. (2) Consider whether the surplus has been improperly accumulated beyond the reasonable needs of the business. 232.7-Surplus Reserves Review nature and sources of all accounts and ascertain whether they are being used as a means of diverting or understating income, or claiming unallowable deductions. 232.8-Schedule M-1 (1) Schedule M-1 is the reconciliation between the net income per books and the taxable income before the net operating loss deduction and special deductions from Schedule I of Form 1120, U.S. Corporation Income Tax Return. (See Exhibit 200-1, Examples of Reconciliation of Income and Analysis of Unappropriated Retained Earnings). (2) A complete and detailed Schedule M-1 will provide an examiner with the information needed to reconcile income per books and income reported on the return. Variations can arise either because of tirning differences or permanent differences between financial accounting and tax accounting. These could surface in lines 4, 5, 7, or 8 of Schedule M-1. (3) Statement No. 5, Accounting for Contingencies, of the Financial Accounting Standards Board (March 1975), issued by the American Institute of Certified Public Accountants, defines a loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to the possible loss that will be resolved when one or more future events occur or fail to occur. An estimated loss from such a contingency shall be accrued by a charge to income if the following conditions are met: It is probable that a liability has been incurred at the date of the financial statement; and The amount of the loss can reasonably be estimated. The Standards define "probable" to mean that the future event or events are likely to occur. With respect to unasserted claims, litigation, and assessments, the Standards provide that an enterprise must determine the degree of probability that suit may be filed or a claim or assessment may be asserted, and the probability of an unfavorable outcome. If an unfavorable outcome is probable and the amount of the loss can be reasonably estimated, accrual of the loss is required. (4) "Tax Accrual workpapers" are produced by the independent auditor in conjunction with the auditing of financial statements required for companies that file financial statements with the SEC. Part of the auditing function is to evaluate the sufficiency of the client's reserves to meet its potential tax liability. This eva!uation is based in part on the accountant's analysis of corporate records and in part on its assessment of opinions and projections communicated in confidence by the client. In reaching its conclusion the accountant considers all uncertain tax positions taken by the client and determines the extent of reserves necessary to cover the liability that would result assuming that all such questions were resolved against the client. (5) Line 2, Federal income tax, may be the actual tax shown on the return or an accrual of the income taxes allocable to the period, which was entered on the books before the return was prepared. (a) If line 2 is an accrual, an analysis of the taxes payable account and the deferred tax account should be made and explained in the examiner's workpapers. The analysis will require the use of the books, the tax return and tax payment records. The analysis would consist of the reconciliation of the beginning and ending balance of the taxes payable account and the deferred tax account. (b) After the examination is substantially completed, i.e. the major issues are identified and quantified, and if the examiner determines that a material irreconcilable difference exists in the analysis of line 2, the examiner will ascertain from the taxpayer information to permit reconciliation of the difference. To the extent such difference includes a provision for tax contingencies, the workpapers supporting such provision should only be requested under the guidelines of IRM 4024.4. In any event, tax accrual workpapers as defined in IRM 4024.2:(3) will not be requested as a standard examination procedure. 233-Change in Accounting Period by Certain Partnerships, S corporation and Personal Service Corporations 233.1-lntroduction (1) Allowable Accounting Peeriods-IRC 441 provides that a taxpayer may adopt one of three different annual tax accounting periods: (a) The calendar year, or a period of 12 months ending on December 31; (b) The fiscal year, ending on the last day of any month other than December; or, (c) The 52-53 week period. (2) IRC 441 further provides that the taxable year is always the calendar year if any one of three circumstances is present; (a) The taxpayer keeps no books, (b) The taxpayer does not have an annual accounting period, or (c) The taxpayer has an annual accounting period not qualifying as a fiscal year. (3) IRC 441 provides other limitations on the taxable year: (a) The end of the year must end on the last day of a month, except for the 52-53 week period. (b) No more than 12 month's income and expense can be reported in one year except for the 52-53 week period. (c) IRC section 442 provides that, once adopted, an accounting period cannot be changed without the Commissioner's consent. Prior approval is NOT required if the change is made to a 52-53 week year that ends on a day that refers to the same month in which the taxpayer's prior tax year ended. The selection in this case is made by a statement enclosed with a return in which the election applies (Treas. Reg. 1.44 1-2T(c)(2)). (4) Changing the Accounting Period-In order to secure prior approval of a change of the accounting period, the taxpayer must file an application on Form 1128 with the Commissioner of Internal Revenue, Washington, D.C. (Treas. Reg. 1.442-1(b)(1)) (See IRM 4163 for further National Office procedures with respect to this form and special rule cases). (5) In general, a change of annual accounting period will be approved where the taxpayer establishes a substantial business purpose for making the change. In determining whether a taxpayer has established a substantial business purpose for making the change, consideration will be given to all the facts and circumstances relating to the change, including the tax consequences resulting therefrom. (6) Under Rev. Proc. 74-33, the intent of an entity to make its tax year coincide with its natural business year constitutes a valid business purpose. Other operative published guidelines are contained in Rev. Proc. 87-32, 1987-2 C.B. 396 and Rev. Rul. 87-57, 1987-2 C.B. 117 (see IRM 233.2(6)). 233.2-Background (1) 1986 Tax Reform Act-Section 806 of the Tax Reform Act (Pub. L. 99-514) (the "1986 Act") amended Sections 441 (to add new section 441(i)), 706(b), and 1378 of the Internal Revenue Code. It required personal service corporations, partnerships, and S corporations, respectively, to conform their taxable years to the taxable years of their owners except when these entities establish to the satisfaction of the Secretary a business purpose for having a different tax year. These sections are effective for taxable years beginning after December 31, 1986. This change in the law would have required the vast majority of such entities to change to, retain, or adopt the calendar year as the entity's taxable year. (2) Omnibus Budget Reconciliation Act of 1987 (OBRA)--Congress provided relief for affected entities and their owners with new section 444 of the Code, as added by section 10206 and OBRA (Pub. L. 100-203) (the "1987 Act") enacted into law on December 22, 1987. It allows certain partnerships, S corporations and personal service corporations to elect the use of a taxable year that is different from the taxable year that such entities would otherwise be required to use under section 806 of the 1986 Act (the "required taxable year"). Section 444 is effective for taxable years beginning after December 31, 1986. (3) An entity may not make a section 444 election if the entity is a member of a tiered structure other than a tiered structure comprised of one or more partnerships or S corporations, all of which have the same taxable year (Treas. Regs. Section 1.444-2T(e)(1)). In addition, tiered structure de minirnis exceptions are provided under Treas. Regs. 1 .444-2T(c). (4) Under the 1987 Act, partnerships and S corporations may elect the use of a taxable year that is different from their required taxable year if those partnerships and S corporations follow the procedures established under sections 444 and 7519 of the Code. Under those procedures, electing partnerships and S corporations are required to make payments ("required payments"-see IRM 233.2:(8)4) to the Federal government that are intended to represent the value of the tax deferral obtained by the owners of those entities through the use of a taxable year different from a required taxable year. (5) Similarly, under the 1987 Act, personal service corporations may elect the use of a taxable year that is different from their required taxable year if those corporations follow the procedures established under sections 444 and 280H of the Code. Under those procedures, electing personal service corporations failing to distribute ("Minimum Distribution Requirement") certain amounts ("applicable payments") to employee-owners by December 31 of any taxable year may be required to defer certain deductions for amounts paid to employee-owners. (6) Temporary Regulations provide that partnerships, S corporations and personal service corporations which have a taxable year for which such entity establishes a business purpose to the satisfaction of the secretary of the Treasury, as provided under the law, are not required to use a section 444 election in order to use such taxable year. As such, the required payment provision of section 7519(b) or the minimum distribution rules of section 280H would not apply. Thus, for example, a partnership which has a taxable year for which it has established a business purpose to the satisfaction of the Secretary, as provided under section 706(b)(1)(C) of the Code, may use such year. See Rev. Rul. 87-57, 1987-2 C.B. 117 for examples of whether in the situations described, the taxpayers have established, to the satisfaction of the Secretary, a business purpose for adopting, retaining or changing their tax years. Also, see Revenue Procedure 87-32, 1987-2 C.B. 396 for expeditious approval provisions for any partnership, S corporation, corporation electing to be an S corporation, or personal service corporation that desire to adopt, retain or change a tax year. (7) The general rule of section 444 allows for taxable years that create no more than three-months deferral for these affected entities. However, the principal effect of the election provision is to allow an existing entity, otherwise required to change its accounting period under section 806 of the 1986 Tax Reform Act, to retain such year but only for the first year beginning after 1986 (Treas. Regs. 1 .444-1T(b)(3)). Therefore, taxpayers that did not make this election for their year beginning in 1987 must change to the required tax year. (8) Technical and Miscellaneous Revenue Act of 1988 (TAMRA)-This bill provided amendments to section 10206 of OBRA (Code sections 280H, 444 and 7519) as follows: (a) Tiered structures 1 Any section 444 election is terminated if the entity becomes part of a tiered structure. However, tiered structure de minimis exceptions are provided under Treas. Regs. 1 .444-2T(c). 2 The exception to the prohibition for tiered structures (IRM 233.2:(3)) applies during the entire period an entity desires to have a section 444 in effect. It also applies whether all such entities are partnerships, S corporations, or both partnerships and S corporations, so long as all such entities have the same taxable year. No other tiered structures satisfy the exception to the prohibition. (b) Definitions 1 The bill provides a definition of "personal service corporation" and clarifies the definition of "employee owner" (section 444(e)(f), (g); these terms have the same meaning given them in section 269A, as modified by section 441(i)(2). 2 Applicable payment-means amounts paid by a partnership or S corporation that are includible in the gross income of a partner or shareholder. An applicable payment is not considered to occur prior to the date it is includible in the gross income of the partner or shareholder receiving the payment. The applicable payment does not include any gain from the sale or exchange of property between a partner or shareholder and a partnership or S corporation or any dividend paid by an S corporation (Code section 751 9(e)). 3 Deferral Period-for a partnership, S corporation, or personal service corporation that desires to retain its taxable year by making a section 444 election, the term "deferral period" means the months between the beginning of such year and the close of the first required taxable year (Code section 444(b)(4)). 4 Required Payment-TAMRA clarified the computation of the required payment by electing partnerships and S corporations. The amount is the excess of (1) the applicable percentage of the adjusted highest section 1 rate multiplied by the net base year income of the entity, over (2) the net required payment balance. The net required payment balance is the aggregate amount of required payments and refunds for all preceding election years. Thus, the amount of required payments for all preceding election years, net of any refunds of such payments, is taken into account in determining the amount of payment required for the current election year. In the case of an electing S corporation that was a C corporation during the base year, the corporation is treated as having been an S corporation during the base year for purpose of determining the amount and timing ofapplicable payments (Code section 75 19(d)(2)(B)). In the case of an electing partnership, the net income is determined without reduction for any guaranteed payments. Also, a guaranteed payment is not treated as an applicable payment for the purpose of computing the required payment of the partnership (Code section 75 19(d)). (c) Refunds of Required Payments Under certain circumstances, an electing partnership or S corp oration is entitled to the following refunds (all or portion) of the net required payment balance: 1 that portion of the net required payment balance that exceeds the amount of the required payment for the current year before reduction by the net required payment balance 2 the entire amount of the net required payment balance if the election is terminated or if the partnership or S corporation is liquidated during an election year. If so, the refund is payable, on the latest of April 15 of the calendar year following the calendar year in which the termination or liquidation occurs, or 90 days, after the claim for such refund is filed with the Secretary of the Treasury. An election is terminated when an S corporation revokes, its S corporation status. (d) Applicable Percentage-the bill restricts the use of phase-in rules for required payments if more than 50 percent of the S corporation's or partnership's net income is allocable to ineligible shareholders or partners. In this case, the applicable percentage for any partnership or S corporation is 100 percent for any taxable year beginning after 1987 (Code section 751 9(d)(4)). (e) Tax-exempt Income-If this type of income is earned by an electing partnership or S corporation, it will not be included in determining the net income of an electing partnership or S corporation (Code section 751 9(d)(2)). (f) Minimum Distribution Requirement-the requirements are met if the applicable amounts paid during the deferral period equal or exceed the lesser of: 1 the applicable amounts paid during the preceding taxable year divided by the number of months in such preceding taxable year multiplied by the number of months in the deferral period of the preceding taxable year, or 2 the applicable percentage of the adjusted taxable income for the deferral period of the current taxable year (Code section 280H(c)). For this purpose, the adjusted taxable income for the deferral period is determined without regard to a deduction for any amount paid to an employee owner that is includible in the gross income of such employee-owner and without regard to any net operating loss (NOL) carryover to the extent that such NOL carryover is aftributable to amounts paid to employee-owners (Code section 280H(f)(4)). 233.3-Effect of Required Change of Tax Year (1) In general, a partnership, S corporation, or personal service corporation that must change its tax year is required to file a return for the short year that begins with the first day of its first tax year beginning after 1986. For example, a partnership with a tax year ending on September 30, 1987, that is required to change to a calendar tax year has a short tax year beginning on October 1, 1987, and ending on December 31, 1987. (2) In the case of a partnership or an S corporation, each partner or shareholder is allowed to take the net income for any such tax year into account ratably over the first four tax years beginning after 1986. According to the Conference Connniflee Report, this treatment is available to any partner or S corporation shareholder. For example, a personal service corporation that is a partner in a partnership required to adopt a new tax year, is eligible to include the partner's distributive share of partnership income over four tax years. However, a partner or shareholder may elect to include all such income in its taxable year in which the short taxable year ends. These options are available to a shareholder of an S corporation only if the corporation was an S corporation for a taxable year beginning in 1986. (3) The Conference Connnittee Report indicates that partnerships and S corporations that had received permission to use a tax year providing a deferral of income to the owners of three months or less and that were required to include the amount of deferral in income over a 10-year period, may use any portion of such amount that is not taken into income as of the beginning of the first tax year beginning after 1986 to reduce the income aflributable to any short tax year required by the new rules. (4) In the case of a personal service corporation, the short tax year is subject to the annualization rules of Code Section 443. (5) A partnership, S corporation, or personal service corporation that changes to a tax year required by the Act is not required to obtain the IRS's permission to make this change. These taxpayers must file with the service center in accordance with section 5, Rev. Proc. 87-32. (6) The change in accounting period has no effect on the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) administrative provisions for partnerships and corporations (IRM 4226 and 4227). 233.4-If Business Purpose is Not Met and lRC 444 Election is Not Made (1) Secure the return for the short period referred to in IRM 233.3(1). (2) Additional procedures may be found under 233(7) through 233(15) of the Law Enforcement Manual (LEM); these can be obtained through your supervisor. 233.5-Forms to be Used to Comply with the Above Provisions (1) Form 720, Quarterly Federal Excise Tax Return This form is to be used temporarily to show the required payments under section 7519 even if the required payment for the app!icable election year is zero. It will be used for an applicable election year beginning in 1987. For an applicable election year beginning after 1987 the return shall also be made on Form 720 unless another form is prescribed by the Secretary. See Treasury Regs. 1.7519-2T for procedures and administration on required payments. Abstract 11 or line item number 11 will specifically be used to show the payments. The payments will show as deposits; a transaction code (TC) 650 will post to the master file if it is a regular deposit or a TC 610 will post to the master file if payment accompanies the Form 720 at the time of filing. Payments made through June 30, 1988 will automatically roll over to the quarter ending March 31, 1989. These would show with a TC 766 corresponding to abstract 11, Form 720. (2) Form 8716, Election to Have a Tax Year Other Than a Required Tax Year-This form is to be filed by partnerships, S corporations, and personal service corporations to elect to have a tax year other than a required tax year as provided under Code section 444(a). A TC 055 will be posted on the master file to show that a section 444 election has been approved. The date posted will be the date the form has been received. 233.6-Other Affected Forms (1) Form 2553, Election by Small Business Corporation-This form was revised to provide that Form 8716 may be attached to Form 2553 when a corporation is making the section 444 election at the same time it files Form 2553 to be an S corporation. In certain cases, personal service corporations that previously have filed Form 8716 and are later filing Form 2553 will attach a copy of their previously filed Form 8716 to Form 2553. If a taxpayer filing a Form 2553 after September 26, 1988 does not manifest the intent to make a section 444 election or "back-up section 444 election", the District Director may, at his discretion, disregard any Form 8716 subsequently filed (Treas. Regs. 1 .444-3T(b)(3)(i)). (2) Form 1120, U. S. Corporation Income Tax Return and Form 1120-A, U. S. Corporation Short Form Income Tax Return-Both of these forms were revised by adding a box to identify those personal service corporations that are required to have a calendar year as their tax year under 441(i) (unless the section 444 election is made). (3) Form 1128, Application for Change in Accounting Period-Under the specific instructions for Section A of this form, line item 1d was added to emphasize that the retention of the present tax year generally applies to entities with a valid section 444 election. (4) Form SS-4, Application for Employer Identification Number-Boxes have been added to identify S corporations and personal service corporations. 233.7-Penalties (1) In general-in the case of failure by any person to make timely payment of any amount required under IRC section 7519, a 10 percent penalty of the underpayment will be imposed (See IRC 7519(f)(4)). (2) No reasonable cause will be allowed in these cases. (3) If there is willful disregard of rules, section 444 election could be terminated at the discretion of the District Director (See LEM 233:(12) for discussion on when termination should occur). 233.8-Reference Material (1) The following published material provides guidance as follows: (a) Notice 88-10, 1988-1 C.B. 478, provides guidance on the application of new code sections 444, 7519 and 280H which allow certain partnerships, S corporations and personal service corporations to elect to use a different taxable year than would otherwise be required. (b) Notice 88-36, 1988-1 C.B. 517, defines the term "tiered structure" under Code section 444(d)(3). (c) Announcement 88-49, 1988-13 I.R.B. 34, tells taxpayers which forms to use in connection with a section 444 election to have a fiscal tax year. (d) Notice 88-49, 1988-1 I.R.B. 532, provides guidance on various issues of immediate concern to partnerships and S corporations that are considering whether to make a section 444 election. (e) Announcement 88-90, 1988-23 I.R.B. 55, announces the availability of new Form 8716 (May 1988), Election to Have a Tax Year Other Than a Required Tax Year. This form is for use by partnerships, S corporations and personal service corporations to make the election under Code section 444. (f) T.D. 8205, andLR-53-88, 53 Fed. Reg. 19688, 19715 (1988), provide proposed and temporary regulations on the election by partnerships, S corporations, and personal service corporations to use a taxable year other than their required taxable year. Notices 88-10, 88-36, and 88-49 have been incorporated in T.D. 8205, except for certain guidance to owners in Notice 88-49. (g) IR-88-97, released June 10, 1988, advises taxpayers owning an interest in an entity that may file Form 8716 that the IRS will not waive penalties for underpayments of estimated tax for the second quarter of 1988. (h) Notice 88-85, 1988-2 C.B. 400, clarifies additional issues relating to the election to use a taxable year other than the required taxable year. ################################################################################### Exhibit 200-1: Examples of Reconciliation of Income and Analysis of Unappropriated Retained Earnings Schedule M-1 -- Reconciliation of Income Per Books with Income Per Return 1. Net income per books...............................................(g) $ 42,000 2. Federal income tax.................................................(h) 38,000 3. Excess of capital loss over capital gains..........................(d) 1,000 4. Income subject to tax not recorded on books this year (itemized)...... Prior year income................................................(k) 30,000 Advance rent.....................................................(1) 10,000 5. Expenses recorded on books this year not deducted on this return...... officer's Life Insurance.........................................(i) 9,000 -------- 6. Total of lines 1 through 5........................................... $130,000 -------- 7. Income recorded on books this year not included in this return.......... Tax exempt interest................................................(j) 20,000 8. Deductions in this tax return not charged against book income......(m) 2,000 -------- 9. Total lines 7 and 8.................................................. 22,000 -------- 10. Income (line 6 less 9)............................................(p) 108,000 ======== Schedule M-2 -- Analysis of Unappropriated Retained Earnings Per Books ---------------------------------------------------------------------- 1. Balance at beginning of year (1/1/77).............................(a) 100,000 2. Net income per books..............................................(g) 42,000 3. other increases...................................................... Prior year tax accrual reversed.................................(p) 10,000 -------- 4. Total of lines 1 through 3.......................................... 152,000 -------- 5. Distributions....................................................... Cash...........................................................(n) 11,900 6. other decreases..................................................... Prior year expenses.............................................(b) 3,500 Tax deficit (1974)..............................................(c) 1,200 Reserve for damages.............................................(e) 8,000 -------- 7. Total of lines 5 and 6.............................................. 24,600 -------- 8. Balance at end of year (line 4 less 7) (12/31/77).................(f) 127,400 ======== Book Income - 1977 ----------- Taxable Gross Income....................................................(q) $300,000 Tax Exempt Interest Income.....................................(3) 20,000 -------- Total................................................................... $320,000 Deductible Business Expenses............................................(r) 230,000 -------- 90,000 officer's Life Insurance................................................(i) 9,000 -------- 81,000 Excess capital Loss.....................................................(d) 1,000 -------- 80,000 Federal Income Tax......................................................(h) 38,000 -------- Net Book Income.......................................................(g) 42,000 Current Non-Book Income and Expenses ------------------------------------ Prior Year Income.......................................................(k) $30,000 Advance Rents...........................................................(l) 10,000 Unbooked Expenses.......................................................(m) 2,000 Taxable Income - 1977 -------------- Taxable Gross Income....................................................(q) $300,000 Deductible Business Expenses............................................(r) 230,000 -------- 70,000 Unbooked Expenses.......................................................(m) 2,000 -------- 68,000 Prior Year Income.......................................................(k) 30,000 Advance Rents...........................................................(l) 10,000 -------- Taxable Income.......................................................... $108,000 ======== Taxes (approx.)...................................................... $ 45,000 Explanatory Notes (Keyed to Schedules M-1 and M-2 and to Book and Taxable Income) (a) You will note that the balance as of the beginning of the year is $100,000.00. This is the figure that should be entered on line 24, column (B) of Schedule L, of the return. It should also be entered on line 1 of Schedule M-2. If an agent finds a disagreement between the figure reported in Schedule L, with the actual books and also a disagreement between amount report in Schedule M-2 with that of the books, it is an indication that taxpayer is not showing an adjustment made for tax purposes. Unless these figures agree, the amounts reported in Schedule M-2 should be examined. (b) Prior year expenses represent expenses which had been claimed as a deduction in the 1976 tax return, but not actually booked until 1977. If actually handled properly by the taxpayer, it would have been reported as a Schedule M-1, item 8 of the 1976 tax return. When booked in 1977, it was charged directly to unappropriated retained earnings. (c) The 1974 Income deficiency was charged directly to retained earnings in 1977, as evidenced in our analysis of unappropriated retained earnings. This should be reported on line 6 of Schedule M-2. (d) Excess capital loss reported as a charge to Book income is not claimed as a deduction for Income Tax purposes. This should be shown on line 3 on Schedule M-1. (e) It is apparent that taxpayer set up a liability account Reserve for Damages by charging unappropriated retained earnings and crediting that account. (f) The end of the year balance amounting to $127,400.00 should be reported on Schedule L, line 24, column (D), and should also be shown on line 8 of Schedule M-2. See comments above about the importance of this figure agreeing with the actual books. (g) When reconciling income per books with income per return, agents should always use the figure recorded in the Book income account. Many agents make the mistake of working from the return back to the books, rather than the books to the return. The figure appearing on line 1 of Schedule M-1, and line 2 of Schedule M-2 should always be taken from the actual book figure, rather than from a set of workpapers. (h) In Schedule M-1 the taxpayer adds back the book provision for Federal income tax, because this is not deductible for Federal income tax purposes. The entry may be the actual tax shown on the return or an accrual entered on the books. If the entry is an accrual or a provision for estimated taxes, a reconciliation of the beginning and ending balances in the taxes payable and the deferred tax account(s) should be made using the books, tax return, and tax payment records. An unexplained difference may be due to one or more factors such as: 1. The independent auditor might have computed the tax liability based on certain facts. Someone else may later prepare the tax return and compute the tax without reconciling all aspects of the financial statements. 2. The tax effect on inconsistent positions taken on items shown on lines 4, 5, 7, or 8 of Schedule M-1. 3. An income or expense item might have been treated the same for book and tax purposes but the tax position is questionable. In those instances the taxpayer's workpapers and/or schedules used in setting up the accrual or provision for taxes may be required to clarify the differences. An example of Journal Entries, T-Account Entries and reconciliation of taxes payable and deferred taxes are as follows: Journal Entries Accrued Taxes....................................... $25,000 Taxes Payable......................................... $25,000 Provision for Estimated Taxes ----------------------------- Deferred Taxes...................................... $ 5,000 Taxes Payable......................................... $ 5,000 Provision for Taxes on Advance Rent Receipts -------------------------------------------- Accrued Taxes....................................... $10,000 Deferred Taxes........................................ $10,000 To Amortize Taxes Paid in Prior Year for Current Book Income ------------------------------------------------------------ Deferred Taxes...................................... $15,000 Taxes Payable......................................... $15,000 To Set Up Actual Tax Liability for Accrual in a Prior Year ---------------------------------------------------------- Accrued Taxes....................................... $ 3,000 Deferred Taxes........................................ $ 3,000 Provision for Tax on Current Income Payable in Future Year ---------------------------------------------------------- Deferred Taxes...................................... $10,000 Retained Earnings..................................... $10,000 To Reverse Accrual in Prior Year for Taxes Determined to be Not Payable ----------------------------------------------------------------------- Taxes Payable....................................... $35,000 Cash.................................................. $35,000 Tax Payments for Prior Year Taxes and Current Estimated Taxes ------------------------------------------------------------- Selected T-Accounts (B) = Beginning Balance Accrued Taxes Taxes Payable Cash ------------- ------------- -------------- | | | 25,000 | 35,000 | (B) 10,000 | 35,000 3,000 | | 25,000 | 10,000 | | 5,000 | | | 15,000 | Dr. 38,000 = Clos. Bal. | ====== | Clos. Bal. = 20,000 Cr. Retained Earnings * Deferred Tax ----------------- -------------- | | | 10, 000 5,000 | (B) 15,000 | 15,000 | 10,000 | 10,000 | 3,000 | ====== | ====== Dr. 2,000 = Clos. Bal. * This is a combined account. In some instances it may appear as two accounts (Prepaid Taxes & Deferred Taxes). Reconciliation of Deferred Taxes and Taxes Payable Deferred Taxes -------------- Accrued Taxes................................... $38,000 Plus: Opening balance in deferred taxes........... *15,000 ------- 53,000 Plus: Closing balance in deferred taxes........... **2,000 $55,000 $55,000 ======= * = A credit balance (+) is added: a debit balance is subtracted ** = A debit balance is added: a credit balance is subtracted Taxes Payable ------------- Taxes Paid..................................... $35,000 Less opening balance.............................. 10,000 ------- 25,000 Plus closing balance.............................. 20,000 ------- Taxes current period (approx.).................. $45,000 $45,000 ======= Difference (see note)........................ $10,000 Note: Difference attributable to reversal of prior year accrual determined by taxpayer to be non-payable. (i) It is indicated that taxpayer had charged book income for a nondeductible officers' life insurance premium. For tax purposes, the deduction has been eliminated. This should be shown on line S of Schedule M-1. (j) While book income has been increased by receipt of tax exempt interest, it is not taxable for Federal income tax purposes, and so is eliminated in Schedule M-1. It should be shown on Line 7 of Schedule M-1. (k) Taxpayer has included income in the 1977 tax return which was reported as book income in a prior year. Agents should be alert to the possibility that income of this nature may be entirely omitted in the return. For example, all insurance proceeds over basis on involuntary conversion may not have been reinvested as originally intended. This would result in taxable income in the year the reinvestment period runs out. The item appears on line 4 of Schedule M-l. (1) This adjustment to taxable income represents rents collected in advance. It must be included on the return in the year received although it will not be recorded on the books until a later period. This item appears on line 4 of Schedule M=1. (m) Taxpayer is claiming a deduction for expenses which were not booked during the current year. This should be shown on line 8 of Schedule M-1 of the return. (n) Taxpayer distributed a cash dividend which is charged to unappropriated retained earnings. This item appears on line S of Schedule M-2. (o) This should be the amount shown on line 10 of Schedule M-1. (p) Taxpayer determined that a prior year provision for taxes was incorrect and has reversed the accrual by crediting unappropriated retained earnings. This is an issue which the agent should examine carefully since it may represent an inconsistent position between the book income and tax income. (q) This item represents income which is both book and taxable income. It is subject to standard auditing techniques. (r) This entry represent expenses deductible on the books and on the tax return. It is subject to standard auditing techniques. ###################################################################################### 300-Audit Techniques-Foreign Corporations 310-Foreign Corporations The additional techniques outlined below were devised for use in examinations involving foreign corporations. Certain of the techniques are also applicable in examinations involving allocation of income and deductions between related domestic entities. 320-Recognition of the Corporate Entity (1) Secure statement from the appropriate officer of the domestic parent corporation giving reasons for the formation of the foreign subsidiary and the selection of the foreign country in which it was organized. (2) Scrutinize the minute book of the domestic parent corporation to determine whether it contains a record of any discussion or other information concerning the decision to form the subsidiary. (3) Prepare a schedule comparing the capital invested with the subsequent sales and earnings and show ratios. (4) Determine if there was a significant change in the operating results of the parent after the creation of the subsidiary. (5) Request copies of the parent's procedural manuals covering operations before and after the creation of the subsidiary. Compare and determine if there has been any substantive change in the method of operations. (6) Determine whether the subsidiary has assets commensurate with the scope and volume of business. (7) Analyze payroll records of the subsidiary to determine the number, type and function of the employees and officers. (8) Prepare schedule of officers and directors of both the parent and subsidiary. (9) Determine whether the subsidiary operates on the credit and goodwill of the parent. (10) Determine whether the subsidiary is absorbing its own bad debt losses or is shifting them to the parent. (11) Determine whether the subsidiary's liquid assets are being appropriated by the parent. From the subsidiary's financial statements, prepare a statement of source and application offunds. (12) Determine whether the subsidiary is still in existence and operating. If it was liquidated within a short period after its creation, ascertain the reason. If it is dormant, ascertain what disposition was made of its assets. (13) If the subsidiary is allegedly a sales or purchasing organization, determine the following. (a) whether the sales or purchases are directly or indirectly negotiated by the parent. (b) whether it took actual possession of the goods. (c) whether it maintains an inventory of goods, exclusive of goods in transit. (d) If an inventory is maintained abroad, determine what portion of the sa!es or purchases are filled from the foreign warehouse. (e) whether new business or sources of supply are being developed through the efforts of the subsidiary or that of the parent. 330-Constructive Dividends (1) Prepare a schedule of dividends actually paid by the subsidiary since its inception. (2) Prepare a schedule showing dates and amounts of loans to the parent or controlling interests, and dates and amounts of repayments together with all other pertinent information. (3) Prepare a schedule comparing, on an annual basis, the parent's payables to the subsidiary at the end of each year with the subsidiary's annual sales and the subsidiary's accumulated earnings at the end of each year. (4) Prepare a schedule on a monthly basis showing the subsidiary's net quick assets ba!ance and the net working capital balance and compare with loans to and repayments by the parent. (5) where the subsidiary is repaying long-outstanding loans, determine if the subsidiary was ever thinly capitalized. (6) where there is a long-outstanding payable to an unrelated party on the parent's books, determine if the foreign subsidiary rnight have paid the debt. (7) where there are any sales to or purchases from the subsidiary resulting in long-term gains to the parent or large losses to the subsidiary, determine if the consideration was a fair price and trace the history of the asset before and after the transaction. (8) Analyze any dividends from the subsidiary which are allegedly liquidating dividends. 340-Engaged in Trade or Business (1) Determine whether the activity in which the foreign corporation engaged constitutes carrying on a trade or business. (2) Determine if a significant part of the vital business activities are conducted in the United States, such as; (a) having an agent in the United States who has authority either expressed or implied, and exercises this authority to negotiate and execute contracts; (b) operating property located in the United States; (c) having substantial assets, including bank accounts, in the United States; (d) having an office or place of business in the United States; (e) having officers in the United States who make management decisions; (f) deriving a significant part of its income from sources within the United States. (3) where applicable, determine whether the foreign corporation has a permanent establishment in the United States within the meaning of the treaty involved. 350-Sources of Income-Sales of Personal Property (1) Secure copies of the distributor agreement between the affiliates. (2) Secure copies of the subdistributors' agreements granted by the foreign subsidiary and compare these with the distributor agreements granted by the domestic parent prior to the formation of the subsidiary. (3) Review the correspondence between the domestic parent and the foreign distributors notifying them of the new general foreign distributor. (4) Schedule the dates on which each foreign subdistributors' business was first channeled through the foreign subsidiary. where the change-over was unduly delayed, determine whether the delay was occasioned by negotiating changes in the terms of sale. (5) Secure the domestic parent's operating manual before and after the creation of the foreign subsidiary. Note changes in instructions regarding terms of sale and routing of shipments. (6) Secure copies of instructions to the freight forwarders before and after the creation of the foreign subsidiary. Note changes in routing of shipments. (7) Obtain a full set of all correspondence and documents prepared by the domestic and foreign affiliate, for a representative number of typical sales. Analyze and determine where in form title passed to the foreign customer and whether the form agrees with the substance of the transaction. (8) Determine whether the trade association for the industry has published trading rules. If affirmative, note if the form of the transactions follows the usages of the trade. 360-Sources of Income-Other Determine that all other income, such as interest, dividends, rents and royalties and gains from sale or real property, derived from sources within and without the United States, were properly treated. 370-Allocation of Income and Deductions (1) Determine whether the foreign corporation controls or is controlled by a foreign or domestic corporation. (2) Determine if they are doing business with each other. (3) Discuss with the appropriate officer the policy regarding dealings between the related or affiliated entities as compared with unrelated entities. (4) Secure copies of returns filed by the domestic corporation, if any, and compare gross profit and expenditures with those of the foreign corporation. (5) Make a tentative computation of the tax consequences of any apparent shifting of income. (6) If it is necessary to allocate intercompany sales, purchases, connnissions, royalties, or servicing income, refer to appropriate techniques. 400-(Reserved)