December 28, 2017 The Tax Lawyer

The IRS’s Tax Determination Authority

Volume 71, No.1 - Fall 2017

Allen D. Madison


     Even with severe negative consequences to cheating, a taxpayer has little incentive to comply with the tax laws if he believes the Service will not catch him. To increase the probability the Service will detect noncompliant activity, federal tax law grants the Service the authority to investigate any taxpayer’s return and determine whether the taxpayer owes more tax. To exercise this authority, the Service reviews all taxpayer returns, examines on a deeper level the returns that appear the most questionable, provides (in general) an appeals process to taxpayers that disagree with the examination results, and issues a final determination.

    The first step, administrative review of all taxpayer returns, involves scoring the returns and matching them to information returns filed by third parties. The Service scores returns by applying an algorithm to each return called the Discriminant Index Function (DIF). The higher the DIF Score, the more likely a return will undergo further scrutiny. When the Service receives a tax return that is inconsistent with third-party information returns, the Service follows up with the automated underreporter program to resolve the discrepancy. Finally, the Service contacts taxpayers in some cases to verify certain information. None of these administrative return reviews are considered an “examination” by the Service’s standards.

    The second step in the Service’s tax determination is to examine returns that the Service suspects have underreported the taxpayers’ tax liability. To do this, the Service must select returns, obtain information from taxpayers by compulsion if necessary, address taxpayer responses to its requests for information, and, if an examiner concludes a taxpayer owes more tax, propose any adjustments to the taxpayer’s return. During the process, the Service must keep all tax return information confidential.

    The third step, if the taxpayer disagrees with the Service’s proposed adjustments, is to provide an internal appeal to the Service’s appeals office. These appeals procedures are discretionary. If the Service permits an appeal, the taxpayer files a protest with the Appeals Officer. The Appeals Officer then sets up a conference with the taxpayer to help decide whether the case will settle.

    If the case does not settle, the final step is for the Service to issue a final determination. If the Service is deciding a case that arose from an examination (i.e., a deficiency) the Service issues a statutory notice of deficiency. The deficiency notice gives the taxpayer the right to petition the Tax Court for review of the Service’s determination. If the Service is deciding a case that arose from a refund request, the Service issues a notice of refund disallowance. Once a refund request is disallowed, the taxpayer may sue in federal district court or the Court of Federal Claims to obtain the refund.

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