Taxpayers think there is an audit lottery. Tax professionals know better. True, there is an audit lottery in the sense that only a very, very small percentage of returns are subject to human scrutiny. But what most taxpayers overlook is that the IRS relies heavily on machines to process returns and, in that process, uses myriad automated programs to review all returns. The truth is that every single return filed is subject to some level of review by the IRS. One well known program is the Automated Underreporting program (AUR). It matches information returns against taxpayer returns to catch under-reporting of income.
Last week’s case of Richard Essner v. Commissioner, T.C. Memo. 2020-23 (Feb. 12, 2020) (Judge Marvel) teaches a lesson about what happens when machine and human review of the same tax return overlap. There, the IRS issued an NOD based on an AUR review while the same tax year was, at the same time, under human review. The taxpayer argued that this duplicative review violated the §7605(b) restrictions on unnecessary or duplicative examinations. Judge Marvel sympathized but hewed to a long line of precedent holding that AUR review does not trigger the §7605(b) restrictions. Details below the fold.
Law: The One Examination Rule and the Reason For It
Section 7605(b) provides that:
“No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.”
The statutory language thus creates two restrictions: (1) a prohibition of “unnecessary examination or investigation” and (2) a restriction of one “inspection of a taxpayer’s books” unless the IRS, “after investigation,” notifies the taxpayer that additional inspection is necessary.
Section 7605(b) first appeared as §1309 of the Revenue Act of 1921, 42 Stat. 227, 310. It was one of the earliest anti-abuse---or “taxpayer rights”---statutes that Congress enacted. Recall that at that time only the wealthy were subject to an income tax. If you do not recall that, you can go read this informative article by Carolyn Jones. And recall that at this time, tax administration was performed almost entirely by humans, with very little machine help. If you do not recall that, you can go read my own informative article that details the history of IRS automation.
The reason you need to remember both these facts is because they explain why courts have interpreted the §7605(b) restrictions narrowly, and they help you understand how the IRS administers it.
The key interpretation comes from the seminal case of United States v. Powell, 379 U.S. 48 (1964). There, the taxpayer was resisting a summons issued by the IRS to investigate two tax years that had already been closed by a prior examination. Lower courts were in conflict on how strictly to apply §7605(b). Some courts had interpreted the section broadly as requiring probable cause and others had interpreted the section narrowly. For example, in United States v. Ryan, 320 F.2d 500 (6th Cir. 1963), aff’d 379 U.S. 61 (1964), the Sixth Circuit rejected the taxpayer’s argument that the “unnecessary” language created a probable cause requirement with this emphatic language:
“To construe the statute as contended by the taxpayer would seriously curtail the powers of investigation granted to the Secretary by Congress. It would impose a condition precedent on the exercise of that power not authorized by Congress. It would permit the court and not the Secretary to determine whether an investigation was necessary. It would hamper the Secretary in the performance of his statutory duties. It would convert a summary enforcement proceeding into a full scale trial to determine whether the Secretary had reasonable grounds or probable cause for the investigation.”
In Powell, the Supreme Court agreed with the courts, like Ryan, who had read the statute narrowly. Relying on floor statements by the Senator who managed the Revenue Act of 1921 the Court concluded that: “Congress recognized a need for a curb on the investigating powers of low-echelon revenue agents, and considered that it met this need simply and fully by requiring such agents to clear any repetitive examination with a superior.” Id. at 55-56. The statute did not otherwise interfere with how the IRS chose to exercise its powers of inquisition.
Since Powell, courts have consistently construed the statute to accomplish its purpose to restrain overzealous IRS employees---humans, mind you, not machines---from “repetitive examination.” Since Powell, courts have read both restrictions in the statute as directed at this underlying purpose: to prevent “repetitive examinations” by abusive IRS employees. Hence the sobriquet “one examination rule.” See generally, United States v. Garrett, 571 F.2d 1323 (5th Cir. 1971).
Following this narrow interpretation, courts have held that the two §7605(b) restrictions only kick in once the IRS has completed a full initial examination. See e.g. United States v. Giordano, 419 F.2d 564, 567 (8th Cir. 1969), cert. denied 397 U.S. 1037 (1970) ( “§7605(b) could not possibly and reasonably lend itself to a construction that would preclude the Government from making at least one meaningful examination of the books of account for the years involved.”).
The IRS has also consistently followed this “one examination” interpretation in a series of Rev. Procs, the current one being Rev. Proc. 2005-32. That Rev. Proc. sets out the conditions under which IRS employees need to secure supervisory approval to comply with §7605(b). It also “describes, by category, a non-exclusive list of contacts with taxpayers and other actions by the Service that are not examinations, inspections, or reopenings of closed cases.” One of the listed contacts that the Rev. Proc. says is not an examination, inspection, or reopening is “adjustments resulting from...a discrepancy between a filed tax return and information received from...an information-return matching program, or other correction programs operated by Internal Revenue Service Centers or Campuses.” §.03(1)(d). That’s what the AUR program does.
Dr. Essner is a cancer surgeon. He inherited an IRA in 2014. From it he took a distribution of roughly $361,000 in 2014 and $148,000 in 2015. After reading guidance on the IRS website, Dr. Essner concluded the distribution was not taxable income to him. Like many really smart people, he was so convinced of his conclusion that he saw no need to even tell his tax return preparer about the distributions. Yeah, you know where this is going: penalty land!
Dr. Essner got snagged by the matching program because the payor reported the distribution on Form 1099-R. Starting in March 2016 the AUR system sent him multiple notices---but only as to the 2014 tax year---to which he made inadequate responses and so, on January 3, 2107, the AUR system generated an NOD for 2014. Dr. Essner filed a Tax Court petition on March 27, 2017. I cannot tell whether or why the AUR program failed to pick up the 2015 omission.
Overlapping with the AUR process, Dr. Essner’s 2014 tax return was selected for examination by a Revenue Agent (RA) in October 2016. The scope of the examination was limited to various questionable deduction items. The 2015 tax year was also selected, apparently out of the same concern about the accuracy of various deductions.
The RA continued examining the 2014 return even after the AUR NOD issued for 2014. This was all confusing and frustrating for Dr. Essner. Judge Marvel writes: “Various offices of the IRS contacted petitioner without coordination, without clarity as to what the other parts were doing, and without providing petitioner a clear explanation as to why the IRS was speaking out of many mouths.” Dr. Essner apparently informed the RA about the AUR, but the opinion is silent on what internal IRS coordination either did or did not take place.
It was all over in December 2017 when the RA issued an NOD for 2015. Dr. Essner timely petitioned for review. The Court consolidated both petitions. As to 2014, it appears that the IRS relied only on the AUR NOD for the presumption of correctness and raised the deduction issues as additional issues, on which the IRS would have the burden of proof. See Tax Court Rule 142(a). I say “it appears” because after finding Dr. Essner liable for the omitted income in 2014, Judge Marvel writes that Dr. Essner “conceded other adjustment for tax year 2014.” I don’t think she would be saying that if the only adjustments at issue were the omitted income items.
At any rate, Dr. Essner (representing himself, natch), argued that the overlapping reviews of his 2014 return violated §7605(b). Judge Marvel was sympathetic but disagreed. Instead, she hewed to the long-standing narrow interpretation of §7605(b) as a “one examination rule” and held that “the AUR program’s matching of third-party reported payment information against petitioner’s already-filed 2014 tax return is not an examination of petition’s records.” That holding is consistent with Rev. Proc. 2005-32 and supports the IRS position.
All returns are reviewed. But this lesson reminds us that the AUR review of income items on a return via matching third-party information is not a complete examination. It cannot be because machine review simply cannot review deduction items. It can only review income items and then only those income items for which the payor was required to file an information return. Reviewing returns for errors in deductions is still a labor-intensive process requiring human eyes.
Even if a court finds that the IRS violated §7605(b), this is one of those statutory commands that lacks a statutory consequence for its violation. For example, what if the IRS had indeed improperly conducted a second examination of Dr. Essner’s 2014 tax year? What should be the consequence of doing that? Taxpayers would really like the court to void the resulting NOD! I doubt that would happen. In Suarez v. Commissioner, 58 T.C. 792 (1972), the taxpayer argued that the examination process had violated his constitutional rights. Even there, however, the Court refused to consider voiding the NOD. Here's why:
“Where infringements of constitutional rights are involved, we are convinced that the determination in a statutory notice should be carefully scrutinized and that some sanction should be imposed to discourage the Commissioner's use of and reliance on constitutionally inadmissible evidence.
We are unable to agree, however, with the suggestion that the statutory notice here must be declared a nullity. We find no authority for this conclusion. On the contrary, Helvering v. Taylor, 293 U.S. 507 (1935), teaches that when a petitioner makes a showing casting doubt on the validity of a deficiency determination, the statutory notice itself is not rendered void; the result of such showing is that the respondent must then come forward with evidence to establish the existence and amount of any deficiency.”
Well, gosh. If a constitutional violation does not render an NOD void, then it is unlikely the Tax Court would find that statutory violation would do so. Instead, the likely consequence would be to shift at least the burden of production and perhaps even the burden of persuasion to the IRS.
Coda: About those penalties.... The IRS initially asserted §6662(a) penalties for both years, but conceded the 2014 penalties. Judge Marvel upheld the 2015 penalties finding that Dr. Essner had no reasonable cause “given petitioner’s background and the substantial size of the distribution.” Dr. Essner could have avoided penalties had he told his return preparer about the IRA distributions. Of course, that would also likely have resulted in his taking the correct reporting position, thus avoiding all this fuss and bother...and extra costs.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law