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Exhibit 0-1

How Classifiers Identify Significant Issues on Individual Nonbusiness and
Business Tax Returns (Internal Revenue Manual, Part IV)

Listed below are suggested guidelines to assist classifiers in identifying significant issues on individual nonbusiness tax returns.


Exemptions and Itemized Deductions

General

  • Important! Look first at overall potential based on the amount of excess itemized deductions above the zero bracket amount.
  • Verify that itemized deductions are not claimed elsewhere on the return when the standard deduction has been elected (e.g., personal real estate taxes and mortgage interest deducted on rental schedule).

Exemptions

  • Exemptions claimed by the noncustodial parent have proven to have high potential for adjustment.
  • When married persons file separately, both taxpayers may not have made the same election for standard, or itemized, deductions. If dependent children are claimed, the other spouse may also be claiming them.

Medical Expenses

  • High medical expenses for large families, deceased taxpayers, or older taxpayers are usually not productive to yield more taxes, if the return is audited.

Taxes

  • Real Estate Taxes- Consider changes in address (i.e., W-2, 1040, 2119) to verify the claimed deduction.

Interest Expense

  • Interest is generally not productive when questioning all the small items that may be listed or combined.
  • Productive issues could come from payments to individuals, and closing costs on real estate transactions.
  • Home mortgage interest usually is unproductive.

Contributions

  • Check to see if contributions exceed 50 percent of Adjusted Gross Income (AGI).
  • Check large donations made to questionable miscellaneous charities.
  • Check for payments which may represent tuition.
  • Check for large donations of property, other than cash.

Casualty or Theft Losses

  • Watch for business assets, valuation methods, and limitations.

Miscellaneous Deductions

  • Scrutinize large, unusual, or questionable items.


Income

Capital Transaction

  • Gains on sales of rental and other depreciable property, where the taxpayer has been using an accelerated method of depreciation or ACRS, should be questioned since the taxpayer may have to report ordinary income.
  • Loss on the sale of rental property, recently converted from a personal residence, is usually productive.
  • Current-year installment sales and exchanges of property should be carefully scrutinized as taxpayers frequently make errors in computing the recognized gain.
  • Check to see if the gain on a sale is large enough to require the alternative minimum tax computation.

Pension and/or Annuity

  • Verify if distribution qualifies under the three-year rule.
  • Check whether distribution qualifies as a lump-sum distribution.

Rental Properties

  • Consider fair rental value.
  • If the rental property is located at the same address as the taxpayer's residence, consider whether the allocation is proper between the rental portion and the portion used personally by the taxpayer.
  • Repairs may be capital improvements.
  • Consider whether the cost of land is included in the basis.
  • The rental of vacation/resort homes should be scrutinized.

Sales of Residence

  • Check to be sure that the taxpayer purchases a more expensive residence to qualify for deferral of the gain.

Unreported Income

  • Is the income sufficient to support the exemptions claimed?
  • Installment sale of property but no interest reported.
  • Does the taxpayer show interest and real estate tax deductions for two residences but no rental income?
  • If a taxpayer lists his/her occupation as waiter, cab driver, porter, beautician, etc., tip income is a productive issue.
  • Are there substantial interest expenses with no apparent source of funds to repay the loans?
  • Does the taxpayer claim business expenses for an activity that shows no income on the return (i.e., beautician supplies, but no Form 1099 or W-2 for that occupation)?

Copy of Schedule K-1

  • Items of self-employment income shown on Schedule K-1 should be matched to Schedule SE to ensure that the amounts are properly included in the self-employment tax computation.


Adjustments to Income

Moving Expenses

  • Review W-2's for address and other compensation. Also, consider sale of residence.

Employee Business Expenses

  • Amounts should be reasonable when compared to the taxpayer's occupation and income level.
  • Avoid auto expenses as an issue where the standard mileage computation is used and the mileage shown does not appear excessive.
  • Transportation expenses for construction workers, carpenters, etc., who appear to have several different employers at different locations, have not proven to be productive. However, be alert for expenses claimed for travel to a remote job site(s).
  • Expenses for clubs, yachts, airplanes, etc., must meet the facilities requirements of IRC 274 and therefore are usually productive issues.


Taxpayer's Previous / Subsequent Year Return

Determine whether the previous/ subsequent year return should be inspected. If so, you must note the checksheet. Situations where inspection may be warranted are:

  • Probable carryover adjustments (i.e., capital loss carryover, substantial depreciation changes).
  • Items which, if disallowed in the selected year, may be allowable in the following year.


Business Individual Returns

  • Determination of Office/ Field Examinations- One of the key contributions to the success or failure of our Examination Program in the business categories is the selection of the proper function to conduct the examination. If we are to meet out Program objectives, it is essential that we input those returns that are most adaptable for office interview to Office Examination and those requiring the skills of a revenue agent to Field Examination. This decision is very important from several aspects:
    1. The planned time of an examination of a business return in Office Examination is about half of that planned for Field Examination. However, substantial issues should not be excluded as identified issues to convert what would be a Revenue Agent assignment, to a Tax Auditor assignment.
    2. Office examinations usually do not involve a visitation to the taxpayer's place of business. Field Examination returns should require a more in-depth knowledge of accounting principles.
  • Generally, business returns should be selected for Field Examination when the following conditions occur:
    1. Voluminous records.
    2. Complex accounting method.
    3. Extensive time frame required to complete the examination.
    4. Advisability of on-site inspection of business.
    5. Inventories are substantial and material.
    6. Termination of business before the end of a taxable year.
    7. Unusual issues that appear to be complex and time consuming to develop. For example:
      a. Nontaxable transfers.
      b. Complex oil or mineral explorations.
      c. Sale of IRC 1231 assets.
      d. Unstated interest (IRC 483).
    8. The size of a business is also an indicator of what may be involved when an actual examination is made of the books and records of any particular taxpayer.
    9. The businesses listed below would normally not be adaptable to Office Examination:
      a. Contractors.
      b. Manufacturers.
      c. Auto dealers.
      d. Funeral parlors.
  • The areas discussed above are meant to operate only as a guide. In addition to considering these items, heavy reliance must be placed on judgment and experience.

Net Profit

  • Is the taxpayer engaged in the type of business or profession normally considered to be more profitable than reflected on the return?
  • Is the zero bracket amount used with high gross income and low net profit shown on the business schedule? Experience has shown that the incidence of fraud is greater on low business returns when the return reflects large receipts ($100,000 or more), a sizable investment, and the standard deduction is used.
  • Does the address, real estate taxes, and/or mortgage interest indicate a higher mode of living than justified by the reported income?
  • Does the return reveal large amount of interest/ dividend income not commensurate with current sources of income?

Cost of Goods Sold

  • Check for the possibility of withdrawal of items for personal use.
  • Is the ending inventory inclusive of all costs, direct and indirect?

Bad Debt Deduction

  • Is it a cash business?
  • Is it disproportionate for the indicated value of sales?

Depreciation

  • Does the schedule contain an adequate description of the asset?
  • Are personal assets being depreciated?
  • Consider investment credit aspects and sales of property simultaneously with depreciation issues.

Sales of Assets

  • Is there a sale of business assets during the year without investment credit or depreciation recapture?
  • Is the gain large enough to require the alternative minimum tax computation?

Farm Returns

In the analysis of a Schedule F, you should keep in mind the usual features of a farm return. The farmer may be engaged in a specialized area of dairy cattle, beef cattle, grain, swine, vegetables, poultry, or a multiple of these items. The operation may vary from that of a few acres to several thousand acres. The operator of the farm may own all or a portion of it. Consider whether the farm is an actual business operation or a hobby.


Other Taxes

Self-Employment Tax

  • All returns should be screened for self-employment tax issues, including returns with Schedule SE attached. Look for income such as director's fees, janitorial services, miscellaneous income, partnership income, etc., which may be subject to self-employment tax.
  • Some items of income earned by independent contractors may be reported as wages or other income. Where the income appears to be personal service income, it must be considered for Social Security tax purposes.


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