IRS instills new "LIFE" into its audits.

In response to long cycle times, the need to expand audit coverage to other compliance risk areas, and limited resources, the Internal Revenue Service recently implemented a new process known as Limited Issue Focused Examination (LIFE). LIFE is a streamlined, focused examination process, which utilizes a risk-based methodology and materiality thresholds to limit the scope of IRS examinations. Both parties must enter into a formal agreement to participate in the process. LIFE is currently only available to Large and Mid-Size Business (LMSB) taxpayers (taxpayers with assets greater than $10 million). The taxpayer, revenue agent (with team manager's approval), or the team manager may suggest utilizing LIFE for the audit. The introduction of LIFE in the audit process should decrease cycle time and reduce the cost and burden to both the taxpayer and the IRS.

Summary of LIFE Initiative

LIFE utilizes a risk-based methodology in determining which issues will be examined during the audit. This approach allows both the IRS and the taxpayer to focus on the most significant issues on the return. At the beginning of an audit, the examiner will perform a full risk analysis of the taxpayer. Based on this analysis, the examiner will limit the scope of the audit by focusing only on those issues with the greatest risk of non-compliance.

The risk analysis also contributes to the establishment of materiality thresholds. These thresholds further limit the scope of the examination. Other factors that are considered in determining the thresholds include: input from IRS specialists and the taxpayer, dollar amounts involved, timing (issues that affect a short time frame are less material than issues that affect a longer one), and whether the transaction creates a permanent or temporary difference. Usually, different thresholds are established for temporary versus permanent differences. New materiality thresholds are established for each cycle or tax year. Once established, the materiality thresholds must be disclosed to the taxpayer.

In general, taxpayers are not allowed to submit claims or affirmative issues below the materiality threshold. Likewise, issues whose dollar value is below the materiality threshold will generally not be examined. There are, however, some exceptions to this rule. Tax shelters, coordinated issues, fraudulent issues, and items contrary to public policy are not subject to the thresholds and will be examined even if they are below the materiality level. In addition, corrections of a computational or accounting error or clear-cut adjustments that are below the threshold are allowed if both parties agree and little time will be required to make these adjustments. Random checks below the threshold may be made, but they must be infrequent and the taxpayer must be notified before the checks. If the examiner discovers a non-disclosed tax shelter or listed transaction during the examination, he or she may expand the scope of the examination to include that issue. Other expansions of scope are only permitted if the manager approves. The examination team may perform tests on the taxpayer's accounting practices and policies. The results of these tests may affect the materiality threshold and the scope of the audit as originally established.

LIFE is a cooperative effort between the IRS and the taxpayer. Both parties must sign a Memorandum of Understanding (MOU), a formal agreement between the parties detailing the process and each party's role in the process. The agreement outlines the years to be examined and the targeted timeframe for completion. Additionally, it describes what information each party must provide the other. Furthermore, it documents the established materiality thresholds and the procedures surrounding these limits. It establishes timeframes for claim submissions, the taxpayer's response to Information Document Requests (IDRs), and the IRS's response to the information provided by the taxpayer. The MOU also contains a recommendation that the examiner and the taxpayer discuss all IDRs and the notice of proposed adjustment before their issuance. Finally, the MOU outlines the items that will cause the LIFE process to terminate. A sample MOU template is located at http://www.irs.gov/pub/irs-utl/ life_mou_for_irs.gov.doc.

If either party fails to meet its commitments established in the MOU, the LIFE process will be terminated. If terminated, normal audit procedures may apply; in other words, the scope may be expanded to include additional items and the time frame for completion may be extended.

Benefits

LIFE should provide many benefits to both the taxpayer and the IRS. It should reduce the time needed to complete an audit, thereby reducing the cost and burden to both the taxpayer and the IRS. In addition, it should promote teamwork between the taxpayer and the IRS and increase the communication between the parties. Optimally, this will create a more cooperative relationship between the parties.

Disadvantages

The disadvantages of utilizing LIFE are minimal. As with all new procedures, it will take time to "iron out the wrinkles." There will be the normal implementation problems that are common with all new processes. Field examiners were trained in November and December of 2002, but it will take them time to become accustomed to and accept the new procedures.

Another con to the LIFE process is subjectivity in establishing the materiality threshold. The process relies on the examiner to establish the threshold rather than using an objective approach. This method does not ensure consistency among taxpayers. One examiner may establish more stringent materiality limits and audit more items than another examiner who is more liberal with the threshold. This approach does not provide for fair and equal treatment to all taxpayers. There are, however, a couple of mitigating factors. The first is that the examiner should seek input in determining the thresholds from IRS specialists and the taxpayer. Furthermore, if the taxpayer disagrees with the materiality level, the taxpayer should ask to speak to the team manager. These steps should provide greater consistency between examiners in establishing materiality thresholds.

In conclusion, LIFE is a new process that offers a lot of benefits to both taxpayers and the IRS. It is a focused process that limits the scope of an audit through the use of a risk-based methodology and materiality thresholds. It encourages active participation by the taxpayer and a team approach to the exam. While LIFE is not appropriate for everyone, taxpayers should consider and discuss the appropriateness of LIFE with their examiner.

JAMES A. DOUGHERTY is Director, Tax Controversy Services for Deloitte & Touche LLP in Washington, D.C. He formerly served as National Director of Appeals for the Internal Revenue Service, and is a frequent contributor to The Tax Executive.

RONA M. FAUST is a Manager, Tax Controversy Services for Deloitte & Touche LLP in Washington, D.C. She is a frequent contributor to The Tax Executive.