The "new" IRS audits.

Editor's note: Mr. Ely is former chair of the AICPA Tax Division's Relations with the IRS Committee. Messrs. Taylor, turner and Parker are members of the IRS Practice and Procedure Committee.

The IRS realizes that the "old way" of conducting its audits will be changed forever once it fully realizes two new endeavors--the National Research Program (NRP) and the Small Business/Self-Employed Division (SBSE) audit reengineering project. The NRP replaces the notorious Taxpayer Compliance Measurement Program (TCPM). To meet the demands of these new compliance methods, both practitioners and the Service will have to be ready to make changes.

Reengineering the Audit Process

The IRS had recognized that rapid improvements in work practices in the private sector were far ahead of its methods of auditing returns. 111 2001, it began an ambitious examination reingineering project to completely rethink, redesign and modernize how it conducts audits. This was not only a good idea, but also a necessity; the IRS had not undertaken such a course of action since the early 1950s, when it established the current procedures.

To evaluate the project's concepts, it initiated a pilot program in October 2002 in New York. Although the pilot was supposed to be completed in March 2003, it is still ongoing. When it is completed, the Service will analyze the results and make adjustments before the SBSE rolls it out nationally. The overhaul. With the help of Booz Allen Hamilton, the strategy and technology global consulting firm, the IRS initially analyzed the leading practices of over 200 organizations from the public and private sectors and determined that it needed to redesign four areas:

* Case management;

* Inventory control;

* Risk-based auditing; and

* Standardized practices.

It also discovered that the following processes required improvement:

* Examination planning;

* Standardization of policies and procedures;

* Communications with taxpayers;

* Preplanning for the examination; and

* Manager involvement.

This analysis led to "key concepts" that the IRS will incorporate into the "new" audit process:

1. Return classification: This will be coordinated at the national level; by the time a case is assigned to an examiner, the audit issues will already have been designated by the classification function (CF).

2. Examination scope: The CF will designate specifically the issues the examiner will have to audit.

3. Manager involvement: Managers will be proactive, getting involved at the front-end, rather than reacting to problems as they unfold or at the conclusion of the audit. A group manager will approve audit plans any changes in an examination's scope. The manager and examiner will also determine the time that will be needed to conduct an examination and will project a completion date. This will be discussed with the taxpayer and/or representative at an audit engagement meeting.

4. Workpapers and templates: Workpaper formats and approaches to specific audit items will be standardized to ensure consistency in examinations.

5. Audit engagement meeting: This will be the initial meeting between a taxpayer and/or a representative and an auditor (and, in some cases, a group manager). The purpose is to reach agreement on how the audit will be conducted, and to discuss the (1) examination issues, (2) time frames for responding to information document requests (IDRs), (3) projected completion date, (4) "black out" dates when the practitioner and/or the taxpayer will be unable to meet and/or furnish information (e.g., vacations, year-end closing and "busy season") and (5) materiality of items to be examined.

Project's Effects

What does the SBSE examination reengineering project mean for practitioners and taxpayers? Because examiners will focus more on specific issues, taxpayers and/or their representatives will have to be prepared to provide appropriate documentation as the examination progresses. Because the examination's scope is set and controlled nationally, the auditor should not be able to adjust either the scope or the materiality of items to be examined without a manager's approval. The representative and/or taxpayer will also have to meet their obligations to the auditor for IDR response times, etc.

If a problem develops during the examination that cannot be resolved with an examiner, a manager should be brought in at once. If the issue cannot be handled with the manager, it can be elevated to the Office of Appeals under Fast Track Mediation with a group manager's approval, while the rest of the examination continues with the agent.

Importantly, taxpayers do not lose their appeal rights under the reengineering project's provisions: the bottom line for both practitioners and the SBSE is more cooperation and coordination from both parties, which promotes success, reduces audit time, ensures fairness and encourages taxpayer compliance (IR News Release 2001-68 (8/2/01)).

NRP

In addition to the SBSE audit reengineering, the other closely watched project is the NRP. This project, which began in fall 2002,is an IRS effort to determine how taxpayers are meeting their tax filing, reporting and payment obligations. It was initiated as part of the Internal Revenue Service Restructuring and Reform Act of 1998, which mandated that the IRS find ways of delivering services to taxpayers at much higher levels than in the past.

In setting strategic goals to meet its service objectives, the IRS identified "top quality service to each taxpayer in every interaction" as its first goal. To accomplish this, it had to find a way to measure taxpayer compliance. The program's initial steps aim at individual taxpayers; later on, the program will probably be expanded to cover various business taxes as well.

Unlike the TCMP which was a very intrusive and detailed audit that required taxpayers to substantiate every single item on a return, the NRP will select on a national basis, a statistically valid sample of approximately 50,0011 returns at various levels. The Service will use internal data to verify return items, to the extent possible. Approximately 8,000 of the sampled returns will not require taxpayer contact, as they will most likely be verified by the IRS's internal data. Approximately 9,000 returns will require correspondence, rather than a meeting with an auditor; roughly 30,000 returns will result in face-to-face audits. However, these examinations will probably be significantly less intrusive than the TCMP audits, because many of the return items will be verified by the IRS internally. Only selected return items will have to be fully substantiated, with appropriate documentation.

Finally, there will also be "calibration" audits, which will check about 2,000 returns nationwide on a line-by-line basis, but will not require substantiation for every item.

The IRS will use the NRP's results to recalculate discriminant function formulas, which means that NRP examinations will have to be thorough; see Internal Revenue Manual (IRM) 4.22.4.4.1 (10/1/02)). Line items subject to examination will have to be fully verified. If there are de minimis adjustments, they will have to be reported internally, but will not be part of any Revenue Agent's Report; see IR2Vl 4.22.4.4.3--De minimis adjustments (10/1/02)).

Taxpayers audited as part of the NRP retain all their appeal rights; thus, they can appeal unagreed issues.

At the NRP's conclusion, the IRS hopes to have current, reliable compliance data on filing, remitting payments and reporting, which will help it better use its resources to provide more efficient service to taxpayers in the most cost-effective manner possible.

FROM STEPHEN R, BUSCHEL, CPA, MBA, BDO SEIDMAN, LLP, NEW YORK, NY

Mark H. Ely, J.D., CPA

Partner

Washington National Tax

KPMG LLP

Washington, DC