IRS Has Right to Look at Records for Year Previously Examined to Verify Net Operating Deduction for Exam of Later Year

Beyond the simple issue that it may lead to an IRS claim that the taxpayer owes additional taxes, an IRS inspection of the taxpayer’s books and records is also simply a huge (and often expensive) inconvenience.  IRC §7605(b) is meant to limit that disruption by giving the IRS “one shot” at the records on an audit.

The provision reads as follows:

(b) Restrictions on examination of taxpayer

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.

However, in the view of the Seventh Circuit in the case of United States v. Titan International, No. 14-3789, 117 AFTR 2d ¶ 2016-389, (7th Cir. Feb. 1, 2016) that is one review of any specific books per exam not one inspection of that year's books covering all exams.

The IRS had inspected Titan’s 2009 books and records as part of its examination of Titan’s 2009 income tax return.  That year Titan had incurred a net operating loss that was carried to Titan’s 2010 return.

In February of 2014 the IRS, now conducting an examination of Titan’s 2010 income tax return, issued an administrative summons for those same 2009 books and records.  Titan refused to comply with the summons, citing §7605(b)’s above provision to hold that the IRS had already had their chance to look at the 2009 records and the IRS had not notified Titan that an additional inspection was necessary.

The appellate panel agreed with the District Court that the provision was not applicable in this case.  While Titan claimed the provision should limit the IRS to one inspection of the records created for each taxable year, the Court found that this isn’t the proper interpretation of the provision.

As the panel writes:

Titan's interpretation is disjointed and curiously omits some of the language of the statute. The key statutory phrase is this: “[O]nly one inspection of a taxpayer's books of account shall be made for each taxable year.” The more natural reading of this language limits the IRS to one inspection of a taxpayer's books per audit of a given year's tax return (subject, of course, to notice and a finding by the Secretary that a second inspection is necessary). Read in this more natural way, § 7605(b) does not bar the summons of Titan's 2009 records for the purpose of auditing its 2010 tax return.

The Court looked at two prior cases to illustrate the differences and limitations of what the IRS can do with the records.  The key issue is the IRS going back into the same records for another shot at adjusting that year and assessing tax on that year when there is no connection to the new year under exam.  The Court notes:

In Reineman v. United States, the taxpayers purchased six horses in 1954 for their horse-breeding business. 301 F.2d 267, 268 (7th Cir. 1962). They then deducted the entire cost of the horses on their 1954 tax return. Id. In 1956 the IRS audited the 1954 tax return and adjusted that deduction. Id. at 269. Later the IRS audited the taxpayers' 1955 tax return; in the process the agency reopened the 1954 audit (without written notice from the Secretary) and again adjusted the deduction for the six horses. Id. at 269-71. The 1954 records inspected by the IRS to adjust the deduction for the second time were wholly irrelevant to the 1955 audit. Id. at 271. We concluded that the second inspection of those records violated § 7605(b) because it was an “additional inspection” of the taxpayers' books for the purpose of reopening the 1954 tax return. Id. at 272.

In contrast the panel cited another case, this time involving basis:

The second relevant case is Digby v. Commissioner, 103 T.C. 441 (1994). There the IRS audited a married couple's 1987 tax return and allowed them to claim a pass-through loss for that year from their S corporation. Id. at 443. In the course of that audit, the IRS inspected records showing the couple's basis in its S corporation stock. See id. at 444. The IRS later audited their 1988 tax return, a year in which the couple claimed another pass-through loss from the same S corporation. Id. To complete this audit, the IRS necessarily summoned the same basis records it inspected for the 1987 audit; as the tax court explained, the agency was “in possession of the information necessary to make a [basis] determination for 1988 and/or 1987.” Id. at 448. Based on these summoned records, the IRS determined that the couple's basis was inadequate to support the pass-through loss for 1988 and 1987, despite its prior 1987 audit. Id. at 445-46. The IRS therefore disallowed the pass-through loss for both years. Id. at 446.

The tax court concluded that the second inspection of the records was not a violation of § 7605(b) because that inspection was undertaken for the purpose of examining the 1988 tax return, and—unlike Reineman —those records were necessary to complete that audit. Id. at 448-49. The court ruled that an additional adjustment of the tax return for an earlier taxable year is not a violation of § 7605(b) so long as it was not coupled with an additional inspection of the taxpayer's books for the purpose of adjusting that year's tax liability. Id.

The panel then concludes that Titan’s situation is closer to the second than the first, noting:

The IRS first inspected Titan's 2009 records to verify its net operating loss in connection with an audit of its 2009 tax return. The IRS now seeks to inspect those same records for the purpose of auditing Titan's 2010 tax return in order to determine the validity of its 2010 net-operating-loss carryforward. Much like the pass-through loss at issue in Digby (and unlike the deduction at issue in Reineman), the net-operating-loss carryforward on the 2010 tax return cannot be verified unless the IRS inspects the 2009 records.