IRS Within Its Rights to Increase Tax Due for Audit When Taxpayer Filed an Amended Return After Audit Report Was Accepted

In the case of Planty v. Commissioner, TC Memo 2017-240, the Tax Court found the IRS did not conduct an impermissible second examination barred by IRC §7605(b) when the taxpayers filed an amended tax return after accepting the original examination report. 

In effect, the taxpayer took a slightly bad situation (owing tax on an exam) and made it far worse (IRS determined they owed far more tax for the year in question) by attempting to amend the return for the year in question.

IRC §7605(b) generally bars the IRS from conducting multiple exams on the same tax year.  As the provision states:

(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.

The Tax Court summarized the facts in this case as follows:

On January 4, 2012, respondent sent petitioners a second revised examination report showing an amount due of $2,518. By notice dated May 7, 2012, respondent notified petitioners of an increase in tax of $2,755 and a balance due of $2,103 after taking into account an increase in a credit as well as additional interest. Respondent assessed the $2,755 increase in tax on that same day. On May 25, 2012, petitioners submitted a Form 1040X, Amended U.S. Individual Income Tax Return, for 2010, reporting a $4,091 increase in tax but, on account of additional withholding and a refundable credit, claiming an overpayment and refund due of $1,560. The Form 1040X, like the Form 1040, claimed a deduction for substantial real estate losses ($147,135 on the Form 1040X and $147,136 on the Form 1040). On September 5, 2012, respondent informed petitioners by letter that he had accepted the examination report that, previously, he had given to them (it is unclear to which report respondent is referring) and that he did not plan to make any additional changes to their 2010 return. Respondent did, however, treat the Form 1040X as petitioners' request for audit reconsideration, and he reconsidered the result of his prior examinations, determining not only that petitioners were not entitled to any refund but that they owed additional tax. In part, respondent's determination that petitioners owed additional tax was due to his disallowance of petitioners' $147,135 deduction for real estate losses. Respondent disallowed the deduction because of the passive activity loss rules found in section 469. On July 31, 2013, respondent mailed petitioners notice of the deficiency here in question, showing a corrected tax liability of $64,704 and including an adjustment disallowing the $147,135 deduction. Petitioners concede that the adjustment is correct.

While agreeing the final report is correct, the taxpayers argued that the IRS should be held to the first report, since after the exam was over the agency looked back at the information during which they discovered the passive activity loss issue.

The IRS argued, successfully, that they did not conduct a second inspection of the taxpayer’s books—rather they just looked at the records the agency already had in its possession from the exam and uncovered the new issue.  The provision is meant to prevent overly intrusive multiple investigations of the taxpayer’s records for the year in question.

As the Tax Court concludes:

Indeed, petitioners have presented no evidence that, in reconsidering his prior examination, respondent inspected petitioners' books and records. Nor can petitioners plausibly claim that an examination of the items reported on the Form 1040X was not necessary to evaluate their overpayment claim. Respondent's examination undertaken in response to the Form 1040X did not run afoul of [*6] section 7605(b). See Jackson v. Commissioner, T.C. Memo. 1982-556, 44 T.C.M. (CCH) 1213, 1218-1219 (1982).

The result here reminds us of the risks that result the longer that an examination stays open.  Had the taxpayers not filed the amended return, almost certainly the IRS would never have looked into the passive loss issue.  But by attempting to modify the result of the exam after it concluded, the taxpayers ended up allowing the IRS to uncover an issue that the agency had not originally uncovered as part of the exam.