A Simpler ‘Life’ for Some Business Taxpayers

By Matthew Monippallil

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On December 4, 2002, the IRS announced an accelerated examination process for selected business taxpayers with assets exceeding $10 million. The Limited Issue Focused Examination (LIFE) is a simpler, streamlined method that restricts the scope of examination to mutually agreed-upon material issues. The process formally incorporates the best practices developed by the IRS in its attempts to be more efficient, customer friendly, and professional in its compliance efforts.

The new audit process is designed to substantially reduce time, expense, and disagreements by focusing on important issues and permitting the IRS to direct its resources to higher-risk areas. Additionally, LIFE provides consistent and fair taxpayer treatment, encourages open communications with the IRS, and increases cooperation with the examining team.


LIFE is available to selected taxpayers. All large and medium-size businesses facing IRS scrutiny may seek participation in LIFE; approval is not always granted. Some LIFE features are incorporated into the audit process even when a taxpayer is not selected.

Excluded from the LIFE program are taxpayers with a significant number of material issues outstanding during the audit; taxpayers that have been uncooperative in the past and shown little or no inclination to change their behavior; and “game-playing” taxpayers, fraudulent taxpayers, and participants in abusive tax shelters.

The IRS audit team will conduct a comprehensive risk analysis to identify the range of issues that need to be resolved. In close consultation with IRS specialists and a team manager, the audit team will determine the material issues that pose the greatest compliance risk. If the taxpayer is an appropriate candidate for LIFE, the range of issues uncovered during the comprehensive risk analysis and the material issues to be addressed and resolved during the audit will be presented. Both parties will discuss and negotiate the selected issue materiality thresholds for the examination, and prepare for their resolution.

Materiality Thresholds

Crucial parts of the new audit approach include determining the issues to be examined and setting the materiality thresholds. There are no common materiality thresholds for taxpayers. As a general rule, lower materiality thresholds apply to permanent or recurring items and higher thresholds apply to items affecting longer periods of time.

The IRS will not establish common materiality thresholds for industries or businesses, and a threshold established for one tax year may not be valid the following year. The IRS will usually agree to identical thresholds covering multiple tax years under examination except when an acquisition substantially increases the taxpayer’s size.

Taxpayers cannot benefit from materiality thresholds if the examination indicates fraud, abusive tax shelters, or activities contrary to public policy. Nor will a threshold apply when a taxpayer has a recurring problem or a problematic policy, such as erroneously expensing all acquisitions of machinery and equipment when purchased. In such a case, the taxpayer must furnish information on all acquisitions of machinery and equipment by all entities for all tax years under audit.

Taxpayers are well advised to request a waiver of certain traditional audit procedures, including income probes and inventory analysis, in order to streamline the process. Taxpayer requests not withstanding, the IRS will not grant waivers from examining prior, subsequent, or related tax returns.

Because the selection of the issues to be examined and the determination of their materiality are not unilateral but are subject to negotiation, taxpayers should participate in preliminary discussions to determine the scope of the examination.

Memorandum of Understanding

A memorandum of understanding is executed by the taxpayer and the manager of the audit team. The memorandum sets forth and controls all important aspects of the audit and specifies the responsibilities of each party. It binds both parties to act in good faith and work diligently toward a timely completion of the examination. Both parties agree to abandon all claims and affirmative defenses below the materiality thresholds and to participate in alternative dispute resolution tools such as fast track appeals, accelerated issue resolution agreements, and early referral appeals.

The principal promises made by the audit team in the memorandum of understanding are as follows:

  • The scope of the audit will not be expanded without approval from the team manager.
  • At the earliest opportunity, the IRS team will furnish the taxpayer with a list of specific accounts, transactions, and Schedule M items that are expected to be examined.
  • Information Document Requests (IDR) will not be sent without prior discussion with the taxpayer.
  • A Notice of Proposed Adjustment (NOPA) will not be issued without meaningful discussions of the facts and the technical positions adopted by both parties.

In return, the taxpayer promises to do the following:

  • Brief the audit team regarding the industry, company structure, financial performance, accounting records, significant events or transactions, and workpapers and supporting documents for selected accounts or transactions, as specified by the IRS;
  • Furnish the audit team with schedules and computations covering all agreed-upon rollover and recurring adjustments from previously examined years;
  • Change a previously established materiality threshold that was found to be invalid by the audit team;
  • File all claims and affirmative defenses with supporting documentation by mutually agreed-upon dates;
  • Respond to any IDR within the agreed response time; and
  • Expand the scope of the examination to include any previously nondisclosed abusive tax shelter or listed transaction discovered during the course of the audit.

Once the memorandum of understanding is executed, LIFE may be terminated only for significant or repeated failures to comply with the terms of the agreement. In the event of termination, the IRS will revert to the traditional, broad-based examination.

LIFE seeks to avoid the adversarial approach often encountered in IRS examinations and to utilize best-practices methods for resolving issues with taxpayers. The new policy views audits as necessary business transactions that may be conducted without unnecessary acrimony, cost, or delay when both parties are committed to mutual respect, good faith, and fair dealing. LIFE presumes that audited taxpayers are willing to cooperate and participate in a businesslike manner, and is the most recent and welcome example of the IRS’ major culture shift.

Matthew Monippallil, JD, CPA, is a professor and director of the accountancy program at Eastern Illinois University, Charleston, Ill.




















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