Election of Subchapter S status allows a business the advantages of the corporate structure of organization without being subject to the potential tax disadvantages of C corporations. Examples of these advantages include: exclusion from the double taxation on distributions and liquidations and the ability for the shareholders to use corporate losses. IRC 1361(a)(1) defines an "S corporation" , with respect to any taxable year, as a small business corporation for which an election under IRC 1362(a) is in effect.

TEFRA was passed in 1982 to allow examinations and statutes to be controlled at the partnership level. TEFRA was replaced by the centralized partnership audit regime in the BBA for tax years beginning after December 31, 2017. Certain small partnerships and S corporations are not subject to TEFRA. The period to assess investors of entities not subject to TEFRA or BBA is determined at the investor level.

BBA applies to all partnerships, but allows some eligible partnerships to elect out. Partnerships that elect out of BBA require investor level statute control. Partnership returns beginning after November 2, 2015 and before January 1, 2018 may elect into BBA. BBA does not impact S corporation entity examinations.

There are four possible partnership regimes:

PCS is a database that was created to establish an electronic linkage between pass-through entities and their underlying investors. This helps ensure that all investors are noticed and adjusted in a timely manner. PCS linkage allows Business Operation Divisions (BODs) to recognize when a taxpayer is subject to a pass-through examination. If an examiner chooses not to control investors returns, it allows the campus to work those investors so the examiner can focus on examining the pass-through entity. PCS also allows the campus to systemically generate notices, control statutes, and gather closing information.

Linkage policy was established in response to the partnership provisions of the TEFRA. Similar policies exist for S corporations and those partnerships that elect out of BBA.

The Director, Examination Field and Campus Policy (EFCP) is responsible for:

The Program Manager, SB/SE Examination - Field and Campus Policy, Campus Exam and Field Support (SE:S:E:HQ:EFCP:CEFS) is responsible for:

Field Territory Managers, Field Area Directors, Director over LB&I Ogden and Director, Examination - Brookhaven, are responsible for ensuring that linked pass-through policies and procedures are followed.

Field Examination Managers and Campus Field Support Operations managers are responsible for:

Following are specific Campus Pass-through Function (CPF) ILSC Coordinator responsibilities:

The campus PCS Coordinator is charged with:

Program Reports: Each year an exam plan is created for pass-through examinations.

Program Effectiveness: The exam plan is monitored to ensure the linked pass-through examination objectives are met. Open partnership examinations are monitored to ensure the correct audit regime is recorded on ERCS.

The Audit Inventory Management System (AIMS) provides a statute report, AIMS Table 4.0, that the field monitors to ensure field controlled investor cases are worked timely. See IRM 4.4.27.5 , AIMS Reports Generated at the Campuses.

There are several terms unique to PCS linked returns. Examples of these words:

The following IRM cross-references may be helpful:

S corporations are not subject to TEFRA or BBA. All S corporations are ILSC examinations, however the S corporation may also be a partner in a partnership under examination and subject to those regimes as a partner.

IRC 1361(a)(1) defines an "S corporation" , with respect to any taxable year, as a small business corporation for which an election under IRC 1362(a) is in effect. A corporation elects S corporation status by properly completing Form 2553, Election by a Small Business Corporation. When an election is filed and accepted by the campus, transaction code (TC) 090 is assigned on BMFOLE and the entity's "1120 filing requirement" changes from "01" (indicating an 1120 return is due) to "02" , (indicating that it has an S corporation filing requirement).

Generally, an S election can be made at any time during the prior year or on or before the 15th day of the third month of the taxable year. A corporation may qualify for late election relief under Rev. Proc. 2013-30. Examiners do not have the authority to grant a late election. So, if the corporation qualifies for late election relief, contact the S corporation Specialist by sending an email to sbse.scorp.inquiry@irs.gov. The S corporation Specialist will work with the campus to consider the request and (if granted) establish the effective date of the S election. If the corporation does not qualify for late election relief their only recourse is to request a Private Letter Ruling. See S corporation S Election Identification & Late Election Relief Issue Guide for additional information.

For more information on S corporation issues, Issue Guides and Audit Tools visit the S Corporation Knowledge Base. This site provides extensive resources to help examiners with their examinations. Some of the resources include S Corporation Issues Guides that address many issues identified in S corporation examinations.

Subchapter K governs the formation, operation and termination of partnerships. Due to the flexibility afforded by Subchapter K, the partnership entity often becomes the vehicle of choice for abusive transactions.

For more information on partnership issues, resources and training materials visit the Partnership & TEFRA IPG or for a great resource on partnerships see the Partnership Knowledge Database.

The Form 15260, Determination of Pass-through Audit Regime, is required to be used for the identification of returns as TEFRA vs. ILSC. It is necessary in order to have a valid assessment of tax because the TEFRA and BBA partnership rules and the deficiency procedures that ILSC entities fall under are different. If the Service applies the wrong procedures, e.g., erroneously proceeds as TEFRA at the partnership level rather than deficiency procedures at the investor level, or vice versa, barred deficiencies and/or refunds can result.

Form 1120S returns are not subject to TEFRA by statute.

For Form 1065, the examiner must determine, for each taxable year, whether TEFRA, BBA, or ILSC procedures apply. Comments on Form 4318, Examination Workpapers Index, are required from the examiner as to whether the pass-through return is TEFRA or ILSC, and the reasons supporting this conclusion. The Form 15260, Determination of Pass-through Audit Regime, which is required to be completed will assist the examiner in making the determination.

The small partnership exception applies to partnerships or LLCs treated as a partnership, consisting of 10 or fewer partners or members, each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner.

Generally, most S corporation income is allocated to individual shareholders. It is possible for an LLC, owned by a single individual member, and certain trusts to be a shareholder in an S corporation. The Schedule K-1 may reflect the LLC or trust name and identification number rather than the individual to which the income is reported. In order to properly link the case, it is extremely important that the true shareholder is identified; the individual, trust (in the case of an Electing Small Business Trust) or estate to which the income should be reported. If the examiner cannot look at the Schedule K-1 and determine who is reporting the pass-through items, the Campus will not be able to determine it either. See also IRM 4.31.5.10.1, True/Taxable Investor Statutes (Trusts and Disregarded Entities).

There are a variety of command codes that can assist with pass-through examinations.

Audit codes exist for each return type. They are specific codes to help identify specific characteristics of a tax return. They are available for use in filtering returns for classification.

Audit codes can be found on a BRTVU or BMFOLR print. Examiners may want to review these codes on the year(s) under exam as well as prior and subsequent years to identify potential issues and gauge audit risk.

Audit codes currently assigned to S corporations can be found in IRM 3.11.217.13.1; for partnerships, they are located in IRM 3.11.15.19.1.

Audit code 4 is an indicator that the entity filed an improper return based upon its filing requirement. In order for there to be an S corporation filing requirement, an S election must be on file. See IRM 4.31.5.2.1.1, S Corporation Filed – Campus Processed as a C Corporation.

If the type of entity on the investor’s Schedule K-1 is “Limited Liability Company”, the agent should always check for MFT 02 on a BMFOL or check on INOLET to see if the type of return required is Form1120, as it would be if the LLC partner has elected to be treated as a C corporation. If it has elected to be treated as a C corporation for Federal tax purposes, it will be treated as a C corporation for purposes of making an election out of BBA, and for the small partnership exception under TEFRA partnership rules.

To secure missing Schedules K-1 the examiner needs to ascertain whether the return was filed via paper or electronically. Use IDRS command code TRDBV. In the upper right-hand corner of the document, it states by form type and tax year one of the following:

yK1 is a valuable tool for larger entities. It allows the user to evaluate the size of the partnership structure. It can help the examiner determine the impact of an adjustment on the underlying partners.

The yK1 tool is an Interactive Software Tool and Database which uses Schedule K-1 data from pass-through returns to visually depict relationships and income/loss allocations from pass-through entities to their owners. The data provided helps users visualize complex corporate and pass-through structures.

The yK1 Program is a useful tool in planning the scope of the audit. The graphs help the examiner identify related entities and returns of interest. In additional, looking beneath the graph to the entity’s return transaction file (RTF) and Schedule K-1 data may help determine if there are potential issues worth pursuing. There are 10 years of data available.

To gain access, submit a BEARS (Business Entitlement Access Request System) requesting the following program:

Once the a BEARS request is approved, the examiner may access the yK1 Application. The examiner will have access to user guides and other assistance once they enter the system.

Whether an individual taxpayer, a corporate taxpayer or a pass-through entity is assigned, it is important to ask questions concerning related entities. The examination scope should be modified to establish if what is reflected on the return is accurate and complete.

If the taxpayer has transactions with related entities in which they can exercise control, it is important that the examiner understand the transactions fully. It is not suggested that when the examiner initiates an examination that all related entities be automatically placed under examination. During the initial interview, ask the taxpayer about ownership in related entities and about transactions occurring between entities. All entities should be reviewed to gain an understanding of what transactions occur between them. If material transactions involving related entities are discovered, ask questions to help establish the facts about these transactions. Also, analyze the transactions. A yK1 printout can be secured to see the big picture when looking at related returns. External websites can also assist in determining information about the taxpayer.

With related party transactions, it is important to look at the whole picture to determine the proper tax treatment of the transaction(s). In general, documents can be requested from another entity that pertain to a related transaction if it supports a deduction being claimed on the taxpayer’s return without placing the other entity under examination.

Compliance checks require inspection of related returns including required filing checks. See IRM 4.10.5, Required Filing Checks. During inspection of the investor’s returns, it is important to remember the impact of loss limitations:

Employment tax returns should be reviewed to establish that they were properly filed and that amounts reflected agree with the pass-through entity’s return. In addition, consideration should be made as to whether the S corporation shareholders have been properly compensated.

PCS was created to monitor and control pass-through entity investors. Pass-through entities can have many investors and many levels of tiering. Tiering occurs when an investor in a pass-through entity is also a pass-through entity. This complexity can make it difficult to keep track of statutes and monitor all the investors. PCS establishes an electronic link between the entity and it’s investors. When the link is established a PICF Code will appear on it’s AIMS record.

An AMDISA should be secured for each investor to determine if the investors are controlled by another area. A PICF code indicates linkage has been established with at least one key case, though it will not state the key case. The AMDISA will also show the investor’s statute. Since an AMDISA only shows the PICF Code, requesting a CC TSUMYI will show the entities to which the investor is linked. There may be more than one linkage. See IRM 4.31.5.12.2 – Pass-through Control System (PCS)

It is important to know if investors are subject to adjustments from more than one pass-through examination due to ILSC statute considerations. ILSC adjustments require deficiency procedures. It is best that only one statutory notice of deficiency be issued per investors to avoid barring statutes.

For tax years prior to 2018, ILSC entities can be an investor in a TEFRA partnership, thereby causing the S corporation or partnership to also be subject to TEFRA proceedings. For tax years 2018 and subsequent, S corporations can be investors in partnerships that elect out of BBA. Examiners should check PCS to see if their entity is linked to any open TEFRA key case. Request IDRS command code TSUMY. TSUMY with definer code "I" (PCS investor case) will show the cases to which the ILSC entity is linked.

TSINQ command code provides complete PCS information and partial AIMS information for all of the various types of linkages; that is key cases, investors and tiers. Definers P shows the entity information and I shows the individual information.

When an investor is linked to an entity on PCS, a Form 5546, Examination Return Charge-Out Sheet, will be generated and sent to the area controlling the investor return. The Form 5546 will show the TIN, MFT and Tax Period of the entity to which the investor was linked. This may be the entity being examined or may be a pass-through investor.

If the ILSC entity is linked to another entity, contact the CPF ILCS Coordinator for assistance.

The Elect Out of BBA Code is required on all partnership tax years beginning after December 31, 2017, with MFT Code 06 or a NMFT of 35. The Field Values are as follows:

There is a TEFRA indicator on ERCS that must be entered for anyForm 1065 for tax years prior to 201812. The return cannot be updated beyond status 12 until the TEFRA indicator is entered. The TEFRA Indicator should be considered "Not Applicable" for all partnership records with a tax period of 201812 and later.

The TEFRA indicator should be entered on the system as soon as the TEFRA determination is made, but no later than 60 days after the case is updated to status 12.

The RA should request that the manager and/or secretary set the TEFRA indicator through the "correct and display" screen on ERCS. The TEFRA indicator can be set or changed on this screen. See IRM 4.7, Examination Returns Control System (ERCS), for further information.

The TEFRA indicator is required on all partnership tax years beginning before January 1, 2018 with a Master File Transaction (MFT) Code of 06 or a Non Master File Transaction (NMFT) Code of 35. The Field Values are as follows:

As with any taxpayer, the statute of limitations should be verified. The AIMS database will generally reflect a statute based on 3 years from the date the S corporation’s return was filed. S corporation examinations are not subject to the TEFRA or BBA audit regimes, so statutes are generally controlled at the shareholder level.

Generally, when auditing an S corporation it is the examiner’s responsibility to protect the entity statute and all shareholders’ statutes. If adjustments result from the S corporation examination, the examiner will need to control the shareholder(s) return(s) or link the shareholders on PCS to the corporate return. When linked on PCS, any shareholder returns not currently on AIMS will be established on AIMS and controlled to the CPF. The CPF is responsible for protecting the statutes of the shareholders they control.

In "Bufferd v Commissioner " 506 U.S. 523, 113 S.Ct. 927(1993) the Supreme Court held that the limitation period for assessing the tax liability of a Subchapter S corporation shareholder who claimed pass-through items, began to run from the filing date of the individual return and not the filing date of the corporate return.

In determining whether the corporate statute needs to be protected, in addition to the shareholder level statutes, examiners should first determine whether the entity is a C corporation or is a taxable S corporation. The S corporation may be a taxable entity and have its own statute which needs to be protected. An example of when an S corporation would be a taxable entity is when it is subject to the Built-in Gains Tax of IRC 1374 or the Excess Net Passive Income Tax of IRC 1375. Form 14769, S Corporation - Statute Analysis Tool can be used to assist with determining the correct statute.

If there is any chance that there is a corporate level tax or there is an invalid S corporation election, protect the corporate statute. Form 872, Consent to Extend the Time to Assess Tax, is used to control the corporate statute – whether it is an S corporation or C corporation.

Often the entity will have a different statute from its investors. If the investor statutes are shorter than the entity statute, steps should be taken to ensure the investor statutes are protected. Investor statutes must be protected by the examiner (establish group control on AIMS) whether linked on PCS or not.

The entity level statute may also need to be protected to assert entity level penalties. Applicable entity level penalties include IRC 6707, Failure to furnish information regarding reportable transactions, IRC 6698, Failure to file partnership return, and IRC 6699, Failure to file S corporation return. The failure to file penalty is normally assessed by the Campus but occasionally it will need to be assessed by an examiner. See IRM 4.31.5.14.1.4.4.7, Who Asserts the Penalty.

Protect the entity statute if the entity has the potential of being a taxable entity or may be subject to entity level penalties. Secure a consent from the S corporation or Partnership for entity level taxes or penalties, on Form 872, Consent to Extend the Time to Assess Tax. Please note if the IRC 6707A penalty is applicable, there may be special language required. IRM 25.6.22.6, Preparation of Consents for Specific Entities and Taxes.

Form 872 is used to extend the ILSC entity statute – whether it is an S corporation, a partnership with a valid election out of BBA or a non-TEFRA partnership.

The "Kind of tax" line on Form 872 for a corporation will be "income" if one or more of the following situations apply to the entity:

If the entity is subject to a penalty, then the applicable penalty will be specified on the "Kind of tax" line. IRM 25.6.22.5.4, Kind of Tax. Additionally, the phrase "tax due" after the "Kind of tax" space must be changed to reflect the phrase "penalty due" .

Alpha code "GG" is a two-digit code designating that the ILSC entity statute is controlled by the individual investors. Alpha Code GG can be used to update the entity statute on AIMS if it is determined that the entity does not come within the BBA or TEFRA provisions or there is not an entity level statute (i.e., the entity is not taxable). For BBA see IRM 4.31.9, and for TEFRA see IRM 4.31.2.

Alpha statute "GG" should be used only if all of the following items are confirmed:

Generally, Form 5348, AIMS/ERCS Update, is used to update the statute date to alpha code GG. For example, if the three-year corporate statute would normally expire March 15, 20XX, the statute date on the Form 5348 would be updated to 03GG20XX.

Document the determination of the statute before updating the statute to GG on Form 895. Notice of Statute Expiration.

Always exercise caution in updating the statute to any alpha code. Once an alpha code is input, the statute will not be reflected as imminent on Statute Expiration Reports. Improper use of an alpha code may result in a barred statute. Any time a case is received with an alpha statute, steps should be taken to verify that it is correct.

Remember, the ILSC pass-through alpha code "GG" should only be used when all investor statutes are protected.

As indicated above, alpha code "GG" is a two-digit code designating that the ILSC entity statute is controlled by the individual investor statutes. Generally, when the entity statute is updated to alpha code GG, it relates to the same entity year of its investors. However, when a carryover deduction (e.g. NOL, capital loss, passive activity loss, charitable contribution, credit) is involved, it is possible for the GG date to relate to a closed statute year of its investors. This is because the statute with respect to the carryover deduction is the year the deduction is claimed, but may require an adjustment to an item on the entity’s Schedule K-1 (such as the amount or character of a loss) in the year the deduction was created.

PLR 9504032 stated that when an NOL deduction is made up entirely of carryovers from prior loss years, the relevant year for statute of limitation purposes is the year in which the deduction is eventually taken, not the loss years. The fact that the loss year is closed for statute of limitations purposes is irrelevant since the relevant limitations periods are, or will be, those years to which the losses are carried and used as NOL deductions.

"State Farming Co., Inc. v. Comm’r" , 40 TC 774 (1963) held that the Commissioner may disallow net operating loss carryforwards by adjusting income in years prior to those covered in statutory notices of deficiency even though the relevant prior years are barred for deficiency purposes by the statute of limitations.

The statute of an ILSC entity resides with that of the investors. Even when the entity and investor statutes have expired (based upon the entity filing and the investor filing), there is an open statute with respect to the deduction carryover claimed by the investor.

The true/taxable investors are the individuals or entities who are responsible for reporting the items of income, loss, deduction and credit passing through from the ILSC entity return. It is important that their statutes be protected.

A non-TEFRA partnership investor must be a natural person, C corporation, or an estate of a deceased partner. Thus, there should be no issue in identifying the true/taxable investor of a non-TEFRA partnership.

BEO partnerships may only have individuals, and estate of decedent, and S corporations as direct partners. They cannot have direct partners that are trusts or disregarded entities.

For S corporations, most shareholders are individuals. However, it is possible for a LLC, owned by a single individual member, and certain trusts to be S corporation shareholders. The Schedule K-1 may erroneously reflect the LLC or trust name and identification number, rather than an individual who is responsible for reporting the Schedule K-1 amounts.

It is important to protect the true/taxable investor statute. Generally, only the true/taxable investor statute, versus the trust or disregarded entity, must be protected –

If the examiner cannot determine the true/taxable investor by looking at the Schedule K-1, ask the representative or S corporation to clarify who is reporting the pass-through items from the S corporation. It is the responsibility of the S corporation to substantiate that all shareholders are qualifying shareholders, as an invalid shareholder will terminate the S election.

Generally, all ILSC pass-through investors must have their statutes secured. However, there are times when it is clear that not all investors will be affected by an adjustment. When this occurs, Form 15041, ILSC Pass-Through Entity Intent Not to Pursue Investor - Statute Protection, may be used to secure approval to let an investor statute expire. Investors will not be linked on PCS if their statutes are allowed to expire.

The examining agent or the campus may identify investors that may not be subject to adjustment and may not require statute protection. When this occurs, Form 15041 will be used to:

Approval must be secured prior to the expiration of the investor’s statute, and ideally at least 12 months prior. See 25.6.23.4.5.1, Inconsistent Application of Investor Returns - ILSC.

The initiator of the Form 15041 must not only have their manager sign in agreement with the decision to not protect the statute, but must also have their Department Manager or Territory Manager sign the agreement as well. The higher level of approval is necessary since the statute will be allowed to expire.

Allowing an investor’s statute to expire may make sense if it is highly likely the investor will not be adjusted. This will save resources and reduce taxpayer burden. Protecting such an investor will result in unnecessarily contacting them, and potentially requesting statute extensions or other communication. ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡

The campus may contact the examining agent to gain their concurrence if they think an investor’s statute doesn’t need to be protected. The examining agent may have other information that would require the statute of a investor to be protected that not might not otherwise appear to need protecting.

If an investor’s statute expires while the S corporation and partnership is under examination, the statute of the pass-through entity is deemed as having not been properly protected, unless the decision to allow the investor statute to expire is properly document [with Form 15041] prior to its expiration. See 25.6.23.4.5 Responsibility for Investor Returns - Investor Level Statute Control. When the investor statute is not properly protected the IRS is prevented from making adjustments to the investor’s return based on items reported on the return of the S corporation or ILSC partnership. If an investor’s ASED does expire and an assessment cannot be made, examiners should refer to IRM 25.6.1.13, Barred Assessments/Barred Statute Cases, (or other procedures required by their organization) for procedures to prepare and submit Form 3999, Statute Expiration Report.

The examiner needs to file a Form 3999, Statute Expiration Report, if any investor’s statute, not linked and controlled in the campus, expires during the entity examination; regardless of whether the investor was controlled on AIMS. Investors whose statutes are allowed to expire by using a properly approved Form 15041 are not considered to be barred.

To ensure all investor statutes are protected, the case must either be linked (see IRM 4.31.5.12.2.4, When to Link the ILSC Key Case on PCS) or the investors must be controlled by the examiner. Whether to link or control a case should be considered early in the examination.

All open investor statutes should be protected. Generally, the examiner should treat all investors consistently and make the appropriate pass-through entity adjustments to the investors’ returns. However, there are times when one investor statute has expired prior to the start of the pass-through entity examination and another investor statute has not. There is nothing preventing an examiner from making adjustments to the investor whose statute is open when another investor statute has expired. When placing the entity on AIMS, the Form 895, Notice of Statute Expiration, should indicate any investors’ statutes that expired before the pass-through entity examination began.

Approval may be obtained to allow an open investor statute to expire through use of Form 15041, ILSC Pass-Through Entity Intent Not to Pursue Investor – Statute Protection. Approval is sought by obtaining the concurrence of the examiner’s Territory Manager or Campus Department Manager. Approval must be obtained prior to the expiration of the investor’s statute and, whenever possible, should be secured at least 12 months prior to the expiration of any investor’s statute. IRM 25.6.23.4.5.1, Inconsistent Application for Investor Returns - ILSC.

Generally, restricted consents are not recommended on a pass-through entity and investors that are subject to a pass-through entity examination as it can present some hazards. If a request for a restricted consent is received the examiner should obtain Area Counsel approval. See IRM 25.6.22.8.6, Area Counsel Approval. If the examiner proceeds with the restricted consent, they should, include the language provided in IRM 25.6.22.8, Restricted Consents, and obtain group manager approval.

Research the investor for other linkages. If other linkages exist, a restricted consent should not be considered as it may limit the ability to make other pass-through adjustments.

There is a restricted consent indicator on AIMS that signifies if a restricted consent is secured. An "R" will follow the Statute Date if a restricted consent was secured. If an extension was secured with no restriction, an "X" will follow the Statute Date.

No other restricted issues may be added after the original IRC 6501 statute has passed.

If it can be shown that a taxpayer understated their gross income by 25 percent, a special 6-year statute applies per IRC 6501(e). On a non-taxable, ILSC entity return, the computation of the substantial understatement will be made at the investor level.

The general rule is the investor’s gross income includes the investor's pro rata share of the pass-through entity's gross income. Treas. Reg. 1.1366-1(c)(1). Gross income for a business is the total amount of sales received or accrued prior to the reduction for cost of goods sold.

In determining whether an individual has a substantial understatement of income, the examiner would total the gross income reported on the individual tax return and compare it to the correct total of gross income.

The following items would be totaled in arriving at the investor’s gross income:

In establishing a 25 percent omission of income case, the burden is on the government. An item other than an overstatement of basis is not considered omitted from gross income if the taxpayer adequately disclosed the item on the return or on an attached statement. The disclosure must adequately apprise the Service of the nature and approximate amount of the item; the actual dollar amount of the omission need not be disclosed. An understatement of gross income caused by an overstatement of basis is an omission from gross income for the tax period for which the assessment statute was open on July 31, 2015 and for returns filed after July 31, 2015.

Due to the requirement to use the proportionate share of gross receipts, it may be difficult to trigger the 25 percent omission rule where the individual investor reports the distributive share of income or loss of the S corporation or partnership ownership interests.

On the other hand, this gross income test could actually trigger the 6-year statute if the investor failed to report his entire share of the entities pass-through income.

Based on Treas. Reg. 1.1366-1(c)(2), the amount of gross income reported by the investor depends on whether the investor reports all of their pro-rata share of pass-through income. If all of the pass-through income is not reported, then all of the gross income for the 25 percent omission test has not been reported.

Be careful when computing substantial understatement of income, especially relating to pass-through entities. The pass-through entity’s gross income versus pass-through taxable income should be used in the calculation. Situations where an individual fails to include their entire share of S corporation or partnership income can result in a 25 percent omission of income. It is recommended that Counsel approve computations prior to expiration of the normal three-year assessment statute if any uncertainty exists.

CCA 201333008 addressed items disclosed on an amended return. It concluded that the determination of whether the six-year statute applies is made at the time the original return is filed. Information discovered or provided by the taxpayer after that return is filed (for example, during an audit, on amended returns, or on subsequent information returns), regardless of whether such information would ordinarily be considered disclosed, is only includable if it is filed with, or prior to, the return of the taxpayer.

The examiner will issue a regular appointment letter confirming the initiation of an examination with an accompanying Information Document Request (IDR). If, within 120 days, the examiner and their manager have determined that PCS linkage will not be used, the examiner will request exam controls for any investor returns that are not already controlled by the examiner.

If an investor return is being controlled by another examiner outside of the exam group the ILSC entity must have PCS linkage. The CPF will use Form 6657, Related ILSC Pass-through Examination, to send a Schedule K-1 to the examiner outside of the exam group. It is also recommended the agent examining the pass-through entity reach out to the agent controlling the investor.

The entity return cannot be surveyed once the examination has started and time has been applied on the case and the entity is notified of the examination. The investors should be sent notification of the examination by the examining agent, or by the CPF when they are linked.

The PCS was created to establish an electronic linkage between pass-through entities and their underlying investors. This helps ensure that all investors are issued notices and adjusted in a timely manner. PCS linkage allows Business Operation Divisions (BODs) to recognize when a taxpayer is involved in a pass-through examination. If an examiner chooses not to control the investors, PCS linkage can be established. It allows the campus to work those investors so the examiner can focus on the pass-through entity examination. PCS also allows the campus to systemically generate notices. PCS linkage assists with statute control and gathering pass-through entity business results.

PCS does not replace AIMS inventory control, but it provides the additional information needed to control investor and pass-through returns. It interfaces with AIMS to establish returns, access information, and provide mass updates to AIMS.

PCS allows an unlimited number of investors to be linked to each key case or tier and allows an investor to be linked to an unlimited number of pass-through entities. The linkage charges the returns to the appropriate area office or CPF. In addition, it places the pass-through entity Partnership Investor Control File (PICF) Code 2 on the key case on AIMS and ERCS databases. It also places an investor PICF Code of 6 on AIMS and ERCS databases so that any other part of the service can see that an entity related to the investor return is under examination. The PICF code appears on AMDISA. This prevents premature closure of an investor return until all key case issues are resolved. It should also prevent improperly restricted statute extensions. See IRM 4.31.5.11.1 – Restricted Consents.

The campus will input an H freeze on the pass-through entity as part of the linkage process. The H freeze will appear on the key case AIMS transcript when PCS is established. This prevents premature closure of the ILSC key case until investors are addressed.

The PCS is described in the text of IRM 4.29, Pass-through Control System (PCS) Handbook.

If the examiner has not determined that the examination will result in a No-Change within 120 days of the initial interview they should prepare a linkage package and submit it to their manager. The group manager will review the package for timeliness and accuracy. The group manager will indicate approval by signing the Form 14092 or Form 14093.

The examiner should make every effort to have the linkage package in the hands of the campus at least 12 months before the expiration of the shortest investor statute in order to be controlled by the CPF.

It is important to remember that when a key case is linked, all material investors will be linked no matter where they are controlled. Establishing the pass-through entity on PCS does not require the investor returns be controlled in the campus.

The linkage package should alert the CPF if any material partners have not filed or have processing problem with their return.

The requirement for consistency or notification of inconsistent treatment is contained in IRC 6037(c) for S corporations and IRC 6222(a) for TEFRA and BBA partnerships. They require that the investor’s return be consistent with the entity return – or that the Secretary be notified of any inconsistencies. IRC 6222(a) does not apply to partnerships not subject to TEFRA or BBA.

Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), must be filed by S corporation shareholder to take an inconsistent position. See Form 8082 Instructions for more information.

An S corporation shareholder is required to report the items of income, loss, deductions, and credits as reflected on the Schedule K-1. These items cannot be changed or re-classified by the investor unless the Secretary is notified of any inconsistencies. In a similar vein, the IRS cannot change an item on the Schedule K-1 unless the Service examines the entity.

The key case examiner may need to examine both the entity and investors for some issues such as passive loss, at-risk, and basis issues. Determinations at the key case level and the investor level are required to develop the issue factually. Adjustments are made as part of the same report to the investor. If the investor level arguments below are made, the investor’s return must be controlled by the agent on AIMS. See IRM 4.10.5.4.2, Examination of Related and Spin-Off Returns.

Pass-through level components for basis:

A partner level component for basis is: "Did the partner buy his interest from another partner without the partnership making a IRC 754 election?" In this situation the partnership does not have to know the purchase price because the partnership cannot adjust the basis of partnership without IRC 754 election in effect for the taxable year. In addition, the partnership does not have to take the purchase price into account for its taxable year.

An at-risk issue requires certain determinations at the key case level. In situations where loans or notes appear on the books of an entity, it must be determined in the entity level examination whether the loans or notes are recourse or nonrecourse to the entity. In determining the amount for which a investor is at-risk, several items must be addressed, including situations where:

Pass-through level components for at-risk are:

Investor level components for at-risk are:

A passive activity loss issue requires certain determinations at the entity and investor level as to type(s) of activity.

Pass-through level components for passive loss are:

An investor level determination for passive activity loss is: "Did the investor materially participate in the business?" In this situation the pass-through may know if the investor materially participates.

For ILSC partnerships or S corporations, reasonable advance notice is provided (by issuing any one of Letters 3164 A through 3164 V), as appropriate, to the entity when the examination is being conducted at the entity level. When the examination of the entity is being made as part of the examination of a particular partner/member or shareholder's return, a Letter 3164 should be issued to both the entity and the particular investor. If an entity level examination is being conducted, contacts with the partners/members or shareholders of the entity are not considered IRC 7602(c) contacts. On the other hand, if the examination of the entity is being done as part of the examination of a particular partner or shareholder's return, then contact with any other partner or shareholder (other than the partner or shareholder under exam) should be treated as a third party contact. See IRM 4.11.57 Third-Party Contacts.

Only those representatives with a valid Power of Attorney (POA) on file for the taxable year(s) under discussion are permitted to receive information about the ILSC entity examination.

A hard copy of the POA should be secured and maintained in the case file. The only way to determine if the POA was completed correctly for entity issues is to have a copy. It is best not to rely on the Centralized Authorization File (CAF) due to the special language required.

Returns and return information for individuals filing income tax returns jointly may be disclosed to either of the individuals identified on the return. This only applies to the joint return itself, including attachments to such a return (the MFT 30 module). IRC 6103(e) provides that certain limited collection information regarding one spouse must be disclosed to the other spouse relative to tax deficiencies with respect to a jointly filed return where the individuals filing such return are no longer married or no longer reside in the same household. A written or verbal request can be accepted. This also applies when the modules are split.

Information from the split module that must be disclosed to either spouse, if requested, includes:

Information which will not be disclosed includes:

Exercise caution when spouses do not have the same power of attorney (POA) to ensure the information of one spouse is not inadvertently disclosed to the POA of the other spouse.

For additional disclosure information, see IRM 21.1.3.2, General Disclosure Guidelines, and IRM 11.3.2.4, Persons Who May Have Access to Returns and Return Information Pursuant to IRC 6103(e).

When examining agent decides to examine investor returns, those returns should be checked to see if they are already controlled on AIMS. They should also be checked to see if they are already linked on PCS to another pass-through examination.

If the investor return is already controlled on AIMS, the examiner will need to contact the controlling area to either request controls or a copy of the return. If requesting control of a return held in the CPF, use Form 15277, AIMS Database Transfer Request Campus Pass-Through Function (CPF), to request the AIMS transfer. Manager’s signature is required.

If the investor return is already controlled on PCS, the examining agent will now be required to establish their entity on PCS. If the investor is not linked on PCS, but is involved in multiple pass-through examinations, both agents will need to establish their pass-through entities on PCS.

The agent should review and process all amended returns and claims received per IRM 4.10.8.10, Claims.

Many amended returns can be found on the Correspondence Imaging System (CIS). If they were scanned into the CIS there will be a CIS Indicator of 1 on TXMOD, BMFOL or IMFOL. See IRM 21.5.1.5.1, CIS General Guidelines.

The individual investor’s Form 1040 should have timely filed amended returns relating to the amended S corporation or partnership return. AIMS should be reviewed for each investor before beginning to write reports to see if any new amended returns were filed and whether the claims were paid.

Claims and taxable amended returns received for any investor controlled by the examiner should be reviewed for potential examination or statute issues.

If an amended return is received directly from the ILSC pass-through entity or investor, the examiner should verify if it is a copy or an original. If it’s an original, make a copy and forward the original to the Service Center where the original tax return was filed.

The audit report for a pass-through entity is similar to an information return. The pass-through entity report, Form 4605, Examination Changes - Partnerships, Fiduciaries, S Corps., & Interest Charge Domestic International Sales Corporations, is used to reflect adjustments made during the examination.

Line 1, Adjustments to ordinary, distributable net or taxable income, should reflect the audit adjustments that impact the ordinary business income (loss), from the front page of the entity return.

Line 5. Other adjustments, should reflect the per return and corrected amounts of Schedule K or Schedule K-1 items that were changed. If there are no changes to any separately stated item for the entity or investor, leave Line 5 blank.

Remarks can be used to notify the entity of other information or determinations made as a result of the audit, examples include:

It can also be used to explain the impact of the adjustments to shareholders’ basis.

IRM 4.10.8.4.2.1, Form 4605, contains detailed instructions on how to complete the forms.

A signed Form 4605 is generally an indication of an agreement to the entity’s examination adjustments and if linked can assist with determining if the entity return should be forwarded to the CPF.

A signature on Form 4605 does not bind any of the investors. The investor(s) must agree to the entity level findings by signing their individual Form 4549, Report of Income Tax Examination Changes, which incorporates the pass-through entity’s adjustments.

Use Form 4605-A, Examination Changes – Partnership, Fiduciaries, S Corporations, and interest Charge Domestic International Sales Corporations, when the entity is no-changed. Use Form 4605 when the entity has adjustments, whether it is agreed or unagreed. If the S corporation is subject to tax, use Form 4549 in addition to Form 4605 with a notation to refer back.

Form 4605, reflects the corrected amounts made to the entity’s ordinary income/loss and separately stated items of income, loss, deduction and credit. Form 886-X, Shareholders’ Shares of Income, Deductions, and Credits and Form 886-S, Partners’ Share of Income, Deduction and Credits, are forms used to reflect changes to the shareholders or partners Schedule K-1. Form 886-X and Form 886-S should clearly reflect corrected items of income, separately stated items, and distributions to be adjusted at the investor level. The Letter 921 , Report Transmittal From ILSC Partnership, Fiduciary & S Corporation, is a report transmittal letter for ILSC entity cases.

The pass-through examination results should then be reflected on each investor’s examination report (i.e., Form 4549). The Form 4605, and respective Form 886 (sanitized as necessary), is generally attached to the individual investor’s report.

Examiners are responsible for issuing the investor reports and letters for any investor they control. CPF will prepare and issue reports for investors they control. The report should include the pass-through adjustments from the entity examination. In addition, the investor reports should include other adjustments that do not pertain directly to the entity examination, that can only be addressed at the investor level. These adjustments include stock and debt basis limitations for S corporation shareholders, outside basis limitations for partners in partnerships, at-risk limitations, passive activity limitations, taxable loan repayments, and taxable distributions.

Generally, the Campus will not examine any non-pass-through items on the return. For example, the Campus does not audit the investor to determine whether there is sufficient basis to claim the loss. Likewise, they do not audit at-risk, passive activity loss limitations, taxable loan repayment, or the determination of a taxable distribution in excess of basis. The examiner is responsible for the examination of these issues.

IRM 4.31.5.10(2), Investor Statutes, states that if less than 210 days remain on the statute the examiner should solicit an extension.

If a statutory notice of deficiency is issued, it must contain all adjustments – pass-through and non-pass-through adjustments. (However, it should not include any TEFRA adjustments.) Generally, unagreed non-docketed cases sent to Appeals must include both pass-through and non-pass-through issues (an exception may be made under the Early Referral Program, see Rev. Proc. 99-28).

Form 4549, or Form 4549-A along with Form 870, Waiver of Restrictions on Assessment & Collection of Deficiency in Tax & Acceptance of Over Assessment, are the forms that are used to reflect the appropriate adjustments. Each shareholder must sign a separate Form 4549 as part of their examination. The only difference between Form 4549 and Form 4549-A, Income Tax Examination Changes, is that the Form 4549 has a signature line and Form 4549-A does not.

Form 4549, Form 870 can be accepted by fax from the taxpayer if contact has been made with the taxpayer by phone or in-person and the taxpayer history file is documented with the date of contact and notation is made that the taxpayer wishes to send the form by fax.

Upon completion of the examination of the pass-through entity, various reports and letters to the entity and its investors’ will be necessary (unless they are PCS linked).

Examiners in LB&I utilize the services of a Tax Computation Specialist (TCS) during this process. However, ultimately it is the examiner’s responsibility to ensure the accuracy of the information prepared by the TCS. As such, it is imperative that examiners understand what reports and letters are used for the various types of case closures (i.e., agreed, unagreed, and no-change).

Once the TCS has been assigned to a case, the examiner will communicate directly with that TCS for all the services listed below:

The TCS is a team member; as such, the examiner needs to keep in contact with them on a regular basis. This is particularly important on large and complex cases.

With an S corporation, ensure the adjustments are clear on the impact of the adjustment to ordinary income or separately stated items. It is best practice to list the schedule and line number affect (e.g. Page 1, Line 19 Other Deductions or Schedule K, Line 4 Interest Income). Remember that an adjustment may have an impact on more than one item (i.e., IRC 199).

Be sure to identify all adjustments recommended for penalties. This includes penalties for late filing, late payment, accuracy related, etc.

The accuracy of the reports issued by the TCS is the responsibility of the examiner who is assigned the case. Please review the reports carefully.

For questions about the TCS referral process, please see the Procedure Guide - Tax Computation Specialist.

The entity examination results in a no change if there are no adjustments made to ordinary income/loss or any separately stated items of income/loss, deduction, credit or distributions. However, if a change is made to the allocation of any ordinary income/loss or separately stated items, the examination is no longer considered a no change.

If the taxpayer raises affirmative issues during the examination, consider them as part of the examination. If adjustments are made in the entity’s favor, make the adjustments on the entity’s and on the investors’ returns. It is no longer considered a no-change.

If it is determined that the affirmative issues are not allowable, issue a no change report. The fact that the issues were considered but not allowed will be noted in the remarks section of the Form 4605-A and explained on Form 886-A. This report should be associated with the relevant investors’ files for future reference. There is no procedure similar to the Administrative Adjustment Request (AAR) procedure under TEFRA for non-TEFRA partnerships. Investors must file a claim for any further consideration.

For a non-taxable entity, the entity examination is agreed when, all investors agree to the findings impacting their individual return. Individual investors will receive a report incorporating the entity pass-through adjustments when it results in an income tax liability to their return. If the case is linked, the entity return should be closed agreed if the Form 4605 is signed by a person authorized to sign agreements and the examiner is not aware of any investor who disagrees.

For a taxable S corporation, the entity examination is agreed when an authorized corporate officer signs Form 4549 and all investors agree to the findings impacting their individual returns.

The case is unagreed if one or more of the investors do not agree.

The entity examination is unagreed when one or more of the investors does not agree to the findings impacting their individual return. If the return is linked, an entity is considered unagreed if the entity does not sign in agreement with the entity level adjustments. Although an entity agreement is not binding, it has been found that when an entity "agrees" to the adjustments, the investors usually agreed. The linked entity examination is also considered unagreed when the entity "agrees" but the examiner is aware that one or more of the investors does not agree to the findings impacting their individual return. Individual investors will receive a report incorporating the entity pass-through adjustments when it results in an income tax liability to their return. The investor has the opportunity to protest the findings. The protest is not made at the entity level since it is not a taxable entity.

If the S corporation is a taxable entity, in addition to the pass-through adjustments, the entity is able to protest the entity level tax adjustments.

The entity examination is considered to be unagreed if the case consists of both agreed and unagreed investors.

If the S corporation is subject to an entity level tax (including Built-in Gains per IRC 1374, Excess Net Passive Investment Income Tax per IRC 1375, LIFO Recapture Tax per IRC 1363(d), recapture of prior years’ investment credit, or tax paid on fuels), use Form 4549 to reflect the tax. The Form should be signed by a responsible person authorized to sign binding agreements.

If an S corporation is subject to tax, the examiner will set up the issue in RGS by selecting "Income Tax Computation and Credits" and then choose the appropriate Standard Audit Index Number (SAIN). After that select "Taxes" and the appropriate issue. A pop-up box will appear on RGS. After the examiner completes the pop-up box, RGS will compute the tax. Form 4549 will reflect the tax on Line 10; no entries are reflected on Lines 1-4.

If it is determined that the corporation is not an S corporation but rather a C corporation, a Form 4549 or Form 4549-A will also be used to make the corporate level adjustments. See IRM 4.31.5.14.1.1, Conversion of S corporation to C Corporation.

If the corporation is a taxable entity, follow the same case closing procedures as for a C corporation. Additionally, a Form 4605 needs to be prepared to reflect adjustments to the pass-through items.

If the case is unagreed, the examiner will send the Form 4549-A, Form 870, and Letter 950 to the corporation in addition to the Letter 921. Follow regular corporation 30 day letter procedures. If the issue is whether the S corporation election is valid, please see "Conversion of S corporation to C Corporation" discussion below.

If converting the S corporation to a C corporation, the Form 4605 will zero out the income/loss, deduction, and credits previously reflected on the originally filed S corporation return.

In addition, the return’s activity code must be updated to 202 for the assessment to be made. The examiner should change the activity code using Form 5348, AIMS/ERCS Update. If the return was subject to tax upon filing, its activity code will have been updated to 202.

Remember that if the examiner establishes AIMS controls for the investor return, that is treated as an audit. Follow normal audit procedures for the investor. The report should include both pass-through and non-pass-through issues.

Below are some general guidelines for closing the pass-through entity case.

Key cases with PCS linkages must be closed to Technical Service Pass-through Coordinators for special handling regardless of the audit outcome. This is true even when an in-area investor has requested an Appeals hearing.

When a pass-through entity return is linked, it must be closed through Technical Services to ensure the results are forwarded to the proper Campus and the investor returns closed accordingly. Verify that all the investors are properly linked by requesting a TSUMYP for the key case. The TSUMYP lists all the linked investors. Verify the PICF Code is 2. If other than a 2, see sections below. The PICF Code appears on PCS and AMDISA.

Check the "TEFRA or ILSC Key Case" box on Form 3198, Special Handling Notice, and forward the case to Technical Services. Indicate how the case is being closed (No-Change, Change/No-Change, Agreed or Unagreed) and whether any of the investors are being closed with the key case.

Entity report Form 4605 or Form 4605-A and related forms are used by the Campus to pass through the adjustments to the investors. The report should clearly support the Service’s position on each of the issues.

When examining individual returns with related pass-through entities, it is important that examiners properly record RGS Reason codes. Since pass-through entities are generally not subject to tax, it is hard to determine if the audit of a pass-through entity is productive. Individual returns are often impacted by the pass-through entity audit. To capture this impact, RGS Pass-Through Reason Codes were established.

These specific codes are important in helping the Service track adjustments made to partners and shareholders related to ILSC pass-through entities. The RGS Reason code is a two-digit code that identifies the reason for an adjustment and is entered on the Issue Adjustment screen. Do not use the Penalty and No Penalty codes for these adjustments.

The following codes (34 – 40) are reason codes used for all Form 1040 adjustments related to pass-through limitation issues:

The following codes (24 – 26) should be used for all other Form 1040 adjustments related to pass-through entities. Therefore, it includes:

The notice date for the purposes of IRC 6404(g) is the date adequate notice is mailed or provided to the individual investor. For ILSC pass-through purposes, it is not the date a report is given to the entity. All other IRC 6404(g) rules apply. See IRM 4.10.8.14.13, Notice Under IRC Section 6404(g), Suspension of Interest, to ensure these procedures are current.

In the case of an individual who files a return on or before the due date for the return (including extensions), the Service has a 36-month period (18 months effective for tax years where the 18 month period ended on or before November 25, 2007) beginning on the later of:

If notice is not provided to the taxpayer before the close of the 36-month period, then any imposition of interest, penalty, additions to tax or additional amounts that are calculated in reference to the 36 month time frame (18 months effective for tax years whose 18 months end on or before November 25, 2007) are suspended.

The exceptions to the 36 month (18 months effective for tax years where the 18 month period ended on or before November 25, 2007) notice requirements:

The term suspension period means the period:

The IRC 6404(g) date should be included on the back of Form 3198 in the Special/Restricted Interest Features section. If IRC 6404(g) applies, the date should also be entered on RGS when prompted.

Generally, when the examiner has adjustments to an entity, the investors’ returns should be placed under examination or linked to reflect changes to the entity’s income, loss, deduction, credit or distribution items.

In some situations, the adjustments made to the pass-through entity has no current year tax consequences to an investor. In this case, it is appropriate to issue an examination report to the investor since the report may impact subsequent tax returns (e.g., suspended loss carry overs, Net Operating Losses, etc.).

An investor who received a Letter 3457 should receive a no-change letter if the ILSC entity was closed no change. See Exhibit 4.31.5-1, Entity Closing Chart.

Carryback or carryover years should be reviewed to determine if there will be a tax impact. If there will be a tax impact to an ILSC investor under audit, the relevant prior or subsequent investor returns should be secured and reports should be prepared.

Upon receipt in Technical Services of an ILSC key case closed from a group, the Technical Services Pass-Through Coordinator should review the following areas of the case file:

If SNOD needed, TSPC will route to local TS.

When TP defaults, or agrees, the case is returned to the TSPC.

If the TP petitions, local TS will forward to Appeals.

Prepare Form 14729, Investor Level Statute Control (ILSC) Closing Package Check Sheet.

Email Form 14729 and required enclosures to the campus and await a response. Campus should respond within 14 days.

The CPF will release the H freeze for agreed and no change cases once all required information is received.

If after 14 days the H freeze is not released, contact the CPF ILSC Coordinator.

The pass-through entity is linked as a key case and not linked as an investor, and is ready to close:

The pass-through entity is linked as a key case and also linked as an investor, and is ready to close:

All linked investor returns must close to Technical Services in Status 21.

If Investor 1040 exam is closed agreed or no change without key case pass-through adjustments. TSPC will forward to CCP with instructions to forward to CPF for open linkage. CCP will partial agreed adjustments.

If Investor 1040 exam is agreed or no change to the key case pass through adjustments and there are no other open linkage, the case can be final closed to CCP. If there are other open linkages TSPC will instruct CCP to forward the investor to CPF.

If unagreed, with protest, the cases is sent to Appeals.

If unagreed, for stat notice, TSPC will need to ensure pass-through adjustments are included.

If the stat notice is petitioned, forward to Appeals.