In United States v. Titan International, Inc., the Illinois district court enforced an Internal Revenue Service (IRS) administrative summons and rejected the taxpayer's claim that the summons, issued in connection with the examination of the taxpayer's 2010 income tax return but seeking the taxpayer's 2009 books and records, violated the "second inspection rule" in Internal Revenue Code Section 7605(b).  The court concluded that a re-examination of the 2009 books and records would be prohibited if the IRS was seeking to make additional assessments for 2009.  The court, however, accepted the IRS's assertion that the taxpayer's 2009 books and records were necessary to verify a deduction claimed on the taxpayer's 2010 income tax return, and the IRS did not intend to make any additional tax assessments with respect to tax year 2009.

In order to ensure the proper determination of a tax liability, Congress "has endowed the IRS with expansive information-gathering authority."  United States v. Arthur Young & Co., 465 U.S. 805, 816 (1984).  Code Section 7602 is the "centerpiece of that congressional design."  Id. at 816.  Under Section 7602, the IRS is authorized to "examine any books, papers, records, or other data which may be relevant or material to" a tax investigation, and to summon any person to produce such documents.  Section 7602(a)(1), (2).

That authority, however, is subject to judicial review.  When a summoned party refuses to comply, the IRS must petition a federal district court to enforce the summons.  Code Sections 7402(b), 7604(a).  Fifty years ago, in United States v. Powell, 379 U.S. 48 (11964), the Supreme Court of the United States sketched out the analytical framework governing summons enforcement.  To establish a prima facie case, the government must demonstrate the following:

  • Its investigation is "conducted pursuant to a legitimate purpose."
  • The information sought "may be relevant to that purpose."
  • The IRS does not already possess the "information sought" to be summoned.
  • All statutorily imposed administrative steps have been followed.

Id. at 57-58.  Generally, the government can satisfy this initial burden by filing an affidavit executed by the investigating agent simply stating that the four criteria have been met.  See, e.g., United States v. Kis, 658 F.2d 526, 536 (7th Cir. 1981); United States v. Davis, 636 F.2d 1028, 1034 (5th Cir. 1981).

Once the government satisfies these minimal requirements, the burden shifts to the summoned party to either disprove one of the four elements of the government's prima facie showing or demonstrate that judicial enforcement of the summons would constitute an abuse of the court's process.  Powell, 379 U.S. at 58.  Although there is no all-inclusive list as to what constitutes such an abuse, Powell did provide some guidance: it stated that an "abuse would take place if the summons had been issued for an improper purpose, such as to harass the taxpayer or put pressure on him to settle a collateral dispute, or for any other purpose reflecting on the good faith of the particular investigation."  Id.

In Titan, the taxpayer maintained that the summons was issued for an improper purpose—to commence a second inspection of the taxpayer's books and records for 2009 in violation of the provision in Code Section 7605(b), commonly referred to as the second inspection rule.  The taxpayer maintained that the IRS was conducting an improper second inspection of its 2009 records in connection with the audit of the taxpayer's 2010 income tax return.

Code Section 7605(b) provides, "No taxpayer shall be subjected to unnecessary examinations 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 additional inspection is necessary."

The notice required under Section 7605(b) is not treated as a perfunctory matter and is not designed to warn taxpayers of impending inspections.  The second inspection rule "is designed rather, to curb an abuse of investigatory powers of lower-echelon revenue agents.  The provision imposes this curb by reallocating decision-making power within the administrative system.  . . . [T]he revenue agent retains power to decide whether to conduct an initial inspection of books and accounts but the 'Secretary or his delegate, after investigation' must approve all subsequent inspections and give notice that they are necessary."  United States v. Schwartz, 469 F.2d 977, 985-86 (5th Cir. 1974) (Bell dissenting) citing Powell, 379 U.S. at 55-56 (1964).

In Titan, the taxpayer cited to Reineman v. United States, 301 F.2d 267 (7th Cir. 1962), to support its claim that the IRS summons for its 2009 general ledger and 2009 airplane flight logs issued in connection with the 2010 audit must be quashed.  In Reineman, the IRS audited the taxpayers' 1954 income tax return and determined a deficiency that was satisfied in 1957.  In August 1957, another agent notified the taxpayers that he was assigned to audit the taxpayers' 1955 income tax return; no mention was made about re-examining the 1954 tax return.  The taxpayers first learned that the agent had reopened their 1954 return when they received in the mail a 10-day letter.  The taxpayers protested the re-examination.  The agent stated that although he reopened the 1954 return, he did not examine the taxpayers' books and records from 1954, but obtained the information and data necessary to adjust the allowable depreciation expenses from the taxpayers' accountant's workpapers for 1955.  The court discredited the agent's testimony and concluded that the agent would have had to reopen and re-examine the 1954 records in order to make the proposed adjustments.  Accordingly, the court concluded that the deficiency assessment for 1954 "should be set aside because the Commissioner made a second inspection of taxpayers' books of account for the year 1954" without providing the required notice.  Id. at 268.

In Titan, the district court distinguished Reineman on the basis that the IRS in that case attempted to make a second tax assessment for the same tax year. The court concluded that in Titan, the IRS was not attempting to inspect the 2009 records in order to make an additional assessment with respect to tax year 2009.  Instead, the records for 2009 were sought to assist the IRS in verifying the amount of the deduction claimed on the taxpayer's 2010 tax return.  Moreover, the court found no basis to conclude that "the IRS is requesting the records for a 2010 audit under the guise of seeking to make an additional assessment for tax year 2009."

Courts have historically interpreted the second inspection rule narrowly.  For example, the second inspection rule has been found inapplicable where the adjustment to an already "inspected" year was based upon information already in the Commissioner's possession.  See Hough v. Commissioner, 882 F.2d 1271, 1275-1276 (7th Cir. 1989) affg. T.C. Memo 1986-229, or Pleasanton Gravel Co. v. Commissioner, 64 T.C. 510 (1975) affd. per curiam 578 F.2d 827 (9th Cir. 1978).  Moreover, if presented with an IRS violation of the second inspection rule, taxpayers must take care not to waive their rights to a second inspection notice by failing to object or voluntarily consenting to a re-examination.  See Philip Mangone Co. v. United States, 54 F.2d 168 (Ct. Cl. 1931).  Finally, to limit the IRS's ability to re-examine prior years, taxpayers should keep track of the statutes of limitations for assessment for prior audited tax years, and should not execute Form 872-A, which provides for an open-ended statute extension.

When Is A Second Inspection Not A Second Inspection?

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.