The IRS Market Segment Specialization Program

The Internal Revenue Service recently promised to increase audit (and by inference, collection) activity. It has hired more than 1,000 examiners and collectors. Naturally, self-employed and small-business owners are anxious, because the Service makes no secret that it believes noncompliance is widespread among small businesses. (Then, too, after years of declining audit and collection activities, tax professionals have also noted a trend toward "more aggressive" tax practices among clients.) No one outside of the IRS can say what triggers an audit (and the Service itself has recently begun a program to re-evaluate its own criteria), but the Service has made great strides in addressing small-business issues (consider its current restructuring activities), and has become more sophisticated in identifying areas in certain industries and professions where examinations are likeliest to be most effective in generating revenue and encouraging compliance.

A major element of the Service's efforts to improve examination practices is its Market Segment Specialization Program (MSSP). The program was initiated in the 1990s to help IRS agents correctly evaluate tax returns, identify and resolve tax issues, and educate, encourage, and assist taxpayers in voluntary compliance with tax regulations. More than 80 MSSP reports have been published. About 60 of them address specific industries (for example, construction and entertainment) or professions (such as attorneys and child care providers). The others focus on major tax issues such as passive activity losses or the alternative minimum tax. One can question whether the Service uses such terms as "encourage" and "voluntary compliance" in the same way the general public does, but semantic quibbles aside, business owners and managers can use these guides as business and tax planning tools, as well as crib sheets for tax examinations.

The Service selects tax returns for examination based on the income, the relationship of deductions to income, and the nature of the deductions. The formulas used for this process are highly confidential, but high travel, auto, club membership, and entertainment expenses are always suspect. (In addition to these perennial favorites, the Service occasionally does a "flavor of the month" on some topic – for example, straddle and wash transactions or, the current favorite, offshore tax shelter accounts.) Although the MSSPs are primarily audit guides, the Service has indicated that they can also be used to weight return selection criteria.

Tax legislation and regulations are rife with unintended or unforeseen consequences. A positive (probably) unforeseen consequence of the Market Segment Specialization Program was to create a small-business operator's handbook of realistic business practice. The Internal Revenue Service's primary purpose is to assess and collect the "correct" amount of tax (not the most money, as many people, including some IRS personnel, think). To help examiners correctly identify and examine tax issues, each MSSP defines the business environment in which the industry or profession functions, considers the business purpose and profit motive of entities involved in the operation, and, in some cases, assesses the degree of an individual's actual involvement in the business. Small-business managers can learn a lot about themselves and their businesses when they reassess the business against the Service's guidelines for evaluating profit motivation and degree of participation.

On the nuts-and-bolts level, the audit guides do not list "red flags" for auditors or business owners (although most practitioners can readily summarize certain "hot buttons" for the IRS in any and all industries: travel, entertainment, and auto are among the hottest). However, the MSSPs were originally developed for industries and professions in which the Service had extensive experience with tax reporting improprieties (not necessarily fraud, but areas in which misunderstandings were common, as well). The point of the program is to give examiners an understanding of unique industry terminology, issues, and business practices, and help in developing examination techniques. For business planners, the handbooks and examination guides help identify industry-specific accounting (particularly cash income and expense distribution) issues and records-retention guidelines for tax compliance and substantiation. Good tax accounting and record keeping are usually good business practices, as well. For tax return preparation and examination, the guides identify tax issues that the Service will inevitably focus on in an audit.

The quality of the MSSPs varies (some are very well-written), but they share certain traits that affect their utility. Many bite off more than they can chew: They try to describe and assess large industries with major subcategories within a segment, and can treat agglomerations only superficially. Each MSSP starts with a brief description of the market segment to be covered and (more or less) defines key terms. The MSSP for artists and art galleries defines artists (there are two kinds, living and dead), briefly describes artistic genres (ranging from Realism through Cubism through Western) in two or three sentences each, and then explains the methodology used to identify art galleries for evaluation in the MSSP. The entertainment industry MSSP defines above-the-line and below-the-line artists, then focuses almost exclusively on one group of above-the-line personnel – performers (perhaps the sole instance since Ishtar when actors would rather avoid the spotlight). The MSSP for the wine industry tries to cover everything from cost per acre to establish a vineyard to details about bench grafts, trellising, and irrigation. Usually there is too much background material for the MSSPs to cover adequately, but they make a game effort, sometimes resulting in too much attention to relatively unimportant issues.

Nevertheless, when the MSSP, no matter how poorly written, addresses tax examination issues, the material is usually coherent and succinct. These sections give a good idea of where an IRS examiner expects to find problems and how potential issues should be identified, developed, documented, and examined. Many MSSPs include generic discussion sections on audit methodologies for problem areas found across the board (underreported income and commonly overstated deductions, such as automobile expense and travel and entertainment expense). These sections merit review because they usually discuss industry variations, as well. The entertainment industry MSSP discusses actors' residences as the point of origin for automobile and travel expense deductions; the music industry MSSP discusses performers' wardrobe and home office issues at some length.

Taxpayers and practitioners should keep in mind that the Service views these guides as "educational" tools that can help taxpayers with "correct" identification of tax issues and reporting procedures. Unfortunately, it often happens that a single alternative for handling an issue is identified and treated in detail, suggesting by omission that it is the only alternative. Even when an MSSP is written to recognize alternatives, there is a tendency to favor quantifiable measures over conceptual evaluation.

We hope this explanation of Market Segment Specialization Programs sheds light on how the IRS chooses what to audit based on these programs.

Editor's note: As enrolled agents, in addition to tax preparation, Yolanda Smulik-Roche and Roger C. Roche are licensed by the Treasury Department to represent and defend clients before the IRS nationwide. Their book, The Tax Guide for Gamblers, is the most comprehensive one on the subject. See their website at www.rbstaxes.com for more information regarding their practice, articles, and useful tax links. They do business as RBS Tax Services, are located in Las Vegas, Nevada, and can be reached at (800) 829-7271. They also maintain an office in California.