10.2 IRS Procedure, Statutes, and Penalties
Key Takeaways
- REG procedure questions trace the path from IRS examination through the Independent Office of Appeals to the correct judicial forum based on the taxpayer's payment posture.
- The ordinary assessment statute is 3 years from the later of filing or the due date; a substantial omission of gross income (over 25%) extends it to 6 years; fraud and non-filing have no limitation period.
- A refund claim is timely if filed within 3 years of filing the return or 2 years of paying the tax, whichever is later, and the lookback rule caps the recoverable amount.
- Taxpayer penalties, preparer penalties, and interest are three separate consequences that must be identified separately in every fact pattern.
- Tax authority follows a hierarchy (Code, regulations, administrative guidance, case law), and H.R. 1 (OBBBA) provisions with 2024-2025 effective dates become REG-testable starting July 1, 2026.
IRS Procedure as a Timeline
Federal tax procedure is easiest as a timeline: a taxpayer files (or fails to file), the IRS examines or assesses, the taxpayer may seek administrative review, and unresolved disputes move to court. The 2026 AICPA REG blueprint expressly includes audits, the appeals process, the judicial system, substantiation, taxpayer penalties, and the authority hierarchy.
Examination, Appeals, and Courts
Examinations come in three forms: correspondence (mailed letters for simple issues), office (in-person at an IRS office), and field (an agent visits the taxpayer's premises for complex returns). If the examiner proposes an adjustment, the taxpayer receives a 30-day letter offering review by the IRS Independent Office of Appeals. Appeals is not a second audit; it settles disputes by weighing the hazards of litigation — the realistic probability either side would prevail in court.
If Appeals fails or is skipped, the IRS issues a statutory notice of deficiency (the "90-day letter," 150 days if addressed abroad). This is the taxpayer's ticket to the United States Tax Court, where the deficiency can be challenged without first paying the disputed amount.
| Stage | High-yield point | Common exam trap |
|---|---|---|
| 30-day letter | Opens IRS Appeals | Treating an IRS notice as automatically correct |
| Appeals | Settles on hazards of litigation | Ignoring the right to dispute |
| 90-day letter (deficiency) | Opens prepayment Tax Court route | Paying first when the question asks for a prepayment forum |
| Refund claim | Follows payment + Form 843/amended return | Suing before the administrative claim is denied |
| Judicial review | Forum depends on posture | Confusing Tax Court with refund forums |
Forum map. Tax Court = no prepayment required, judges are tax specialists, no jury. U.S. District Court = must pay first and sue for refund; only forum offering a jury trial. U.S. Court of Federal Claims = must pay first; nationwide jurisdiction, follows Federal Circuit precedent. REG rewards matching the forum to the taxpayer's posture, not memorizing courthouse labels.
Statutes of Limitation
The assessment clock generally starts from the later of the return's filing date or its due date.
- Ordinary period: 3 years. The standard window to assess additional tax.
- Substantial omission: 6 years. Triggered when the taxpayer omits gross income exceeding 25% of the gross income reported on the return (overstated basis can count).
- No limit: a fraudulent return or a failure to file keeps the period open indefinitely.
Worked example. A taxpayer reports $200,000 of gross income but omits $60,000. Because $60,000 exceeds 25% of $200,000 ($50,000), the 6-year statute applies even with no fraud. If the omission were $40,000, the ordinary 3-year rule would govern.
The refund claim has its own timing: a claim is timely if filed within 3 years from filing the return or 2 years from paying the tax, whichever is later. The lookback rule then caps the recoverable amount to taxes paid within the applicable 3-year (plus extension) or 2-year window — so a claim can be timely yet recover nothing if the payments fall outside the lookback.
Penalty Framework
Taxpayer penalties differ from preparer penalties. Key taxpayer civil penalties:
| Penalty | Trigger | Notable feature |
|---|---|---|
| Failure to file (Sec. 6651(a)(1)) | Late return | 5% per month, max 25%; harsher than failure-to-pay |
| Failure to pay (Sec. 6651(a)(2)) | Unpaid balance | 0.5% per month; offsets the FTF penalty in a month both apply |
| Estimated tax (Sec. 6654) | Underpaid quarterly tax | No reasonable-cause waiver in most cases |
| Accuracy-related (Sec. 6662) | Negligence or substantial understatement | 20% of the underpayment |
| Civil fraud (Sec. 6663) | Intentional wrongdoing | 75% of the fraud-attributable underpayment |
The accuracy-related penalty under Sec. 6662 applies to negligence, disregard of rules, a substantial understatement (generally the greater of 10% of correct tax or $5,000), or valuation misstatements. Reasonable cause and good faith (Sec. 6664) can waive most accuracy and failure penalties — but NOT the Sec. 6654 estimated-tax penalty and NOT civil fraud. Fraud requires clear-and-convincing evidence of intent and shifts the burden to the IRS.
Authority Hierarchy and Current-Law Timing
Tax authority is ranked: the Internal Revenue Code (statutory, highest), Treasury Regulations (legislative regs strongest), then administrative guidance (revenue rulings, revenue procedures, private letter rulings — PLRs bind only the requesting taxpayer), then case law. For 2026, watch AICPA timing policy: in-scope provisions of H.R. 1 (the One Big Beautiful Bill Act) with 2024 or 2025 effective dates become eligible for REG and TCP testing on July 1, 2026; later-effective provisions become testable in the quarter beginning six months after their effective date.
Older provisions scheduled to expire remain testable through June 30, 2026, so the eligible body of law turns on the candidate's specific test date. Match a new rule to the exam date before applying it, and do not assume a headline tax-law change is testable the instant it is signed.
One more interest point worth knowing: interest on an underpayment is statutory and runs automatically; it is not a penalty and is generally not waivable for reasonable cause, which distinguishes it from most civil penalties discussed above.
Exam Pattern
Solve procedure questions with dates, posture, and conduct. Build a mini-file: filed or not filed; paid or unpaid; ordinary error, 25% omission, or fraud; administrative or judicial stage; taxpayer penalty or preparer penalty.
A taxpayer receives a statutory notice of deficiency and wants to challenge the proposed income tax deficiency without first paying it. Which forum is designed for that prepayment challenge?
A taxpayer files a timely return reporting $300,000 of gross income but inadvertently (without fraud) omits $90,000 of gross income. What assessment statute of limitations generally applies?