So You're
Facing
An IRS Audit. What Next?
By Joseph Bayewitch, CPA
Audits over the last 10 years have dropped
by two-thirds and since 1996 the number of audits has dropped
from 1.9 million to 730,000 (1.7% to 0.6% of all tax returns
respectively). However, recently the IRS has hired over 1,000
more auditors and collectors to reverse the slide in the number
of audits conducted by the IRS each year.
For 2001 tax returns,
the IRS audit activity will focus on six areas of possible noncompliance:
(1) Use of trusts/passthrough entities in abusive ways; (2) Corporate
tax shelters; (3) Unpaid payroll and trust fund taxes; (4) Erroneous
refund claims; (5) Income "parked" on offshore accounts
in tax havens; (6) Matching K-1's from Partnerships and S-Corporations
to shareholders.
Returns are selected
in a number of ways. One way they can be selected is based on
a computer checking for mathematical mistakes and by scoring.
Returns are assigned scores by the computer based on what's filed
(i.e., Schedule C's), levels and types of deductions, etc. A
higher score means a higher potential that your return will be
examined. Another selection method is by matching third party
documentation such as 1099's and W-2's against your return. If
you miss reporting an amount of 1099 income (interest dividends,
non-employee compensation, etc.), the IRS will likely catch it.
The percentage of returns
selected each year is still very low. However, if yours is selected,
it does not necessarily mean that you are dishonest. An audit
can result in no change and rebates, not just added taxes owed.
So you find your return
was selected for examination. The IRS will send a letter describing
a change or requesting more information. Generally, these matters
can be resolved by mail. It is important to remember to respond
to all audit notices from the IRS and to do so promptly. Don't
ignore such a letter from the IRS, as the issue will only fester.
The letters are frequently computer generated and the IRS computer
will not go away by itself. If you believe the IRS is in error
and the amount involved is not insignificant, then trade letter
for letter until the issue is resolved. Be firm, but polite when
writing to the IRS. Your accountant should immediately be made
aware of any IRS notice and is usually the best person to handle
responses. If they are not getting resolution-trading letters
with the IRS by mail, they can ratchet up the heat by copying
in the District Director and by contacting the Taxpayer Advocate
Office. If you get a notice and you know the IRS is right, again
immediately inform your accountant. If the amount includes a
significant penalty charge it can be worthwhile to have your
accountant respond back to the IRS. We have at times been successful
in getting penalties waived so you would only pay the tax and
interest. But, if you get a notice for an insignificant amount
of money, sometimes it is more cost effective just to pay it.
If the IRS wants to
do an in-person examination, you will receive an audit notice.
When you do receive the notice tell your accountant. The audit
can take place in your home, place of business, an IRS office
or your accountant's office. You can ask to have the audit where
it is convenient for you, but the IRS does make the final determination
of when, where, and how the examination will take place. You
can have (and should have) your accountant meet with the IRS
as your representative. It is also advisable to request the audit
take place in your accountant's office.
After notification of an audit you will usually need to sign a power of attorney to allow your accountant to represent you. The accountant will respond to the IRS and schedule an appointment to meet with the IRS auditor in the accountant's office. Your accountant will either have the necessary documentation or will request documents from you. The accountant will meet with the auditor; provide the audit documentation and answer auditor questions as appropriate.
If the auditor proposes changes, your accountant will discuss the changes with you. If you agree that the changes are reasonable and it is cost effective to resolve the audit, you can sign the agreement and pay added taxes and interest. Generally issues can be resolved without penalty amounts added to the bill.
The key to cost effectively resolving a field audit generally is, wherever possible, to resolve issues at the lowest level, that is, with the auditor. Many times it is effective to concede a small point and pay nominal additional amounts to get closure on the audit.
As an aside, if an item under audit has been examined in either of the prior two tax years and no change was the outcome, your accountant can usually get the IRS to discontinue examining the item again.
Towards the end of an audit, the auditor may request the client sign an extension to statute of limitations. An extension gives the IRS more time to conduct the audit. Generally, our preference is not to sign unless there is a good reason (i.e., the issues will be favorably resolved given more time). If we expect to sign, a good idea is to sign only a restricted extension, one that is limited to specific issues. Also, consider negotiating a specific ending date.
If the auditor proposed changes that are not acceptable your accountant can request a meeting or a telephone conference with the auditor's supervisor to explain your position. Next on the chain would be the district office.
A local Appeals Office generally handles appeals. The Appeals Office is separate and independent from the IRS office doing the audit. The Appeals Office is the only level of administrative appeal within the IRS. Why go to Appeals? Factors in favor include: 1. Opportunity for review of errors made by the IRS auditor at a higher level in the IRS. 2. Opportunity for settlement based on hazards of litigation. You can make an offer to settle the audit. The case officer when considering whether to accept your offered amount can weigh the costs and hazards of litigating the case. Generally, the appeals officer won't seriously consider offers of less than 20% of the disputed amount. 3. Appeals are a necessary step in the process if you expect to win and hope to collect attorney and accounting fees down the road. 4. The appeals process is also a way of getting more time to search for more details.
Factors against going to appeal include: 1. Added time and expense involved. 2. Risk of new issues being raised of a material amount (biggest reason not to go to appeals).
If you don't reach agreement with the appeals office or you choose not to appeal, you will get a 90-day letter. You have 90 days to file a petition with the Tax Court. You do not need to pay the disputed amounts before petitioning the Tax Court. However, do not use the Court as a way to delay payment if you have a weak case. If you unreasonably fail to pursue the IRS appeals system, or if your case is frivolous or groundless, or the Court considers that your case is intended to cause a delay, the Tax Court may impose penalties up to $25,000.
If, at the end of the process, you feel that you will likely owe money, you can stop the accruing of interest by paying or depositing that amount of money with the IRS. Such deposit or payment will stop interest accrual on that amount of money. You can still pursue your appeals process through the courts. If, in fact, you pay the taxes that the IRS claims you owe and you file for refund (which the IRS will reject) you will have up to two years to file a refund claim petition with the Courts, including a District Court where you can get a jury trial.
The best advice when you get an audit notice is to call your accountant. The second best advice is be reasonable when we take reasonable but aggressive stands on tax issues sometimes it is better to settle for a partial victory then to fight on.
Editor's Note: Joseph Bayewitch, CPA is a Tax Manager at RBZ, LLP. Founded in 1975, RBZ is a leading accounting and strategic business-consulting firm with offices in Los Angeles and the Southbay. The firm offers a comprehensive range of accounting; tax, consulting, and litigation support services and serve a wide array of clients in diverse industries, ranging from high net worth individuals to multi-million dollar international companies. He can be reached at (310) 478-4148 or online at www.rbz.com.
