Sam Brotman, JD, LLM, MBA July 2, 2020 65 min read

An Overview of IRS Audits

IRS EXAMINATION

INTRODUCTION TO IRS EXAMINATION

IRS Examination is often likened unto and often referred to as the IRS audit function. Typically, the IRS accepts most federal tax returns when filed. However, there are circumstances in which the IRS examines, or “audits,” to determine if reported income, expenses, and credits have been reported accurately by the taxpayer. When a taxpayer’s return is selected for examination, it is first randomly chosen by computerized screening and then secondly selected by audit by a human reviewer who decided the level of audit that the taxpayer’s return will undergo.

If an IRS Examination investigation results in a finding of additional tax owed, whether or not this is intentional or unintentional, the IRS requires the payment of a penalty in addition to the remaining tax obligation. IRS Examination determines the due date, if appropriate, for taxes reported by the taxpayer and assesses penalties and interest from the date of assessment. The Examination Division also establishes procedures for assessing and collecting tax. For more information about the IRS examination process, review IRS Publication 556: Examination of Returns, Appeal Rights & Refund Claims.[1]

The IRS examination, or audit, process begins in one of ten service centers, which depends upon the location of the taxpayer. The service centers receive taxpayer returns; service center representatives catch errors and enter tax return data. The computer matching software the IRS uses reviews the items on the return and matches the information with sources received from other parties such as an employer or third-party filer. A tax return is scored for audit potential and a notice and demand is generated when a taxpayer may be required to pay additional taxes.

If a particular service center is unable to handle a taxpayer’s case, particularly if the taxpayer does not live near the service center, then the case is referred to a revenue agent in a local field office. The purpose of the revenue agent is to conduct a more through investigation of the taxpayer and the facts and circumstances surrounding their return. In some cases, the revenue agent will ask the taxpayer to come in and discuss their case and also produce supporting documents. In some cases, the revenue agent will go into the taxpayer’s home or place of business. The revenue agent then reviews the facts, makes adjustments when appropriate, and issues a “revenue agent’s report,” which is a summary of their findings.

The IRS audit ends when the revenue agent issues a report stating either one of two outcomes. The taxpayer with either recieve a no-change letter or a notice of proposing adjustments. An IRS audit may not be closed for several months following the date the taxpayer meets with the revenue agent. Throughout the period, the IRS will issue a series of letters and/or notices that require the taxpayer to respond to one or more deadlines. These letters and/or notices may come in the forms of thirty day or ninety day response times and these documents help to move the case out of the IRS examination function and into IRS collections.

Responding to one or more of these notices is important. Taxpayers are often unaware of the consequences for failing to respond to notices. In addition, the IRS is only required to mail out letters and/or notices, but the agency is not required to make sure that a taxpayer receives the notice. In other words, the IRS mails these types of documents to the taxpayer’s last known address, even if the taxpayer no longer resides there.

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[1] The document is available here: http://www.irs.gov/publications/p556/index.html.

 

HOW TAX RETURNS ARE SELECTED FOR AUDIT: EXPLAINING DIF SCORES AND UI DIF SCORES

 

Ever wonder how tax returns are selected for audit? Well, it comes down to two simple numbers which are your DIF Score and your UI DIF Score.

According to the IRS, tax returns are selected for audit based on computer scoring. The IRS states in Publication 556 that it uses a computer program called the Discriminant Inventory Function System (DIF). The Discriminant Inventory Function System assigns a numeric score to each individual and some corporate tax returns after they have been processed.

If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability.[1]

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Purpose of Discriminant Inventory Function (DIF)

Essentially, the two-fold purpose of the DIF is to identify and select tax returns for examination utilizing a pre-configured scoring formula. Each type of taxpayer and tax return is subject to a different DIF formula. There are particular items on a tax return that may cause concern.

For example, participation in a tax shelter might send up a red flag to the Internal Revenue Service. In addition, “large charitable contributions, home office deductions, large travel and entertainment expense or large automobile expense” may send up additional red flags (MBBP).

Once a tax return is selected under the DIF program, it is then manually screened so attachments and related data can be evaluated.

Purpose of Unreported Income DIF

The IRS uses an additional tool, namely the Unreported Income Discriminant Index Formula (UI DIF). The UI DIF is used for two purposes:

  • To rate the probability of inaccurate information
  • To rate the probability of omitted income on a tax return

Both steps are evaluated in conjunction with the other.

For example, if a taxpayer files a 1040-EZ tax return, reporting earnings from a W-2 only, then it is unlikely that the tax filing will be subject to an audit; this is because the earnings reported on the tax return also match those earnings reported with Social Security.

However, a tax filer that reports income from various sources and fails to provide hard-copy documentation evidencing self-employment earnings, for example, will likely have a better chance of responding to an audit request.

With this in mind, with regard to the UI DIF, the IRS typically targets four areas when considering an audit.

High income, high risk taxpayer

The first area is “high income, high risk taxpayers.”

A taxpayer with a higher income tends to file a more complicated tax return. Under this category, the taxpayer engages in pass-through activities that include tax shelters, the establishment of trusts, and related taxation shielding options.

Because some activities may be illegal, tax returns that fall under this category are likely to be audited.

High income non-filer taxpayer

The second category is “high income non-filers.”

A taxpayer with high income reported on their social security number, but who has not filed a tax return yet, is screened by the IRS. The IRS will send multiple notices, advising the high income taxpayer of their legal obligation to file and will also prepare a Substitute for Return (SFR).

For more information on Substitute for Return, see section “Other Types of Balances Due: Proposed Assessments and Substitute for Returns.”

High amounts of itemized deductions taxpayer

The third area the IRS evaluates is the “high amounts of itemized deductions” reported by the taxpayer.

A taxpayer can itemize their own tax deductions using Schedule A (Form 1040); using the form is an alternative to taking the standard deductions based upon individual filing status. Although the taxpayer can elect to itemize their deductions, too many discretionary deductions and calculations may result in error and fraud.

Self-employed taxpayers

Self-employed taxpayers are also vulnerable to an audit.

Self-employed taxpayers are different from earning individuals because the income derived as a result of self-employment is not subject to a standard verification system. However, self-employed taxpayers are still required to report 100 percent of their earnings and are free to deduct all legal expenses. Too many deductions without documentation will eventually subject the self-employed taxpayer to an audit.

 

[1] See Publication 556, available at: http://www.irs.gov/pub/irs-pdf/p556.pdf

 

 

 

IRS AUDIT STRATEGY: SEEING THE PLAYING FIELD

IRS AUDIT STRATEGY – INTRODUCTION

A favorite saying of mine when it comes to audits is that I like to see the playing field in order to know all the issues and the potential issues that could arise during the course of representation. Upon initial receipt of the audit letter from the Internal Revenue Service, you will have an idea of the areas that are being called into question. However, this is often only the starting point for the areas that may be examined during the course of the audit. When I first approach an audit, I do a through review of the return to look for other unknown and potentially dangerous issues with the underlying return. Specifically, I am looking for items that may either be misreported, overstated, or will likely need to be explained to the auditor in greater detail during the examination process. By getting a sense of these issues, as well as any potential issues on tax returns in the preceding and succeeding years (which may also be audited), I start to formulate a strategy can determine the best way to approach the audit.

Taxpayer returns are generally audited by the IRS because of either their participation in questionable tax avoidance transactions or because of their likelihood that an audit will yield a change in favor of the government. This potential for change is quantified into one of two computerized scores, the Discriminant Function System (DIF) score and the Unreported Income DIF (UIDIF). The DIF score calculates the probability that an examination will yield additional tax liability whereas the UIDIF calculates the probability that there is unreported income on a return. Those returns that yield high scores are then forwarded to examination personnel, who select which returns will be audited.

IRS AUDIT STRATEGY – BEFORE THE AUDIT BEGINS

Contrary to popular belief, most audits begin prior to the initial meeting with the taxpayer or their representative. Auditors generally conduct a full pre-audit investigation, which involves conducting both asset searches (reviewing Department of Motor Vehicles, property records, and other public information) as well as income searches (reviewing past and present sources of income reported on taxpayer returns, pulling IRS transcripts, reviewing information submitted by third parties). As a result, the taxpayer and their representatives must consider the possibility that the auditor knows much more about the taxpayer than they let on in their initial meeting. As such, representatives are going to want to be vigilant with respect to any representations that they make about the taxpayer’s assets and sources of income to avoid making potentially false statements to the auditor and subjecting the taxpayer to additional civil/potentially criminal liability.

IRS AUDIT STRATEGY – LIMIT THE SCOPE

The principal objective of any representative, other than to ensure there is little or no examination change, is to limit the scope of the audit from the outset. Although auditors begin with one tax year, it is not uncommon for them to open up as many as three years. Limiting the scope of the audit to one year will significantly reduce the overall effort involved on the part of the taxpayer (and their representative).

In addition, skilled representatives may be able to narrow the scope of information requested for a particular tax year. Often auditors will send out a generic list of items that are generally required, rather than a specific list of the categories or items that they are interested in examining. By limiting the first meeting to a few select items and proving up these items to the satisfaction of the auditor, the audit may be closed fairly quickly with minimal effort expended on the part of the taxpayer.

IRS AUDIT STRATEGY – INCOME ISSUES

Although many audits begin by questioning expenses or deductions taken on the return, often the auditor will also challenge the amount of income being claimed. This is often the case with business owners, especially those own businesses that deal with large amounts of cash (retail stores, restaurants, gas stations, etc…). As such, a thorough review of a client’s bank statements, general ledgers, and other financial information in connection with the return in question may be necessary to ensure that gross receipts were accurately reported. For clients who have comingled business and personal expenses on their bank accounts, it is necessary to separate out any personal deposits or expenses. These reconciliations may also be helpful during the initial meeting, as your attorney may be able to resolve preliminary matters with the auditor and further streamline the audit.

IRS AUDIT STRATEGY – OTHER POINTS TO CONSIDER

Two other points that should be noted. First, although the auditor will request performing the audit at the taxpayer’s home or place of business, it is unadvisable to do so and the audit should be conducted at a neutral location. This is because the auditor may use outside information, such as their observations about their locations or their conversations with the taxpayer’s employees against them in the audit. Second, it is important to review applicable audit procedures and guidelines for auditors issued under the Market Segment Specialization Program. These are specialized guides issued by the IRS, which discuss protocol and guidelines for field agents when conducting an audit. Often, they are divided by industry segment or by technical issue, and can be helpful for insight into where the auditor will be looking. Knowing what areas the auditor is going to examine leads to better preparation and faster resolution of the audit.

While not nearly as frightening as many taxpayers imagine, IRS audits are nevertheless serious matters that require attentiveness to the issues and potential issues at hand. The longer an audit continues, the more likely it is to expose the taxpayer to hefty examination changes and the more expense the taxpayer will accrue in defending themselves in the audit. Those who prepare for the audit in advance and who are able to control the scope of the audit and flow of the information that the auditor receives will likely encounter better success during their audit meetings. In this case, better preparation yields better results.

 

GOING SOLO: HOW TO REPRESENT YOURSELF IN AN IRS AUDIT – PART ONE

First, it should be noted that the decision to represent yourself in an audit should be made carefully. Examination changes during the audit process can ultimately be extremely costly with the extra interest and penalties that the auditor may add to your final tax bill. Even though audits are different for everyone, I have compiled a few helpful tips to assist those who ultimately decide to represent themselves.

IRS AUDIT TIP #1: SEE THE PLAYING FIELD

The IRS has limited resources and taxpayers mostly do not get audited by the government without a reason. This does not mean you have done anything wrong, but you may have unusual circumstances like working in a cash intensive business or have an unusual deduction that the government wants to take a second look at. The most valuable indication of what the government is after is the auditor’s Information Document Request (IDR), which is provided when you are initially contacted by the IRS. By understanding what the government is looking for, you can start mentally preparing and organize your documents in the most efficient way to provide the most complete substantiation possible. The more complete your substantiation is for an item requested, the less likely the government is to challenge the information stated on your return for a particular category.

IRS AUDIT TIP #2: LIMIT THE SCOPE OF THE AUDIT

The IRS typically has three years to request examination of a return, except in the cases of late/no filings, significant errors or omissions in the reporting of income or expenses, and fraud. Because the significant case load of the auditor, the IRS will normally start auditing with one year and then open up other years if there are examination changes. As counsel, my number one priority is to limit the scope to only one year and that should likewise be your goal as well. Opening other years will often equate to more changes and ultimately increases the size of your final bill.

IRS AUDIT TIP #3: CONTROL THE FLOW OF INFORMATION

Taxpayers representing themselves have the distinct disadvantage of having to answer the auditor’s questions point blank when asked. You should never lie or make a material misstatement to an auditor, as this is a federal crime that carries possible jail time. During the audit, however, taxpayers should make every effort to control the flow of information. Carefully listen to the questions that the auditor is asking and answer only the question being asked. Do not provide more documents than what is being requested by the auditor. More information gives the auditor more ammunition to make assessments and, therefore, brevity is the key to successfully navigating an audit.

Continue to Going Solo: How to Represent Yourself in an IRS Audit – Part Two

 

 

 

WHY THE IRS AUDITS TAX RETURNS?

The Examination Division of the Internal Revenue Service is responsible for auditing federal tax returns to determine if income, expenses, and credits are reported accurately. Although the IRS accepts most tax returns when filed, there are circumstances that warrant an audit. Within this context, the IRS is motivated to evaluate those areas of a tax return that fail to comply with current policies and provisions. In general, the IRS motivation behind auditing taxpayer returns falls under multiple categories.

First, the IRS is motivated to audit returns for the purpose of finding unreported income. In conducting both random and strategic audits, the “IRS has taken a renewed interest in finding unreported income” (Kane, p. 4). The IRS examines a taxpayer’s lifestyle to determine if income has been reported properly. For example, agents may use Form 4822[1] to determine how much a taxpayer spends annually for the purpose of comparing amounts to what the taxpayer reports on the return. If the agent is compelled to prepare a “cash T,” which represents a simple source and application of funds analysis, then the agent will pursue options that include questioning the taxpayer and indirect methods.

Second, the IRS Examination Division is motivated to audit returns to ensure customer service goals are met; these goals are specific to applying the provisions of the Taxpayer Act. In 1998, the Taxpayer Bill of Rights III[2] mandated changes in the type of customer service solutions the IRS must provide to both taxpayers and audited taxpayers. The IRS is motivated to ensure that the Taxpayer Act is implemented correctly and efficiently.

Third, the IRS Examination Division is motivated to audit returns of businesses in specific industries. For example, when it comes to conducting audits for a particular industry, the IRS gathers information about an industry for the purpose of creating an average profile. “Actual returns will then be compared against the profile to help find compliance problems” (Kane, p. 5, 5/21/2013). The IRS then issues guidelines, between 40 and 90 to date. In Bob Kane’s[3] article titled “What is the IRS Examination Division Up To Today (October 19, 1998),” he suggests that “[a]udit coverage has dropped off considerably from the mid-1970s when it was at the 2.59% level overall, to the 1.38% level of today” (Kane, p.1, 5/21/2013). However, the IRS is still motivated to evaluate particular industries. “The construction and fishing industries are two constant areas of scrutiny by the local IRS office. The IRS locally also has been focusing on mobile cart vendors, Laundromats, car dealers, bed and breakfasts, and businesses involved with . . . freight forwarding, import/export businesses, and storage and transportation businesses” (Kane, p. 4, 5/21/2013).

Lastly, the IRS is concerned about an additional area, namely employee/independent contractor audits because it represents a huge revenue loss. The IRS cannot collect payroll taxes from independent contractors. In addition, because there are issues with audits in this area, agents have received considerable training specific to worker misclassification. For example, the IRS unveiled the Classification Settlement Program, giving employers the option of settling cases where they have misclassified workers at reduced assessments. Tax attorney, Bob Kane, comments on this, stating, “To obtain the reduced assessments, the taxpayer must agree to treat the workers as employees in the future. The assessments vary between 25 and 100 percent of the tax liability for one year, depending upon the taxpayer’s level of compliance with the Section 530[4] requirements” (Kane, p. 6, 5/21/2013). The Small Business Job Protection Act (1996) modified Section 530, thereby changing the worker classification; the changes shift the burden of proof to the IRS “if the taxpayer establishes prima facie a reasonable basis for having not treated workers as employees” (Kane, p. 6, 5/21/2013). Employee training (IRS) within this area will increase the number of compliance incidences.

Motivations around IRS audits tend to reveal much about the purpose of each type of audit and the overall strategy of the Internal Revenue Service. By learning more about the motivations behind an IRS audit, taxpayers can hopefully avoid facing the scrutiny of the IRS. If you would like to know more about IRS audits, please read my other writings, available at: https://www.sambrotman.com/category/irs-audits-and-examination/

[1] Form 4822, Statement of Annual Personal and Family Expenses

[2] The 1998 Tax Act is formally referred to as the Internal Revenue Service Restructuring and Reform Act of 1998. It is known as the Taxpayer Bill of Rights III (Pub.L. 105-206, 112 Stat. 685, enacted July 22, 1998).

[3] Robert M. Kane, Jr. is a civil tax attorney with LeSourd & Patten, P.S. Attorneys at Law. Kane handles tax dispute resolution, tax litigation, and administrative appeals. Kane graduated with a J.D. from Gonzaga University School of Law and with an LLM from New York University. For more information or to view his profile, visit: http://www.lesourd.com/attorneys/robert_kane.

[4] Section 530 of the Revenue Act of 1978

 

 

IRS AUDITS: THE TYPES OF AUDITS – PART ONE

IRS audits, or civil examinations, are conducted based upon the type of taxpayer, the scope of the examination, and the complexity of the tax return. All taxpayers are expected to provide supporting documentation with regard to questionable items. Examinations may be conducted by correspondence, telephone, or through field interview. Business returns are typically examined in an office or field interview rather than by correspondence because of the complexity of the issues involved in a business audit. In this article, I discuss the different types of audits along with their similarities and differences.

Correspondence Audits

Correspondence audits, otherwise known internally by the IRS as a Campus Examination, are the most basic type of audit. Correspondence audits involve less technical tax issues and can be completed, much like their name implies, through the mail. As the IRS notes, the purpose of a correspondence audit is to resolve tax problems quickly and easily through correspondence and/or by telephone. “[E]xaminers at the correspondence and office levels are much less invasive”.[1] The examining agent is required to process many cases without much familiarity with the return itself. It is often the case that the examiner has not reviewed the taxpayer’s file and the return after the taxpayer has replied to the agent’s correspondence. The agent will generally review the taxpayer’s file on the day of the interview.

OFFICE AUDITS

Office audits, or Area Office (AO) Examinations,[2] are face-to-face audits that are conducted at the office of an IRS revenue agent. They are typically appropriate for somewhat complicated issues, which may include small business returns and complex non-business returns. Office audits may also be conducted by either correspondence and/or office interview.

In general, examination of a taxpayer’s income tax return falls initially under the responsibility of an area office where the taxpayer resides, conducts business, or maintains a principal office. The responsibility for the examination is assigned to “an examiner at the post-of-duty nearest to the taxpayer’s residence or place of business.”[3] If it becomes necessary to transfer a return to an office within another area after the examination process has begun, the convenience of the taxpayer will be taken into consideration as long as the transfer process aligns with “sound and efficient tax administration”. [4] However, what typically controls the decision-making with regard to the transfer of a case between area offices is the location of the taxpayer’s records, the purpose of principal investigative work, and where the taxpayer’s issues can be resolved most efficiently. These factors will overrule the taxpayer’s request for a case transferal.

With this in mind, a taxpayer’s case may be transferred (back) to the Area Office or between area offices. When the case is transferred, it receives audit reconsideration. “The examiner in the CRU[5] will send a case to the area examination function to be worked if the taxpayer requests a face to face examination, and/or [if] the completion of the case requires an examination of books and records, and/or [if] the CRU has not received the training to work the reconsideration issue(s)”.[6] Regarding face-to-face examinations, the Central Reconsideration Unit (CRU) receives those tax returns that were previously examined by the Area Office or Campus Examination function.

In this respect, the purpose of the audit reconsideration process is to examine those tax issues previously overlooked. For example, if “the taxpayer presents new information that was not previously considered, [IRS employees] evaluate that information and determine if a change to the assessment is warranted.”[7] The Area Office function will then make that change.

Continue to IRS Audits: The Types of Audits – Part Two

[1] See: http://www.mbbp.com/resources/tax/irs_tax_audit.html

[2] Area Office Examination is a term commonly used in the Internal Revenue Manual, but it refers to office audits here for the sake of this discussion.

[3] See: www.irs.gov, “Part 4. Examining Process, Chapter 11. Examining Officers Guide, Section 29. Transfer of Returns Open for Examination,” 9/9/2013.

[4] Id.

[5] The acronym CRU stands for Central Reconsideration Unit.

[6] See: www.irs.gov, “Part 4. Examining Process, Chapter 13. Audit Reconsideration, Section 4. Area Office Examination,” 9/9/2013.

[7] See: www.irs.gov, “Part 4. Examining Process, Chapter 13. Audit Reconsideration, Section 4. Area Office Examination,” 9/9/2013).

 

IRS AUDITS: THE TYPES OF AUDITS – PART TWO

Continued from IRS Audits: The Types of Audits – Part One

OFFICE AUDITS (CONTINUED)

After the AO examiner receives and evaluates the taxpayer’s information, the examiner will issue a decision based upon the type of case. For example, the AO examiner may “issue the audit reconsideration full allowance (full abatement of assessment)” by completing and submitting Letter 2738 DO, which is a service letter the IRS uses when the taxpayer’s case is eligible for full abatement. The examiner may issue an audit reconsideration full disallowance letter, which means the taxpayer would not receive an abatement of tax. Lastly, the examiner may issue another letter, an audit reconsideration partial disallowance letter (Letter 2737 DO, Examination Report). With this letter, the examiner must send to the taxpayers two publications: Publication 3598, What You Should Know About the Audit Reconsideration Process and Publication 5, Your Appeal Rights and How to Prepare a Protest If You Don’t Agree. Taxpayers may request an appeal for full disallowance and partial disallowance determinations.

Area Office examiners have little discretion and are typically required to verify income and deductions. “A taxpayer’s inability to produce adequate records may lead not only to disallowance of the disputed items for the year at issue, but also to audits of other years’ returns”.[1] It is important for taxpayers to maintain good records.

FIELD AUDITS

Field examinations, or field audits, are used for the most complex issues. The method of the audit is governed by the difficulty of the issues. Field audits are defined as in-person audits conducted at the organization’s location, the organization’s representative office, and/or at the local IRS office.[2] There are two types of field audits: general program and Team Examination Program. The first is defined as a type of field exam conducted by a revenue agent at the organization’s location. The second is defined as a type of exam involving a team of examiners; it is more specific to large, complex organizations.

Within this context, the examining agent will function as a revenue agent,[3] who may be an accountant who works for the Internal Revenue Service. Unlike other types of examinations, revenue agents spend considerable time reviewing the taxpayer’s return. The revenue agent examines and audits financial records of individuals, businesses, and corporations to ensure tax liabilities are met. The revenue agent reviews the taxpayer’s books and records at the place of business or warehousing location. In addition, the revenue agent reviews the taxpayer’s return and related supporting documentation. The agent may be assisted by an engineer agent, who supports the mission of the IRS by providing “professional and accurate development of issues and efficient and effective resolutions to more significant and complex engineering and valuation issues. Engineers provide expertise to issues encountered in all types of tax returns”.[4] The engineer agent plays a key role in supporting all IRS organizations that provide for the examination of taxpayer returns.

The type of IRS audit tends to reveal much about the purpose of each type of audit and the overall strategy of the Internal Revenue Service. By learning more about the motivations behind an IRS audit, taxpayers can hopefully avoid facing the scrutiny of the IRS. If you would like to know more about IRS audits, please read my other writings, available at: https://www.sambrotman.com/category/irs-audits-and-examination/

 

IRS RECONSIDERATIONS – HOW TO GET THE IRS TO RECONSIDER A TAX ASSESSMENT

IRS reconsiderations are when the IRS reconsiders taxes it has assessed when it receives information related to the assessment that was not previously considered by the IRS when it made its initial determination. It is important to note that this must be NEW information that leads the IRS to conclude that the assessment was improper. In addition, the taxpayer must demonstrate that they could not have presented or did not have the information available at the time the original assessment was made.

IRS RECONSIDERATIONS – AUDIT RECONSIDERATIONS AND AUR RECONSIDERATIONS

IRS reconsiderations of assessments come in three forms: Audit Reconsiderations, AUR Reconsiderations, and SFR/ASFR reconsiderations. Audit reconsiderations[1] (obviously by their name) are reviews of assessments made during the course of an audit that resulted in an additional liability for the taxpayer.[2] It is rare for the IRS to reconsider an audit that results in an additional refund for the taxpayer because of the statute of limitations on seeking a refund; however this does occasionally happen as well. AUR reconsiderations are reconsiderations of refunds and abatement requests for penalties and interest.

IRS RECONSIDERATIONS – SFR RECONSIDERATIONS

Finally, SFR (or Substitute for Return[3]) reconsiderations occur when the taxpayer has failed to file a tax return and the IRS has filed a return and made an assessment on their behalf. Normally, a taxpayer can trigger an SFR reconsideration by simply filing the return in question as the IRS will give preference to the return that was actually filed by the taxpayer over their own estimation. These are the instances where the IRS will reconsider an assessment of a liability and, by default, they generally will not reconsider assessments for any other circumstance. However, asking the IRS to reconsider an assessment is nevertheless a good strategy to mitigate taxes in certain circumstances. Keep in mind that reducing the underlying assessment will also reduce interest and penalties associated with the account (make sure the IRS calculates these correctly).

As a final note, the IRS is not in the business of reducing liabilities or giving money back to taxpayers simply because they ask. Many abatement requests are therefore denied or taxpayers fail to submit them properly. Although many IRS problems can be handled on your own, I would recommend consulting with a tax professional if you are considering submitting a reconsideration request. The professional will likely have a good understanding of the procedural requirements and any pitfalls associated with the process and can walk you through the process. Obviously, there may be some out of pocket expense associated with hiring a tax professional, but their help often substantially increases the likelihood that your request will be reconsidered. The potential tax savings can often outweigh the costs in these circumstances.

[1] Here is in-depth information from the IRS on IRS audit reconsiderations.

[2] Author’s note: it is better to fight an audit at the time the audit occurs, rather than rely solely on an IRS reconsideration to get your assessment reversed. I have written a good article here on IRS audit strategy.

[3] More information from the Internal Revenue Manual on substitute for returns can be found here: http://www.irs.gov/irm/part4/irm_04-004-009.html#d0e1223.

 

 

GOING SOLO: HOW TO REPRESENT YOURSELF IN AN IRS AUDIT – PART TWO

Continued from Going Solo: How to Represent Yourself in an IRS Audit – Part One

IRS AUDIT TIP #4: WIN MORE FLIES WITH HONEY THAN WITH VINEGAR

It is difficult for many taxpayers to keep their emotions in check during an audit. Many are scared of the government examining their records, angry at the inconvenience of the audit, and some auditors can be very difficult to deal with. However, the best audit results are gained by working with the auditor collaboratively rather than butting heads with them. Auditors are people too and they will often cut breaks to those taxpayers that they like personally or who make their job easier by coming to the audit organized and prepared. With this in mind, be nice to your auditor and do everything you can to facilitate the audit process.

IRS AUDIT TIP #5: PICK YOUR BATTLES

I handle audits from a big picture perspective. It does not make sense to fight tooth and nail for a small deduction when it may lead the auditor to open up other years or risk jeopardizing your working relationship with the auditor. Also, conceding deductions in some areas or by only taking a certain percentage when you do not have sufficient receipts or substantiation may ultimately serve you well. Auditors tend to respond positively when taxpayers are reasonable and small concessions may lead the auditor to be more lenient in other areas. Try to keep yourself focused on the final goal, which is getting the smallest examination change possible.

IRS AUDIT TIP #6: WHEN TO GET HELP

There is nothing wrong with the decision to represent yourself in an IRS audit, especially when you are organized and have nothing to hide. However, if your return is not entirely accurate, you failed to report income or overstated expenses, you did not keep very good receipts and records, or you feel you have reached an impasse with the auditor then it is a good idea to seek help. Since the ultimate goal is to have the smallest final bill or to obtain a “no-change,” hiring an attorney to represent you for a few thousand dollars has significant advantages. Attorneys often have a prior good working relationship with the IRS, have expert knowledge of IRS audit procedures, know the right time to elevate an issue to appeals, and can often move through the audit quicker than a taxpayer can alone. In addition, the attorney client privilege offers a greater level of protection than an accountant or enrolled agent and is especially important in cases where wrongdoing has or may have been committed. Because of the attorney client privilege, anything you say to an attorney will be held in confidence unlike any other representation. When in doubt, most attorneys offer free consultations and it is best to seek advice from a few sources before moving forward. Doing so can often save time, worry, and money when the audit is all said and done.

 

 

[1] See: http://www.mbbp.com/resources/tax/irs_tax_audit.html

[2] See: www.irs.gov, “Charity and Nonprofit Audits: In Person [Field] Examination Audit,” 9/9/2013).

[3] Within this context, not all revenue agents are considered accountants.

[4] See: www.IRS.gov, “Part 4. Examining Process, Chapter 48. Engineering Program, Section 1. Overview of Engineering Program,” 9/9/2013).

 

 

HOW TO AUDIT-PROOF YOUR TAX RETURN (ALMOST)

Full disclosure here, the IRS does not reveal the exact criteria that it uses to audit a tax return. However, this closely guarded statistic is not so much of a secret anymore. Not surprisingly, the government uses statistics to analyze tax returns and to determine which taxpayers it selects for IRS audits. Shameless self-promotion alert: I have also written a pretty comprehensive list of the factors that the IRS that are known by tax attorneys as “audit red flags.” However, in this post, I want to discuss perhaps the most important factor in avoiding an IRS audit: essentially making it bulletproof from the scrutiny of the IRS.

Here’s a quick recap about how IRS audits work. All tax returns are processed into a computer, where they are assigned two scores: a DIF score (assessing the potential changes on a tax return [i.e. increased revenue]) and a UDIF score (assessing the potential that there is unreported income on a tax return). Returns with high scores are sent to an IRS reviewer, who manually examines a return to determine its potential for audit. Those that are selected by the reviewer are sent to local field offices where a revenue agent will conduct an IRS audit. Those not selected by the reviewer are tossed back into the pile (so to speak) and are safe from audit.

The fact of the matter is that the IRS can only conduct a certain amount of IRS audits per year, so it selects the tax returns that are most likely to yield revenue or that contain the greatest potential for error for additional review. Think of it from the government’s perspective: why would they devote manpower, time, and limited resources toward auditing a return that is likely not going to yield them additional revenue? Answer: they probably won’t.

So, how does this all relate to you, your tax return and avoiding an IRS audit? Simple. When preparing your return this year, ask yourself this question: DOES MY TAX RETURN MAKE SENSE? Is all my income accounted for and reported correctly? Do the deductions listed on my Schedule A (where you itemize) make sense? Do I have excessive charitable contributions for someone of my income level (especially in comparison to the past three years)? Do my business expenses make sense (are you a plumber that wrote off international travel) and are they likely to be considered ordinary and necessary by the IRS?

Do you see where I am going with this? Most of the tax returns that come across my desk as a tax attorney that have been selected by the IRS for audit have some burning question that I cannot answer off the bat. They are like the video ads in Starship Troopers that keep asking, “Would you like to know more?” (Yes, I was able to make a Starship Troopers reference in a tax article). If your return comes across my desk and I am left asking questions, then that’s probably the reason your return was selected for an IRS audit (i.e. the manual reviewer had those same questions).

So spend the extra time to make sure that everything on your return makes sense and, if it doesn’t, then the IRS allows you to attach a supplemental statement to return that explains certain items. Little used by tax professionals and individuals preparing their returns, these statements can actually help you avoid an audit by giving you a chance to explain out items that may be problematic on the return. More than that though is that a well-written articulate statement written about an item on a tax return sends a message to the reviewer that the person on the other end of this return has the ducks in a row. And if that person is prepared to defend their return, then there is a good chance that auditing that return will lead to no change, and if it leads to no change (hint: the IRS likely does not want to audit it).

So here is the takeaway: if your return makes sense and everything is well explained, then you will likely never encounter the pain of going through an IRS audit (hiring people like me, digging out old records, devoting significant time and expense). My advice here is to take the extra time going over everything to make sure everything on your return is in order. Hire a competent CPA or tax attorney, like this guy, to prepare your return. Go through the motions now and save yourself a lot of trouble later.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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