Sam Brotman, JD, LLM, MBA October 21, 2020 15 min read

How to Create an IRS Audit Strategy

When it comes to audits, a favorite saying of mine is that I like to see the playing field in order to know all the issues and the potential concerns 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 thorough review of the return to look for other underlying and potentially dangerous issues with it. 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. 

Getting a sense of these issues, as well as any potential concerns on tax returns in the preceding and succeeding years (which may also be audited), I start to formulate a strategy that can determine the best way to approach the audit.

The IRS generally audits taxpayer returns because of their participation in questionable tax avoidance transactions or because of their likelihood that the 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. 

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 who 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 commingled 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 additional points should be noted. First, although the auditor will request performing the audit at the taxpayer’s home or place of business, it is inadvisable 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 concerns 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.

 

How to Beat IRS Examinations at Its Own Game

Here are some of the tactics that we use when dealing with IRS examinations in order to get the best results for our clients. I am not necessarily recommending as a layperson that you try to follow these strategies by yourself. I am simply letting you know, because I want you to see the playing field in terms of how IRS audits actually work and some of the tactical maneuvers that we use to get the best results for our clients. 

Again, with an IRS audit, particularly a field audit, you want to make sure that you are handling the situation with an appropriate amount of deference. Usually, with field audits you want to get an attorney involved as quickly as possible.

 

Stay One Step Ahead of the Auditor

Here is the way we handle the situation. First and foremost, when dealing with an examination issue, we stay at least one step ahead of the auditor in order to create a very defined path to lead the auditor down. 

There are three things you must keep in mind: 

  1. Have a clear idea of at what point you are starting on in the audit. 
  2. What are the facts? 
  3. Based on the information you have about your current situation, what are the likely outcomes? 

 

Have a Clearly-Defined Path

In order to get yourself in a clear position, you need to understand what the next step is going to be and what your exposure is. Based on these two points, you want to plot a path. You want to map out the audit and strategize to address the issues before your auditor does.

There are going to be sequences in the audit process that you are going to go through. For example, you are going to have a meeting with the auditor in which you are going to present documents. Your presentation should match your goal.

Every step along the way should match what you are trying to accomplish. In some cases, we are trying to not disclose information to the auditor. We will do everything we can, even at the risk of making our relationship a little bit difficult with the auditor. 

We will not tell the auditor everything about a particular course of action because if the auditor were to discover it, the client would walk into a big problem. One of the other things that we utilize is what we call a “Trojan Horse.”

If we realize that the client is going to get caught in a certain area, then we can use that. We will offer it to the auditors so they can make an adjustment and in exchange, we will focus the attention of the auditor on that particular area and move them around another concern.

 

The Appeals Route

The other thing that we do is leverage our relationship with IRS appeals. There are different ways to handle the audit – you can either be cooperative or not. Generally speaking, it is easier to attract more flies with honey than vinegar. At the same time, sometimes you have to be a little tough with the auditor.

In addition, you have:

  • The appeals division, 
  • The ability to file a tax court petition, and 
  • The ability to speak with both the audit manager and the territory manager. 

You have different avenues to pursue in order to get the best result.

Your end goal may not be through the audit division. You may get your end goal through appeals. If this is the case, your best move may be to get out of the audit as quickly as possible and correct everything once it is gone to appeals. 

Going to appeals is a factual decision based on strategy and on trying to navigate through the process. It is most often the easiest way of moving along and that is how you beat examination.

The Power is in Your Hands

You have the power in an audit. It may seem like the auditor’s in control, but they’re not. You control the moves — you make a move, the auditor has to make the move. They are constantly reacting and they are constantly responding to your moves. 

Think about some of the options I’ve written about and look at the “big picture,” not just the step-by-step. If you do, you’ll be much more likely to achieve the audit result that you want. This is how you beat the examination at its own game. 

At this point you have learned that although IRS audits are serious matters, they are not as frightening as you may have imagined. You should also know how important it is to address the issues before your auditor does. 

Again, I recommend getting an experienced attorney involved. At Brotman Law we can surpass what your CPA, tax preparer or even your CFO can do – and win in tax court. Strategy is very, very important in the context of an audit, so give us a call and we’ll start mapping one out for you.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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