IRS Tax Audit

Overview of an IRS Tax Audit

An IRS audit is a serious event. The IRS takes them very serious and so should you. The IRS devotes an army of specialists to the audit engagement. They have agents, they have investigators, they have managers, the have appeal officers, they have attorneys, and they have massive technology and data behind them. Above all, the IRS has the awesome power of the government behind them.

Audit representation requires both expertise and human skills. Many a times, a positive outcome will depend not only on the high technical expertise that but the ability to negotiate with IRS auditors. We consistently produce results that are second to none. We study your case carefully.

Keep Your Cards Close to Your Chest

On one hand you must always remember that although you may have weak points in your tax audit, the IRS agent does not necessarily know all those weak points. We negotiate based on what the agent knows about your case not what we know. We must always be truthful in any representation. There is however a difference between truth and folly.

It is imperative for taxpayers not to engage such events without an expert or experts on their side. A knowledgeable tax CPA or a tax attorney is a formidable power to navigate the audit ordeal safely and favorably for the taxpayer.

Steps to Take After Receiving Notice of Being Audited

  1. Search for the right audit specialist, be it a CPA or an attorney. Traditionally, audits are handled by a CPA. Attorneys and enrolled agents do represent clients in tax audits as well.

  2. Agree with your representative as to his or her role and your responsibilities to help your CPA or otherwise provide an efficient audit representation. Your CPA or tax attorney should be able to discuss with you the significance of the audit and areas of exposure. They may be able to quantify the expected amount of tax liability at the outset.

  3. Determine in advance, with the help of your CPA, items that you are willing to compromise, and items that you feel strong about.

  4. If you are worried about meeting the IRS Agent, insist in advance that you should not meet with the agent. You have the right to do that unless it is an IRS summons.

  5. Discuss with your CPA or tax attorney the audit fees in advance and the method and timing of payments for such fees.

  6. Your CPA must then prepare you for anticipating questions that you may need to answer such as acquired assets, sold assets, cashier checks bought from the bank, living expenses and other sources of income, just to mention a few. You should be fully prepared if you and your CPA agree for you to be interviewed by the IRS agent.

Types of Tax Audits the IRS Conduct

The IRS will audit individual returns to ascertain that all income is reported and that all expenses and credits are correct. They will also audit business returns such as corporate returns; 1120, 1120S and partnership returns for the same reasons. They will also audit payroll tax returns such as form 941 audits and federal unemployment audits. There are other excise audits as well, such as estate tax audits.

The IRS will conduct an audit in different ways and is based on the magnitude of the audit scope the IRS wish to proceed with. The three ways the IRS will conduct an audit examination on a tax return (business or individuals) are:

  1. Correspondence Audit

  2. Office Audit

  3. Field Audit

IRS Correspondence Audit

Typically taxpayers receive a letter form the IRS Service Center (as opposed to Area Office) a letter asking for support or an explanation of one or more items. If taxpayers respond satisfactorily to the request, that will be the end. Taxpayers, however can ask to transfer the audit to the Area office thus converting it to an Office Audit, which may expose taxpayers to other inquiries. It may be prudent to leave Correspondence Audit at the IRS Service Center rather than bring it to The Area Center. Never mail originals in your correspondence. Maintain a file noted as “items sent to IRS.”

Hopefully the IRS will be satisfied and accept the return as filed by the taxpayer. Otherwise, IRS will issue a thirty day notice. Taxpayer has thirty days to respond to the 30-day notice. If not the IRS will issue 90-day letter which can only be addressed in tax court (Tax Court petition within the 90-day period.)

IRS Office Audit

If the IRS determines that it is not sufficient that return be handled through correspondence, the Service Center will transfer the audit to the appropriate area for an Office Audit. The Office Audit is a regimented audit, because the IRS auditor has to follow a predetermined list that he is presumed not to divert from. He can, however expand the scope of the audit, but he must justify that to his Group Manager.

The audit typically covers items that have an inherent misstatement such as “travel” or “office at home” expenses. Schedule C income and expenses are usually a favorite. They may want to verify dependency exemptions or itemized deductions. They will typically ask if all other returns are filled (payroll returns-941’s.) Be prepared to provide bank statements, cancelled checks and some invoices.

Should You Give the IRS Your Prior Returns?

The auditor may ask that you provide them with copies of prior tax returns. Why do they ask for those returns when they should have them in their system? The answer is that it takes time for the IRS auditor to obtain those returns from his or her own system! Some CPA’s believe that they should provide those returns. Others do not provide them hoping that, under schedule pressure and the need to close the audit, IRS auditor may not be able to look at the prior return in a convenient time. Thus, the hope is that they will overlook this part of the audit and in this manner, are prevented from expanding the scope of the audit.

If client agrees, a report IRS Revenue Agent will issue the report. Form 4549 (Income tax Examination Change) will be issued denoting the adjustments in a summary fashion that delineates the years adjusted with a detail back up for each adjustment. If taxpayer or the CPA signs the report the audit is closed (pending manager’s approval.) This agreement does not preclude you of a negotiated settlement such as installment agreement, offer in compromise or even uncollectible status.

If you disagree, you can proceed to appeal after trying to resolve the issue first at the group manger’s level.

IRS Field Audit

A field audit is usually more involved and is conducted by more experienced or qualified IRS agents. It is usually conducted for taxpayers who can be corporations, partnerships or individuals with business income (schedule C.) IRS agents conduct their audit in the taxpayer’s or taxpayer’s representative place of business.

No Interview Please

As mentioned previously, unless the CPA sees a particular advantage of client being interviewed by IRS agent (it is generally a bad practice), the agent should not be allowed to speak to taxpayer. The IRS auditor, however has the right to visit the business premise. In their tour, they take note of the size of the premise, the inventory, the number of the employees, the machinery or other assets as applicable. The tour should be controlled by the CPA or a designated person.

Good Cop, Bad Cop

In conducting the audit, the CPA must provide only the requested information. Sometimes, pointing an error that the taxpayer made to the IRS auditor can go along way in establishing the trust and the integrity of the relationship. Generally, one should provide only the requested information, no more, no less. How to provide the information is a judgment call on the CPA part.

Neat Records or Fishy Smelling?

Some prefer the shoe box approach thus causing the IRS agent to consume a lot of time trying to make heads from tails, others advocate some sort of order to the data supplied to the IRS representative. A reasonable amount of order in the data, would establish good faith and may help at the time of negotiating the audit outcome with the Revenue Agent.

Again if agreed, the auditor will issue the Form 4549 report if not the case proceeds to appeal.

Appealing an Audit Outcome You Disagree With

The CPA or the representative will generally write the appeal. The appeal process usually starts when the IRS issues the 30-day letter if there is a disagreement in the audit findings. The taxpayer must file the protest within the thirty day window. The protest may include certain language the taxpayer must adhere to.

The Appeal’s Office main purpose is to settle the case and avoid litigation. However, one should prepare a succinct audit appeal and not take the settlement at appeal for granted. Most cases are settled at the appeal’s level, otherwise the next step is court.