Surviving an IRS Audit

If you have already filed your return for 2008, you probably think that you have completed your IRS obligations for the year. However, if you are one of the “lucky” taxpayer’s selected for audit; the “fun” is just beginning. In my 28 years of practice I have been through a number of client audits and there is one common thread that runs through them all:  they are very time consuming and expensive. If you are contacted for examination, you should immediately contact your tax advisor and devise a plan for getting through what will be at best a distasteful process.

The IRS annually publishes various statistics on its examination process. You can download the 2008 IRS Data Book here. As you will see, the IRS tries to audit about 1% of all individual returns; however, of this amount, only 30% involve face-to-face meetings with the IRS. Although the IRS likes to point out that many people actually get additional refunds when their returns are audited, you should not expect that to be true for you.

The IRS selects returns for examination in five ways: 

1. Computer scoring by discriminate information function (the so-called “DIF” score);
2. National Research Project;
3. Local and national projects that look at particular areas;
4. Information matching, such as Forms 1099, and
5. Related returns.

Your chances of being chosen for an audit are higher if:

• You have a relatively high income level
• You have a relatively low income level but live in a high income area
• The data on your return does not match IRS data
  • The IRS computers will automatically correlate your data (W-2, 1099 and state returns) with that provided to the IRS by employers, banks, securities firms, real estate brokers, etc.
• You make mathematical errors
• You are involved in an “abusive” tax shelter, or
• You file a complex tax return

Claiming certain “targeted” deductions may also increase your chances of being audited. Returns are frequently flagged for additional review and possible audit if they contain unusually large deductions for medical expenses, charitable contributions, casualty losses or hobby losses.

However, do not let this deter you from claiming legitimate deductions that may be significantly larger than average for your income level. Simply file an accurate, complete and timely return and save all supporting documentation.

If, despite all the odds, you are selected for an audit, you will be informed of that fact and the type of audit to be conducted. Usually the audit will cover a prior year’s return since most audits involve returns for the tax year two years prior. Three types of audits are possible:

1. A correspondence audit, in which you are required to mail documentation to the IRS supporting the particular items on the return that are being questioned;
2. An office audit, which involves going to an IRS office for an interview with a tax auditor;
3. A field audit, in which a revenue agent is sent to your home or office to review records.

Act Immediately

The first thing you should do upon receiving your audit notice is locate your copy of the return in question and go over it carefully. Gather all the supporting documentation for the return. If the audit is to be conducted in an IRS office, the notification letter probably will outline the specific items that are being questioned and the required documentation for each. In addition, be sure to inform your tax advisor. He or she can advise you of the proper support to submit in a correspondence audit or accompany you on an office or field audit.

You have the right to appoint someone to represent you in the audit which generally means the IRS must deal with your advisor instead of you. Generally, you will be much better off if you appoint a professional to handle the audit. Although you will incur higher profession fees.

When the IRS auditor concludes the investigation, he or she will prepare a Revenue Agent’s Report stating conclusions and recommendations. If you do not agree with the findings, you are entitled to a second opinion from the auditor’s supervisor. Upon receiving the report, you have the option of appealing to a higher level within the IRS or directly to the courts.

IRS Appeals

The IRS has an internal appeals process that is suppose to provide a venue where disagreements concerning the application of tax law can be resolved on a fair and impartial basis for both the taxpayer and the government. While the Appeals office may be a separate office within the IRS, it is still part of the IRS and it leans strongly toward the IRS position. Moreover, IRS auditors often discuss cases with Appeals Officers on an informal basis attempting to influence their decision process. Under the Freedom of Information Act, you can ask for any written correspondence your auditor may have with the Appeals Officer, but in most cases there will be none since the discussions are limited to oral conversations to avoid such disclosure.

If you choose an IRS appeal first, you must respond to the report within 30 days. A written response is not required if the audit was conducted in an IRS office or through the mail and the proposed changes in tax do not exceed $2,500.

If an informal meeting at the Regional Appeals Office does not lead to agreement on the adjustments, or if you chose not to follow this course of appeal, the IRS will mail you a statutory notice of deficiency. At this point, you must turn to the courts for further relief.

Litigation Options

The Tax Court generally hears cases in which the tax has not been paid. In order to appeal to the Tax Court, you must file a petition within 90 days of the date of the statutory notice of deficiency. If the Court does not find in your favor, you may appeal the decision to a Court of Appeals.

The benefit of going to the Tax Court is that you do not have to first pay the challenged tax. However, the Tax Court is generally made up of judges who are well-versed in the tax law and tend to favor the IRS. In addition, there is no jury as the decisions are made by the judge. Normally, there will be a compromise from the IRS position pre-trial.

Tax court cases involving disputes of $10,000 or less for any taxable year may be handled under Small Tax Case procedures, which allow you to argue your own case in court. However, decisions rendered under these procedures are not subject to appeal.

As an alternative, if you have already paid the tax and filed for a refund, you may take your case to a U.S. District Court (in which you have the option of a jury trial) or the Court of Claims. A suit for refund can be filed if the IRS does not act on your refund claim within six months of the date of filing. Such a suit must be filed no later than two years after the IRS has disallowed the claim.

Unless the issue involves a high dollar amount, you are not going to litigate the matter. The IRS understands this and factors it into their position.

Six Steps to Survive an IRS Audit

There are six steps to take to survive an audit once one has been commenced. Most state tax authorities simply follow the findings of the IRS. After the federal audit is complete, the IRS sends a notice to your State, which then sends you a second tax bill for the additional state tax attributable to the IRS adjustments.

1. Hire a professional to help

The auditor’s goal is to increase your taxes. He or she interviews taxpayers every day and is an expert at getting them to make statements that confirm his or her conclusions with respect to a particular tax issue (e.g., that a business is not a business but a hobby; that a charitable expenditure also provided a personal benefit, etc). While I am in no way saying that you should lie or withhold information from the IRS, I do think it is important for you to carefully choose what you say because examining agents often take statements out of context to get to the conclusion they want. If you hire a tax professional with IRS audit experience, you are simply leveling the playing field in terms of conducting the “game.”

2. Postpone the audit if you’re not ready

Your audit notice will include an audit date that is 30 days away. However, that may not give you enough time to find a suitable tax professional or to do homework if you are representing yourself. It is much better to postpone the audit and go in loaded for bear, than to go in with incomplete knowledge of your position. I can assure you that no matter how prepared you are you will leave with at least part of your head handed to you.

3. Appeal when you believe your position is correct

If you lose your IRS audit, ask for the documents supporting the ruling. It is important to review those documents carefully because often the IRS will adopt a position based on a case or ruling that is taken out of context or incorrectly interpreted. You need to double check all of their conclusions. If you still believe you are in the right, you have 30 days from the date on your audit report to appeal. Although you should not expect the problem to go away at Appeals (even if you are correct), you can expect to reduce to some extent the amount of tax and penalties you owe.

4. If you lose the audit, and cannot pay up, ask for an installment plan

If your audit bill amounts to $10,000 or less, you cannot be turned down for a three-year installment schedule. If your audit bill exceeds $10,000, then you must show that you require an installment plan. Complete Form 9465 to obtain this benefit.

Because both the failure-to-pay penalty and interest charges apply to the late payment of tax, borrowing from a commercial lender may be less expensive than paying the IRS penalties plus interest. IRS penalties are nondeductible, and interest expense associated with a federal tax liability, whether paid to the IRS or to a commercial lender, generally is nondeductible personal interest. If you finance the payment with a home equity loan, the interest can be deductible (subject to certain limitations) regardless of how the proceeds are used.

5. Try to settle for less if you cannot pay and it is doubtful you will ever be able to pay

If you think you will never have the cash to settle the full amount with the IRS, you can attempt to negotiate.

Fill out Form 656, Offer in Compromise, and next to “Grounds for acceptance of this offer,” type: “Doubt as to collectability of the full amount of tax, penalty and interest.” Make an offer of at least 10% of your bill; on average, the IRS accepts 15%. Be patient. The IRS usually takes six months to a year to decide on taxpayer offers.

6. Request an IRS Problem Resolution Officer (PRO)

If you face financial hardship because of an IRS seizure of wages or bank accounts, or if you have made at least two unsuccessful attempts to resolve your problem through regular IRS channels, you qualify for special help. File a taxpayer-assistance order, Form 911, with your district office’s so-called problem resolution officer, or PRO, who will try to fix your problem within two weeks.