Understanding Audit, Issues and Strategies (Part 2)
By: Heather L. Marello, Esq.
Types of Audits
Pursuant to the IRS Data Book, during calendar year 2016, the IRS audited almost 1.1 million tax returns, or 0.5% of all returns filed. A representative never can (or should) predict to a client whether his or her return will be selected for audit, as a number of factors can cause the IRS to select a certain return for examination. For example, the IRS may have information (i.e. W-2 or 1099) that was not reported on a return; an examiner may expand the scope of an ongoing audit to include additional years; an amended return taking a position contrary to that of the original return may raise a red flag; the return may have a high Discriminate Function System (DIF) score due to certain items on the return such as large non-cash charitable contributions or consecutive Schedule C losses; or the selection may appear to be random.
These examinations come in three forms (1) correspondence audit; (2) office audit; or (3) field audit. Correspondence audits are common for math errors or minor substantiation cases, such as Earned Income Tax Credits, and are often performed through correspondence with the taxpayer. Office audits require a taxpayer or his representative to appear at the IRS with substantiating documentation for the audited issues, and field audits are conducted at a taxpayer’s home, business location, or representative’s office. The following discussion is focused on office audits, though some strategies and techniques extend to correspondence and field audits as well.
The Audit Letter
When a client receives correspondence from IRS that his or her return has been selected for audit, the letter generally contains Form 4564 Information Document Request (“IDR”), which requests that certain documentation be brought to the initial audit meeting. This document is important to determining the areas of inquiry that the IRS intends to focus on, whether it be a Schedule C business, Schedule E rental property, charitable contributions, etc. It is the practitioner’s job to keep the IRS focused on the issues outlined in the initial audit letter and discourage the audit from expanding to other Schedules or issues.
Initial Audit Appointment
Even if a taxpayer is represented by a Power of Attorney, the IRS generally insists that the taxpayer and/or representative physically present the information to the examiner. The representative should provide organized, responsive information to the IRS at the meeting, and should have an understanding of that information to be aware of any potential red flags and a strategy to deal with those potential issues. The IRS cannot compel a representative or taxpayer to create any documents for purposes of the audit. However, if the client does not have substantiation for a certain category (i.e. mileage), the representative can work with the taxpayer on methods to create a mileage log through a contemporaneous calendar, industry standards, or other reliable means. The representative should be forthcoming with the agent that the substantiation was created for purposes of the audit and explain the method used to create the log or summary.
As a general rule, clients should not attend the initial audit meeting, or any other meeting with the examiner. The representative is better equipped to keep the audit focused, is more knowledgeable about the legal issues, and often can work with the examiner to resolve the case without testimony from the taxpayer. If the IRS deems it absolutely necessary to speak with the client, the examiner can issue a summons for the taxpayer’s testimony. In that circumstance, the representative must decide on a case-by-case basis whether to (1) allow the client appear for the summons and provide substantive testimony to the examiner; (2) allow the client to appear for the summons and assert rights against self-incrimination pursuant to the Fifth Amendment; or (3) challenge the summons.
Requests to Extend the Statute of Limitations for Assessment of Tax
The IRS generally has three years from the later of the date the tax return was due or filed to assess a deficiency in tax. The Internal Revenue Code provides exceptions to that rule if (1) the return contains a substantial understatement (25%) of income; (2) there was fraud on the return; or (3) no return was filed. Additionally, the IRS can solicit consent from the taxpayer – before the statute of limitations expires – to voluntarily extend the IRS’s time to assess a tax. A practitioner should not have a clear cut rule on whether to sign or refuse to sign these consents, but a decision should be made on a case-by-case basis. Some questions to consider are: Is the examiner working cooperatively with you? Is the examiner looking to expand the issues in the audit with the additional time? Are there any areas that cause concern for potential criminal liability? Is there a benefit to going to Appeals before petitioning the Tax Court?
A discussion between an attorney and a client for purposes of securing legal advice are covered by the attorney-client privilege in both civil and criminal matters. The Internal Revenue Code extends a similar – but not identical – privilege to federal tax practitioners who practice before the IRS. The federal practitioner privilege protects discussions between a client and representative with respect to legal issues, but only in civil cases. As the client needs privilege the most in criminal cases, it is imperative that a non-attorney representative ceases discussions with the client and consults a lawyer as soon as the representative senses any issue that may become criminal.
If the representative wishes to continue working with the client on an issue that may turn criminal, the attorney can enter into a Kovel agreement with the non-attorney to assist with the representation under the full protection of attorney-client privilege. However, the Kovel privilege is not retroactive and only applies to discussions and information learned after the Kovel agreement is signed.
Defenses for Audit
Audits often involve a combination of factual (substantiation) and legal issues. Both the Internal Revenue Code and the Treasury Regulations are binding on the IRS, and they must follow the provisions, even if that results in a concession for the taxpayer. Moreover, while not binding, both IRS published guidance and the Internal Revenue Manual can often serve as persuasive authority in support of the taxpayer’s position.
In addition to a deficiency, the examiner will be looking to determine whether any penalties apply. Penalties asserted at the examination phase often include (1) failure to timely file a return; (2) failure to timely pay tax; (3) failure to pay estimated tax; (4) negligence; and (5) fraud. Practitioners should be cognizant of any circumstances or events that give rise to a reasonable cause argument for penalty abatement, and whether the failure to file/pay penalties are eligible for first time penalty abatement.
Furthermore, although the audit phase can be a far cry from the collection phase, representatives should begin thinking about whether a claim of innocent spouse would be effective to relieve a spouse from a joint liability, or whether the taxpayer is a good candidate for a future offer in compromise or bankruptcy.
Closing the Audit
There are four ways to close an audit: (1) fully agreed; (2) partially agreed; (3) unagreed; or (4) no change. If the client agrees with the examiner’s proposed adjustments, the client (or the representative, with the taxpayer’s express authority) will execute Form 4549 Income Tax Examination Changes. The taxpayer’s consent allows the IRS to assess the tax shown on the Form 4549 and begin collection. If a matter is partially or fully unagreed, however, the representative may submit a protest and request the opportunity to have the case reviewed with IRS Office of Appeals. Alternatively, if the examiner issues a statutory notice of deficiency, the case must be petitioned to the United States Tax Court.
The attorneys at Andreozzi Bluestein LLP have extensive experience representing taxpayers under audit with the IRS and are well versed in the nuance of handling issues during the audit process. If you or a client would like assistance in dealing with the IRS at any point during the audit process, please call us anytime for a no obligation consultation.
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