Appealing A Tax Audit
Appealing A Tax Audit Within the IRS
- Pros and Cons of Appealing an Audit
- How to Appeal an Audit
- How the Appeals Office Works
- Preparing for an Appeals Hearing
- Meeting the Appeals Officer
- Presenting a Case to an Appeals Officer
- Negotiating a Settlement
- Should You Hire a Tax Professional for Your Appeal?
- If You Don’t Settle on Appeal
You tried to get the auditor to be reasonable but she just wouldn’t see things your way. In fact, you received a costly examination report. You spoke to the auditor’s manager in an effort to win an informal appeal. Again, you didn’t have any luck. You are not ready to give up, though. What’s next? Appealing Your Audit.
The IRS has an administrative procedure for appealing unagreed examination reports to an IRS Appeals Office. The appeals office has nearly 2,000 employees scattered throughout the United States. Take advantage of this procedure, which is described in IRS Publication 5, Appeal Rights and Preparation of Protests for Unagreed Cases.
Fewer than one in ten audited taxpayers appeal. Many more taxpayers should. Appealing is neither difficult nor time-consuming, and your chance of achieving at least some tax reduction is excellent. You rarely need to hire a tax professional to file an appeal. Despite this, however, most taxpayers are either too discouraged or intimidated to appeal. That’s too bad.
The official IRS position on the appeals process is this:
The appeals mission is to resolve tax controversies, without litigation, on a basis which is fair and impartial to both the government and the taxpayer and in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the [IRS]. (Internal Revenue Manual §8631.)
Appeals of other IRS actions. In addition to audits, many other IRS decisions may be appealed, as discussed throughout this book.
The Odds of Winning an Appeal
Most auditors privately refer to the appeals office as the IRS’s gift shop. There is even an IRS in-joke that appeals officers work on the 50% rule—they like to cut auditors’ adjustments by half.
IRS statistics show that the auditors are exaggerating—but not by much. The average appeal results in a 40% decrease in taxes, penalties, and interest imposed by the auditor. So, even the IRS confirms that it pays to appeal. The only mystery is why more audit victims don’t.
According to the IRS, in a recent year, over 100,000 appeals were taken by taxpayers and over 80% were resolved in a manner acceptable to both sides.
Pros and Cons of Appealing an Audit
There are three solid reasons for appealing an audit and two relatively insignificant reasons not to.
- Appealing is simple and costs nothing unless you use a tax professional, which is not usually necessary for success.
- Appealing, in the majority of cases, results in some savings, although rarely a total victory.
- Appealing delays your audit tax bill for months, buying you time to consider payment options.
- The appeals officer can raise issues the auditor missed—but this almost never happens. Nevertheless, if you are afraid that a missed item will be discovered and you’ll owe a lot more in taxes, you can skip the appeal altogether. In this case, you can go directly to tax court, where new issues can’t be raised. (See Chapter 5.)
- Interest (and sometimes penalties) on the tax bill continue to run while you are appealing. This is typically a small item as compared with the likely tax savings resulting from most appeals.
How to Appeal an Audit
After the audit, the IRS sends an examination report with proposed adjustments—additional taxes, penalties, and interest. If you don’t sign and return a copy of the report within a few weeks, the IRS usually sends a letter (the 30-Day Letter) and an explanation of how to appeal the report.
The IRS Does Not Have to Offer an Appeal
The IRS is not legally required to let you have an administrative appeal after an audit—and sometimes it doesn’t. Instead of a 30-Day Letter offering an appeal, you may get a 90-Day Letter. This means the only way to challenge the audit without paying the additional tax the IRS claims you owe is to file a petition in tax court. (See Chapter 5.)
Here’s something odd: If you don’t get an appeals hearing and do file a tax court petition, your case will be sent to the appeals office anyway. You will now probably be offered an appeal hearing, or you can request one. If you don’t settle in the appeals office, your file will be sent to an IRS lawyer.
Time Limit for an Appeal
“Protest” is the official term for formally appealing an IRS determination. You must protest within 30 days of the date on the appeal notice letter—not the date you received it. As discussed in Chapter 3, you can also informally appeal to the auditor’s manager.
Meeting the manager does not extend the 30-day deadline to file a formal appeal. Make sure you file a written protest, too.
Can’t file your protest in time? Request an extension for another 30 to 60 days to appeal. Requests to auditors or managers are usually granted, but don’t rely on an oral promise. Send a confirming letter stating the terms of the extension and the name of the person granting it.
How to Get Your Audit to the Appeals Office
There are three ways to get your audit to the IRS Appeals Office. Which one to choose depends on your preference and how much the IRS auditor says you owe.
- If you owe less than $2,500: You can simply ask the auditor for an appeal—technically, your oral request is sufficient. But, to make sure you don’t get forgotten, either write a protest letter in your own words and write at the top “Small Case Request” (following the instructions and sample below) or use IRS Form 12203, Request for Appeals Review.
- If you owe between $2,500 and $25,000: Either write a protest letter and write at the top “Small Case Request” (following the instructions and sample below) or use IRS Form 12203. I recommend using the form.
- If you owe more than $25,000: Write a protest letter. The IRS doesn’t have a form for contesting tax debts over this amount. (See below and sample letter.)
IRS Form for Appeals Under $25,000 (Small Case)
To appeal an audit in which the IRS claims you owe $25,000 or less in extra taxes, penalties, and interest, you may use IRS Form 12203, Request for Appeals Review. As you’ll see from the sample below, this is a simple, one-page form that lets you list the items on the IRS examination report with which you disagree and briefly explain your position. Download the form from the IRS website (www.irs.gov). You can use the Adobe “fill-in” feature or type or handwrite on a printed copy of the form. If the space on the form is insufficient, add a separate page or pages. (Be sure to put your name and taxpayer identification number at the top of any extra pages.)
Where the form asks for “Taxpayer Identification Number(s),” use your Social Security number if you’re an individual and your employer identification number (EIN) if you’re representing a business or trust. Also, if you’re appealing on behalf of your business, the line “Tax period(s) ended” can be answered with quarters of tax years—for example, 4th quarter, 2008—rather than a whole year figure.
Send the completed form to the IRS office that issued the audit report—by mail, certified receipt requested.
Protest Letter for Appeals Over $25,000 (Large Case)
To contest an audit debt of more than $25,000, you must file a formal protest, which is a letter, not a form (see the sample below). The letter must contain the following:
- your name (or names, if husband and wife) and Social Security number(s)
- a statement that you are appealing an examination report
- the findings in the report that you disagree with, including penalties and interest
- a brief explanation of why the report is wrong; although not required, you can attach copies of any documents supporting your explanation
- your signature(s) and date under a penalty-of-perjury clause, and
- copies of the 30-Day Letter and examination report.
Make the protest letter short and sweet. Stick to the facts and don’t criticize the auditor or the IRS—whether justified or not. Blowing off steam may make you feel better, but it only detracts from an otherwise valid appeal.
Below is a sample protest letter. This sample is a skeleton type of protest letter, giving only the bare bones of why you are appealing. Some tax professionals recommend very detailed protests with copies of all documents you want to be considered. This can be difficult to do if you are not a tax expert, so go with the minimal approach. This gives you time to either send in supporting documents to the appeals officer later or bring them to the hearing.
Consult a tax professional if you are unsure about preparing your protest. You can also get advice on preparing for the appeals hearing. An experienced professional can tell you what evidence—documents and statements—the appeals officer will look for. (See Chapter 13.)
Send your letter to the IRS office that issued the report—by certified mail, return receipt requested. Also send or give a copy to the auditor.
Sample Protest (Appeal) Letter
August 15, 20xx
Internal Revenue Service
P.O. Box 44687 (Stop 11)
Indianapolis, IN 46244
VIA CERTIFIED MAIL—RETURN RECEIPT REQUESTED
PROTEST OF MICK RODRIGUEZ
111 Elm Street
Bloomington, IN 47000
I wish to appeal the examination report of 8/1/xx, a copy of which is attached. I request a hearing. The tax years protested are 2005 and 2006.
The adjustments that I disagree with are [fill in something like “the disallowance of business expense deductions shown on my Schedule C of $12,999, and penalties and interest in the total amount of $848”].
The adjustments were [again, fill in your explanation, like “incorrect because the deductions I took were legitimate expenses of my music business, and I was trying to make a profit”].
Under penalty of perjury, I declare that the facts presented in this protest and in any accompanying documents are, to the best of my knowledge and belief, true, correct, and complete.
Copy to Auditor
Enclosed: Copy of 30-Day Letter and Copy of Examination Report
Requesting the Auditor’s File
Under the federal Freedom of Information Act, or FOIA, you are entitled to a copy of almost everything in your IRS auditor’s file. Most important are her notes and workpapers showing how she arrived at her conclusions.
There may be nothing new in the file, but you may mine a gold nugget using the FOIA. For instance, once I got a file with a report transmittal form showing fraud suspected by the auditor. This matter can legally be edited out of your copy, but if it is, it may be apparent or you may be told that something has been kept from you.
Certain things, notably the DIF score—the computer score that probably caused the audit in the first place—are protected from disclosure by law. This is no big deal, as the DIF number won’t mean anything to you anyway. (DIF scores are covered in Chapter 3.)
To get your IRS file, you must send a separate letter to the FOIA disclosure officer at your local IRS office. (See sample.) Specifically ask for a copy of your audit file by year audited and offer to pay for copying charges. Hand deliver your letter or send it by certified mail, return receipt requested. Enclose a photocopy of your driver’s license or birth certificate with your letter.
Allow four weeks or more for a response. If you don’t hear from the disclosure office, start calling. Technically, the IRS does not have to make copies for you, although it usually will. Instead, you might be told you have to come into the disclosure office to look at the file. If the date of the appeals hearing is approaching and you haven’t yet received or had a chance to review your file, ask for a postponement from the appeals officer. Send her a letter confirming the postponement.
Sample FOIA Letter
August 15, 20xx
Internal Revenue Service
P.O. Box 44687 (Stop 11)
Indianapolis, IN 46244
VIA CERTIFIED MAIL—RETURN RECEIPT REQUESTED
PROTEST OF MICK RODRIGUEZ
111 Elm Street
Bloomington, IN 47000
Under the Privacy Act of 1974, 5 U.S.C. 552A, and the Freedom of Information Act, 5U.S.C. 552, I request a copy of all files relevant to the audit of my tax return for years 2000 and 2001.
I agree to pay reasonable charges for copying the requested documents, up to $25. If the charges exceed this amount, please contact me for further authorization.
If you determine that any portion of these files is exempt, please identify the portion claimed exempt and the specific exemption that justifies your refusal to release it.
How the Appeals Office Works
The IRS Appeals Office is a separate division from the local IRS office that handled your audit. It may not even be in the same city.
Cases are viewed by appeals officers from a fresh perspective—most of the time. Some officers just rely on work done by auditors, but most review files anew. Your auditor plays no part in the process, other than the fact that her file is before the appeals officer. Auditors’ files often lack detail or notes, however, which can raise questions in the mind of the appeals officer. She may contact the auditor to fill in the gaps and clarify the IRS’s position on a particular issue. If you submit new data to the appeals officer, he may ask the auditor to review it, but not make the final decision on its acceptability.
An appeals officer is aware of the law on recurring issues, like what kinds of documentation are legally sufficient to verify travel and entertainment or home office expenses. So, unless your case is very unusual, the appeals officer will almost surely have considered the same legal issues in the past.
Since an appeals officer already knows the law, he usually wants to learn the facts of your situation—especially anything which might cause a judge to rule for you if you went to court. In short, an appeals officer has a motivation to settle with you, if after considering the facts and applying the law, he believes you have some chance of winning in court—no matter how small.
Unlike IRS auditors, appeals officers have discretion to weigh the hazards of litigation. They often settle cases because they do not want the courts to set any precedents unfavorable to the IRS. Decisions against the IRS could be relied on by other taxpayers and cost the government much more in the long run than giving in on your case would.
Appeals officers are realists and know from IRS statistics that about 50% of all taxpayers win at least partial victories in court. Appeals officers don’t have authority to settle a case based purely on its nuisance value, however. In other words, they are forbidden to settle just to avoid the expense of going to court. If you supply a justification for the appeals officer to make a deal, he will.
Besides the fear of losing in court, the appeals officer has another motivation to make deals: The IRS’s resources are not unlimited. Most of the funding to the IRS in the last decade has gone into computerization and hiring of more collectors—not appeals officers.
No one wants your small potatoes case to use up any more of the government’s time than is absolutely necessary. After all, the same court that will try your case if it isn’t settled also must hear tax disputes with IBM, Exxon, and GE, where the government has hundreds of millions of dollars at risk.
Appeals Officers Are Negotiators
IRS appeals officers are senior IRS employees with accounting or legal backgrounds. Many have been promoted up from the ranks of auditors. Appeals officers have only one job—to settle cases. You might think that their work involves raising more money for the U.S. Treasury, but that’s not the case.
Appeals officers are trained to be flexible and are given discretion in dealing with taxpayers that auditors don’t have. Proof of this lies in IRS statistics showing 70% of appeals cases are settled. Appeals officers’ job performance is judged by their success in compromising with taxpayers—not how often they uphold IRS auditors!
Preparing for an Appeals Hearing
After requesting your appeal, you will have at least 60 days to prepare for your hearing. When you will be heard depends on how backlogged your IRS Appeals Office is. Use this time to analyze and review everything you presented to the auditor.
Get a copy of the auditor’s work papers by making your Freedom of Information Act request. Read it to see if the auditor misrepresented or just plain missed something. Check out any tax law cited by the auditor in her report to see if it really supports her position.
If you don’t get a copy of the auditor’s file before the appeals hearing, ask the appeals officer to show it to you.
Organizing and Presenting Documents
Audits are frequently lost because the taxpayer did not cogently present his case to the auditor. If you provided a jumble of papers or messy files, the auditor may have just thrown up her hands and refused to consider them. So, ask yourself if there are better ways to organize and present your supporting materials to the appeals officer. For instance, run adding machine tapes of payments for each category of deductions and make up schedules of these items.
Try some creativity. For example, you aren’t limited to printed documents. A part-time jazz artist whose musical business was deemed a hobby by an auditor, and his deductions disallowed, brought a demo tape and player to an appeals hearing. Charts, graphs, and drawings can often more effectively make points than words can. And remember the saying about a picture being worth a thousand words. A photo of your professional-looking home office or a group picture at your business’s employee picnic may win the deduction. Everyone seems to prefer looking at pictures to reading a description or listening to an explanation. Appeals officers are no different.
If neatness, typing, preparing schedules, or just plain getting paperwork together is not something you’re good at, find a bookkeeper or friend to do it for you.
Filling in the Gaps
If you were missing records at the audit, try harder to find them. Make renewed attempts to get copies of checks from banks and duplicate receipts from businesses and people with whom you dealt. Recreate items when original documents can’t be found. (See Chapter 3.)
Focusing on Challenged Items
Make a separate file or folder for each item the auditor challenged on your tax return with which you disagree. Write a simple statement next to each explaining why the auditor was wrong.
Collect your documents—canceled checks, receipts, and whatever else—and group them with or attach them to each statement. I use a three-ring binder with dividers for each challenged item. Then I make a second complete copy of the binder. While I give my presentation at the hearing, the appeals officer follows along in his binder. If I lose the appeal, the binder serves me well if I proceed to tax court.
Get written statements from people with knowledge about your disallowed expenses (if you didn’t already do so for your audit). For example, you hired a handyperson to make repairs on your rental property who insisted on being paid in cash and has since left town. You can’t find the receipts for the labor and materials. Prove the work was done through a statement from a tenant, like the following:
Sample Witness Statement
Declaration of Clara Burton
I, Clara Burton, declare that for most of 2008, I was a tenant in an apartment owned by Alexander Woolf, located at 123 Hannah Road, Appleton, Wisconsin.
Early in the spring of 2008, we had a bad storm. The rain caused plaster to fall from the ceiling in my apartment and ruin the carpet. All the damage was repaired by Joe Williams, who did a good job.
I moved out to be closer to my job in November of 2009. I now live at 456 Dover in Appleton, Wisconsin. My phone number is 555-1290.
Under penalty of perjury, I declare that the statements of fact contained in this declaration are, to the best of my knowledge and belief, true, correct, and complete.
Meeting the Appeals Officer
Appeals officers rarely leave their offices—you will go there for the hearing. You will be shown into a small office or meeting room. Seldom will anyone else be present from the IRS. It is theoretically possible for the auditor to attend, but it virtually never happens.
An appeal is rather informal. It is not like a court, where testimony is taken under oath or where technical rules of evidence apply. The IRS won’t tape record the hearing. You have a right to, as long as you inform the appeals officer several days in advance—but I don’t recommend it. It would likely make the appeals officer speak less candidly than he would otherwise and reduce your chance of reaching any settlement. Even if the appeals officer says something in your favor but you don’t reach a settlement, the statement would probably not help you if you go to court.
Speak freely at the hearing. Theoretically, statements made by you could be deemed admissions against interest and used by the government in a court case. But I have never seen the IRS ask an appeals officer to testify as to what was said at an appeals hearing.
Presenting a Case to an Appeals Officer
Before the meeting, write down what you are going to say to the appeals officer—an outline of the points you want to make. List the documents and other evidence you want to present. Then try it out by explaining your case to your friends or family. Ask if they understand it clearly. Their responses may direct you to weaknesses that you can work on before the hearing.
A Formal Appeals Hearing May Not Be Necessary to Make a Deal
One of the larger cases I ever settled on appeal I did without ever meeting the appeals officer. We had trouble arranging our schedules, so I sent him my research and documentation. After several lengthy telephone conversations, we compromised a $250,000 audit bill for zero taxes owed.
The appeals officer conceded that my client was correct and agreed that it would not be in the IRS’s best interest to go to tax court, where an unfavorable precedent might be set. If it is very difficult for you to meet with an appeals officer, ask if you can have your appeal handled by mail and telephone. If the nearest appeals office is hundreds of miles away, it’s worth a try.
Some appeals officers sit back and wait for you to present your case, while others run the show by asking questions. Unless the appeals officer directs otherwise, start with a brief statement outlining your case. Here’s an example:
I believe that the auditor was incorrect in finding that I was not entitled to claim a part of my apartment as a home office deduction for my part-time sales business on my tax return in 2001.
I can show that my home office deduction is legitimate by my testimony and with the following documents:
- floor plan of my apartment showing the space used exclusively for my home office
- business diary showing that I spent more than 50% of my working hours in the business at my home office, and
- bills and canceled checks for the expenses I incurred in running my home office.
Point out to the appeals officer the auditor’s errors before the appeals hearing. For instance, did the auditor leave out facts that you presented? Did the auditor misstate something that you said? Don’t bring up the auditor’s lack of intelligence or mean-spiritedness in making these errors; instead characterize them as misunderstandings or oversights. After all, the appeals officer may take offense at IRS bashing.
If you and the auditor disagreed on a legal issue—such as whether your enterprise is a legitimate business or a nondeductible hobby—then renew the argument to the appeals officer. He will be more knowledgeable about the intricacies of tax law than are auditors. If you did research or consulted a tax professional and came up with something favorable, show it to the appeals officer. He will probably comment on it, one way or the other. If he doesn’t, ask him if he agrees with your research. If he doesn’t agree, ask him why not.
If the appeals officer doesn’t understand something in the auditor’s report, he may call the auditor, but usually not in your presence. This doesn’t mean he will automatically take the auditor’s word over yours.
You may not finish up with the appeals officer at the end of the meeting. He may want to research an issue before rendering a decision. And if you request it, you will usually be given time to send more documents or do further legal research. Ask for a month to get things in. Appeals officers seem to work at a more leisurely pace than the rest of the IRS, so he may agree to an even longer time.
The officer may ask you to sign a waiver extending the normal three-year limit the IRS has for assessing a tax liability. It is usually okay to sign this waiver at the appeals level, although this is contrary to my advice when you are requested by an auditor to sign the same waiver.
Negotiating a Settlement
The Internal Revenue Manual states that:
A settlement may either resolve each issue on the basis of the probable result in litigation or involve mutual concessions of issues based upon the relative strength of the opposing positions where there is substantial uncertainty of the outcome in litigation.
In other words, the appeals officer wants to avoid the possibility of the IRS losing in court.
Your first request should be for the IRS to drop any penalties recommended by the auditor. This is the easiest item for an appeals officer to give in on, as long as he believes that you or your tax preparer made an honest mistake and weren’t trying to cheat the government.
Unless you believe the auditor was completely wrong on everything—be truly objective—then let the appeals officer know that you may agree to some of the adjustments. This breaks the ice, but don’t get specific. Just saying this will show the officer that you can be reasoned with—unlike some of the irrational and irate taxpayers who come through his door. If he doesn’t warm to you, he may at least breathe a sigh of relief. This is good psychology any way you slice it.
Speak the appeals officer’s lingo. Don’t talk in terms of dollars. Use the word “adjustments” or “disallowances” instead.
An auditor disallowed 80% of Monika’s business entertainment expenses because she couldn’t provide complete records of the business purpose of the entertainment. Monika acknowledges to the appeals officer that her records were weak, but emphasizes that they do show that she paid the expenses and that she was in a legitimate business. Monika offered to accept a 20% disallowance of these expenses; the appeals officer responded by meeting her halfway and allowing 50% of the deduction. They finally agree on 35%—a far cry from the auditor disallowing 80%. Monika and the appeals officer never spoke in terms of dollars, only percentages.
The example demonstrates that negotiation is an art, not a science. A successful negotiation is where both sides come out with less than what they wanted but each gets something.
Appeal settlements are usually reached orally and then put in writing on an IRS form. You won’t be asked to prepare the settlement document—the appeals officer will. Most settlements are formalized on IRS Form 870, Consent to Proposed Tax Adjustment, mailed to you after the hearing. Don’t expect the settlement papers right away; it may take several months, as a settlement goes through several levels of approval before leaving the IRS office.
To make sure the settlement contains no surprises or misunderstandings, make careful notes of what was agreed to at the hearing. If the settlement papers don’t match up, call the officer and hash it out. If you have some questions about the terms of the settlement document, run it by a tax professional before you sign. She can check computations and explain the details to you.
Don’t sign a Form 870 settlement unless you are absolutely certain that you understand it. Once you sign it, you are barred from going to tax court if you find an error or change your mind.
In limited situations, the appeals officer is prohibited from negotiating a settlement. If the appeals officer mentions any of the following, your only option is to take the IRS to court:
- Your audit was part of a large group of similar taxpayers and the IRS must be sure that everyone in the group is treated equally.
- A court case or IRS revenue ruling directly on point and supporting the IRS’s position exists. As a practical matter, this is unlikely to happen, because rarely are two cases ever exactly alike or will a revenue ruling prevent you from dealing with an appeals officer.
- Your case has tax crime potential.
- You are a part of a group of investors who are claiming tax benefits from investment losses—tax shelters—that the IRS concludes were not legitimate business deals, but were solely tax dodges.
Case History of an Appeal
Mick was a telephone company executive by day and a rock musician by Saturday nights. For 20 years, he played in local bands. He had his dreams, but never got close to the Big Time. Mick enjoyed performing and was happy—at least until the IRS entered his life.
In recent years, raises and bonuses allowed Mick to buy new musical gear and a Ford van to haul it. He became more enthusiastic about his music, formed his own group, and hired an agent. Following his accountant’s advice, Mick reported his musical income and expenses on his tax returns as a sideline business. Mick’s business showed net losses in two years. These losses were used to offset Mick’s income from his regular job on his tax returns, thereby lowering his total tax bill.
Sideline Business and the Tax Code
A sideline business loss can produce a tax write-off for Mick as long as the IRS believes that he is trying to make a profit. The tax code provides one test for determining if a profit motive exists—if a business does not make money in at least three of the five past years, it is presumed to be not for a profit and is considered a hobby. Hobby losses cannot be deducted for tax purposes. As it turned out, Mick had made a small profit in two of the last four years he had been reporting musical activities on his tax returns.
While this three-of-five-years legal presumption is not final, it puts the burden on Mick to show he was trying to make a profit. The issue would never arise unless Mick was audited.
Mick was audited. IRS audit classifiers are on the lookout for businesses that show losses. This is especially true if business losses offset income from another job—in effect creating a tax shelter. The IRS hunts tax shelters like wolves pursue sheep.
The consequence of an auditor not finding that a business was really run to make a profit is a disallowance of all expenses in excess of income. For example, if your Amway distributorship brought in $1,000 and you claimed $3,000 in expenses, the IRS could disallow your $2,000 tax loss—unless it was convinced that you were seriously trying to make a profit. In this type of case, the IRS has frequently said that the real motive in this type of business was social—entertaining friends and getting home products for personal use. Dabbling in a side business is not good enough.
In the year audited, Mick’s music income was only $300 but he claimed $12,300 in business expenses. Small wonder he was picked for audit. His largest expenses were the new van and music gear. Under the hobby loss rules, the auditor decided Mick’s music expenses were primarily for his personal pleasure, and only incidentally for profit. (Internal Revenue Code §183.) She disallowed the $12,000 tax loss. This meant added taxes, penalties, and interest of $4,500. To make matters worse, she then said she was going to audit two more years and make the same adjustment.
Mick argued that he had worked hard to make a musical career, that he had been getting local jobs, that his band’s reputation was on the rise, and that one hit record would make him millions and the IRS plenty of taxes. The auditor, apparently not a music fan, was unmoved. A meeting, or informal appeal, with her manager did not change things.
Mick got the examination report and then a 30-Day Letter to appeal. He decided to appeal—he had clearly been trying to make money in music, even though his efforts had been largely unsuccessful. Mick knew he had enough to show an appeals officer a justification for compromising the audit result.
The legal principle in Mick’s favor is that the profit motive, not the actual result, distinguishes a business from a hobby. The intention to make a profit is sufficient under the tax law, even if the probability of financial success is small or remote. (Dreicer v. Commissioner of Internal Revenue, 78 U.S.T.C. 642 (1982). See also Cornfield v. U.S., 797 F.2d 1049 (D.C. Cir. 1986).) At least Mick had some income.
Research for Mick’s Appeal
The IRS disallowed Mick’s deduction of his music equipment as a business loss. The examination report said only that the business expense was not established. Mick called the auditor to ask what tax code section she relied on to reach her decision. The answer was IRC §183.
Mick looked at the Master Federal Tax Manual index under tax code Section 183 and losses and found the subhead Business. It directed him to a page that defined a business as “a pursuit or occupation carried on for profit, whether or not profit actually results.” The guide has an excerpt from a tax court case which stated that an activity may be for profit although the investment is not expected to generate profits for several years under the current level of activity. This meant that Mick’s musical activities are not disqualified as a business just because he lost money. Mick photocopied this page.
Next he opened J.K. Lasser’s Your Income Tax and found more specific information. The index lists Hobby as a Sideline Business, which leads to the following: “If you show a profit in three or more years the law presumes you are in an activity for profit. The presumption does not necessarily mean that losses will be automatically allowed; the IRS may rebut the presumption.” Reading further, Mick saw this as significant because it mentioned tax code Section 183 on which the auditor based her decision. Mick made another photocopy.
In two years of his tax returns since claiming his music business, Mick was still using his old equipment. And he did not claim any vehicle expense on his return. The tax result was in year one he showed a profit of $100, and in year two, a $200 profit. In year three, however, Mick bought the van and the new equipment. These purchases caused sizeable losses in years three and four. The appeals hearing took place in year five, for which a tax return was not yet due. So Mick cannot rely on the three-year presumption of profit rule. Mick had only two profitable years.
If Mick’s appeal hearing was held after he filed a tax return for year five, it could be prepared in such a way as to show a profit—for example, by not taking some expense deductions. In this case he could go into the hearing with the benefit of the three-year presumption of profit rule—that is, Mick made money in three of the last five years. This fact would put him in a position that could be strong enough to give him an outright win.
Mick’s Appeal Hearing
After Mick filed his protest requesting an appeal, the IRS set a conference date. Several months later Mick and an appeals officer met at the appeals office. No one else was present. Mick went directly to the most favorable facts of his case. He showed a contract from a talent booking agent who, in two years, had gotten his group one job. He also presented a flyer and event calendar showing the group had performed in public twice during the audited year. He omitted the fact that one appearance was at a charity benefit where no performers were paid. He also gave the appeals officer a publicity photo and his diary showing band rehearsals.
The documents were not strong enough evidence to win his case, but they got Mick in the door. The goal was to give the officer justification for compromising, not to win outright. In a half hour, Mick finished presenting the evidence and said, “Let’s settle the case. I will accept a 25% disallowance of my losses.” In other words, Mick was offering to let the IRS reduce his losses from the $12,000 adjustment the auditor made to $3,000.
The appeals officer replied that he was thinking more like a 75% disallowance, from $12,000 to $9,000. Mick was in! The officer had accepted the possibility that a court might find that Mick was trying to make a profit. They took a break.
After the break, Mick commented on the photo of the Little Leaguer on the officer’s desk. He had a similar picture at home, and Mick and the appeals officer talked about their kids awhile. The officer seemed relieved not to talk taxes for a bit. At 4:30, near IRS quitting time, Mick said that he’d agree to split the difference, and accept a 50% disallowance from $12,000 to $6,000 of his losses and no penalties.
He also requested the appeals officer not to recommend the other two open years for audit. The officer agreed. While this did not guarantee those years would not be audited—appeals officers don’t have this authority—their recommendations carry great weight and their reports are routinely approved. Several weeks later, Mick received a settlement letter.
Mick’s case is typical of how IRS appeals are handled—and settled. If Mick hadn’t appealed, he would have owed the IRS $4,500, plus he would have been audited for two other years.
The potential tax disaster was over $13,000. The settlement made with the appeals officer cost Mick about $2,000.
Mick’s appeal didn’t require great knowledge of tax law. It did involve several hours of preparation as well as a basic understanding of the IRS appeals process. Evidence of Mick’s profit intent was shown; a settlement was proposed and negotiated. The great majority of appeal issues—be they home office deductions, entertainment expenses, or business auto usage—can be handled successfully in this same manner.
Should You Hire a Tax Professional for Your Appeal?
The pros and cons of working with tax professionals are outlined in Chapter 13. Here are a few other suggestions.
Most appeals officers respect an experienced tax representative. Appeals officers and tax professionals often know each other. Tax professionals know what appeals officers are looking for and can make their job easier by getting straight to points.
Hiring a tax professional is largely an economic decision. It may not make sense to hire one if you are contesting less than $5,000 in taxes. Attorneys and CPAs charge upwards of $2,500 for an uncomplicated appeal, although enrolled agents may do it for less. If you hire a tax professional, ask her how much IRS appeals experience she has and how the appeals came out. Listen carefully to her responses.
Bringing in a tax professional also depends on the intricacy of the case and how comfortable you are at arguing and negotiating. For example, if you lost your audit because of inadequate records and you have since located or reconstructed them, there’s no need to hire a tax professional. If your case, however, turns on a point of law, such as whether or not your business’s workers are employees or independent contractors, bringing in a professional could make the difference.
A preappeals consultation with a tax professional is a good idea—even if you do the appeal yourself. An hour or two of professional time should not cost more than several hundred dollars.
Types of Cases Appeals Officers Won’t Hear
IRS appeals officers are prohibited from hearing certain issues under IRS policy, for example, taxpayer refusals to comply with the tax laws based on moral, political, constitutional, religious, and similar grounds. The issues are often raised by what the IRS terms tax resisters or protestors. A word to the wise: If you fit into this category, think long and hard about what you are doing. Get good professional advice before taking on the federal government.
If You Don’t Settle on Appeal
If you and the appeals officer haven’t reached a settlement by the end of your conference, ask what else you can provide to change his mind. Chances are it’s further documentation or supporting legal precedent. Then, ask for time to get this material to him, before his decision becomes final. If in doubt how to follow through, see a tax professional.
If you don’t settle, you will be mailed a letter denying your appeal. With the letter comes a notice of deficiency advising you of your right to go to tax court. If you ignore the notice, after 90 days, the taxes, penalties, and interest become final. A tax bill from the IRS will arrive several months later.
If you want to keep up the fight, see Chapter 5 on going to tax court.
- You can appeal most audits to the IRS Appeals Office.
- Appeals often reduce your tax bill, but seldom are auditors totally reversed.
- Many appeal issues are simple enough for you to handle without hiring a tax professional, but a consultation with one is a good idea.
- The IRS appeals office is independent from the IRS audit division and wants to settle to keep you from going to court.
- Prepare for an appeals hearing by careful record organization and basic tax law research. Consult a tax professional if in doubt.
- If you don’t appeal or don’t win your appeal, you can always go to tax court.