March 24, 2021

Winning Your Audit Part 5: Preparing for an IRS Audit

Posted by | In Taxes & IRS Audits

This is part 5 of 6 of our in-depth guide to winning your audit.

Preparing for an Audit

In preparing for an IRS audit, begin by taking the following four steps:

Step 1. Review the tax return being audited. If it was professionally prepared, go over it with the preparer. If you did it yourself, review it with a tax professional to see if she foresees any problems. Remember, it is always up to you to show the auditor where the data on the return came from. You may decide to hire the pro to represent you depending on your pocketbook and overall comfort level. A seasoned tax professional may be able to offer an educated guess as to why you are being audited.

If you are in business for yourself and had a net operating loss for a year following the year being audited, point this out to the auditor. This may discourage her from spending a lot of time on your audit because any tax adjustment she might find would be reduced by the loss you were entitled to in the subsequent year. If this might be your case, discuss it with a tax professional.

Step 2. Find all the records you used to prepare the return. Organize records logically and clearly according to the deduction category. Run adding machine tapes on totals of receipts for each classification, such as rent, travel, and utilities. If the totals don’t correspond to the numbers on your tax return, be ready to explain why. I cannot overemphasize the importance of well-organized records in an audit.

Step 3. Research tax law if you are unsure whether you were entitled to a deduction or other tax benefit claimed on your tax return. For instance, did you meet all the requirements for a home office deduction? This is another point you should research or cover with a tax professional if you aren’t sure.

Step 4. Look for relevant Audit Technique Guides (ATGs). The IRS has issued guides in its Market Segment Specialization Program (MSSP) telling its auditors what to look for when auditing certain businesses and occupations—real estate agents, entertainers, attorneys, fishermen, and others. Also, ATGs cover items that draw special audit attention, such as lawsuit awards, passive losses, and executive compensation. If there’s a guide covering your line of work (see the IRS website at www.irs.gov; do a site search for MSSP or Audit Technique Guides), you’ll want to read it. It will tell you what the auditor will be looking for beyond the normal audit routine, and you can prepare accordingly.

Your Audit Goals

You have two goals in the audit:

To minimize the financial damage. Because the odds are great that your audit will end with a tax bill, your goal should be damage control—keeping your liability as low as possible. But, don’t go in with a defeatist attitude. If you owe no money, try to prove it. Just don’t have unrealistic expectations. In a recent year, audits resulted in $19 billion in additional taxes and penalties, and about $600 million in refunds—a ratio of 32 to 1 against you.

To prevent expansion. Office audits are initially limited to the items listed on the audit notice. If the auditor sees other problems, however, she will pursue them. This often happens when you show the auditor a document that you weren’t obligated to show her, or you make a slip of the tongue. As a rule, never show the auditor anything not specifically related to the tax year in the audit notice. For example, before showing your check register or business diary, edit out the portions that relate to personal matters or that overlap into other years.

Audits may be expanded into other tax years. An auditor may get permission from her manager to examine any open tax year if it is likely to be fruitful. Open years are those within three years of when a return was filed, or six years if the IRS finds serious underreporting.

Example:

In November 2007, Noreen is audited for 2005. The auditor could expand the examination to 2004 and 2006; Noreen filed those tax returns timely. Without finding evidence of serious problems, the auditor could not expand the audit any farther back, as Noreen filed her 2003 tax return on April 15, 2004, more than three years before the audit date.

Remember not to show the auditor copies of tax returns for years other than the one being audited. If the IRS expands the audit, you should demand an official written notice from the auditor.

What Not to Bring to an Audit

Don’t bring anything not directly related to the year being audited. The auditor’s fishing license is restricted to the year being audited, but he can look at materials from other years—and make adjustments—if these items are in front of his nose.

Your audit letter includes a list of things to bring. Don’t take anything else—unless it supports a deduction you missed when you filed your tax return. For example, if your checking account statements overlap two years—January’s statement has checks for December—then remove the checks for the year that isn’t being audited. Leave at home checks and receipts for personal expenses not claimed as deductions on your tax return. Again, don’t bring tax returns for any years other than the one being audited, even if requested by the auditor.

Who Should Attend the Audit?

If you are handling the audit yourself, you can bring someone else to the audit. The auditor may ask you to sign a form waiving your right of privacy. This person can assist, but cannot represent you, however, unless he is the tax return preparer or an enrolled agent, CPA, or attorney. Chapter 13 contains tips on selecting a tax professional. It may make sense to bring any of the following people to the audit:

  • an employee—your bookkeeper, accounts payable supervisor, or similar employee who has knowledge of your business records and can help you explain them
  • your spouse—only one spouse needs to attend an audit when a joint tax return is being audited. Both should go if they both have financial knowledge, provided different information on the return, or can substantiate that information. If only one of you is being audited, the other can attend to offer emotional support. Or,
  • another family member or friend—to offer moral support, translate if your English isn’t very good, wipe your eyes with a handkerchief, or do whatever would help you get through the examination.

Not Cooperating in an Audit—When You Have Something to Hide

If you have some “dirty laundry,” it’s in your best interest not to cooperate in, or even go to, an audit appointment. For example, if your bank records show deposits in great excess of your reported income or you claimed phony deductions, it may be wiser to suffer the consequences of skipping an audit appointment. Blurting something out could earn you a visit from the criminal investigation division, or CID. Never say “I guess you caught me, ha, ha,” or “I didn’t think you would find that account.” On hearing such things, auditors are instructed to stop an audit and refer the case to CID. In such cases, it’s almost always advisable to seek the advice of an experienced criminal tax defense attorney.

When you don’t show up, the IRS will take one of three actions:

Conduct the audit without you. The IRS may also examine tax years not covered by the initial audit. The auditor may look at all open years—returns due and filed within the past three years. And if the auditor suspects serious misdeeds, he may go back as far as six years. At the conclusion, the IRS will issue a report disallowing all items listed as questionable. A month or so later you’ll receive a bill. Depending on the circumstances, you may want to accept the bill and move on with your life.

Contact you again. You may be contacted by the auditor and asked why you are not cooperating. Eventually, she’ll give up and issue a report, finding unreported income or disallowing most of your deductions and exemptions. A tax bill will follow.

Serve a summons and order you to appear. A summons is a legally enforceable order and you could be held in contempt of court—and even jailed—if you ignore it. See a tax attorney before making your next move.

Tip

Even if you skip the audit, you can contest the outcome by going to tax court.  The strategy is to skip the audit so as to keep the auditor from looking into your records. By going to court, you pick the items to contest and can stay away from the problem areas. Before taking this approach, however, check with a tax professional, preferably a tax attorney.

How to Act at an Audit

The Internal Revenue Manual tells auditors that the initial taxpayer interview is the most important phase of an audit. You, the taxpayer—not just your tax return—are under examination. Your actions and behavior are being observed. Does it look like you are being evasive—trying to hide something? Do you become visibly shaken when some items are being discussed?

Mum’s the Word

IRS encounters are inherently stressful, and people under stress often talk too much. The IRS knows this principle of human behavior, so auditors are trained to listen and to create silence. They examine records without speaking, with the hope that you will jabber away. Take this advice seriously: Don’t talk. Auditors get damaging information from taxpayers who blurt out answers to questions that weren’t asked. For example, one clueless soul volunteered that he always deducted clothing expenses because he had to come to work dressed. The auditor then made a disallowance of this expense in two other years.

Dress Like Yourself

Dress according to your occupation and station in life. Anything else may make you uncomfortable and an audit is uncomfortable enough already. Use your common sense. Don’t wear expensive clothes and jewelry if you work at Burger King, and don’t dress like a fry cook if you are a dentist. If you are a bus driver coming from work, wear your uniform. Don’t try to look like someone you are not. It’s simple, really. Be yourself.

The six best responses to a question posed by an auditor are:

  • Yes.
  • No.
  • I don’t recall.
  • I’ll have to check on that.
  • What specific items do you want to see?
  • Why do you want that?

Again, don’t say more unless absolutely necessary. As a rule, you can’t hurt yourself when your mouth is shut.

Caution

Don’t lie to, or mislead, an auditor. IRS examiners are trained to ask for the information they already have to test your credibility. A favorite question is to ask if you have investments when the IRS computer shows you earned interest and dividends. Or, the IRS may ask you about vehicles you own when the auditor has a printout from your state motor vehicles department.

Don’t Offer Any Favors to the Auditor

Auditors are trained to watch out for, and report, all offers of favors of any kind. Some taxpayers are from countries where bribing government officials is the norm. IRS employees are closely watched and are among the cleanest of all officials anywhere. Some auditors will accept a cup of coffee, but that’s as far as it goes. An offer of a favor, say tickets to a ball game, may be ignored. But any suggestion of an outright bribe will get you a visit from the criminal investigation division and a very thorough audit. Don’t try it.

Try to Get Along With the Auditor

When you meet an auditor, be polite and offer some chitchat about the weather, traffic, or sports to break the ice. Office auditors are under time pressures and may want to get right down to business. Field auditors, on the other hand, are encouraged to get to know you; they will chat.

It doesn’t hurt to show an interest in the auditor as a person. Ask friendly questions—How long have you been with the IRS? How does someone get to be an auditor? How long have you worked in this area? Everyone likes to talk about their favorite subject—themselves. If the auditor responds, it may get him to like you, or at least it will reduce the amount of time he spends examining your return.

In short, don’t go in with an anti-IRS attitude. You are not happy to be there, but make the best of it. Remember what Grandma told you about catching more flies with honey than with vinegar.

What about turning this advice on its head and taking a defiant, aggressive attitude into an audit? This is not my style, but it might work with auditors who are timid, or so unused to being challenged that they will give in to get rid of you. One tax professional suggests that you continually ask the auditor why he wants to know whenever he asks a question. Obnoxious or peculiar behavior, or even bad B.O., may work. Similarly, some taxpayers give an agent a poorly lighted, noisy, and cramped space to conduct a field audit. If the offensive approach works, let me know.

When the Auditor Is Unreasonable

You may run into an auditor intent on giving you a hard time. She may be impolite, hostile, or rude. Worse, she may disallow your deductions unless you produce ironclad documentation in triplicate. Perhaps you did something to upset her, she is having a bad day, or all of her days are bad and everyone upsets her.

The important thing to understand is that you don’t have to take guff from an auditor. Ask her politely to lighten up. If she doesn’t, tell her you are too upset to continue and want to recess the audit to another day. If she balks, tell her that you want to consult a tax professional before continuing. Legally, she must grant your request. You don’t have to consult the tax professional, but the audit is finished for the day.

Threatening to leave—or demanding a recess—can have positive results. The auditor may well change her tune and try to be more accommodating. She doesn’t want to have to see you again if she can help it, as she already has a backlog of cases. Because her performance is judged by how many files she closes, she won’t want anything to delay her. In the end, she is looking for your agreement to close the case. If you have a second meeting, the auditor may be in a better mood. She also knows that a tax professional won’t put up with her lack of professionalism. And it’s even possible that your file will be transferred to another auditor for the next meeting. Remember, you never know what is going on in the auditor’s life. If she seemed unhappy, it might not have had anything to do with you. She may have been ill, or in the process of quitting, getting fired, or transferring to another IRS department.

Asking for a New Auditor

If the recess didn’t help and the auditor continues to abuse you, demand to see her manager. Tell him that you are not being treated respectfully, and that you want a different auditor. While chances are slim that you’ll be granted your request, the auditor you have should start treating you more civilly.

Have You Seen This Auditor Before?

The Internal Revenue Manual discourages an examination by an auditor who has examined your tax return within the previous three years, if that audit was concluded and your case was closed. If you recognize the auditor from your recent past (this might happen if your local office has only a few auditors) and you don’t want to deal with her again, complain to her manager.

When a New Auditor Appears on the Scene

Field audits commonly drag on for months or even years. Your original auditor may suddenly vanish. It is usually for some perfectly understandable reason, like a job transfer, promotion, maternity leave, training, resignation, or firing. For some reason, the IRS treats this as some kind of national security secret and doesn’t like to tell you what happened.

The first auditor may call you or send you an examination report prior to her moving on. Her motive is to try to close your file by asking you to agree to certain adjustments. Maybe you are agreeable, but before taking the bait, read “Negotiating With an Auditor,” below. For now, just realize you may have some leverage if this happens.

A second way to benefit from a change in auditors is by understanding that the new person will not want to do any more work on a half-done audit than is necessary. Few people like to clean up another person’s mess. For example, no two people document their work the same way, and few people write in a way to be easily understood by others. The newcomer will probably jump at a chance to close the file as soon as possible. The following example, taken from real life, shows how a change of auditors can be a godsend.

Example:

Laura had mistakenly claimed a large and improper business deduction for three years running, totaling $120,000. Auditor One raised this issue, and Laura stalled by asking for time to contact her tax professional and do further investigation and research. To her dismay, Laura found out that she was dead in the water and could only be saved by a miracle. She got one when Auditor One was replaced by Auditor Two. The new guy was either too lazy to read the file or didn’t understand it, and completely missed this issue. He quickly closed the case after finding another and much smaller adjustment, and Laura cheerfully signed the examination report.

Protest if asked to produce records twice. A new auditor is not always a positive development. She may be determined to replow old ground. You or your representative may be asked questions you’ve already answered or to produce documents you showed the first auditor.

If you have produced records once during an audit, it is reasonable to object to doing so again. The longer the audit has been going on, the louder you should complain. Argue that the change of auditors isn’t your fault and you shouldn’t be punished. Get indignant; take control of the situation by telling the new auditor what the records show and maybe produce a few items to back up what you say. If appropriate, propose a few small adjustments and an immediate settlement.

If the new auditor persists in traveling over old terrain, demand to speak to her manager and renew your complaint. The manager might agree or suggest a compromise just to get rid of you. If you don’t get anywhere, and have a serious basis for objecting (the records are voluminous and have taken a lot of your time) ask for the head person, the examination branch chief. Even if everyone turns you down, by squeaking your wheels you have shown yourself to be someone unlikely to accept an examination report.

Standing Up to the Auditor

As your audit progresses, the auditor will be continually making notes and filling in her workpapers. Seldom will she tell you what she is writing or thinking. Typically, the more she writes, the more adjustments she plans to make. To keep an auditor from running amok, I suggest that immediately after she finishes questioning your documents for one group of items (say, business travel expenses) ask her point blank, “Do you find any problems?” If she says yes, don’t let her go onto another area without first explaining the facts or law she is relying on.

This approach identifies you as someone who will not meekly take whatever the auditor dishes out and makes her justify her actions to your face. You are perfectly within your rights to politely ask questions during the audit. If she says the adjustment is because your records are missing, ask her to hold off for at least 15 days to give you time to get the missing records. And if she claims you don’t have a legal right to the deduction—for instance, she says your business is really just a nondeductible hobby—ask her to point out the specific legal authority on which she is relying. Tell her you want to research the matter or talk to a tax professional, and ask her to hold off making the adjustment until you get back to her.

If you continually challenge the auditor to justify her decisions, she’ll soon grow weary and think longer and harder about making more waves. This isn’t surprising. It’s basic human nature to want to avoid conflict. This tack softens the auditor up for negotiation. I know people who have refused to leave the IRS office until the auditor gives in on at least one point! Many auditors don’t like to have to justify their actions, as they would prefer to hide behind a mailed examination report rather than give you the bad news to your face.

Don’t presume that standing up for yourself will get you a tougher audit—just the opposite is usually true. The more you make the auditor work, the more she will want to get rid of you and go on to easier marks.

Proving Your Deductions

You must show that you prepared your tax return properly to win your audit; the IRS is not legally required to prove that you are wrong. Ideally, your proof should be in writing, but auditors have some discretion to accept oral explanations as well.

If you deducted business expenses or expenses that helped you produce income, the expenses must be reasonable and necessary as well as verifiable. This means that even if your expenses are legally allowable, if they are unreasonably large or extravagant, they won’t pass muster. For example, Elmer owned a hot dog stand and claimed $20,000 in entertainment expenses. The auditor would disallow this amount as unreasonable, even if Elmer could substantiate it. Size or reasonableness of a deduction, however, is not usually grounds for disallowance.

Documents to Bring to the Audit

With an audit notice is a list of documents the IRS requests you bring to the audit. And you may want to show the auditor items not on the list if you need to explain or reconstruct missing records. IRS Publication 552, Recordkeeping for Individuals, shows how the IRS wants you to keep your records. Don’t be concerned if you haven’t followed all the IRS suggestions. As long as you can show your income and expenses to the auditor in some understandable manner, you are okay.

Here are specific documents to bring:

Canceled checks and receipts. Take only the checks and receipts relating to the areas listed in the audit notice. Don’t let the auditor rummage through all your checks and receipts. One reason is that if it appears you are spending more money than you are reporting, the auditor may become suspicious. The IRS’s policy is in line with modern electronic business and banking. The IRS will allow an account statement from a financial institution showing a check has cleared instead of the canceled check itself. (IRS Revenue Procedure 92-71.)

Books and records, if you operated a business. You aren’t required to have a formal set of books as long as the auditor believes your records reflect your true income and expenses. A check register may take the place of a set of books, if it’s backed up by canceled checks and receipts.

If your business has no records to show an auditor, you can be fined for failure to keep adequate records. In the final analysis, the law allows the auditor to make up missing records by guesswork. For example, she may double the gross receipts you claimed by estimating the volume of your business based on published industry or government statistics. This forces you either to come up with your own records or to accept her figures.

Appointment books or business diaries. If you claimed travel or entertainment expenses, you will need a writing showing dates and times the expenses were incurred, their business purpose, and who was visited or entertained. If you have no diary, you can write one up for the audit, but tell the auditor it is a reconstruction if she asks.

Auto logs. Auto logs aren’t required by law—despite what some auditors say—but they will help you prove business auto expenses. Again, you can create one after the fact, but be up-front about it. Repair and maintenance receipts should have odometer mileage written on them, and your diary may have notations of trips and expenses.

Escrow papers. These are necessary if you claim rental property depreciation deductions to show how much of a deduction you are entitled to.

Tip

Never give or mail your original documents to an IRS agent. If the auditor wants a copy, make him use his copy machine. Don’t leave the auditor’s office without your originals. IRS offices are black holes when it comes to misplacing things. If the IRS claims not to have received something, it’s your word against the IRS’s and guess who wins? Courts have said that you can’t rely on “the IRS lost it” (or “the dog ate it”) excuse. The burden of proof as to whatever the auditor is challenging on your tax return is always on you, and you may have to prove it more than once.

If You Don’t Have Documentation

Myth: If you can’t prove a deduction in writing, it won’t be allowed by an auditor because you are required to keep records.
Fact: Courts have repeatedly told the IRS that taxpayers can’t be expected to keep flawless records. Tax regulations allow taxpayers, within limits, to offer oral explanations, use approximations for some expenses, claim expenses under $75 without receipts, and reconstruct records when the originals are missing.

Despite what an auditor may tell you, here are the real audit rules on missing records taken from Income Tax Regulations and court cases.

Substantial Compliance

Begin by claiming that you are in substantial compliance with the tax laws. Substantial compliance means that you have enough proof that you obeyed the tax reporting law even though your evidence is less than complete.

Example:

The auditor agrees that Rufus is entitled to deduct a portion of his maintenance expenses as a home office expense. But the auditor finds that four months of bills that were paid in cash are missing. Rufus asserts that he is in substantial compliance and the auditor should accept the average of the other eight months of receipts to approximate the missing four and allow this much as a deduction.

This example shows the wisdom of going through your files long before the audit appointment. If you can’t find bills, credit card statements, or canceled checks, order them from the companies and banks. Expect a delay in getting copies. Few businesses keep sales receipts beyond a year or two, and most do not give a priority to getting copies to you. If getting records in time looks like it will be a problem, ask the IRS for a postponement or request that your auditor allow you more time. Most businesses don’t charge for copies of invoices or receipts, but banks charge as much as $3 per canceled check. So, you may want to order copies of major expense checks only.

Oral Explanations

Tell the auditor you are entitled to the deduction. Your spoken justification of why you can’t produce a record must be given some weight by an auditor, as long as it is reasonable. If your records were lost along with your furniture and other belongings in a move from Iowa to New Mexico, your explanation should pass the believability test. But “burglars stole them when I was asleep” or “aliens with ray guns vaporized them” won’t, even if the auditor is an X Files fan.

This is a good time to repeat the First Commandment of winning your audit: Establish and maintain credibility with the auditor. Once the auditor catches you in one lie, no matter how small, she will have a hard time believing anything else you say.

Business Expenses Under $75 Each

You can claim business deductions for expenses without substantiation (such as a receipt) up to $75 per item. Lodging expenses, however, require receipts, no matter the amount.

Before you rush out to throw away all traces of these lesser expenses, keep in mind that you always need a record. This means a business calendar notation, log, or diary showing the amount, who it was paid to, the time and place of the expense, the business purpose, and relationship of the person you spent the money on.

While this regulation purports to cover only travel and entertainment, many auditors will allow other business deductions under $75 without receipts as well. If you have small expenses without receipts and the auditor wants to disallow them, explain that you thought you didn’t need a receipt for items under $75. It might work, and the worst thing the auditor can do is say no.

Reconstruction of Records

Gaps due to missing documents may be filled by reconstruction—a process by which you rebuild lost or destroyed records. As long as the newly minted records appear to be reasonable, the auditor must consider them. This is a judgment call, however, and different auditors apply different standards. The advice that follows is necessarily general.

Courts have given some guidance on what it takes to successfully reconstruct records. If you can establish that at one time you possessed adequate records and that you no longer have them due to circumstances beyond your control, you are allowed to reconstruct them. (Internal Revenue Regulation 1.274-5(c)(5); see also Gizzi v. Commissioner of Internal Revenue, 65 T.C. 342 (1975).) You also must explain why they are missing. For instance, if your documents were destroyed when the town river flooded your basement, add a photo of your flooded basement or newspaper clipping of the flood in your area.

Documenting the expense is a little different. Let’s say you spent $1,200 cash in fixing up a rented office but lost the file with the receipts for materials. You could reconstruct your expenses with a letter from your landlord attesting to the improvements or a statement from one of your clients who saw you doing the work. Typically, if you think hard enough about reconstructing paperwork to verify an expense, you can do it. Be creative.

If you can’t come up with any kind of paper showing an expense, create your own document. For example, you spent $700 cash on carpeting your building and Karpet King has since gone out of business. Write up your own receipt showing the name of store, amount, and date of purchase, or as close as you can get. But, be up-front with the auditor; tell her you prepared the receipt as reconstruction because it was not possible to document it in any other way.

Cohan Rule. An old, well-known tax case has saved many an audit victim with missing records. George M. “I’m a Yankee Doodle Dandy” Cohan was nailed for not having receipts in a 1920s IRS audit. George fought the IRS to a U.S. Court of Appeals, which held that a taxpayer may approximate expenditures for tax purposes, as long as he can reasonably show that some amount was spent. (Cohan v. Commissioner of Internal Revenue, 349 F.2d 540 (2nd Cir. 1930).)

The Cohan Rule has its limits. First, you must make some showing of why the records are not available. They may have been lost or destroyed or be in such small amounts and from transactions in which receipts are not normally given, such as cab fares or tips. And the rule can’t be applied to approximate travel and entertainment, as mentioned above.

In reality, the Cohan Rule is useful as a bargaining chip to use with the auditor. If she says “no deduction without documentation,” cry the Cohan Rule. Her eyebrows will likely raise in surprise, and she may back down, at least part of the way.

Negotiating With an Auditor

An auditor has no power to change your tax return. She can only propose tax changes to you. An auditor fully realizes that if you don’t go along with her proposals, you may appeal an audit in most instances or go to tax court in all cases. In fact, the IRS’s guiding principle for auditors is to close examinations with your consent to keep you from clogging up the Appeals Office and tax court. Because an auditor’s performance is judged on her closing ratio —how many examination reports are accepted by taxpayers—you are in a perfect position to negotiate with an auditor.

Oddly, however, auditors aren’t officially supposed to negotiate. They are told to discover the facts of a case and apply the tax law to those facts. In reality, if you can show an auditor that the facts are not black or white, you can reach a compromise. Let me emphasize—you can compromise based on the facts; you cannot wheel and deal just because you cannot afford the tax bill. For instance, never offer an auditor 50¢ on the dollar; instead, ask for a 50% allowance of a questioned deduction. You can negotiate specific adjustments on particular items using this principle. Here are two examples:

Missing documentation. If your documentation is lacking, you have what the IRS calls a substantiation or verification problem. Suppose you claimed a storage rental expense of $50 per week, paid in cash and lost your receipts. The auditor says she will disallow the $2,600 item for lack of verification. The former manager of the storage facility writes a letter attesting to your regular payments, but the storage building has been torn down and replaced by a mall. Try proposing a compromise: suggest a disallowance of 25% to get the audit over with. If the auditor agrees or offers a 50% disallowance, you have just negotiated a fairly decent settlement and you’ve learned a lesson about keeping your records.

Questionable legal ground. You may have perfect records, but a shaky legal position. For instance, suppose you spent $5,000 to replace a deck and $5,000 for a new roof on a rental property you own. On your tax return, you deducted both items as repairs. The auditor claims that these are capital improvements that must be deducted, or amortized, over the life of the improvements. Assuming the auditor is right, and each has a ten-year estimated life, you would be limited to deducting only 1/10 of the cost ($1,000), for each of the next ten years.

To propose a compromise, you can suggest that one item is an improvement, perhaps the deck, but the other is a repair—the roof, which was leaking like a sieve. You could then deduct all $5,000 for the roof and $500 for the deck. While you wanted to deduct $10,000, deducting $5,500 is much better than the IRS’s initial position that you deduct only $1,000. You can still take deductions for the balance ($4,500) over the next nine years.

Adjustments in Your Favor—Taking the Offensive

Auditors must make any adjustments in your favor whenever they are found during an audit. Even the most hard-nosed auditor knows that taxpayers occasionally make mistakes that hurt them, not the IRS, or overlook claiming tax benefits on their returns. This is another good reason to see a tax professional before meeting with an auditor: to find out if you missed any deductions or can find anything else in your favor to show the auditor. (I’d suggest reading some publications that might help you identify deductions you may have missed. Or, if you are self-employed, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo).)

If you or your preparer were overly conservative—for example, you decided not to take a certain expense as a deduction because you had no receipt—then claim it at the audit. It just might be accepted by the auditor, and nothing ventured, nothing gained.

Don’t, however, bring up any favorable items until the auditor has completed her review and decided on any changes for the IRS. Then present your positive adjustments. If you show them earlier, she might counter by looking harder for some offsetting adjustments. After she is locked into her position, things can only get better if she accepts any of your new, positive change items.

Ending the Audit

Although it never hurts to delay the start of an audit, once it begins you may want to rush it along. For instance, if a problem lurks that the auditor has not yet found, the longer she looks, the greater the chance of discovery. If the auditor hasn’t yet seen your bank statements and found the mysterious $10,000 deposits, you want out of there before having to explain them. Also, having the IRS in your life is just plain stressful.

A field auditor may be maneuvered into closing a file, depending on her personality.

Bored, lazy, or unexcited. As soon as the audit begins, tell the auditor that you have heard that audits usually produce adjustments. Say that you would appreciate it if she finds them quickly and gets it over with so you can go about your business. If she gets the idea that you won’t fight (at least small adjustments) she might take you up on your offer. This is especially true if you point out any obvious errors in your return or records (such as 6 + 6 = 13) that she will almost surely find anyway. Many auditors have a personal tax adjustment level, which they know will satisfy their manager. Conversely, the more time the agent puts into your case, the more she expects to find—and will.

Example:

Alison took a questionable tax position on a $2,000 deduction for her business. Nearing the end of a full day of an audit, the auditor hadn’t yet reached the item. Alison volunteered that there was a $350 deduction that should not have been taken the year before. The auditor had already found $1,200 in other items to disallow, and Alison thought he might be satisfied with one more adjustment. She was right. The auditor said that another day would not be necessary. Even if she had not kept the auditor away from the $2,000 item, by volunteering the $350 item, Alison came across as reasonable. Such good deeds are often rewarded later by an auditor, such as by giving you the benefit of the doubt when documents are missing.

Overly conscientious. Some auditors (usually the younger ones straight from IRS basic training) come on strong, looking at every little thing and laying down the law like a Marine drill instructor. When this happens, drop the nice guy approach, get your back up and argue over every item that he looks at, even when you know you are wrong. Let him know two can play his game and that you won’t be steamrolled. If you know serious problems are ahead due to questionable items or missing documents, demand an end to the audit for that day. Say that you want to consult a tax professional. He won’t like being slowed down, but he knows he must grant your request.

At your next meeting, the auditor should at least be more reasonable, if not anxious to conclude the audit. If not, threaten to call in the auditor’s manager. This usually causes the auditor to adjust his attitude. He’ll figure he can better use his time working on other files where the taxpayer does not stand up to him instead of putting more time into your case.

IRS Pressure on an Auditor to Finish —Extending the Audit Time Limit

The IRS does not have forever to audit you. The deadline is normally three years after your return is due (usually April 15) or actually filed, whichever is later. If the IRS suspects serious fraud or underreporting of income by at least 25%, the period is extended to six years or indefinitely. But audits started beyond the normal three-year limit are rare.

The Internal Revenue Manual directs an auditor to issue an audit report within 28 months after the date you filed the return. If an auditor hasn’t completed her work by then, you will be asked to extend the deadline by signing IRS Form 872, Consent to Extend the Time to Assess Tax. When asked, you have three options:

  • sign the consent form
  • don’t sign, or
  • negotiate the terms of the extension.

I recommend the second or third approach in most cases.

The auditor wants you to sign an open-ended extension agreement, meaning that an audit adjustment can be made on any item, at any time in the future. Don’t do it; you have the right to refuse to sign. Instead, ask that the form be limited to specific items—those on which the auditor says she needs to do more work. Also, agree to an extension for no longer than six months. These perfectly reasonable limitations on the auditor narrow your risk of further IRS fishing into your affairs.

If you don’t negotiate or sign the Form 872 extension, one of two things will happen:

  • The auditor will issue the examination report, and a notice of deficiency simultaneously. This means that you cannot appeal the report within the IRS, but you can go to court. This is not so bad, as it isn’t that difficult to take the IRS to tax court.
  • The auditor may slip up and let the three-year audit deadline pass—meaning that no assessment can ever be made. This does not happen very often. The IRS gets very upset with auditors who blow the deadline. But when it does happen, it’s like winning the lottery.

Continue to part 6

Bishop L Toups

Bishop L. Toups is an estate planning, elder law, and tax attorney in Southwest Florida.

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