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We call them audits; the IRS prefers examinations. Whatever term you use, it describes one of life’s most dreaded experiences—the IRS probing into your financial affairs.
This chapter deals with the types of IRS audits—both correspondence and face-to-face—that individuals and small business owners are most likely to face. The IRS also has a Large and Mid-Sized Business Division for auditing corporations with assets over $5 million, as well as a Tax-Exempt and Government Entities Division.
The vast majority of tax returns are accepted by the IRS without question. Your chance of being contacted by the IRS about a discrepancy on your return in any one year is only one in a hundred. But if you are self-employed, the odds of at least one IRS examination in your taxpaying lifetime are closer to 50%. These are the cases where IRS defense becomes relevant.
As your income increases, so does your audit likelihood. If you regularly earn over $100,000 per year, your probability of an audit has increased every year over the past decade. And when your time does come, expect it to cost you—five out of seven people who are audited owe additional taxes. A few people get tax refunds after an audit, but don’t count on it. The amount of money the IRS assesses in audits is 32 times greater than the amount given back.
Federal courts have long held that if the IRS determines at an audit that you owe taxes, there is a rebuttable presumption that the determination is correct. This means that you have the burden of proof when up against the IRS. Critics have said that it really means you are guilty until proven innocent.
While this is the standard in audits, it is not the standard in court proceedings where the IRS has the burden of proof. If you take the IRS to court, the government must show that you were wrong on a disputed factual issue, not vice versa. See Going to Tax Court
Never file a tax return while an audit is in progress, even if asked to do so by an auditor. You risk having the audit expanded to include that return. Instead, file an application for an extension until October 15.
If the audit is still alive on October 15, consider not filing until it is completed. If you’ve paid all taxes due, you won’t incur any penalties or interest for not meeting the filing deadline. If you owe additional money, send in your payment with a letter stating that the payment is to be applied to that year’s tax return.
If you didn’t read this in time and have already filed a return during an audit, politely refuse to give a copy to the auditor if she asks.
Generally, your tax return cannot be audited after three years from its original filing date. If you filed before the due date, April 15, the three years start running from April 15 of the year it was due.
There are a few exceptions, however:
Audit notices are usually mailed between 12 and 18 months after you file your return. Generally, if you haven’t heard from the IRS within 18 months, you won’t be audited. IRS audit notices are sent by first class mail and never by email or telephone contact.
The Internal Revenue Manual directs auditors to complete audits within 28 months after you file your tax return. Legally, the IRS has 36 months. The 28-month internal deadline is imposed, however, to allow eight additional months for the IRS to process any appeal you might request.
Read More: Winning Your Audit: an In-Depth Guide
These internal IRS time limits usually work to your benefit. Audit cases are often delayed within the IRS for various reasons—backlogs, agent transfers, postponements, complex issues, and lost files. The older your file gets, the more anxious the IRS is to close it. Auditors can be fired for missing the 36-month deadline, known as blowing the statute, but it still happens.
Stopping an audit once it begins. Once the IRS sends an examination notice to your last known address, the audit has begun. It is difficult to stop an audit. Even if you die, your spouse or the executor of your estate is obligated to carry on the audit.
You may be able to slow down—or even stop—an audit, however, if you ask for a transfer of your file to another IRS district. Audit transfers are discretionary with the IRS, and you need a good reason to get one—such as a more convenient location of your tax documents.
Janiel, who lived in Pennsylvania but had a jewelry business in New York, received an audit notice for Pennsylvania. She requested a transfer to where her business was located. Janiel told the IRS that her records were at the business location in New York, which was true. The transfer was granted, but the New York office’s audit plate was already full and the office never got around to Janiel’s audit. The three-year statute of limitations expired and Janiel’s worries came to an end.
Will the auditor discover the money I made from playing the organ at weddings?
I lost my records in a move last year—what am I going to do?
Was I entitled to claim my mother as an exemption?
Will the IRS question my home office deductions?
Is the IRS going to put me in jail if they find out I’ve been cheating?
These are common taxpayer concerns. So, let’s look at what really goes on when the IRS decides to audit you. We’ll look at the two primary issues in every audit:
IRS Publication 17, Your Federal Income Tax, explains the audit process—from the IRS point of view.
An audit is the process by which the IRS determines whether you properly reported all income—from earnings and investments—and took the correct deductions, exemptions, and credits. If the IRS finds that you didn’t, you will be assessed additional taxes, interest, and—usually—penalties. An assessment is the formal entry of a tax liability in your records.
To do its job, Congress has given the IRS wide powers to inspect your financial records and to ask you and others about your financial affairs, to determine whether you are cheating Uncle Sam. (Internal Revenue Code §§ 7601 and 7602.) The IRS will investigate the items listed on an audit notice checklist given to you and scrutinize any other areas deemed questionable. And the law specifically places the audit burden on you to demonstrate that the information shown on your tax return is correct—think of the IRS as the Show-Me state of Missouri. If your dispute gets to court, however, the burden shifts to the IRS under certain conditions.
Proving the correctness of your tax return may not be that easy. The IRS wins over 80% of all audits, mostly because taxpayers can’t properly verify the information on their tax returns. IRS auditors say that the biggest reason for adjustments is poor recordkeeping, not taxpayer dishonesty.
To understand the audit process, start with the Internal Revenue Code, or tax code. The tax code contains 8,500-plus pages of very fine print. Add to that IRS regulations, revenue rulings, letter rulings, manuals, and official publications, all of which add another 100,000 or so pages of tax law. Finally, there are thousands of court decisions telling us how tax laws should be applied in individual cases. The total number of tax law pages exceeds one million!
How will I ever understand the tax laws?
You won’t. But that may not be as much of a disadvantage as you might think. Tax law is so voluminous and complex, most IRS auditors don’t know it well either. Moreover, the training and experience level of IRS personnel is declining while the law is getting more difficult to master. This means that auditors normally stick to predictable audit issues. A taxpayer with very high income or an intricate tax issue, however, may be assigned an auditor with more training and experience. But normally, if you are well prepared, you will come out okay—experiencing the minimum damage—most of the time.
In a few hours, you can learn the basic tax law for your particular audit issues. The information is in this book and other sources mentioned in this article. And you can—and probably should—consult with a tax professional before taking on the auditor.
The truth is that most people succeed in an audit without knowing any tax law at all. This is because many audit issues are factual, not legal. The distinction will become clear as you read this chapter. And it’s as important to know IRS procedures—the rules of the game and your rights in dealing with the IRS—as tax law. This book explains the rules to follow and psychology for dealing with the IRS as well.
You just got an examination notice from the IRS. Are you merely unlucky, or are there more sinister forces at work?
The IRS computer is to blame for most audits. Each year, your tax return data is sent to the IRS National Computer Center where it is analyzed by a computer program called the Discriminant Function. Your tax return is given a numerical DIF score—the higher the score, the more audit potential the return has.
The DIF program is super-secret—few people even in the IRS know how it works or why a return is given a particular score. Outsiders guess that hundreds of variables on a return are weighed by the IRS computer. One known variable is called “total positive income,” which means everything you took in from your services and investments, before any deductions or exemptions. If this number is over $100,000, your chances of an audit double (roughly). If you earn more than $1 million, your audit rate is nearly 10%. The key variable is believed to be the percentage of deductions and the number of exemptions claimed.
The IRS has a second computer scoring program to catch people not reporting all of their income. This is a slightly different approach from the DIF program, which relies heavily on deductions and exemptions claimed. This program is called the Unreported Income Discriminate Information Function (UIDIF). It scores individuals based on a high-expense/low-income ratio. In plain English, the tax man is looking for folks who look like they are living beyond their means. For instance, you and your spouse report income from your jobs of $40,000 and you claim mortgage interest and real estate taxes of $35,000. Even assuming that you didn’t owe any taxes that year, it would be tough to live on $5,000—so the IRS believes. Of course, some people have down income years and simply borrow or dip into savings to get by. These explanations can always be made to an auditor, if necessary.
One in ten tax returns—those with the highest computer scores—are initially selected for further review. IRS classifiers (human beings) then look at this batch and recommend approximately 10% for audit.
The final say-so on who gets audited face-to-face is made at local IRS offices by examination group managers. These people supervise and assign the auditors, often according to their experience and expertise. Managers decide whether you will be audited at the IRS office or will get a more rigorous field audit.
IRS field offices have their own audit-screening selection process which takes into account income and expense levels in their communities—for instance, people are more likely to claim car expenses for business in Los Angeles than Manhattan. Group managers select less than 10% of the returns received from the IRS classifiers—the 10% of all tax returns—to be audited. Historically, the net result is that only about ¾ of 1% of all returns are actually audited.
The computer is not the only way the IRS picks its audit victims. See, “Other Reasons for Audits,” below for other ways your number might come up.
According to the IRS Manual, only significant items should be examined. What is considered significant depends on the IRS’s overall view of the return as well as particular items that seem questionable. Factors that are likely to figure into the audit selection process include:
One of the chief components of the IRS DIF scoring system is how close your tax return is to the norm of others with similar deductions. According to author Amir Aczel (How to Beat the IRS at Its Own Game, $14.95, Four Walls Eight Windows Press), the IRS is most likely to audit you if your return shows a high ratio of deductions to income on three schedules:
Aczel claims that, as a rule, as your deductions approach 50% of your income, your audit likelihood rises. He lists precise ratios based on a study of 1,200 audit cases. For example, he claims that taxpayers filing a Schedule C are rarely audited if they claim expenses of less than 52% of gross business income, but are often audited when claiming expenses of more than 63%. If you include a Schedule A with your tax return, Aczel claims you are safe from an audit if your deductions are less than 44% of your gross income. While his book is interesting, don’t use it as a manual to avoid a tax audit. I say if you are entitled to a deduction, take it, no matter what the chances of audit are.
Don’t think that because you didn’t file a return that you will escape the IRS audit telescope. If you are in the IRS’s computer, the IRS will eventually request that you file—if the IRS can find you. If you ignore them, the IRS has the legal authority to file and, in effect, audit a tax return in your name. The Internal Revenue Manual directs the auditor to come up with a reasonable and substantially correct tax return—which gives the auditor a license for invention.
In addition to whatever information may be in the IRS records—typically income reports on W-2 and 1099 forms—the auditor may rely on tables from the Bureau of Labor Statistics (BLS) to estimate your income and expenses. This is often done when either the income sources on record show an impossibly small income, such as $4,000, when you live in a penthouse apartment in the Beacon Hill section of Boston, or when there is no income record at all. BLS data shows the government’s estimate of the minimum amount of income necessary to live on, taking into account your geographic area, family size, and probable standard of living.
To approximate income from a business, the auditor may rely on industry standards. For example, the auditor may use averages for sales and profit margin on all U.S. auto parts retailers to estimate how much Simon’s Auto Parts World made.
After the auditor’s report of a nonfiled return is completed, the IRS will forward you a copy. If you agree with the figures, you can sign it. If you don’t agree, you will be given an opportunity to dispute it with your own figures or to file a tax return. Or, the IRS will issue a Notice of Deficiency giving you 90 days to contest the IRS report in tax court. (See Going to tax court.)
Why me? Although you may never know for certain why the IRS zeroed in on you, try to figure it out before the audit date. If you know what the IRS suspects, you can better prepare—or get professional help early on. An experienced tax professional can spot probable audit issues in a tax return or from discussing your situation with you.
The IRS targets some people for financial status audits. These are special techniques to detect unreported income, including the UIDIF computer scoring program described above in “Computers and Classifiers.” The IRS looks to whether the income on the tax return supports the financial condition of the taxpayer. The IRS is looking for “economic reality” by approximating expenses for personal assets and living expenses. You might have to explain how you eat at the Ritz on a fast-food salary.
The IRS can’t randomly conduct financial status audits. Financial status audits aren’t to take place unless the IRS sees a “reasonable indication” of a likelihood of unreported income—a fairly vague limitation. (Internal Revenue Code §7602.)
You can understand the IRS’s focus on lifestyle audits by looking at the IRS training materials for auditors. They look at the following lifestyle-related issues.
The standard of living of a taxpayer:
The accumulated wealth of a taxpayer:
The economic history of a taxpayer:
The business environment:
Other nontaxable sources of funds:
Goal: Do the taxpayer’s books and records reflect the economic reality of his or her personal and business activities, or has the taxpayer omitted income in order to minimize tax liability?
The following sample questions are taken from IRS training materials. The suggested answers are strictly legal—and from me. Note that I never use the word no, but I don’t give the IRS what it’s fishing for, either. Unless otherwise noted, the auditor’s questions should relate to the year or years you are being audited for, not the year the audit takes place.
As the above hypothetical questions and answers indicate, try to answer economic reality questions with questions of your own, or don’t answer them at all. Politely remind the auditor that the questions don’t relate to the tax return, that you were merely selected for an audit, and that you shouldn’t be treated like a criminal. Suggest that if the auditor wants to make an adjustment based on economic reality, you’ll appeal. More likely than not, the auditor won’t call your bluff.
The Market Segment Specialization Program, or MSSP, is a cornerstone of the IRS process. The MSSP focuses on specific industries or groups of taxpayers believed to be in significant noncompliance with the tax law. Accordingly, the IRS provides specialized training to its agents and issues Audit Technique Guides for its auditors.
The IRS has made these Guides public —if you fall into one of the targeted categories, you will know what the IRS is after. So far, over 100 Guides have been issued on topics from architects to veterinarians. You can locate these Guides:
Besides getting picked by the IRS computer, there are seven—and in some years eight—other ways you can get into the audit soup:
Local projects. Local IRS offices can initiate special audit projects based on their perceptions of abuses by individuals and groups in the community. Recent projects include gamblers, people who claim excessive earned income credits, ex-spouses who deduct or receive alimony, and people whose mortgage loan applications show different income from what was reported on their tax return.
National projects. Every year, the IRS national office decides that certain occupations merit audit attention. Past favorites have included airline pilots and flight attendants, physicians, and morticians. Perennial targets are operators of cash businesses, such as bars and laundromats, food servers, cab drivers, and owners and employees of gambling establishments. This program is being phased into the MSSP audit, described above.
The IRS receives several clues to your occupation. W-2 and 1099 forms filed by others might indicate it. You are required to state it on your tax return. If you are self-employed, you must list a six-digit business identification code. Some people have tried creativity here, such as the prostitute whose return stated “public relations.” She was fined by the IRS and could have been criminally prosecuted when the auditor learned the exact nature of those relations. Misstating the source of your income is illegal, even if you report all of it.
Prior and related audits. Audit lightning does strike twice. Previous IRS audits often beget new ones—if they produced tax bills of at least several thousand dollars. But this is not a sure thing. I have seen people audited and hit with an enormous tax bill who never hear from the IRS again. If you are a partner, limited liability company member, or shareholder, and the business entity or any others in it are audited, you may not be far behind.
Criminal activity. Like grapes, trouble usually comes in bunches. If you are investigated for a drug crime or crime involving a lot of money, the IRS may be tipped off by the law enforcement agency and decide to audit. The tax code is morally neutral—it requires that all income, from sources legal or otherwise, be reported. The IRS doesn’t care if you made the money as a Mafia hitman as long as you declare it.
If you’d prefer not to disclose the source of income, you can file a Fifth Amendment tax return on which you claim your Constitutional right against self-incrimination. You enter the amount of your income on your 1040 Form and write Fifth Amendment next to the lines where you list the source and where the form asks for your occupation. While this may keep you out of the criminal investigation division of the IRS, it undoubtedly increases your audit potential.
Never file a Fifth Amendment tax return without first consulting a tax attorney.
Amended tax returns. You may file an amended tax return any time after you file an original one. The IRS has discretion to reject amended returns, but it usually accepts them. A few people file amended returns and wind up owing more in taxes, but most people amend their tax returns to get a refund. To get a refund, you must file the amended return within three years of the date you filed the original return, or within two years of the date you paid the tax. Because the IRS doesn’t like to give back money, it investigates all refund claims, sometimes by auditing. And if you are audited, everything on the return—not just the items amended—are fair game.
Filing an amended tax return doesn’t extend the time the IRS has to audit you—normally three years from the original filing date. So, the closer to the end of the three-year period you file the amended return, the less time the IRS has to audit you. But, the IRS has the discretion to reject amended returns and sometimes will accept them only on the condition the taxpayer agrees to extend the three-year audit limit.
Informants’ tips. Undoubtedly, you have heard stories about disgruntled ex-spouses, business associates, and former employees turning someone in to the IRS. While an audit could result, it should put your mind at ease to know that fewer than 5% of all audits result from tattletales. IRS sources say that most tips, particularly anonymous ones, are not seriously followed up. The IRS prefers to rely on its computers for audit selection. Historically, the IRS has found that many tips are not provable and are motivated by spite.
Where you live. Everyone knows that Kansas gets tornadoes, Florida gets hurricanes, and California gets earthquakes. Similarly, some locales get more than their fair share of audits. The audit rate is 150% higher than the national average in Nevada, but 150% lower than that average in Wisconsin. Other high-audit states are Alaska, California, and Colorado. Low-audit states include Illinois, Indiana, Iowa, Maryland, Massachusetts, Michigan, New York (excluding Manhattan), Ohio, Pennsylvania, and West Virginia. The second-lowest audit rate locale is the District of Columbia.
What’s more, how you come out of an audit depends on where you call home, too. Your chance of getting away without owing a nickel is more than twice as good in Las Vegas (32%) than in Manhattan (15%).
Random selection. The IRS is currently selecting some audit victims at random under its new National Research Program (NRP). These audits are reminiscent of the dreaded TCMP (Taxpayer Compliance Measurement Program) audits that were discontinued in the 1990s. The stated purpose of NRP audits is to gather data to update the statistical models used to score individual tax returns. Nevertheless, these are very “real” audits—in fact, they are much more intensive than ordinary audits.
Frivolous tax return. Claiming that your income is not subject to federal taxes is a surefire way to get on the audit list.
Political selection. It is a crime for a non-IRS employee to request that the IRS conduct or terminate an audit of a taxpayer. An IRS employee must report such a request to his superiors. (Internal Revenue Code § 7217.)
The IRS increasingly relies on computer-generated tax bills that are technically not audits. This means your tax return still could be examined in the future.
The IRS is authorized to make changes to your tax account without a formal audit in some cases. (Internal Revenue Code § 6213(g)(2).) The IRS has programs (described below) that often exceed Congressional intent of the law, which was to let the IRS correct minor taxpayer errors. Instead, the IRS effectively performs one-sided mail audits. Many poor souls pay up without question.
Underreporting notices are the most common of the four programs.
The most common automated adjustment notice is the CP-2000 (see sample below). Look at the top right-hand corner of the first page of the notice for the code. The problem with CP-2000 notices is that many are totally or partly wrong. Money Magazine estimates that at least 25% are in error. A common IRS mistake is failing to see that the income was reported elsewhere on the form than where the computer looked. For instance, one year I reported earnings in a money market fund as interest instead of dividends, and the IRS computer spit out a CP-2000 notice stating that I did not report $450 of income and billed me for additional tax, and penalties and interest.
If so many of these notices are wrong, why does the IRS keep sending them? The Money Magazine article reported that most people who were billed for $589 or less simply paid it. The magazine estimates that IRS collects seven billion dollars a year it is not entitled to.
Can you fight an automated adjustment notice? Absolutely. If you receive one of these notices, just follow these steps:
Step 1. Call the IRS. Call the number on the notice (or 800-829-1040) to start. Ask for a full explanation even if you suspect the IRS may be right, but you aren’t sure. Ask for an abatement if you believe the IRS is, or probably is, wrong—abatement is the IRS word for canceling a bill. Tell the IRS person why the notice is wrong or that your records are different from the IRS’s and promise to send the proof. You probably won’t settle this during the telephone call, but you want the fact that you are disputing the notice entered into the IRS computer.
Step 2. Contest in writing. Don’t rely on a telephone call to straighten out an IRS problem. The tax code provides that if you don’t object to an automated adjustment notice within 60 days, it becomes final.
There is no preprinted IRS form to contest automated tax notices. Send a typewritten letter to the IRS office that sent the notice. Use the format in the sample letter below. Make the letter brief and to the point. IRS people have short attention spans and won’t struggle through long-winded explanations or unclear handwriting. Staple a copy, not the original, of the IRS notice to the front of your letter. Mail it certified, return receipt requested. Use the IRS bar-coded return envelope that was included with your notice to speed up processing.
When writing the IRS, always make several photocopies of whatever you send. If the IRS misplaces your correspondence, you can send it again—and again, if necessary.
Step 3. Go to tax court. If you fail to respond to a CP-2000 notice, or if you do respond but the IRS ignores or disagrees with your explanation, the IRS will issue a Notice of Deficiency. You will know when it comes because these notices—also called 90-Day Letters—are sent by certified mail and labeled Notice of Deficiency. If you get one, your only recourse is to file a petition in U.S. Tax Court within 90 days after the date of the letter. This is not a difficult thing to do, but does cost $60. See Chapter 5 for instructions.
Hamilton and Jill O’Brien
123 Elm St.
Ukiah, CA 90000
June 16, 20xx
Fresno, CA 93888
REQUEST FOR ADJUSTMENT
Re: IRS Notice Dated 6/2/xx
To Whom It May Concern:
I am responding to your notice of 6/2/xx, a copy of which is attached.
The notice is wrong. I did not make any math errors in my tax return. Here is how I made the calculations: $10,432 – $3,190 = $7,242.
The 1099 form filed by Apex Industries was wrong and the company has prepared a letter stating the correct amount, which is attached to this letter.
The W-2 form filed by my former employer is incorrect in that I made $42,815 in 1991, not $ 49,815.
I responded to your notice of 5/2/xx but you did not fully correct your error. Enclosed is a copy of my letter of 5/9/xx with a full explanation.
In your letter to me of 5/2/xx you said that the tax bill of $666 was corrected to $222 (copy enclosed), but I just got a notice dated 6/2/xx for the $666 again.
Please abate the taxes, penalties, and interest in the amount of $1,612.
We can be reached at 707-555-0562 anytime.
Hamilton and Jill O’Brien
Enclosed: Copies of IRS notices,
Don’t be surprised if you keep getting bills in spite of your letters contesting an automated adjustment notice. It takes a month or more to get your response into the system to stop the computerized cycle. Simply respond to later IRS notices with a photocopy of your earlier letter. Never ignore IRS letters, and never send originals. If notices ignoring your letters keep coming after 90 days, call the Taxpayer Advocate Service at 800-829-4059. Tell the taxpayer advocate that the IRS has not answered your letters and ask for help.
Consider calling a tax professional for advice, although it is seldom cost-effective to hire one for this type of problem. Many tax professionals will talk to you on the phone free of charge. If the erroneous IRS bill is a biggie, consult with a tax professional first or have them contact the IRS on your behalf.
Even if the IRS eventually proves to be correct, by sending letters, requesting help from the taxpayer advocate, or filing a petition in tax court you will have greatly delayed the final tax bill. This gives you extra time to get the payment together or to figure out another way to deal with the tax bill (see When You Owe the IRS for alternatives in dealing with a tax debt).
IRS Publication 1, Your Rights as a Taxpayer, should be included with your audit notice. (A copy is in the Taxpayer Bill of Rights.) It very clearly explains the Taxpayer Bill of Rights. The most important audit rights are to:
There are three types of IRS audits: correspondence, office, and field.
The way the IRS goes about auditing you can produce very different results. A few years back, office audits resulted in additional tax and penalties averaging $1,965 per individual return, correspondence audits $3,817, and field audits a whopping $16,248. For those taxpayers who made more than $100,000 per year, field audits resulted in added taxes, penalties, and interest averaging $35,295!
The correspondence audit is by far the IRS’s preferred method of attack. Seventy-five percent of all IRS audits are by mail. Similar to the Automated Adjustment process described above, a correspondence audit comes by first-class mail. The IRS never notifies by telephone or email at the beginning of an audit. The IRS requests that you mail information or documents instead of meeting with you. This method of auditing is used to verify such things as stock market transactions, real estate sales, and itemized deductions. Amended tax returns are often audited by mail. These audits often result from a mismatch of a third-party payment report on a Form 1099 or W-2.
You should almost always cooperate with an audit by mail and be thankful that you weren’t chosen for a field or office audit. Unless the documents requested are lost or nonexistent, promptly send copies. Don’t send originals—you won’t get them back. It’s possible to call the auditor to discuss your case. Or, write and ask the auditor to call you. A name and telephone number should be listed in the IRS notice you received. As a precaution, send document copies by certified mail, return receipt requested. Always keep photocopies of everything you send to the IRS.
If you have a problem with the correspondence auditor—for example, he is not satisfied with your supporting receipts and canceled checks—you can request that your file be transferred to your local IRS office for a face-to-face meeting. Just making this request may cause the IRS to reconsider. And sometimes, mail audits forwarded to local IRS offices are closed with no adjustments—without even contacting you. If you’re given a meeting with an auditor at the local office, consider it a second chance.
The office audit is announced by a form letter sent by first-class mail to your last known address either setting a time or requesting you to call the IRS for an appointment. The letter tells you the year being audited and often specifies documents you are requested to bring with you, such as receipts and canceled checks. It may also list up to four specific areas the IRS wants to examine—such as rental property income, deducted interest expenses, deducted unreimbursed business expenses, and charitable contributions. At the audit, if you are questioned about unlisted items and you don’t want to answer, just say that you are not prepared to discuss those issues. The auditor will probably drop it or give you more time to get prepared and set a second meeting date.
Thankfully, the IRS doesn’t expect auditors to examine every item on a tax return. Remember—only significant items are selected by classifiers, although IRS examination group managers may modify the list.
By law, the IRS normally has three years to audit you after you file a tax return. So, if the year on your notice is more than three years ago, either the IRS made a mistake or the IRS suspects you of fraud or of substantially understating your income. If you believe it’s a mistake, call the number on the notice and ask that the audit be canceled. If you’re told it is no mistake, then head straight for a tax professional’s office.
If you were audited in either of the two previous years and the IRS made a small, $100 or so, adjustment—or issued a no change report—you may be able to get the audit canceled under the no repetitive audit rule discussed above. Explain the prior audit and the outcome to the clerk; if she seems not to know what you are talking about, ask to speak to a manager. This defense has only limited application, however, and probably won’t work if you report any self-employment income.
In general, the words to live by are, “Don’t hurry, be happy,” and “An audit delayed is an audit well played.” The more time an audit drags on, the better the result in most cases. This is because auditors are under pressure to close files, and they want your cooperation to do it. The later it gets, the greater the pressure. The main drawback of prolonging an audit is that interest and penalties are growing—but this may be insignificant next to the damage caused by a large audit bill.
There are two ways to delay an office audit:
After you get over the shock of reading “We have selected your federal income tax return for examination,” call the IRS phone number on the letter. However, the IRS does not award gold stars for calling as soon as you get the notice and waiting a while is usually a good idea.
Even if you don’t want to delay, when you call the IRS for an appointment, ask for the furthest date available so you have sufficient time to get your records in order. A month or two is common. If you need more time, ask to speak to a supervisor. The Taxpayer Bill of Rights requires that you be given a say in the appointment process.
Also, some tax professionals advise getting an appointment on the last day of the week toward the end of the month, in the late morning—just before the auditor’s lunch break—or late afternoon. Friday afternoons are perfect, especially if a three-day weekend is coming up. Auditors do not get paid overtime and look forward to going home as much as you do.
Consequently, the auditor may race through your audit without digging too deep. Much like car dealers, IRS offices track monthly case closings. If you come in near the end of the month and your auditor hasn’t kept pace, he may need to finish your case or else suffer a bad performance review from his manager.
Don’t answer the auditor’s questions on the phone. The auditor might try to speak to you over the phone about the facts of your case prior to your appointment. It’s better to say that you aren’t prepared to talk right now than to give off-the-cuff answers which could come back to haunt you later.
If you can’t go to the IRS offices without great hardship—you are disabled or aren’t capable of transporting large amounts of records—you may request that a tax auditor come to your home or business. This goes against my general advice of keeping the auditor as far away from your stomping grounds as possible.
You might turn an office audit into a mail audit. If there’s a good reason as to why you can’t travel—illness or disability, lack of transportation, or whatever—when you call to schedule your audit, request a correspondence audit.
Many auditors are young, and some are foreign-born with limited English skills. In general, you may have to take extra time to explain some of your deductions or exemptions. If you are a small business person or self-employed, you may have to carefully explain how your particular enterprise functions.
Office auditors start with some easy questions to make sure you are the person under audit (you don’t have to show any identification) and to get some background on you—questions like “Are you married?” or “Where do you live?” Ordinarily, these background questions won’t cause you any problem.
Before meeting an auditor on your own, review IRS Form 4700 Supplement and, if you operate a business, Form 4700 Business Supplement. Both forms are reproduced at the end of this chapter. These internal IRS forms are used as checklists by auditors. They will tip you off to the types of questions you should expect. If any question might be difficult for you to answer, see a tax professional before the audit or consider hiring one to handle the audit for you.
After the background questions, the audit will start in earnest. IRS office auditors don’t waste time in idle chitchat. Every question has a reason, even if it is not obvious to you. The Internal Revenue training manual instructs office auditors to conduct the initial taxpayer interview as follows. (My comments follow in the brackets.)
(1) the initial interview is the most important part of the audit process. The first few minutes should be spent making the taxpayer comfortable and explaining the examination process … [Read that first sentence again; first impressions are vital.]
(3) sufficient information should be developed to reach informed judgments as to:
(a) financial history and standard of living. [See the next section for a lengthy discussion of new IRS lifestyle auditing.]
(b) nature of employment to determine the relationship with other entities. [This means that the auditor may want to look at your partnership or corporation tax returns too, and look for the possibility of any bartering.]
(c) money or property received … determined to be … not taxable … [For instance, did you get loans or inheritances or sell assets during the year?]
(d) potential for moonlighting income. [For example, are you a firefighter who does odd jobs on your days off?]
(4) if warranted … [If after covering the above areas the auditor gets responses or sees things on the return that cause her suspicion, she should go on to find out more about these areas.]
(a) … property owned, including bank accounts, stocks and bonds, real estate, automobiles, etc., in this country and abroad [Asking these kinds of questions used to be optional; it has become common in most audits.]
(b) … purchases, sales, transfers, contributions or exchanges of … assets [Did you buy or sell anything worth in the thousands of dollars?]
(c) the correctness of exemptions and dependents claimed. [If you claimed a large number of dependents, be prepared to explain, especially if any of the dependents are not members of your immediate family.]
(5) remember, the taxpayer is being examined and not just the return. [I can’t overemphasize the importance of this one sentence—it is what an audit is really about.]
Expect the following topics to be covered at an office audit. Not all will apply, but be prepared for the ones that do.
Income. The IRS claims that it loses infinitely more tax dollars from unreported income than from overstated deductions. Once the preliminary questions are over, the auditor will ask point-blank if you reported all your income.
Auditors are taught to probe for side income—moonlighting electricians and homemakers who do child care. They are concerned with the types of income not reported to the IRS by the person who paid you or income from which no taxes were withheld, such as tips or rent from an in-law unit in your home.
Auditors are instructed to probe further into living expenses once omitted income is suspected. For example, the auditor may want to see your insurance policies to see if you have covered expensive items like jewelry, furs, art, and other such assets. Auditors seldom go to this trouble, however.
Exemptions. Were you entitled to claim everyone listed on your return as a dependent? For instance, if you support elderly parents, take documents showing their expenses and sources of limited income. If you are a divorced parent and claim your child as an exemption, have proof of court-ordered child support payments or costs you paid directly for the child’s benefit. Also, get a copy of your ex-spouse’s Form 8332 to show that she or he didn’t claim the exemption. If, however, you both claimed the exemption, produce your divorce papers showing that you are entitled to it.
Theft and casualty losses. Were you legally entitled to claim losses? Produce a list of items lost plus documentation that the loss occurred—copies of police reports and insurance claim forms are good ways to prove losses to the IRS.
Charitable deductions. Can you verify charitable deductions—particularly if the total exceeded $250? For example, if you dropped $40 into the collection plate every Sunday, you will need more evidence than your own statement. Prove it by getting a letter from your church secretary attesting to your regular attendance and copies of automatic teller withdrawal slips made on Sunday mornings.
Employee business expenses. If you are a wage earner, can you verify any unreimbursed employee business expenses claimed on your return—especially for car, travel, entertainment, and home office? At a minimum, you will need a letter from your employer describing its reimbursement policy—that it pays you back for some expenses, but not for other items or beyond certain limits. Keep receipts and a calendar. If you don’t have a business diary, you can create one after the fact, but you should tell the IRS that it is a reconstruction. Note that the IRS is very picky in the employee expense area.
Itemized deductions. Can you verify large itemized deductions on your Schedule A—such as mortgage interest or medical expenses? You should have mortgage lender statements on IRS Form 1098 and medical bills or canceled checks and bank statements.
Previous audits. IRS records of previous audits are spotty. Your prior audit history may or may not be noted in the auditor’s file. Thus, you will be asked if you’ve been audited and how it came out. Unless you came out clean, tell the auditor that you were audited, but don’t recall the details. If she really wants to dig out the prior report, she might do it. Don’t make it easy by showing her a copy—which might point her toward issues to probe in the new audit.
Other years’ tax returns. Auditors usually ask to see copies of your tax returns for the year before and after the audit year. The reason is obvious—to see if any adjustments are appropriate in those years. Don’t bring other returns to the audit, even though they will probably be on the list of items you are told to bring. Simply say you didn’t bring them with you or couldn’t find them, but make a vague offer to look for them. Just stall—an auditor cannot force you to provide past returns.
Don’t worry about making the auditor mad by not supplying other year’s tax returns. She knows that you never have to provide a copy of a tax return to the IRS once it has been filed. The only qualification is if the IRS denies receiving a return and you can’t prove you sent it. Then you can give the IRS a copy to get on the record. But, in the normal audit situation when the IRS requests a copy of your return, it is not because the auditor is denying that you filed it—it’s because she doesn’t have it.
Even in this electronic age, the IRS doesn’t scan copies of paper tax returns in its computers. Old tax returns are buried in warehouses across the country for ten years and are then destroyed. Yours may be in box 147963a-7 in the middle of Kansas. Unless you filed electronically, it will take weeks or months to find it—and there is no guarantee that it hasn’t been misplaced. Usually, if you don’t come up with a copy of your tax return, the auditor just forgets it. And, even if the auditor eventually finds the return, you will have delayed the process.
Auditors frequently ask you for information not related to the year or areas listed on the audit notice. Sadly, most audit victims blindly provide whatever is asked for, often needlessly providing the rope to be hung with.
The IRS cannot require you to furnish data unless it is directly related to the year under audit. If the auditor asks for something you don’t think pertains, make her explain specifically how it relates to the audit year. If you are given written notice that the audit has been expanded to other years, however, then you must submit information for those years.
Sometimes data on other years’ tax returns—such as loss carryovers or depreciation of assets—does relate to the tax year under audit. In this case, show the auditor only the portion of the other year’s tax
return in question (such as a schedule of depreciation) not the whole return. Similarly, avoid letting the auditor photocopy your records unless you are certain there is nothing harmful in them. Tell her that you don’t see why she needs copies and she will probably back down.
If you are asked if you filed all other years’ tax returns and you haven’t, reply that you will check your records and get back, or simply shrug your shoulders. Don’t lie. If you want to avoid this question altogether, hire a tax professional to go to the audit in your place. Unless you have told him otherwise, he should answer that as far as he knows you filed all tax returns when due. Unless the auditor has reason to believe otherwise, she almost always just moves on.
Expect to spend from one to four hours with the office auditor. In most IRS offices, two audits per day are set for taxpayers with a small business and four audits where there is no self-employment income. Auditors must write up their findings between appointments, so they must keep moving and can’t scrutinize every piece of paper. An auditor wants to zip through your audit and get you out the door every bit as much as you want to leave.
It is okay not to resolve all audit issues at one meeting. Auditors often ask for something you didn’t bring. No problem. Just ask for a reasonable amount of time to submit it (15 to 30 days) and mail it in with a letter to jog the auditor’s memory explaining how it helps your audit. To be sure the auditor got what you sent, call four or five days later and ask. If she wants voluminous records or you are concerned that she may not understand what you send, request another face-to-face meeting.
If you don’t want the auditor to see a particular item, you can vaguely promise to send it in but conveniently forget to—the auditor may forget it, too. If he doesn’t forget, you will probably not lose any more than you would have had you cooperated.
Any IRS auditor will tell you she is overworked. Because the IRS doesn’t pay bonuses or overtime, there is little incentive for her to break her back on any case. Her job performance is judged on how many files she closes a month. The Taxpayer Bill of Rights forbids the IRS to evaluate auditors on the dollars produced from their audits. Judging auditors on the number of files closed, however, probably produces much the same result. There is evidence that IRS managers give bonuses, however. Prior to 1998, auditors were evaluated by their yield—the total dollar amount of the tax adjustment on an audit, divided by the number of hours the auditor spent on the examination. For example, in the Northern California District, an auditor had to produce $1,000 in taxes for each hour the auditor devoted to a case. Hopefully, these days are gone.
A heavy caseload can work to your advantage. Auditors don’t have the time to go over every tax return with a fine-tooth comb. Auditors often miss taxpayer errors that could have resulted in large adjustments in the IRS’s favor.
If you get a letter notifying you of an audit and asking to meet at your home or business, you have been picked for a field audit.
If you get a phone call from the IRS. Before getting notice by mail, you might get a call from someone saying she is from the IRS and wants to audit you. Politely tell her you want notification in writing to make sure she is really with the IRS. Refuse to discuss anything with her until you get a notice in the mail. Don’t worry about upsetting her; you are within your rights. Some agents like to catch you off guard, in the hope you’ll say something revealing.
Field audits are the big leagues, whereas correspondence and office audits are the minors. The IRS puts its best auditors here and expects them to pay their keep. In fact, field audit tax bills are, on average, eight times higher than those from office audits.
Local IRS audit managers make the final decision as to who gets field audited. Normally, it is the self-employed, owners of multiple real estate rental properties, or people with exceptionally complex tax returns. Also, corporation, partnership, estate, gift, and trust tax returns are always field, not office, audited.
Revenue agents who conduct field audits must have a college degree in accounting or a minimum of 24 semester hours of college-level accounting courses. At IRS audit training, they are taught techniques similar to detectives—looking for clues to see if your tax reporting matches the home you live in, your business and investments. If you live in a $700,000 home, drive a Range Rover, and report only $20,000 income from your dental practice, she will dig deep.
The initial notice you get will probably be signed by a revenue agent. The letter will either set a date for the audit or ask you to call to arrange it. An attachment will list items the IRS wants you to produce at the meeting. However, the list should not be taken as inclusive— everything is fair game in a field audit. A revenue agent can probe into any area of your tax return as well as your financial or personal life. Remember that you, not just your tax return, are under the IRS microscope.
Carefully consider when and where you want the audit to be held. The Taxpayer Bill of Rights (see The Taxpayer Bill of Rights) gives you the right to have a say in when an audit is to be scheduled. You should be given sufficient time to prepare and convenient date. The IRS doesn’t start before 7:30 a.m. and won’t go beyond 5 p.m., weekdays only. Field audits last a minimum of four hours and may go into dozens of meetings extending over a year’s time.
Agents prefer to come to wherever your records are kept. Ordinarily, this is at your business, if you are self-employed. So if you work at home, the IRS will want to come there. If a representative will handle the audit for you, the agent can go to that person’s office if requested.
Be sure to read “What an IRS Office Auditor Looks For” and “Primary Issues in an Office Audit,” above— that information applies here as well. This section covers other issues likely to come up at a field audit.
Revenue agents’ primary focus is to find unreported income and personal expenses claimed as business deductions. Field audits typically zero in on the following areas of your business and personal lives:
Unreported income. This is the auditor’s number one concern. An agent is particularly suspicious if your business or profession has a lot of cash transactions. This is why so many restaurant, bar, liquor store, laundromat, and grocery store owners are audited. The IRS is always looking for the skimming of cash off the gross receipts of the business.
To ferret out unreported income, the IRS uses indirect methods of detection, unless you furnish direct evidence, such as confessing to the auditor that you didn’t report everything you earned.
There are four common methods the IRS uses to probe for income. All four methods have been challenged in federal court; all four methods have survived the challenge. Each one is explained below, with possible defenses you can raise.
Some business owners take great pains to skim receipts, but then stupidly put that money into their bank accounts. Financial records can easily be obtained by the IRS from your bank or stockbroker if you don’t produce them voluntarily. Revenue agents almost always perform a bank deposit analysis early on in a field audit.
Do your own bank deposit analysis before the audit. Make notes on your bank statements that explain the source of the deposits. There can be any number of explanations when deposits exceed taxable income—loans, redeposits of bad checks, transfers between accounts, inheritances and gifts received, sales of assets, and the like.
Defense. Check the IRS’s math for mistakes. And, again, the funds may have been from nontaxable sources or from cash on hand from income from prior years. Also, if you have several accounts, chances are some of the deposits reflect transfers of money between accounts. Adding up deposits leads to double-counting, a common mistake.
An auditor may ask you to verify your tax basis in an asset used in your business or sold by you. “Basis” is the figure from which the IRS calculates how much depreciation you get or profit or loss you’ve made on the sale of an asset. Essentially, tax basis starts with the amount you paid. To this figure, add the cost of improvements and tax benefits, such as rollover of gains from property exchanges, and subtract costs such as the depreciation taken on equipment or rental property. If you received a gift, the tax basis is figured from the date of the original purchase. For property you inherit, the basis is the property’s value on the date of the death. A detailed explanation of tax basis is in Tax Savvy for Small Business, by Frederick W. Daily (Nolo).
Avoid holding an audit at your home or business, even if you have nothing to hide. Maybe you really earn only $20,000 but appear to live much better. It could be that you inherited a $700,000 house from your aunt, rebuilt your BMW from junkyard parts, and made a few good investments. Assuming you have paperwork to prove all this, you should have no problems with the IRS, right? Well, maybe not. These are the kinds of things that can cause the auditor to dig deeper until she finds something to justify her efforts.
Here are some tips on how to keep the IRS auditor away from your home or business.
Taxpayer Bill of Rights. The Taxpayer Bill of Rights gives small business owners the right to refuse an audit on their business premises if an audit would virtually shut the business down. In this case, request the audit to be held at the IRS office or at your tax professional’s place. If denied, complain to the agent’s manager and then, if necessary, to the Taxpayer Advocate Service.
Tax professionals. If you give a qualified representative a signed Form 2848, Power of Attorney, he can insist that the audit is at his office, not yours. The representative must be the audited tax return’s preparer, or an enrolled agent, CPA or attorney, and he must be in possession of your business records.
If the IRS holds the audit at your place, don’t make it too comfortable. This doesn’t mean that you should stick the agent in an unheated storeroom, but you don’t have to give up your personal office, either.
Even if the audit is held at your tax professional’s or an IRS office, however, an agent has the right to observe your business premises. She may want to verify tax return items by spot-checking your inventory or seeing that you use equipment you tax deducted. Remember—auditors are trained to be nosy and routinely want to eyeball business operations.
Before the IRS shows up, remove any items that might cause suspicion, like the picture of your Chris-Craft, Lear jet, or alpine ski cabin. If the agent wants to tour your business, try to schedule it at a time when employees or customers aren’t present. This keeps the agent from talking to your employees and tipping them off that you’re being audited. An employee’s innocent remark could do a lot of harm, and a vengeful one could stab you in the back. Don’t let the agent wander around on her own—stay by her side.
If the agent asks to see any records during an observation, tell her that they are not readily available, are at home, or are at your tax professional’s office. She won’t start opening your file cabinets to verify the truthfulness of your assertions.
An auditor does not have the right to enter your home to see your home office or for any other reason. If you don’t let her inside, however, she may legitimately retaliate by disallowing a home office deduction.
The tax code gives the auditor wide latitude and authority to pry into your financial affairs. The basic tools in the auditor’s kit are the interview, summons, IRS and other government files and contacts with third parties, like your bank, who have knowledge of your finances.
Information Document Request. Along with your audit notice may come a separate form called an Information Document Request or IDR. An auditor commonly issues multiple IDRs if the audit, usually a field audit, continues beyond one meeting. An IDR is a written solicitation of records or other papers either in your possession or accessible to you. Typically, bank statements and canceled checks are listed on an IDR. The IRS knows the truth of the words of a former U.S. Supreme Court justice that “a person can be defined by the checks he writes.” Ordinarily, you will be given until a follow-up audit appointment or a few weeks to mail these things to the auditor. A sample IDR follows.
Just because the IRS issues an IDR doesn’t mean that you have to produce the items requested. You may decline unless the items are really relevant to your audit. For instance, the IRS commonly uses IDRs to request copies of other years’ tax returns—which normally you don’t have to supply. If in doubt, don’t furnish the item on the IDR and see if the auditor pursues it. If she does, ask her to justify how it relates to the year selected for audit. If you believe she is crossing the line, just say no. An IDR is merely an informal administrative request—it does not carry any legal force. If what is being requested may seriously hurt or even incriminate you, see a tax attorney before responding.
Summons. If the IRS doesn’t get information from you voluntarily—through an IDR—it may issue a summons. (Internal Revenue Code §§ 7602(a) and 7604(b).) A summons is a legally enforceable order and is not to be taken lightly. It orders you to appear before the auditor to answer questions and to bring certain documents. You can raise legal objections to a summons, including:
In the rather unlikely event you get a summons, contact a tax lawyer. If you don’t comply, the IRS may bring you before a federal court judge in a summons enforcement proceeding. The judge can order you to produce the documents listed in the summons or face a heavy fine or even a jail sentence. It should give you comfort to know that the IRS rarely goes to this trouble, preferring to compromise or back down.
When you don’t give the auditor information that she has requested, she has three choices:
Third-party summons. An auditor can issue a summons to get information from banks, employers, business associates, and anyone else. Auditors routinely summons records from others when you don’t cooperate, or when the auditor wants verification of the information you have given. You must be notified in writing when a third-party summons is issued and you have a right to object. Practically speaking, however, you can’t stop a third-party summons.
Never tell another person not to comply with an IRS summons of your records. That is illegal and could get you both into serious trouble.
IRS files. Your previous tax returns, audit reports, and tax account history can be accessed by auditors. The auditor might first ask you for this information. As discussed above, you don’t have to give everything requested to an auditor. Because a lot of IRS information on you is not accessible by computer, it isn’t all that easy for an auditor to get older IRS records. Recovering items from IRS record storage facilities could take months. As a rule, auditors don’t go to this trouble unless they mistrust you or feel that a large adjustment—tax bill against you—will result.
Other government and public records. Auditors have direct computer access to the Treasury Enforcement Communication Systems, or TECS, computer, which has all kinds of data on you. TECS is not public, so you can’t be sure what is in the files. The auditor can also access your Social Security Administration, passport office, and postal service records. Auditors can view local and state public records showing ownership of vehicles, boats, airplanes, real estate, and business entities you might be involved in. Private databases such as LexisNexis and credit reporting agency files contain a wealth of personal data about all of us and are accessible to auditors. As a rule, office auditors don’t make these types of searches, but field agents, who conduct audits at homes or businesses, often do.
Third-party contacts. Auditors can send letters or call or visit businesses and people who have dealt with you, such as the secretary of a church where you claimed a charitable contribution. First, they must give you Notice 1219A, Notice of Potential Third Party Contact. You can legally object to these contacts, at least in theory. If the auditor reveals personal or financial information about you to the third party, you can file a complaint with the IRS that your right to privacy has been violated by an unauthorized disclosure.
In preparing for an audit, begin by taking the following three 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.
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.
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.
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.
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:
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.
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.
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?
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 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:
Again, don’t say more unless absolutely necessary. As a rule, you can’t hurt yourself when your mouth is shut.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Despite what an auditor may tell you, here are the real audit rules on missing records taken from Income Tax Regulations and court cases.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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:
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:
Toward the end of every meeting with the auditor, ask her what adjustments she intends to make. While she may not be willing to commit without running it by her manager, she may have some idea. Try to pin her down. If you disagree, argue your case on the spot or ask her for time to get more documents together. Offer to pay any balance in full, if she will make a concession. It may not work, but it’s always worth a try.
Audit files sometimes get lost in the IRS bureaucratic maze for many months. When found, an unfinished audit file could be assigned to a new auditor who will not want to work on a half-done case and will look for a quick way to close out the file. Even better, the normal three-year deadline for auditing your return may expire before the file resurfaces. This means that the IRS forever loses its right to make adjustments, and you are in the clear.
When the auditor completes her work, you will be handed or mailed IRS Form 4549, an examination report. It shows changes proposed to your tax liability for the years under audit, and for any other open years if the auditor expanded the examination. The report also provides a brief explanation for each change, such as “You did not prove the amount shown was a rental expense.”
Internal Revenue Service Department of the TreasuryDate: 8/10/xx Tax Year Ended: 2007
Person to Contact:
Contact Telephone Number
Dear Ms. McMillian:
Enclosed are two copies of our report explaining why we believe adjustments should be made in the amount of your tax. Please look at this report over and let us know whether you agree with our findings.
If you accept our findings, please sign the consent to the assessment and collection portion at the bottom of the report and mail one copy to this office within 30 days from the date of this letter. If additional tax is due, you may want to pay it now and limit the interest charge; otherwise, we will bill you. (See enclosed Publication 5 for payment details.)
If you do not accept our findings, you have 30 days from the date of this letter to do one of the following:
1. Mail us any additional evidence or information you would like us to consider.
2. Request a discussion of our findings with the examiner who conducted the examination. At that time, you may submit any additional evidence or information you would like us to consider. If you plan to come in for a discussion, please phone or write to us in advance so that we can arrange a convenient time and place.
3. Discuss your position with the group manager or a senior examiner (designated by the group manager), if an examination has been held and you have been unable to reach an agreement with the examiner.
If you do not accept our findings and do not want to take any of the above actions, you may write us at the address shown above or call us at the telephone number shown above within 30 days from the date of this letter to request a conference with an Appeals Officer. You must provide all pertinent documentation and facts concerning disputed issues to the examiner before your case is forwarded to the Appeals Office. If your examination was conducted entirely by mail, we would appreciate your first discussing our findings with one of our examiners.
The Appeals Office is independent of the District Director. The Appeals Officer, who has not examined your return previously, will take a fresh look at your case. Most disputes considered by Appeals are resolved informally and promptly. By going to Appeals, you may avoid court costs (such as the United States Tax Court filing fee of $60), clear up this matter sooner, and prevent interest from mounting. An Appeals Officer will promptly telephone you and, if necessary, arrange an appointment. If you decide to bypass Appeals and petition the Tax Court, your case will normally be assigned for settlement to an Appeals Officer before the Tax Court hears the case.
Under Internal Revenue Code Section 6673, the Tax Court is authorized to award damages of up to $5,000 to the United States when a taxpayer unreasonably fails to pursue available administrative remedies. Damages could be awarded under this provision, for example, if the Court concludes that it was unreasonable for a taxpayer to bypass Appeals and then file a petition in the Tax Court. The Tax Court will make that determination based upon the facts and circumstances of each case. Generally, the Service will not ask the Court to award damages under this provision if you make a good faith effort to meet with Appeals and to settle your case before petitioning the Tax Court.
The enclosed Publication 5 explains your appeal rights.
If we do not hear from you within 30 days, we will have to process your case on the basis of the adjustments shown in the examination report. If you write us about your case, please write to the person whose name and address are shown in the heading of this letter and refer to the symbols in the upper right corner of the enclosed report. An envelope is enclosed for your convenience. Please include your telephone number, area code, and the most convenient time for us to call, in case we find it necessary to contact you for further information.
If you prefer, you may call the person at the telephone number shown in the heading of this letter. This person will be able to answer any questions you may have. Thank you for your cooperation.
From your point of view, the examination report falls into one of three categories:
Win. Instead of a report, you will receive a “no change” or even a refund letter. These require no explanation. You’ve won.
Lose. The report makes changes—you owe more taxes, plus interest and maybe penalties. This means you didn’t have good documentation or what you had was not accepted. Or, perhaps the auditor didn’t buy your legal entitlement to the tax benefits claimed.
Draw. A mixed bag. Some of your documents and explanations were accepted, but others weren’t. Or maybe your legal position was shaky on one or two items but strong on another.
Don’t worry if it seems to take forever for the IRS to send you the final report. Three to four weeks is standard, but I have waited for six months. Don’t take a long delay to mean that the IRS is giving your case special attention. More likely, your case has a low priority and is sitting on someone’s desk for routine processing.
The total amount of taxes, penalties, and interest added by the audit is shown on your report. Each change is listed, the tax code section cited, and a general explanation was given. As stated, most explanations are vague. You are usually not specifically told how you failed to prove your case. If you don’t know, call the auditor and ask. She must tell you where you failed. (See the sample examination report on the preceding pages.)
You have three choices after you receive the examination report.
Agree. The IRS hopes you will sign, date, and return a copy of the report along with IRS Form 870, Consent to Proposed Tax Adjustment. This is referred to by the IRS as an agreed case.
By signing Form 870, you agree to the immediate assessment of the tax deficiency found, plus any penalties and interest listed on the examination report. You give up your right to appeal or go to tax court. Theoretically, you could pay, change your mind, and sue the IRS for a refund in court, but this seldom makes sense. Although most tax lawsuits are filed in U.S. Tax Court, a refund case must be brought in a U.S. Federal District Court or the U.S. Court of Claims.
A report, even if signed by you, is not final until approved by the auditor’s manager. Occasionally, a report you signed will be kicked back to the auditor for correction of obvious errors or to further develop issues. If this happens, the auditor may contact you once more. It may seem unfair, but, you can’t complain about being audited twice. The first audit was not officially concluded.
Signing doesn’t mean you have to pay when you sign the report. Paying, however, may seal the deal. Auditors can offer a payment plan if you owe less than $10,000. You have up to three years to pay on a monthly basis. Interest and late payment penalties still accrue on the unpaid balance. Interest and penalties on late tax payments get added on. For bills over $10,000, you may have to reveal your finances and living expenses to get a payment plan. For such cases, consult a tax attorney to ensure adequate compliance.
It is okay to tell the auditor that you will just wait until a bill comes from the IRS campus center computer and then decide how to pay. Sometimes, the bill is less than the audit report figure because a penalty was dropped or a computation error was made or corrected. If the bill is more than the amount on the report, complain; if it is less, let your conscience be your guide. If you pay the lesser amount, no one may ever notice. Don’t be surprised, however, if you are later billed for the difference.
Argue. Examination reports are not cast in stone until you sign off. If you want to fight the report, call the auditor. Tell her what findings you disagree with. Ask what additional proof it would take to get her to change the report. Request 30 days to get a missing document or reconstruct a record. Most auditors will hold off until you mail the proof to them. Pushing for another appointment may be better. It forces them to face you again and shows that you are serious about contesting the report’s findings. If she is not cooperative, ask to speak to her manager. If you are ultimately successful, you’ll be sent an amended examination report to sign.
If your new documentation doesn’t help, ask the auditor for a copy of her work papers. These are the notes the IRS requires an auditor to put in a file. Workpapers should explain and justify any changes made to a tax return. If the auditor shows you her notes, ask her to fully explain them (and the conclusions she drew) if it isn’t obvious. Don’t be surprised if the auditor refuses to show you her work papers. If she refuses, tell her you to know you are entitled to see them under the Freedom of Information Act, and if she won’t show them to you, you will make a formal request for them. See Appealing a Tax Audit Within the IRS for more info.
If you don’t get anywhere with the auditor, ask to meet with her manager. Generally, the manager will speak to you. I call this an informal appeal. Managers don’t always back their auditors. They have a strong motive to close files handled by their group with an “agreed” notation, so they may appease you.
If you talk to or meet with the manager, don’t criticize the auditor. The manager may then concentrate on defending his employee instead of considering your position. Instead, talk about the adjustments you don’t agree with and suggest a compromise. Even if this doesn’t get you anywhere, the manager’s explanations may make the IRS’s position clearer to you or point out the weaknesses in your case. As a last resort, if the manager won’t budge, calmly say that you are disappointed and that you don’t want to appeal, but you don’t know what else to do. Again, keep in mind that the IRS doesn’t like appeals, and this subtle threat may get you what you want.
(For an example of compromising with an auditor’s manager, see the case history below.)
Managers may delegate audit disputes to acting managers. These are usually the more experienced auditors who know how to smooth things over. Remember, auditors are instructed to get you to agree to the audit report, if possible. It’s perfectly okay if you get an acting manager. This person may already be familiar with your case, especially if the auditor is a trainee or fairly new at the IRS. If your auditor ever excused herself for lengthy periods during your audit, ostensibly to make copies or check on something, she may have been asking a senior auditor what to do.
If you explain your position to the acting manager and he won’t help you, you can still insist on talking to the real manager. The IRS, like most others organizations, doesn’t like to be bothered by squeaking wheels—you may eventually get greased.
Do nothing. You don’t have to respond to a proposed examination report at all. If you ignore it, the auditor may call, or in a month or two you will receive something called a 30-Day Letter. This is your formal notice that your case is considered “unagreed” and that you have 30 days to start an appeal or the findings become final.
Appeal Rights and Preparation of Protests for Unagreed Cases. You should receive a copy of Publication 5 with your examination report. Read the article on the IRS audit appeals process for more clarification.
The IRS does not have to grant you an administrative appeal—it is discretionary. However, the IRS must eventually send you a 90-Day Letter, before the audit can become final. This letter may not arrive for months after the audit was completed. The IRS must send it by certified mail. To contest the audit results now, you must file a petition in the U.S. Tax Court within 90 days. If you don’t, the examination report becomes final—your right to contest the audit without first making the full payment has ended.
You can also contest by paying the tax bill and filing a claim with the IRS for a refund. Refund claims are always denied. You can then file a refund suit in U.S. District Court or the court of claims.
Eventually, you will get a Notice of Tax Due. This is the beginning of the IRS collection effort. See the article When You Owe the IRS for more on what to expect there.
There is a procedure for reopening a closed audit, called assessment reconsideration, initiated either by you or the IRS. Fortunately, the IRS rarely reopens closed audits. If it does, see a tax pro to find out if the IRS is acting properly, or do a little legal research yourself. (See Help Beyond the Book; the relevant laws are Internal Revenue Code § 7605(b); IRS Regulation 601.105; Revenue Procedure 85-13; and IRS Policy Statement P-4-3.)
Mr. Ky, a Vietnamese immigrant, and San Francisco restaurant owner, was audited. When he received the examination report, Ky was so distraught he considered jumping off the Golden Gate Bridge. Ky had fallen victim to a dishonest tax return preparer who guaranteed his clients they would never have IRS problems. His clients almost always got tax refunds, and he charged a percentage of the refund received.
One day, the office of the bogus tax adviser was raided and his records seized by the IRS. All of his clients got audit notices. Ky was understandably suspicious of anyone calling himself a tax expert, so he decided to handle the audit himself. He wanted to come clean knowing he would have to pay some additional taxes.
The auditor knew Ky was selected as part of a special IRS project involving the crooked tax preparer. At the meeting, things went from bad to worse. Ky spoke broken English and produced records written in his native language. The auditor became irritated and impatient. The examination report came quickly, disallowing most of Ky’s business deductions and finding a great deal of unreported income. The resulting taxes, with heavy fraud penalties and interest added, came to $79,500. To pay meant Ky would have had to sell his business and lose everything he had worked for in the ten years he had been in America.
Ky finally sought a tax professional. During their meeting, the tax professional became convinced that Ky should not owe anywhere near $79,500. The tax professional called the auditor’s manager and made an appointment to meet her in two weeks. He then found a Vietnamese-American accountant to convert Ky’s records and notes into a more conventional set of books. The accountant acted as an interpreter and helped the tax professional take sworn statements from Vietnamese people who had worked in the restaurant. These books and statements created a true financial picture of the business, in clear English.
When the tax professional met with the auditor’s manager, he presented the statements and records. In less than an hour they had agreed on a total tax of $13,000 and no harsh fraud penalty. After the tax bill came, Ky negotiated an installment payment agreement with the IRS Collection Division. Ky did not jump off the Golden Gate or any other bridge. His family now owns two restaurants in San Francisco.
While everyone considers being audited a problem, a few uncommon, yet serious, audit issues merit special discussion.
Many taxpayers receive bills from examinations they didn’t know about—phantom audits. Yes, the IRS is required to notify you in writing of an audit. Theoretically, if the IRS doesn’t let you know about an audit, your return can’t be audited. In reality, however, the IRS is only required to mail a letter to your last known address. It is not required to verify that you actually receive the notice.
The tax court says the IRS must update its files regularly and send notices to the address on your most recent tax return or newer address that you have provided. (Abeles v. Commissioner of Internal Revenue, 91 U.S.T.C. 1019 (1991).) The IRS is allowed three months to update its records on a change of address after it receives notification.
If you don’t answer an audit letter and it is not returned to the IRS by the post office, auditors can treat you as a “no show.” Exemptions and deductions are disallowed in whatever manner the auditor wishes and an audit bill is issued. It is not a pretty picture.
To make sure you get all IRS notices, file IRS Form 8822, Change of Address, whenever you move. (A copy is available at the IRS website www.irs.gov.) Do not just rely on a post office change of address form.
The unfairness of the IRS’s charging ahead when you don’t get the audit notice is underscored by what happens next. The IRS usually sends an audit report and a letter informing you of the appeal process to your old address. Or, the IRS may send a Notice of Deficiency giving you 90 days to object in tax court. This notice comes by certified mail. But, again, the law does not require that you actually receive the letter, only that the IRS sends it. The IRS doesn’t seem to care if you get any of these notices. Legally, as long as the notices are sent to your address in the IRS records, the audit was legitimate. Hardly fair, but you can fight back.
There are three ways to fight a phantom audit.
Assessment reconsideration. (Formerly called audit reconsideration.) If you receive a mysterious tax bill, immediately write or call the IRS office that sent it. Tell them you never received notice of the audit and you are requesting an assessment reconsideration. Or, call the Taxpayer Advocate Service. Make an appointment or send him the notices by fax or mail. Ask the advocate to help you get an assessment reconsideration meeting with an auditor. See IRS Publication 3598 for details on making a request.
You do not have a right to an assessment reconsideration—it is discretionary with the IRS. Usually, however, requests are granted. The IRS also has an audit reexamination procedure, which differs from an assessment reconsideration. A reexamination can open up your entire file for audit —and not just the items that were charged in the phantom audit.
Petition the tax court. If your assessment reconsideration is denied, file a petition in tax court, stating that a notice of deficiency was not sent to your last known address as required by law. See Going to Tax Court for more information.
Offer in Compromise. In addition to audit reconsideration and tax court, you can challenge a phantom audit by making an Offer in Compromise, based on doubt as to your liability for the tax bill. Unlike most Offers in Compromise, which are made to settle an undisputed tax bill, with an Offer in Compromise based on doubt as to liability, you do not offer any money to the IRS. The IRS may treat your Offer as it would treat an assessment reconsideration and reopen your case.
The IRS has a “shoot first, ask questions later” power to make quick tax assessments without an audit. This is called the jeopardy assessment. Normally there must be a formal assessment of taxes against you before the IRS can legally collect. The jeopardy assessment process allows the IRS to immediately grab your assets without prior notice. You have a right to a hearing, but not until after the seizure.
Thankfully, jeopardy assessments are authorized only if the IRS believes its right to collect taxes will be harmed, and:
Jeopardy assessments are most frequently made against foreign companies or foreigners operating a business in the United States, or persons arrested with large amounts of cash, especially suspected drug dealers. If you are ever faced with a jeopardy assessment, see a tax lawyer right away.
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