High up in the ranks of things that people fear most are public speaking, death and the Internal Revenue Service.  The most contact that taxpayers have with the Internal Revenue Service consists of matching notices.  This typically is a form letter that questions whether something was missed on a return.  It could be a 1099 with some form of income that the IRS was not able to trace to your return.  These notices are usually responded to via correspondence with an explanation of where the income was reported or why the item was omitted from the return.  These notices are computer generated and can take six or more weeks to resolve themselves.  Many times the IRS will respond indicating they received the correspondence and are working on resolving the issue.

When it comes to auditing taxpayers the Internal Revenue Service is divided into two main groups. The Small Business and Self Employed Group audits individuals and companies with assets under ten million dollars and the Large Business and International group audits companies with assets in excess of ten million.  The Small Business and Self Employed group may conduct a correspondence audit questioning a number of items on a particular return.  We typically will get a Power of Attorney (POA) form in order to respond for our clients as the audit may expand into other areas, take longer and can be more complicated than a matching notice.  In this case, we are dealing with a specific agent that allows us to probe into what they are looking for and what type of information they need to resolve the issue.

The next level up is the notice of examination and this can come from either group depending on how big a company you have.  This will give you a date, a time and a contact person and a preliminary Information Document Request (IDR).  This is a case where we file a Power of Attorney form covering the return and all years up to the present.  The IRS has the right to interview the taxpayer and inspect their place of business, but as long as we are on the POA must do so in our presence.  After the taxpayer interview the IRS will deal directly with us which allows us to filter the questioning.  We will change the location to our office as you do not want the IRS disrupting your business and change it to a time that is agreeable to both. The IDR will give us an idea of what the IRS is looking into and how extensive the audit will be.

There may be several reasons why you were selected for an audit.  The IRS uses a scoring methodology to select certain taxpayers based on their industry code and the likelihood of underreporting.  These types of audits tend to be broad based and somewhat invasive. The IRS may be targeting a particular industry or issue that they feel may be prone to error or abuse.  The captive insurance industry and companies that employ them are currently the focus of a wide ranging effort by the IRS to ensure that are operating properly and meet the criteria for deductibility.  These audits are narrowly focused and highly technical in their nature.

The Internal Revenue Manual is the template for the audit process.  The IRS is looking for understated revenue and overstated expenses and wants documentation to back up the items on your return.  They will also look for proper classification of employees and to make sure you are filing all your required information reports.  The process can be a bit slow with fairly clean, straight forward audits lasting six months or more.  The more complicated or contentious audits can drag on for a year or more.

Towards the end of an audit the agent will present their findings and proposed adjustments.  This is where we will conduct a little horse trading to resolve most of the issues.  The IRS wants to clear their caseload and we want to minimize the impact of any adverse findings.  If we disagree with the findings we can request a meeting with the agent’s group manager, but we will only request that if we believe the agent is not properly focused on the facts or the law involved.

When the auditor has concluded their process and we do not agree with the findings, we have the opportunity to use the quasi-independent appeals process.  The Appeals Office is an opportunity for an administrative appeal where the IRS is not bound by the Internal Revenue Manual.  They are looking at litigation risk and whether the taxpayer may prevail at trial.  Our approach here is to assess the cost of proceeding against the cost of conceding the issue.  We want to settle it here as much as possible as the next step is United States Tax Court.

United States Tax Court is a legal proceeding with an administrative law judge hearing the case.  This process can involve significant legal fees, time and resources.  It is possible that if you prevail in Tax Court and the Internal Revenue Service did not have a reasonable basis for their position, you can petition to obtain legal fees. It’s akin to going all in in a poker match so you should be prepared with strong facts and a strong legal argument before proceeding in Tax Court. In my career, I have recommended this position exactly twice and in both instances it has worked to the benefit of the taxpayer.

Once the audit is settled and the tax is calculated, the Internal Revenue Service will always assess interest and very likely penalties as well.  Accuracy related penalties for negligence or disregard of the rules will tack on an additional 20% to the tax adjustment.  These are not supposed to be automatic penalties as long as the adjustment was less than 10% of the tax.  If you have a reasonable basis for the position taken, the penalty is generally waived.  Interest is automatic and cannot be waived and is calculated from the original due date of the return.  In the happy event that the return is adjusted in your favor, the interest will accrue to your benefit in the same manner.

Once everything is settled and agreed to, you will then have to make arrangements to pay what is due.  Late night cable TV and AM radio are rife with advertisements for tax relief organizations.  They state that the IRS has a new “Fresh Start” program and can settle your tax debt for pennies on the dollar.  Sounds too good to be true because it is too good to be true.  The new “Fresh Start” is the same as the old collection process.  The IRS is charged with collecting every tax dollar that has been legitimately assessed.  If you owe less than $50,000 and can pay it off in six years you can apply for an installment agreement.  The IRS will generally approve that and not take further collection action such as levying bank accounts or paychecks.  The interest rate on this loan from the government is 9%, which is the 3% annual floating rate plus the half percent per month failure to pay penalty, so it behooves you to try to pay from another source if you can.   Any installment agreement above those thresholds requires providing significant financial information, higher level approvals and the potential filing of tax liens.

If you are in the position that you cannot pay the tax assessment there is an offer in compromise program.  The theory is to allow the taxpayer to become a productive part of the economy and to get back on the tax rolls.  The reality is that it is a very difficult program to negotiate.  If there is doubt as to whether the tax was legitimately assessed then you can make the argument to recalculate the tax to the proper amount.  If you have gone through the audit process that is not too likely to work.  The IRS will require information on all sources of income, all your assets and all your liabilities and living expenses.  They will require you dispose of unnecessary assets, reduce your spending to the bare minimum and come up with an offer.  The bottom line is they want everything you have and then some.  In the rare occasion that they do approve the offer in compromise, you must be current with all taxes for the next five years or the whole tax liability can be re-imposed.  Any tax refunds (state or federal) will be fair game for the government to collect during this five year period.

Receiving mail with the Department of the Treasury return address is generally not a welcome sight.  Most notices can be disposed of quickly and easily.  Notices of examinations will quicken the heart rate, but for the most part are dealt with fairly routinely.  The IRS is looking for something in the exam and generally involve the timing of a deduction as opposed to the legitimacy of a deduction.  If there is an adjustment it is typically not too large and can be handled at the exam level.  In all cases if you receive a notice from the IRS or any other taxing authority, please contact your Dermody, Burke & Brown professional to guide you through the process.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.