Someone once said that the IRS can make even the bravest of us hold our breath for a second or two.  We deal with these issues often enough to know that most notices and audits can be dispensed with rather expeditiously and without a great deal of angst.

The increased complexity of the tax code, the rapid changes (five tax acts in three years) and the expansion of information reporting increase the likelihood that an error may occur on a return.  The matching capabilities of the IRS have grown over the past few years and the number of examinations has increased dramatically as well.  While the odds of an exam are little less than 1%, you would rather not be part of the 1%. 

The IRS does conduct a few random exams for research purposes and most exams are for a particular purpose.  The IRS uses a discriminate index function or DIF score to segment returns for possible examination.  Returns with a high likelihood of generating additional tax will be selected for exam.  These returns may be segmented by industry, size, levels of income or the nature of deductions or expenses claimed.  The IRS is looking for returns where income may be understated or expenses improperly recorded. 

There are varying levels of examination.  The most common is the correspondence exam resulting in a matching notice.  These notices occur when the IRS has a 1099 with your tax ID number and cannot find the income on your return.  A typical matching notice will be for missing securities proceeds.  They have a 1099-B and don’t see it reported on your Schedule D.  The IRS will generally recalculate your taxable income using zero for basis, resulting in a large increase in tax.  This needs to be responded to with the correct basis along with a brief explanation as to why it was an inadvertent oversight to avoid the imposition of penalties.  It may be that, as it sometimes happens when the missing security results in a loss, a refund can result when all the correct information is sent to the IRS.

The next level of exam is the desk audit where the IRS may ask an individual to appear at the local IRS audit and undergo an exam of their return.  Generally they will include a letter requesting specific additional information to support items on the return such as medical expenses or charitable contributions.  You can have an authorized representative appear with you or in your place.  We generally will represent our clients and have the location changed to our office.  By representing our clients we can find out what they are really looking for which gives our clients plausible deniability and avoids misstatements or misinterpretation by our clients or the IRS agent.  If the IRS asks a direct question about something on the return, we can reasonable say we are not sure and get back to them with more information or an explanation.

The next type of exam is the field audit, which is typically for businesses and the IRS comes to your place of business and conducts the exam.  The IRS audit area for businesses is divided up between the Small Business / Self Employed division and the Large Business / International division with the latter focusing on companies with assets over $10 million. The IRS does have a right to inspect the location but cannot disrupt the normal operations of the business.  For that purpose we generally prefer to have these audits done at our office. Along with avoiding misstatements, we as intermediaries in the exam process limit the opportunity for extraneous conversations with your employees that may open up new areas of inquiry.  These exams have a checklist of items that the IRS wants to look at, however, they typically focus on a small number of areas. They may also look at the owners and officers of the business to make sure items from the business are reported properly on the related individual returns.  If everything checks out then the exam is concluded and everyone goes home happy.

If the IRS proposes a change you have the right to challenge the assessment.  If it is a small timing difference where a deduction is disallowed in one year but will be allowed in the next then it is usually not worth pursuing.  You have a right to a meeting with the auditor’s group manager if you think the auditor is incorrect in either the facts of the case or their interpretation of the tax code.  If the audit was conducted in accordance with the Internal Revenue Manual, and followed their procedures, administrative and technical guidance, then the audit results will generally stand.

You have the right to protest the assessment by making a request for an appeals hearing.  This hearing is with a quasi-independent appeals officer.  The appeals officer is an IRS employee but is not necessarily bound by the rules governing the IRS auditor.  They have to look at the merits of the case and the risk of litigation.  They may agree entirely with the auditor, agree with you or offer a compromise position somewhere in between.  The appeals officer is looking at the risk of litigation and whether the IRS can win in court.  If it cannot be settled by the appeals officer the next step is Tax Court.

The Tax Court is comprised of 19 presidentially appointed members that have expertise in the tax law and according to their website “apply that expertise in a manner to ensure that taxpayers are assessed only what they owe, and no more.”  This court only requires a $60 filing fee to initiate a case.  If you lose in Tax Court you then can pursue the case in District Court in front of a federal judge.                                                                                                            

It seems that the cycle between tough administration and taxpayer friendly eras waxes and wanes with the need to collect money for the Treasury.  It is easy to point to the IRS, but the blame is fully on the US Congress who writes these overly complex laws and the Administration that signs these bills into law.  Most IRS employees are professional and do their job to the best of their abilities.  Sometimes the process gets short circuited and the computers seem to take over.  When the process goes awry the Taxpayer Advocate’s Office can be used to bring the process back in line.  This office cannot change an assessment but can prevent immediate collection and get the case put back on track if the IRS did not follow all the proper procedures in resolving disputes with taxpayers.

We have seen a dramatic uptick in the number of audits in the past few years.  Most of them are easily resolved with simple correspondence and supplemental information.  Some are long and involve complicated matters that are not easily resolved.  It seems that once an exam hits a certain point the auditor becomes intransigent and we are forced into the appeals process.  At each step of the process we will weigh the pros and cons of proceeding and the potential results.  Your position may be correct, but the cost and risk of proceeding may not be worthwhile.

If you get a notice from the IRS or any tax authority, please let your Dermody, Burke & Brown tax professional know.  We deal with the IRS, are familiar with their procedures, and can represent you through the process while keeping your anxiety level to a minimum. 

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.