By Stephen J. Dunn
You receive the dreaded letter–the Internal Revenue Service is auditing your tax returns. In 2009 154 million individual income tax returns were filed with the IRS. In the same year the IRS audited 1.4 million individual income tax returns, but 1.1 million of these “audits” were by correspondence. An IRS agent met with the taxpayer or the taxpayer’s representative in only 320,249 cases.
So first determine what sort of adjustment or audit you face. If the IRS is proposing adjustments to your tax return by correspondence, you will have an opportunity to write back and explain why you disagree. Perhaps there was a math or a technical error on your return. Or maybe your return omitted income a third party reported you received on a Form 1099 sent to the IRS. Unless you are confident that you understand the IRS’ proposed adjustments and you agree with them, you should at least discuss these adjustments with a competent tax professional. If you are unable to agree with the IRS on a resolution of the matter and you deem the amount in question sufficient to contest, then you need to retain a professional to represent you before the IRS. (For more on IRS correspondence audits and other mail adjustments,click here.)
What if the IRS is sending out a real live auditor to examine your tax returns? The matter is, frankly, serious. Remember, the IRS does this for only about one in 500 tax returns filed. Do your returns claim abnormally large itemized deductions in relation to your income? Do your claim losses year after year for the same activity–perhaps something the IRS might consider an expensive hobby you’re improperly trying to write off? (For more on hobby losses, click here. For how to avoid an IRS audit, click here.) Do you operate in a cash business, where the IRS might suspect not all your income has been reported? All make it more likely that you may be audited in person. It’s also more likely if you are very wealthy. (To read about the IRS’ new “wealth squads” click here.)
If the IRS is sending an auditor out to examine your income tax returns, you definitely need a competent tax professional to represent you in the matter. The IRS allows three kinds of professionals to represent taxpayers–CPAs, Enrolled Agents and attorneys. If the case is not complex and does not involve a potentially prosecutable offense, then a CPA (experienced in handling tax audits) or an Enrolled Agent may suffice. (Enrolled Agents are trained to represent taxpayers before IRS–they must pass an examination administered by the IRS.) But EAs and CPAs have one big limitation–they are ill-equipped for litigation.
It is in your best interests for the IRS agent and his or her manager to believe that the case might go to court. IRS Appeals Officers are required to consider litigation risks in determining the settlement bounds of a case. For that reason, among others, a tax attorney is the gold standard for representation in a tax case. A taxpayer should always be represented by an attorney if the case involves potential criminal offense, such as tax evasion, filing a willfully false tax return, or failure to file a tax return that is due. Often, if amended returns need to be filed in such a case, the attorney will hire a CPA to do this work.
If at all possible, the audit should take place in your legal or tax representative’s office–not in your home or place of business. This allows your representative to control the information given to the auditor and monitor the audit. If the taxpayer is a medium or large-sized corporation, the audit will have to take place on the taxpayer’s premises. In that case, company employees and the auditor should be instructed that all communication between the company and the auditor must be channeled through a designated representative of the company.
If the audit is taking place in the representative’s office, the client should notbe present. Individuals and small business owners tend to talk too much, since they want to impress the auditor with what honest, likable people they are, and perhaps steer the auditor away from an issue or two they are worried about. Such gratuitous talk tends to have the opposite effect. When a taxpayer speaks to an IRS agent, the agent may make notes in the IRS file of what the taxpayer said or allegedly said. The comments or alleged comments can later be used against the taxpayer. They might be used in assessing penalties against the taxpayer, in persuading a grand jury to indict the taxpayer of a tax crime, or in urging a jury to convict the taxpayer of a tax crime. Taxpayers cannot be compelled to talk with a tax auditor, and they should not be present during an audit.
The representative should answer the auditor’s questions and provide the documentation requested by the auditor unless there is a legal reason not to, such as attorney-client privilege or the attorney work product doctrine. The representative generally should not volunteer information to the auditor, but he should never misrepresent or lie. (The same rule, needless to say, goes for the taxpayer.)
While it’s preferable to have the meeting in a lawyer’s office, the IRS is entitled by law to walk through a taxpayer’s business premises. Once, one of my clients wanted to accompany an IRS agent and me on a walk-through of the client’s business premises. I reluctantly consented, but thought the client talked too much in the brief encounter. Fortunately, the audit was resolved in the client’s favor without assessment of penalties.
The auditor will almost invariably propose adjustments–that is, additional tax and perhaps penalties. (Yes, there is such a thing as a “no-change” audit, but don’t expect one.) The representative can negotiate with the auditor. The auditor often will partly or wholly concede weaker issues.
If the client is not satisfied with the result from the auditor, the representative can talk with the auditor’s manager. If the case is still unresolved, it can go to the IRS Appeals Office. Appeals Officers perform research, hear arguments and consider litigation hazards. Many of my cases are successfully resolved in the IRS Appeals Office. Those that are not generally go to the U.S. Tax Court. (Taxpayers can appeal to a U.S. District Court and to the U.S. Court of Federal Claims instead, but they must first pay the assessed liability and generally litigating there is more expensive. Most tax cases go to Tax Court.)
Once a case is docketed in Tax Court, IRS counsel sends it back to appeals for another shot at settlement. If the case remains unresolved and the IRS sees it could lose the case, the IRS counsel will continue to try to settle.
Tax Court trials tend to be quick, taking hours rather than days. Before trial, counsel stipulate to uncontested factual matters and exchange exhibits that they intend to offer at trial. After trial, there is a lengthy period for counsel to submit briefs, and for the Court to write its opinion. When the Tax Court issues its decision, the taxpayer, IRS or both can appeal it to the U.S. Court of Appeals for the taxpayer’s circuit. The U.S. Court of Appeals is as far as most tax cases can go. The U.S. Supreme Court only rarely hears tax cases.