Help! The IRS is Auditing Me!

The May 2012 issue of WTAS’ For the Record described a number of CP Notices that taxpayers receive.

That article discussed these computer generated notices and what taxpayers should do if they receive one in the mail. This article will focus on the audit process. Audits do vary in scope but clearly, the more complex the taxpayer's return, the higher probability of audit.

The most common type of audit is a "desk" audit. This is also sometimes referred to as a “correspondence" audit. In these audits, Internal Revenue Service (IRS) simply sends a notice of audit to the taxpayer along with an Information Document Request (IDR). The taxpayer (or representative) then compiles the requested information and remits it to the assigned agent. In many cases, the agent does not request a face-to-face meeting, but rather completes their review of the information and provides the taxpayer with a Revenue Agent Report (RAR) depicting their proposed adjustments. Historically the correspondence audit has focused on one or two items of income-deduction. Recently, however, we have seen very detailed IDRs as part of correspondence audits requiring much more communication (phone and correspondence) with the agent to resolve.

This first level of IRS review is known as the “collections” stage. This phase will entail one or more IDRs that allow IRS to gather relevant information regarding specific items or forms reported/included in the return. After all information deemed necessary by IRS has been gathered and reviewed, the agent will informally communicate the findings to the taxpayer where he or she may debate the findings or appeal to the IRS agent's supervisor. If this fails to alter any adverse findings, the IRS agent will provide the taxpayer with a Form 4549-A, Income Tax Discrepancy Report, that details all proposed changes and calculates the tax due. Generally this form is accompanied by Form 886-A, Explanation of Adjustments, which provides the analysis of the changes and IRS Letter 525, General 30 day Letter. At this point the taxpayer can either agree to IRS' findings and pay the tax liability or formally protest the adjustments within the 30-day period. IRS can extend the 30-day period and the extension is generally determined by the complexity of the case. The protest will include a detailed analysis of the taxpayer's position on the disagreed adjustments. Once the taxpayer protests the adjustments, the case will move to IRS’ Appeals Division.

The appeals process is designed to resolve specific areas of disagreement as opposed to revisiting a case in its entirety. The Appeals Division will work through the differences and has the authority to settle the case as it deems appropriate. As opposed to the IDRs at the collections stage, which request substantive information like bank records or cancelled checks, the Appeals Division reviews the legal basis upon which the taxpayer disagrees with IRS. If the case is not settled at appeals, the taxpayer can request further dispute resolution procedures. The options available at this point are post-appeals mediation, arbitration and petition to the U.S. Tax Court.

Post appeals mediation involves the selection of mediators (taxpayer's and IRS') who will review the legal analysis and hear arguments from both IRS and the taxpayer. The goal is to broker a settlement between the parties by first assessing the strength of the various arguments (litigation risk) and then attempting to bring the parties to a settlement. Note that contrary to the name of the process, the taxpayer’s case is still in appeals. The mediation occurs prior to appeals rendering an official decision through the issuance of a Statutory Notice of Deficiency (Letter 531). If the taxpayer chooses to request mediation, he/she does not give up any rights to subsequently petition the U.S. Tax Court or Federal District Court.

Another dispute resolution mechanism is binding arbitration. This procedure is generally available when there are a limited number of factual issues that remain unresolved following settlement discussions in the appeals process. Arbitration is not designed to resolve disputes involving legal arguments, but instead to focus on resolving factual disputes; for instance, the value of an item for gift tax purposes. Arbitration involves the taxpayer and appeals presenting their arguments to an arbitrator (independent third party) who renders a decision based on the information presented. Binding arbitration will yield a final decision that cannot be appealed to U.S. Tax Court or Federal District Court.

If an agreement cannot be reached within appeals, a Statutory Notice of Deficiency will be issued. The taxpayer may:

  1. Accept IRS determination and pay the tax;
  2. Petition the Tax Court within 90 days; or
  3. Pay the tax and file suit in the U.S. District Court to obtain a refund.

If the taxpayer does not prevail at the Tax Court or District Court level, the case can be appealed to the U.S. Court of Appeals, and ultimately the Supreme Court of the United States.

The IRS audit process can be relatively painless or fairly painful depending upon the complexities of a taxpayer's return. However, it is important to know that there are many avenues available to help a taxpayer resolve these issues. Also, because dealing with the various aspects of an audit can be complicated, it is important to obtain professional assistance with the process. There are pitfalls to avoid and opportunities to be aware of. A knowledgeable tax professional can walk you through this maze while hopefully bringing your audit to a favorable conclusion.