Audit Defense

One of the scarier words for a taxpayer to hear is “audit”. No one wants the government poking around in their personal or business affairs. However, audits do occur, either randomly or for a specific reason, and a taxpayer is allowed a representation to help support against an intrusion that is any more than necessary to ascertain the correct amount of tax owed.

Types of Audits Covered

When the IRS audits, there is not a “one size fits all” approach to the agency’s review of a taxpayer file.

One of the least intrusive types of IRS audits is a correspondence exam, where the IRS requests the taxpayer provide supporting documentation for its tax positions in the mail. These audits involve no face-to-face meetings with the IRS, but provide the taxpayer with little room for error if they do not produce the right documentation to the IRS. If the position is not explained properly, the taxpayer should expect to receive a Notice of Deficiency from the IRS, attempting to assert a balance due as a result of a lack of substantiation.

The IRS may have a field auditor assigned to a file, which would necessitate in-person meetings and interviews with the agent and, in the case of a small business owner, a “tour of the taxpayer’s business site”. These audits can typically last 6 months to a year, and involve a series of Information Document Requests being provided over the course of the exam. The issues for field audits range from income tax to employment tax or employment classification.

The Law Offices of Michael Raff tailors its strategy for audit defense based both on the type of exam the IRS has initiated in conjunction with a review of the taxpayer’s books and records and the legal issues at play. The firm will craft its initial and continued responses to IRS inquiries based on the bespoke needs of each client, always being mindful of mitigating any potential penalties as well as exposure to additional tax periods.

Common Audit Triggers

The IRS has a methodology whereby it “scores” each taxpayer’s tax return to compare it to a national average. When the score is too far outside of the standard deviation, it may trigger the IRS to open an examination.

Common red flag items include oversized expenditures for items such as cars, trucks, and meal expenses, as those categories require specific documentation before they can be allowed as deductions. In addition, large charitable contributions, specifically “non-cash” contributions, also draw scrutiny from the IRS, as in addition to documentation requirements, certain times 3rd party appraisals may be required.

The IRS also likes to pick on businesses that generate losses, looking to reclassify the activity as a “hobby” that would not allow expenses that exceed revenue. Furthermore, the IRS applies heightened scrutiny to real estate professionals who take significant depreciation expenses to reduce overall net income. While this is a viable strategy if performed correctly, there are numerous requirements and legal challenges that the agency can (and will) make to one claiming that real estate professional status.

Preparing for an Audit

Receiving an IRS audit notice in the mail can make your heart sink. After that initial shock wears off, the first item to pay attention to is the response date. To establish a good rapport with the examiner, it is important to adhere to response deadlines. With that said, it is a good idea to get counsel involved during this time, so that the initial response can come from the professional representative.

Once you have determined the initial scope of the exam, start gathering the records that will support the items on the return. It is important to determine potential weaknesses in the response, such as bank statements that will show more funds may have been deposited than reported as revenue, or that don’t account for all expenses claimed on the return, before the initial conversations with the examiner. This allows the counselor to control the narrative for the audit as opposed to being placed in a reactionary position.

The earlier a tax lawyer is involved, the more favorable the outcome is likely to be, as strategy will remain consistent from the beginning to the end of the audit.

Choosing the Right Audit Defense Service

The three most common designations for taxpayer representatives before the IRS are attorney, CPA, and Enrolled Agent. It is critical to understand the distinction between the three.

An enrolled agent is an individual who passed a special test to be able to represent taxpayers before the IRS but did not have to attend school to sit for the exam. An enrolled agent may or may not be able to represent the taxpayer before the United States Tax Court. There are no privileges that exist between a taxpayer and an enrolled agent.

A CPA can also represent a taxpayer before the IRS, but oftentimes the representation starts because they are responding to an audit notice for which they are the preparer. This presents a potential conflict of interest within the representation, where the CPA is trying to both argue the taxpayer’s position, but also protect himself against any potential errors or omissions. Furthermore, while a limited tax preparer-Taxpayer privilege exists, it exists only for the purposes of tax preparation, and would not extend to a conversation with a new CPA about a return he or she did not prepare. Further, the tax preparer-taxpayer privilege never extends to a potential criminal violation.

Overall, legal representation, especially with civil or criminal exposure, is crucial. Hiring a lawyer signals to the IRS that you are not going to take the audit lying down, and they should expect a fight if attempting to summon records, talk to third parties, or extend the audit period or scope.

At the Law Offices of Michael Raff, you are working with an attorney who has the educational background and the practical experience necessary to reduce risk associated with IRS review.

Key Strategies for Effective Defense

To effectively defend against IRS examinations, it is important to know the facts, the legal issues at play and IRS policy and procedure better than the IRS agent examining the return. A strong defense starts by a through review of the filed tax returns, often accompanied by a bank deposit analysis and scheduling of supporting expense, before submission to the IRS. Once the strength of the taxpayer position is assessed, it is possible to outline next steps, which may include:

• Limiting contact between the agent and the taxpayer
• Fending off IRS Summons (or requests for documents and information from 3rd parties)
• Keeping the IRS agent from expanding the audit scope (both issues and tax periods)
• Keeping and examination from being referred to a criminal investigation
• Preparing legal briefs for the examiner when the issues are technical and preparing reasonable cause requests to avoid the imposition of penalties

Documentation and Record Keeping

IRS examiners are first looking to substantiate the figures on the tax return before determining if the income was recorded correctly and if the expenses, deductions and credits are allowable.

Therefore, documenting and retaining records such as tax returns and supporting schedules, bank statements, mileage logs, and invoices for at least 3 years is a crucial practice; saving them for 6 years (just in case) is better.

If you don’t have all of the requested information when you are audited, there are other methods to show your position to the IRS. For example, the Cohan rule allows a taxpayer to claim certain deductions on a return on the basis of estimates. That is, if the deductions actually took place, and are reasonable to be taken in the taxpayer’s course of business, they can be allowable on a return even without the corresponding invoice or bank entry proving that they were paid.

Working with Tax Professionals

In some instances, it makes sense to work with other tax professionals, such as CPAs or bookkeepers, during the course of, or in possible preparation for, an exam. There are even ways in which conversations between these other professionals and taxpayers can be protected.

Under a Kovel agreement, if the attorney engages the other tax professional to prepare an estimate of taxes owed, communications between the taxpayer and that professional are protected via the attorney-client privilege. This is an effective tool in the attorney’s arsenal, and, while not for every situation, can facilitate the free flow of communication amongst many professionals to help efficiently and effectively achieve a great outcome for a client.

Common Misconceptions About Audits

“The IRS doesn’t have resources to review my return”: FALSE.

The IRS has indicated that it will expand its use of artificial intelligence to look for common deductions that are often fraudulent or abused. From there, the IRS may generate correspondence or field audit exams in an attempt to assert a deficiency.

“Only rich people get audited”: FALSE.

Despite IRS pledges not to raise the audit rate on low income taxpayers, disproportionately low earning filers show income tax deficiencies when audited. This stems from not having the resources (or often the time) to fight the IRS during an examination. Without a proper defense, the IRS is likely to impose tax, penalties and interest where if counsel had gotten involved, the assessments likely could have been mitigated or defeated.

“I can do this on my own”: TRUE.

While not recommended, audits can be handled by a taxpayer directly with the IRS. With that said, it is highly unadvisable to try and tackle this endeavor without the assistance of a tax counselor as it provides opportunity for the examiner to take advantage of the unprepared. It is best to use the services of a counselor who knows the Internal Revenue Manual inside and out, and often advises the examiners on requirements they are unaware of themselves.

Those who take audits seriously and prepare instead of panicking will yield the best results.