According to guest Philip Karter, a tax controversy and litigation lawyer with Chamberlain Hrdlicka Attorneys at Law in Philadelphia, the frequency of IRS audits are down, but that doesn’t mean they are any easier for those who find themselves going through the process. In today’s podcast, Karter covers best practices for conducting yourself during an IRS audit, factors that may make you more likely to be audited, and ways by which you will be notified if you find yourself under the financial microscope.
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By: Bill Hayes, Pennsylvania CPA Journal Managing Editor
“I'm being audited by the IRS.” Those words are probably pretty high on any list of phrases that no person or organization ever wants to hear themselves uttering. However, should you ever find yourself in such a position, there are ways to conduct yourself to ensure that the process goes as quickly and smoothly as possible. To discuss processes and best practices connected to an IRS audit, today, we are speaking with Philip Karter, a tax controversy and litigation lawyer and shareholder with Chamberlain Hrdlicka Attorneys at Law in Philadelphia.
At this time, what is the landscape of IRS audits like? Are they down? Increasing? Same level? If increasing, what are the factors that are causing audits to rise?
[Karter] The answer is that they are actually dramatically decreasing as budget cutbacks have taken a toll on IRS enforcement efforts all the way from audits to collections to criminal investigations. Just to provide some perspective, the IRS is spending less today than it did 10 years ago, and that's not even taking into account adjustments for inflation.
So roughly out of about 200 million tax returns filed, about 80% of which are individual returns, the audit rate has dropped to less than half a percent of those as compared to more than double that 10 years ago.
When there's the case of an IRS audit, what would you say are some of the issues the IRS focuses on that could result in an audit?
[Karter] There's the average taxpayer filing individual returns and there are certain hot-button issues that will more likely than not cause your return to have certainly a greater likelihood of being spit out and flagged for audit. Initially, they all go through a computerized scoring process and certain hot-button issues will cause that return to be spit out and then examined by an actual person. But before I get to that, let me talk a little about some of the areas that the IRS has identified warranting priority treatment.
For example, in July, the IRS had publicly announced its intention to aggressively audit high-net-worth taxpayers. That's taxpayers who engage in complicated domestic or foreign financial transactions, taxpayers who haven't filed necessary returns; for example, high-wealth taxpayers. Something that's been in the news lately, although that particular audit has been going on for some time.
Another area of priority is fraud enforcement, which follows the formation of a new fraud enforcement office earlier this year. It's worth noting when we talk about audits that, generally speaking, the IRS has the opportunity to audit a return and make an adjustment within three years of the time the tax is filed. In certain instances, where the potential deficiency is larger, it can be up to six years, but unless a taxpayer extends – what's known as the statute of limitations – that's all the time the IRS has.
As far as your questions about the average taxpayer, the more commonplace situations that increase the risk of audit would be, for example, failure to report income or the mismatching of reported income with information returns filed by other reporting entities; for example, 1099 statements. Payroll tax reporting is a big issue for the IRS that can flag, or increase the likelihood of, audits, as are worker classification issues where a business, for example, classifies persons as independent contractors or employees.
Another area that typically receives heightened scrutiny is Schedule C businesses, particularly where there are disproportionately high expenses to income or multiple years of reported business losses. More recently, to get more current, cryptocurrency transactions have become an increasing area of acute attention on the part of the IRS, which has determined that there is the tremendous potential for abuse, including non-reporting. They've been very aggressive in seeking information from third parties to find out who's not reporting at all, or who's reporting incorrectly. Even something as simple as deducting 100% of a car expense for business use can be enough to trigger an audit.
A question of protocol here because I think it can sometimes be a focus of scammers: How will a person be notified that they're under IRS audit?
[Karter] That's a great question because you're exactly right: probably all of us have received a phone call at one time or another from somebody purporting to be from the IRS, claiming you owe money, and anything from paying with a gift card to making a wire transfer.
What you should know is that, in the case of civil audits, the only way that the IRS is going to notify you is by mail and they make that clear on their own website. If you receive a call from the IRS or somebody purporting to be from the IRS or an email, you should disregard it; it is a scam. However, if you're already under audit and communications have begun, it is possible that there'll be communications of another type. But from the outset, mail only.
I just want to make one distinction because, in the case of a criminal case – criminal tax fraud, for example – that can arise from other sources. It can arise from whistleblowers, for example, or third-party information. And there are times when a taxpayer is not notified until the IRS is ready to indict or perhaps even arrest. But for civil cases, which is what most people are concerned about, the only way you'll be notified is through the mail.
What sort of steps should a taxpayer take to prepare for an IRS audit and, maybe more importantly, are there things they should be doing without notice of an audit, just to be safe, such as document retention? What else would you say?
[Karter] The first thing is to understand the purpose of an audit. The goal of the IRS is to review and examine individuals’ or organizations’ accounts, financial information, etc., to ensure that it's reported accurately and to verify that the amount reported is actually the amount of tax that's due under the law. The most critical advice that one can offer a taxpayer, even one who is not expecting an audit, is exactly what you mentioned: to maintain accurate records.
It's important to remember that, with regard to taxes, the burden of proof is almost always on the taxpayer to prove their entitlement to either a tax refund or a tax determination that they're reporting. It's up to the taxpayer to be able to prove that, and I can't tell you the number of times where there were probably bona fide tax positions that failed because the taxpayer was unable to provide adequate records to substantiate their entitlement to the tax amount that was reported.
The types of documents you'll need to show in an audit really depends on the nature of what’s being examined. For example, one of the most common audit inquiries relates to an expense claim as a business deduction, whether it's allowable or not. There has to be a legal justification for claiming the deduction; for example, that it's an ordinary and necessary business expense, as opposed to a personal expense, and that the expense was actually incurred and paid. If you don't have the records, it's going to be very difficult to be able to establish that. So, you said it at the outset: record keeping is critically important and it's good business practice, irrespective of whether you're expecting an audit or not. If you are audited, that's the best way to be able to defend the audit.
I'm sure if someone is being audited by the IRS, it's going to feel like it's taking forever regardless, but is there a certain amount of time that an IRS audit usually takes, or does it vary from case-to-case and the complications?
[Karter] It really runs the gamut from the simple to the extremely complex and, not surprisingly, the amount of time it can take can vary dramatically. The level of complexity, as well as certain pedestrian factors, such as the motivations of the particular auditor assigned to the matter, can bear on the amount of time it takes. Also, with regard to the production of information that's requested, how quickly it can be produced, whether it will be difficult to obtain and the taxpayer needs more time. So, it's not always the IRS that is slowing down the process. There may be practical reasons, or even strategic reasons, why the taxpayer wants to do the same.
The simplest audit inquiries usually arise typically within a year or so after the return is filed and can sometimes even be resolved by correspondence. On the other hand, complex audits can take years.
In those cases, taxpayers are frequently asked ... I mentioned earlier on the statute of limitations. When an audit is likely to be complex and require a lot of time, it's typical for the IRS to ask for an extension of the three-year period of time in which the IRS can make tax adjustments.
Why would you do that or not do that? Well, for example, if the IRS is looking to make an adjustment and they need more time, and you need more time to establish why that adjustment is inappropriate, it may be in your interest to extend the statute of limitations.
In other instances, the IRS may be fishing for information and not really have a case together. For that reason, it may be in your strategic interest not to agree to extend the statute of limitations because the IRS can't prove its case. Each case has to be evaluated based on its own individual circumstances.
In a blog you did for CPA Now, PICPA's blog, you said that these audits usually conclude in one of three ways. Can you take us into detail about what those three scenarios are?
[Karter] There are three typical outcomes in a tax audit. The first, obviously the one taxpayers hope will be the case, is that the IRS concludes there should be no adjustment, in which case you will get what's referred to as a no-change letter. You established to their satisfaction that the amounts reported on the return were correct. Perhaps you provided substantiation that they were looking for, whatever the case may be. There are many instances where there's no change to the taxes as reported, and the matter is closed after that.
The second alternative is where the IRS does propose it adjustment. It's then up to the taxpayer to decide whether to accept that adjustment – known as an agreed adjustment – or not.
If you agree to the adjustment, the IRS will ask you to waive the period of time you have to protest the assessment, and they will issue you an assessment of tax, which is essentially a bill. That gives them the right to collect the amount of tax due. When you're consenting to the adjustment, you should expect to be paying it. If you can't pay it, then we get into issues about ability to pay and perhaps a payment plan or some other type of arrangement that allows you to pay the liability.
The final alternative way that an audit can wrap up is where the taxpayer decides to dispute the proposed adjustment, and that's called an un-agreed adjustment. If you dispute it, typically you have the right to file what's known as a protest. That's an appeal, effectively. It goes to the IRS Office of Appeals. Then you have an appeals officer who is supposed to be independent. In other words, making an independent evaluation, independent of the auditor's determination. Each side gets to present its case, and then the appeals officer decides whether the taxpayer is right or the auditor is right.
If they agree, that's the conclusion of the matter, and, once again, it is resolved in that fashion. If the taxpayer is dissatisfied with the appeals officer's determination, then the taxpayer has the right within a certain time period to file a petition in the United States Tax Court.
They can also go right to the Tax Court and bypass appeals altogether. But the important thing to remember is throughout this process, whether in an audit, whether in appeals, or in litigation, there always remains the prospect of settling a dispute. So it's not necessarily an all-or-nothing proposition.
What are the mistakes organizations or individuals should be avoiding if they find themselves under IRS audit?
[Karter] Once in an audit, the most common mistakes a taxpayer can make is to give reason for the auditor to mistrust them or to be uncooperative, unresponsive to reasonable requests for information to which the IRS, by the way, is often legally entitled. Credibility and cooperation go a long way toward creating a positive working relationship with the auditor, which is more likely to lead to a compromise and an agreed resolution or an outright agreement on the part of the IRS that a no-change is in order.
Having said that, it doesn't necessarily mean that taxpayers must give into unreasonably or overly burdensome demands for information or do the IRS’s work for them in terms of developing a position on an issue. You should approach everything other than a routine audit as not only a time where the IRS is getting information from you, but also an opportunity to learn information about what the IRS is interested in, because that's not always apparent right at the outset.
Sometimes the IRS itself doesn't even know what it's looking for. Throughout the audit, depending on the level of complexity, you have to be strategic and consider whether the matter is likely to resolve favorably at the audit level or more likely to be litigated. For example, there are certain positions, certain types of issues, where the IRS has taken a very hard-line position and taxpayers who have engaged in such transactions pretty much know from the outset that they are unlikely to get a favorable resolution, at least at the audit level. When you know that an issue is likely to be contested, that may bear on how much you push back in an audit against requests or demands for information. It's always important to consider whether to participate in the audit, in settlement or an adversarial mode.
It seems like there's almost a little bit of a fine line there where you want to make sure that you're cooperating and you're not making anyone suspicious about you, but you also don't want to do too much of the work for people. So it's an interesting fine line. What would be your number-one message you would give an individual or organization as far as how they should conduct themselves to ensure this process goes smoothly? What would that takeaway be?
[Karter] Besides the importance of preserving credibility and avoiding confrontation, if possible, it's important to remember that most auditors are just trying to do their jobs and to make sure that taxpayers are in compliance with the tax laws.
So, in some cases, just like the well-known proverb, you can attract more flies with honey and vinegar and cooperation. Particularly if you have information that you think, once the IRS auditor understands it, will be conceived to be favorable to the position that you're taking and substantiate that you're entitled to a no-adjustment determination.
Of course, oftentimes there are multiple issues that are being audited, so you may be successful in one issue and unsuccessful at another. But, as I said before, in terms of being strategic and particularly among the more complex audits, there are circumstances where pushing back may be the best strategic course. For example, sometimes auditors are not sensitive in making requests for information to, let's say, a small business where it can be incredibly burdensome to try to have to come up with all the information the IRS is requesting.
What might be logical in a case like that would be to try to sit down with the auditor and work through what's a reasonable accommodation that provides them some of what they may need, or perhaps even all of what they need without placing such a large burden on the business.
An example might be where large amounts of data are requested from a business that would be difficult to retrieve, so perhaps a sampling of that data might be provided. There's always a discussion, always an negotiation. It should be respectful and non-confrontational if you can avoid it. There are some instances and some auditors that are more difficult than others. And there are instances where one does have to push back, recognizing that you may not achieve success at the audit level in resolving the matter, and you're going to have to take the next step and perhaps try to resolve it at appeals or, in the case of a highly contested issue, in litigation. With the understanding, as I said all along, that these cases are always susceptible to settlement and the vast majority of cases that come out of audit and remain in dispute are settled before they actually go to trial.