By Philip Karter, LLM
The complexities of the federal tax code can be intimidating, if not overwhelming. Yet, despite the complexity of tax law, most of the time taxpayers get it right; even when they don’t, the chances of being audited are exceedingly small – about 1%.
Despite the generally low rates of audits, the IRS tends to gravitate toward certain hot button issues that can increase the chances of instigating an examination. These include unreported income (especially where there is nondisclosure of foreign assets), excessive business tax deductions (particularly for Schedule C businesses), loss limitations (such as passive, hobby, and deductions limited by “at risk” rules), information mismatching (such as on W-2s and 1099s), payroll tax reporting, worker classifications, executive compensation, and large loss partnerships. Not surprisingly, the more income a taxpayer earns, the greater the risk of audit.
IRS Audit Preparation
The IRS’s goal in any audit is to review and examine an organization's or individual's accounts and financial information to ensure information is reported correctly according to tax law and to verify the reported amount of tax is correct. Long before an audit, you should already have a plan in place to retain records to ensure that items on the tax return are adequately supported.
The types of documents you will need to show in an audit depend upon the nature of the issues being examined. For example, one of the most common audit inquiries relates to whether an expense claimed as a business deduction is allowable. In such a case, there has to be a legal justification for claiming the deduction – in that it constitutes an ordinary and necessary business expense as opposed to a personal expense – and that the expense actually was incurred and paid. The burden is on the taxpayer to substantiate that the expense was incurred and that there is a legal basis for claiming the deduction. In other instances, the facts may not even be disputed and, once the issue is examined and understood, it boils down to whether the taxpayer and the IRS can agree on how tax law should be applied.
Federal tax audits run the gamut from the simple to the extremely complex. Thus, the time it takes to complete an audit will depend on the level of complexity. The simplest audit inquiries usually arise within a year or so after a return is filed and can often be resolved by correspondence. On the other hand, complex audits can last for years and, in such cases, taxpayers are frequently asked to extend the normal three-year period of time in which the IRS can make tax adjustments. Although taxpayers are not required to agree to a requested extension of time, they often will if they believe that the extension will help avoid a tax adjustment based on insufficient information that, if provided, can help the parties reach an agreement.
How Long Does an IRS Audit Take?
Even simple audit cases will typically require the taxpayer to produce information, but the more complex the case is, the more extensive the information requested is likely to be. The IRS commonly requests documents, but in complex cases it is not uncommon for the IRS to also seek to interview the taxpayer and nonparty witnesses. Moreover, the IRS has administrative powers to compel the production of documents and testimony if the taxpayer does not produce such information voluntarily.
Once the audit is completed, it will be concluded in one of three ways:
- The IRS can accept the taxpayer’s return as filed and issue a “no change” letter, such as where the substantiating information provided by the taxpayer has been reviewed and accepted.
- The IRS can propose an audit adjustment to which the taxpayer agrees.
- The IRS and the taxpayer may disagree about the proposed changes, whereupon the IRS will issue a Notice of Proposed Adjustment (NOPA). If the taxpayer does not agree with the proposed adjustment, the taxpayer can file a protest with the IRS Office of Appeals. If the matter is not resolved at that level, the taxpayer will receive a Notice of Deficiency and will have 90 days thereafter to dispute the matter by filing a petition in Tax Court. If all of these avenues are pursued, the matter can take years to resolve. However, most audits are resolved at the examination level, often as the result of compromise.
Once in an audit, the most common mistake taxpayers make is to give reason for the auditor to mistrust them or to be uncooperative or unresponsive to reasonable requests for information to which the IRS is 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 agreed resolution. This is not to suggest that taxpayers must bow to unreasonable or overly burdensome demands for information, but it is worth remembering that most auditors are just trying to do their jobs to make sure taxpayers are in compliance with the tax law.
Finally, the IRS is authorized to disclose federal tax information to state and local authorities for tax administration purposes and vice versa, so federal, state, and local taxing authorities will routinely engage in information sharing programs. Because federal tax audit results are shared with state and local authorities, it is not uncommon for a federal audit to be accompanied or followed by a state audit.
Philip Karter, LLM, is a shareholder with Chamberlain Hrdlicka, representing clients in tax planning transactions, federal tax controversies, and tax litigation matters. He can be reached at firstname.lastname@example.org.
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