Are Your Clients Prepared for a Wave of IRS Audits?

Changes to the nation’s tax system are on the horizon, and one of the biggest impacts will likely be a reinvigorated, well-funded IRS. And a well-funded IRS certainly means an increase in IRS audits. Businesses and high-income individuals would be well-advised to get their houses in order ahead of a potential wave of aggressive IRS reviews of tax returns and the consequent audits.

As this issue went to press, a Biden administration proposal would double the IRS workforce over 10 years and increase its budget by 90% over the same period. About $44 billion of the $80 billion that would be added to the agency’s budget over the next decade will go to enforcement activities such as audits. The Congressional Budget Office projects that a fully funded IRS will collect an additional $200 billion in taxes over the same period.

These changes would kick in right away, as the IRS would receive an additional $13.2 billion in funding in the next budget, which is about a 10% increase. Historically, new IRS agents have taken a few years to get up to speed, but IRS Commissioner Charles P. Rettig has said the agency will focus on hiring experienced tax and auditing experts who can hit the ground running.

Now is a good time for businesses to review their practices and put a plan in place that maximizes their chances (and those of their owners) of emerging unscathed from a tax audit.

Best Defense Is Good Recordkeeping

Policies for document retention may vary by type of business or regulatory requirements; regardless, it is imperative to have a policy in place and to ensure everyone throughout the business adheres to it. Unfortunately, there isn’t always a red line for retention as far as the IRS is concerned. Treasury regulations say tax-related records must be kept as long as they are “material,” which usually is assumed to coincide with the statute of limitations. In some circumstances, such as suspected fraud, the retention period may be longer. Taxpayers may also benefit from record retention policies applying to certain aspects of their businesses that extend well beyond the statute of limitations. For example, substantiating a gain or loss on the sale of a long-held asset is likely to require that records establishing the cost basis of that asset be retained all the way back to the time of purchase.

When the IRS Comes Calling

Should an audit notice arrive, don’t panic. Immediately issue a litigation hold, making sure everyone in the company who needs to know is preserving relevant documents, emails, and other evidence. The litigation hold also will help establish the applicability of the work-product doctrine going forward, which will protect any documents prepared for a legal defense from IRS discovery.

At the same time, the company should review its files and databases for critical documents. Pay special attention to anything that may be protected by attorney-client privilege or as work product, which might include legal or accounting advice or opinion letters (the latter potentially applicable under Internal Revenue Code provisions covering communications between taxpayers and “federally authorized tax practitioners”), and any documents prepared in anticipation of litigation.

Identify and interview employees who have pertinent information. This gives you a head start in your audit defense, allowing you to identify potential landmines. Include former employees and third parties who may have information relevant to the audit to get a sense of whether they will support the company’s position. If the IRS insists on interviewing employees, make sure they are prepared in the same way a key witness would be prepped for trial. Employees must always tell the truth, but they should understand they are not required to speculate or volunteer information that has not been requested.

Get Your Team Together

Assign a point person to be the traffic manager for IRS requests, which usually will come in the form of Information Document Requests. From day one, identify a primary representative for communicating with the IRS. If fraud or any criminal behavior is suspected, that person should be the company’s in-house or outside legal counsel. This is important because the tax practitioner privilege does not apply to criminal matters. Similarly, for issues that appear likely to be headed toward litigation, the engagement of outside counsel is advisable. For issues with a lower risk threshold, it may be sufficient to have a representative from the company’s tax department as the contact point for the company, with support from outside specialists as appropriate.

How Much Cooperation?

Most companies voluntarily comply with IRS requests for interviews and documents. If the requests become overly broad or unreasonable, however, it may make sense to force the IRS to seek information through the summons process. Summons proceedings can be costly and time-consuming, but sometimes there are tactical reasons to embark on such an approach, such as if additional time is needed to gather information. Major decisions like this always should follow thoughtful deliberation with counsel.

As the IRS beefs up enforcement efforts, many more companies are likely to face tax audits. A company that has followed best practices in retaining and organizing its records and has thought ahead about how it would respond to an audit inquiry will place itself in the best position to offer a robust audit defense or negotiate a favorable outcome.

Philip Karter, JD, LLM, is a shareholder in the Philadelphia office of Chamberlain Hrdlicka, focusing on civil tax controversy and litigation. He can be reached at pkarter@chamberlainlaw.com.

Kevin F. Sweeney, JD, is a shareholder in the Philadelphia office of Chamberlain Hrdlicka, focusing on civil and criminal tax controversy and litigation. He can be reached at ksweeney@chamberlainlaw.com.