IRS EXAMINATION
INTRODUCTION TO IRS EXAMINATION
IRS Examination is often likened unto and often referred to as the IRS audit function. Typically, the IRS accepts most federal tax returns when filed. However, there are circumstances in which the IRS examines, or “audits,” to determine if reported income, expenses, and credits have been reported accurately by the taxpayer. When a taxpayer’s return is selected for examination, it is first randomly chosen by computerized screening and then secondly selected by audit by a human reviewer who decided the level of audit that the taxpayer’s return will undergo.
If an IRS Examination investigation results in a finding of additional tax owed, whether or not this is intentional or unintentional, the IRS requires the payment of a penalty in addition to the remaining tax obligation. IRS Examination determines the due date, if appropriate, for taxes reported by the taxpayer and assesses penalties and interest from the date of assessment. The Examination Division also establishes procedures for assessing and collecting tax. For more information about the IRS examination process, review IRS Publication 556: Examination of Returns, Appeal Rights & Refund Claims.[1]
The IRS examination, or audit, process begins in one of ten service centers, which depends upon the location of the taxpayer. The service centers receive taxpayer returns; service center representatives catch errors and enter tax return data. The computer matching software the IRS uses reviews the items on the return and matches the information with sources received from other parties such as an employer or third-party filer. A tax return is scored for audit potential and a notice and demand is generated when a taxpayer may be required to pay additional taxes.
If a particular service center is unable to handle a taxpayer’s case, particularly if the taxpayer does not live near the service center, then the case is referred to a revenue agent in a local field office. The purpose of the revenue agent is to conduct a more through investigation of the taxpayer and the facts and circumstances surrounding their return. In some cases, the revenue agent will ask the taxpayer to come in and discuss their case and also produce supporting documents. In some cases, the revenue agent will go into the taxpayer’s home or place of business. The revenue agent then reviews the facts, makes adjustments when appropriate, and issues a “revenue agent’s report,” which is a summary of their findings.
The IRS audit ends when the revenue agent issues a report stating either one of two outcomes. The taxpayer with either recieve a no-change letter or a notice of proposing adjustments. An IRS audit may not be closed for several months following the date the taxpayer meets with the revenue agent. Throughout the period, the IRS will issue a series of letters and/or notices that require the taxpayer to respond to one or more deadlines. These letters and/or notices may come in the forms of thirty day or ninety day response times and these documents help to move the case out of the IRS examination function and into IRS collections.
Responding to one or more of these notices is important. Taxpayers are often unaware of the consequences for failing to respond to notices. In addition, the IRS is only required to mail out letters and/or notices, but the agency is not required to make sure that a taxpayer receives the notice. In other words, the IRS mails these types of documents to the taxpayer’s last known address, even if the taxpayer no longer resides there.
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[1] The document is available here: https://www.irs.gov/publications/p556/index.html.
HOW TAX RETURNS ARE SELECTED FOR AUDIT: EXPLAINING DIF SCORES AND UI DIF SCORES
Ever wonder how tax returns are selected for audit? Well, it comes down to two simple numbers which are your DIF Score and your UI DIF Score.
According to the IRS, tax returns are selected for audit based on computer scoring. The IRS states in Publication 556 that it uses a computer program called the Discriminant Inventory Function System (DIF). The Discriminant Inventory Function System assigns a numeric score to each individual and some corporate tax returns after they have been processed.
If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability.[1]
Purpose of Discriminant Inventory Function (DIF)
Essentially, the two-fold purpose of the DIF is to identify and select tax returns for examination utilizing a pre-configured scoring formula. Each type of taxpayer and tax return is subject to a different DIF formula. There are particular items on a tax return that may cause concern.
For example, participation in a tax shelter might send up a red flag to the Internal Revenue Service. In addition, “large charitable contributions, home office deductions, large travel and entertainment expense or large automobile expense” may send up additional red flags (MBBP).
Once a tax return is selected under the DIF program, it is then manually screened so attachments and related data can be evaluated.
Purpose of Unreported Income DIF
The IRS uses an additional tool, namely the Unreported Income Discriminant Index Formula (UI DIF). The UI DIF is used for two purposes:
- To rate the probability of inaccurate information
- To rate the probability of omitted income on a tax return
Both steps are evaluated in conjunction with the other.
For example, if a taxpayer files a 1040-EZ tax return, reporting earnings from a W-2 only, then it is unlikely that the tax filing will be subject to an audit; this is because the earnings reported on the tax return also match those earnings reported with Social Security.
However, a tax filer that reports income from various sources and fails to provide hard-copy documentation evidencing self-employment earnings, for example, will likely have a better chance of responding to an audit request.
With this in mind, with regard to the UI DIF, the IRS typically targets four areas when considering an audit.
High income, high risk taxpayer
The first area is “high income, high risk taxpayers.”
A taxpayer with a higher income tends to file a more complicated tax return. Under this category, the taxpayer engages in pass-through activities that include tax shelters, the establishment of trusts, and related taxation shielding options.
Because some activities may be illegal, tax returns that fall under this category are likely to be audited.
High income non-filer taxpayer
The second category is “high income non-filers.”
A taxpayer with high income reported on their social security number, but who has not filed a tax return yet, is screened by the IRS. The IRS will send multiple notices, advising the high income taxpayer of their legal obligation to file and will also prepare a Substitute for Return (SFR).
For more information on Substitute for Return, see section “Other Types of Balances Due: Proposed Assessments and Substitute for Returns.”
High amounts of itemized deductions taxpayer
The third area the IRS evaluates is the “high amounts of itemized deductions” reported by the taxpayer.
A taxpayer can itemize their own tax deductions using Schedule A (Form 1040); using the form is an alternative to taking the standard deductions based upon individual filing status. Although the taxpayer can elect to itemize their deductions, too many discretionary deductions and calculations may result in error and fraud.
Self-employed taxpayers
Self-employed taxpayers are also vulnerable to an audit.
Self-employed taxpayers are different from earning individuals because the income derived as a result of self-employment is not subject to a standard verification system. However, self-employed taxpayers are still required to report 100 percent of their earnings and are free to deduct all legal expenses. Too many deductions without documentation will eventually subject the self-employed taxpayer to an audit.
[1] See Publication 556, available at: https://www.irs.gov/pub/irs-pdf/p556.pdf
IRS AUDIT STRATEGY: SEEING THE PLAYING FIELD
IRS AUDIT STRATEGY – INTRODUCTION
A favorite saying of mine when it comes to audits is that I like to see the playing field in order to know all the issues and the potential issues that could arise during the course of representation. Upon initial receipt of the audit letter from the Internal Revenue Service, you will have an idea of the areas that are being called into question. However, this is often only the starting point for the areas that may be examined during the course of the audit. When I first approach an audit, I do a through review of the return to look for other unknown and potentially dangerous issues with the underlying return. Specifically, I am looking for items that may either be misreported, overstated, or will likely need to be explained to the auditor in greater detail during the examination process. By getting a sense of these issues, as well as any potential issues on tax returns in the preceding and succeeding years (which may also be audited), I start to formulate a strategy can determine the best way to approach the audit.
Taxpayer returns are generally audited by the IRS because of either their participation in questionable tax avoidance transactions or because of their likelihood that an audit will yield a change in favor of the government. This potential for change is quantified into one of two computerized scores, the Discriminant Function System (DIF) score and the Unreported Income DIF (UIDIF). The DIF score calculates the probability that an examination will yield additional tax liability whereas the UIDIF calculates the probability that there is unreported income on a return. Those returns that yield high scores are then forwarded to examination personnel, who select which returns will be audited.
IRS AUDIT STRATEGY – BEFORE THE AUDIT BEGINS
Contrary to popular belief, most audits begin prior to the initial meeting with the taxpayer or their representative. Auditors generally conduct a full pre-audit investigation, which involves conducting both asset searches (reviewing Department of Motor Vehicles, property records, and other public information) as well as income searches (reviewing past and present sources of income reported on taxpayer returns, pulling IRS transcripts, reviewing information submitted by third parties). As a result, the taxpayer and their representatives must consider the possibility that the auditor knows much more about the taxpayer than they let on in their initial meeting. As such, representatives are going to want to be vigilant with respect to any representations that they make about the taxpayer’s assets and sources of income to avoid making potentially false statements to the auditor and subjecting the taxpayer to additional civil/potentially criminal liability.
IRS AUDIT STRATEGY – LIMIT THE SCOPE
The principal objective of any representative, other than to ensure there is little or no examination change, is to limit the scope of the audit from the outset. Although auditors begin with one tax year, it is not uncommon for them to open up as many as three years. Limiting the scope of the audit to one year will significantly reduce the overall effort involved on the part of the taxpayer (and their representative).
In addition, skilled representatives may be able to narrow the scope of information requested for a particular tax year. Often auditors will send out a generic list of items that are generally required, rather than a specific list of the categories or items that they are interested in examining. By limiting the first meeting to a few select items and proving up these items to the satisfaction of the auditor, the audit may be closed fairly quickly with minimal effort expended on the part of the taxpayer.
IRS AUDIT STRATEGY – INCOME ISSUES
Although many audits begin by questioning expenses or deductions taken on the return, often the auditor will also challenge the amount of income being claimed. This is often the case with business owners, especially those own businesses that deal with large amounts of cash (retail stores, restaurants, gas stations, etc…). As such, a thorough review of a client’s bank statements, general ledgers, and other financial information in connection with the return in question may be necessary to ensure that gross receipts were accurately reported. For clients who have comingled business and personal expenses on their bank accounts, it is necessary to separate out any personal deposits or expenses. These reconciliations may also be helpful during the initial meeting, as your attorney may be able to resolve preliminary matters with the auditor and further streamline the audit.
IRS AUDIT STRATEGY – OTHER POINTS TO CONSIDER
Two other points that should be noted. First, although the auditor will request performing the audit at the taxpayer’s home or place of business, it is unadvisable to do so and the audit should be conducted at a neutral location. This is because the auditor may use outside information, such as their observations about their locations or their conversations with the taxpayer’s employees against them in the audit. Second, it is important to review applicable audit procedures and guidelines for auditors issued under the Market Segment Specialization Program. These are specialized guides issued by the IRS, which discuss protocol and guidelines for field agents when conducting an audit. Often, they are divided by industry segment or by technical issue, and can be helpful for insight into where the auditor will be looking. Knowing what areas the auditor is going to examine leads to better preparation and faster resolution of the audit.
While not nearly as frightening as many taxpayers imagine, IRS audits are nevertheless serious matters that require attentiveness to the issues and potential issues at hand. The longer an audit continues, the more likely it is to expose the taxpayer to hefty examination changes and the more expense the taxpayer will accrue in defending themselves in the audit. Those who prepare for the audit in advance and who are able to control the scope of the audit and flow of the information that the auditor receives will likely encounter better success during their audit meetings. In this case, better preparation yields better results.
GOING SOLO: HOW TO REPRESENT YOURSELF IN AN IRS AUDIT – PART ONE
First, it should be noted that the decision to represent yourself in an audit should be made carefully. Examination changes during the audit process can ultimately be extremely costly with the extra interest and penalties that the auditor may add to your final tax bill. Even though audits are different for everyone, I have compiled a few helpful tips to assist those who ultimately decide to represent themselves.
IRS AUDIT TIP #1: SEE THE PLAYING FIELD
The IRS has limited resources and taxpayers mostly do not get audited by the government without a reason. This does not mean you have done anything wrong, but you may have unusual circumstances like working in a cash intensive business or have an unusual deduction that the government wants to take a second look at. The most valuable indication of what the government is after is the auditor’s Information Document Request (IDR), which is provided when you are initially contacted by the IRS. By understanding what the government is looking for, you can start mentally preparing and organize your documents in the most efficient way to provide the most complete substantiation possible. The more complete your substantiation is for an item requested, the less likely the government is to challenge the information stated on your return for a particular category.
IRS AUDIT TIP #2: LIMIT THE SCOPE OF THE AUDIT
The IRS typically has three years to request examination of a return, except in the cases of late/no filings, significant errors or omissions in the reporting of income or expenses, and fraud. Because the significant case load of the auditor, the IRS will normally start auditing with one year and then open up other years if there are examination changes. As counsel, my number one priority is to limit the scope to only one year and that should likewise be your goal as well. Opening other years will often equate to more changes and ultimately increases the size of your final bill.
IRS AUDIT TIP #3: CONTROL THE FLOW OF INFORMATION
Taxpayers representing themselves have the distinct disadvantage of having to answer the auditor’s questions point blank when asked. You should never lie or make a material misstatement to an auditor, as this is a federal crime that carries possible jail time. During the audit, however, taxpayers should make every effort to control the flow of information. Carefully listen to the questions that the auditor is asking and answer only the question being asked. Do not provide more documents than what is being requested by the auditor. More information gives the auditor more ammunition to make assessments and, therefore, brevity is the key to successfully navigating an audit.
Continue to Going Solo: How to Represent Yourself in an IRS Audit – Part Two
WHY THE IRS AUDITS TAX RETURNS?
The Examination Division of the Internal Revenue Service is responsible for auditing federal tax returns to determine if income, expenses, and credits are reported accurately. Although the IRS accepts most tax returns when filed, there are circumstances that warrant an audit. Within this context, the IRS is motivated to evaluate those areas of a tax return that fail to comply with current policies and provisions. In general, the IRS motivation behind auditing taxpayer returns falls under multiple categories.
First, the IRS is motivated to audit returns for the purpose of finding unreported income. In conducting both random and strategic audits, the “IRS has taken a renewed interest in finding unreported income” (Kane, p. 4). The IRS examines a taxpayer’s lifestyle to determine if income has been reported properly. For example, agents may use Form 4822[1] to determine how much a taxpayer spends annually for the purpose of comparing amounts to what the taxpayer reports on the return. If the agent is compelled to prepare a “cash T,” which represents a simple source and application of funds analysis, then the agent will pursue options that include questioning the taxpayer and indirect methods.
Second, the IRS Examination Division is motivated to audit returns to ensure customer service goals are met; these goals are specific to applying the provisions of the Taxpayer Act. In 1998, the Taxpayer Bill of Rights III[2] mandated changes in the type of customer service solutions the IRS must provide to both taxpayers and audited taxpayers. The IRS is motivated to ensure that the Taxpayer Act is implemented correctly and efficiently.
Third, the IRS Examination Division is motivated to audit returns of businesses in specific industries. For example, when it comes to conducting audits for a particular industry, the IRS gathers information about an industry for the purpose of creating an average profile. “Actual returns will then be compared against the profile to help find compliance problems” (Kane, p. 5, 5/21/2013). The IRS then issues guidelines, between 40 and 90 to date. In Bob Kane’s[3] article titled “What is the IRS Examination Division Up To Today (October 19, 1998),” he suggests that “[a]udit coverage has dropped off considerably from the mid-1970s when it was at the 2.59% level overall, to the 1.38% level of today” (Kane, p.1, 5/21/2013). However, the IRS is still motivated to evaluate particular industries. “The construction and fishing industries are two constant areas of scrutiny by the local IRS office. The IRS locally also has been focusing on mobile cart vendors, Laundromats, car dealers, bed and breakfasts, and businesses involved with . . . freight forwarding, import/export businesses, and storage and transportation businesses” (Kane, p. 4, 5/21/2013).
Lastly, the IRS is concerned about an additional area, namely employee/independent contractor audits because it represents a huge revenue loss. The IRS cannot collect payroll taxes from independent contractors. In addition, because there are issues with audits in this area, agents have received considerable training specific to worker misclassification. For example, the IRS unveiled the Classification Settlement Program, giving employers the option of settling cases where they have misclassified workers at reduced assessments. Tax attorney, Bob Kane, comments on this, stating, “To obtain the reduced assessments, the taxpayer must agree to treat the workers as employees in the future. The assessments vary between 25 and 100 percent of the tax liability for one year, depending upon the taxpayer’s level of compliance with the Section 530[4] requirements” (Kane, p. 6, 5/21/2013). The Small Business Job Protection Act (1996) modified Section 530, thereby changing the worker classification; the changes shift the burden of proof to the IRS “if the taxpayer establishes prima facie a reasonable basis for having not treated workers as employees” (Kane, p. 6, 5/21/2013). Employee training (IRS) within this area will increase the number of compliance incidences.
Motivations around IRS audits tend to reveal much about the purpose of each type of audit and the overall strategy of the Internal Revenue Service. By learning more about the motivations behind an IRS audit, taxpayers can hopefully avoid facing the scrutiny of the IRS. If you would like to know more about IRS audits, please read my other writings, available at: /category/irs-audits-and-examination/
[1] Form 4822, Statement of Annual Personal and Family Expenses
[2] The 1998 Tax Act is formally referred to as the Internal Revenue Service Restructuring and Reform Act of 1998. It is known as the Taxpayer Bill of Rights III (Pub.L. 105-206, 112 Stat. 685, enacted July 22, 1998).
[3] Robert M. Kane, Jr. is a civil tax attorney with LeSourd & Patten, P.S. Attorneys at Law. Kane handles tax dispute resolution, tax litigation, and administrative appeals. Kane graduated with a J.D. from Gonzaga University School of Law and with an LLM from New York University. For more information or to view his profile, visit: https://www.lesourd.com/attorneys/robert_kane.
[4] Section 530 of the Revenue Act of 1978
IRS AUDITS: THE TYPES OF AUDITS – PART ONE
IRS audits, or civil examinations, are conducted based upon the type of taxpayer, the scope of the examination, and the complexity of the tax return. All taxpayers are expected to provide supporting documentation with regard to questionable items. Examinations may be conducted by correspondence, telephone, or through field interview. Business returns are typically examined in an office or field interview rather than by correspondence because of the complexity of the issues involved in a business audit. In this article, I discuss the different types of audits along with their similarities and differences.
Correspondence Audits
Correspondence audits, otherwise known internally by the IRS as a Campus Examination, are the most basic type of audit. Correspondence audits involve less technical tax issues and can be completed, much like their name implies, through the mail. As the IRS notes, the purpose of a correspondence audit is to resolve tax problems quickly and easily through correspondence and/or by telephone. “[E]xaminers at the correspondence and office levels are much less invasive”.[1] The examining agent is required to process many cases without much familiarity with the return itself. It is often the case that the examiner has not reviewed the taxpayer’s file and the return after the taxpayer has replied to the agent’s correspondence. The agent will generally review the taxpayer’s file on the day of the interview.
OFFICE AUDITS
Office audits, or Area Office (AO) Examinations,[2] are face-to-face audits that are conducted at the office of an IRS revenue agent. They are typically appropriate for somewhat complicated issues, which may include small business returns and complex non-business returns. Office audits may also be conducted by either correspondence and/or office interview.
In general, examination of a taxpayer’s income tax return falls initially under the responsibility of an area office where the taxpayer resides, conducts business, or maintains a principal office. The responsibility for the examination is assigned to “an examiner at the post-of-duty nearest to the taxpayer’s residence or place of business.”[3] If it becomes necessary to transfer a return to an office within another area after the examination process has begun, the convenience of the taxpayer will be taken into consideration as long as the transfer process aligns with “sound and efficient tax administration”. [4] However, what typically controls the decision-making with regard to the transfer of a case between area offices is the location of the taxpayer’s records, the purpose of principal investigative work, and where the taxpayer’s issues can be resolved most efficiently. These factors will overrule the taxpayer’s request for a case transferal.
With this in mind, a taxpayer’s case may be transferred (back) to the Area Office or between area offices. When the case is transferred, it receives audit reconsideration. “The examiner in the CRU[5] will send a case to the area examination function to be worked if the taxpayer requests a face to face examination, and/or [if] the completion of the case requires an examination of books and records, and/or [if] the CRU has not received the training to work the reconsideration issue(s)”.[6] Regarding face-to-face examinations, the Central Reconsideration Unit (CRU) receives those tax returns that were previously examined by the Area Office or Campus Examination function.
In this respect, the purpose of the audit reconsideration process is to examine those tax issues previously overlooked. For example, if “the taxpayer presents new information that was not previously considered, [IRS employees] evaluate that information and determine if a change to the assessment is warranted.”[7] The Area Office function will then make that change.
Continue to IRS Audits: The Types of Audits – Part Two
[1] See: https://www.mbbp.com/resources/tax/irs_tax_audit.html
[2] Area Office Examination is a term commonly used in the Internal Revenue Manual, but it refers to office audits here for the sake of this discussion.
[3] See: www.irs.gov, “Part 4. Examining Process, Chapter 11. Examining Officers Guide, Section 29. Transfer of Returns Open for Examination,” 9/9/2013.