IRS Audit and IRS Audit Appeal Overview
What Is an IRS Audit?
Individual Americans are required to file a tax return each year disclosing income to the Government (IRS). The return is used to calculate tax on income earned. If the income/credits/deductions on the return are incorrect the tax amount is incorrect.
In an effort to prevent this, the IRS engages in the “examination” of certain tax returns. These examinations are commonly called “audits”. The audit allows the IRS employee to review the taxpayer's records, statements, and other information to determine accuracy and issue a report with changes and adjusted debt amounts.
Most audits of individual tax returns are focused on whether the income is correctly disclosed and other items which may be unusual or large. The individual audit typically doesn't require a review of the entire tax return.
3 TYPES OF AUDITS - There are 3 kinds of audits. A mail or “correspondence” audit. a “field audit”, and an “office” audit. Mail Audits are as they sound. The audit is conducted in writing by mail (sometimes fax). The other two are “face to face”, are more complex and can be more serious in terms of potential negative outcomes for the taxpayer. For the 2018 tax year, the IRS conducted more than 900,000 audits, most of which were mail audits, and most mail audits were caused by issues related to the IRS earned income tax credit. The vast majority of audits of all types end up with changes to the tax return. Any changes that add debt result in IRS assessment of penalties.
AUDIT PENALTIES - The most common civil penalties are the 20% accuracy penalty and the failure to pay penalty added on in relation to the increased debt amount. A more serious 75% civil fraud penalty can be applied to the debt when the IRS feels that “fraud” played a role in the missing/incorrect information on the return. More often than taxpayers realize, the IRS auditor will send cases to be reviewed for criminal tax evasion as well.
AUDIT TIMEFRAMES - Audits can take as little as a few months to resolve and as long as a few years to resolve. This discrepancy in time-frames is mostly related to the type of audit, who is handling the audit, how well the taxpayer responds/provides information, and whether the audit decision is appealed.
An IRS Audit Must Follow “Procedural Rules”
Rules require that the taxpayer is provided time to provide information, documentation and other evidence to support the numbers on the tax return. When changes are proposed by the IRS at the end of the audit, the same set of rules provides the taxpayer the ability to file an “appeal” both the IRS Office of Appeals and to the U.S. Tax Court. There are a number of other rules and rulings that define what constitutes evidence, timeframes and other issues.
Appealing the Proposed Audit Adjustment
MANAGER CONFERENCE/INFORMAL - The taxpayer can ask to meet with the Auditor's manager and have the manager review any items of disagreement.
INDEPENDENT APPEAL - At the conclusion of an audit and after the auditor has issued a set of proposed changes with explanation, the taxpayer can ask the IRS for an appeal hearing with an IRS Appeals Officer who is held out by the IRS as “independent”. This appeal request must be submitted within 30 days.
U.S. TAX COURT - The IRS will issue a “Statutory Notice of Deficiency” Letter (Letter 3219) after a final decision is reached. This letter is the IRS' invitation to the taxpayer to file a petition with the U.S. Tax Court. The petition must be filed properly and within 90 days of the date of the letter with no exceptions.
Challenging the Result when No Appeal Filed Timely
CLAIM FOR REFUND - Refund claims can be brought by a taxpayer after the amount of the audit assessment is paid, applied for a refund and been denied. This type of case allows the taxpayer to argue the audit results in U.S. District Court when the Tax Court petition date was missed.
AUDIT RECONSIDERATION - The IRS rules provide the taxpayer the ability to ask for a review of the audit even if the Tax Court deadline was missed. If the taxpayer didn't take part in the audit process, didn't receive the audit report, has new information, or just disagrees with specific items related to the audit, he or she can ask the IRS to review the decision in what can be a lengthy process.
OFFER IN COMPROMISE BASED ON DOUBT AS TO LIABILITY - When the taxpayer has additional information that would clearly change the audit result, a formal request for re-consideration can be made as an Offer in Compromise. This process is different from the “Audit Reconsideration” process primarily because the request must follow the IRS' Offer in Compromise rules, an actual offer to settle must be made and other formalities followed if the Offer is accepted.
Mail Audit Resolution Steps
The vast majority of IRS Audits are “mail” audits. These types of audits can be conducted without meeting an IRS officer but they have strict rules and deadlines. The following are steps the taxpayer can take to help arrive at the best outcome.
REVIEW THE IRS CORRESPONDENCE CLOSELY - The letter sent will contain the year(s) being audited, the items begin audited and it will provide the deadline date to respond that shouldn't be missed.
RESPONSE SHOULD BE CREATED WITH FULL EXPLANATION OF EACH ITEM - The cover letter to the response should contain areas of agreement and disagreement. The Audit Letter should be attached. A summary of each issue with supporting documents and breakdowns should be provided. Penalties should be addressed in the cover letter as well as a request for an appeal should the IRS disagree with all or part of the response.
Evidence Reconstruction Note - When no evidence exists, the taxpayer should specifically list the items that make up the expense and provide an explanation/overview about how the number was calculated based on those items. It often helps to locate records from business', insurance companies, and any other source that can provide any history related to the expense. It helps to provide information/proof about comparable business' in a schedule C audit and the expenses that comparable business' in the taxpayer's industry have as a percentage of income.
KEEP COPIES OF ALL DOCUMENTS - Don't send originals of any documents to the IRS. This includes receipts, billing statements, checks and other proof documents.
RESPOND TIMELY - Failure to respond timely will result in an assessment of debt based on the assumption that there isn't any proof to substantiate the items requested. The burden of proof is on the taxpayer.
REVIEW THE AUDIT RESULT CLOSELY AND ACCEPT OR APPEAL - The IRS should produce an Audit Report (typically on form 4549) and an explanation of the adjustments (typically on form 886-A). If the taxpayer agrees with the result, he or she can simply sign the form and return it to the address requested. If the taxpayer disagrees then the appeal process mentioned above can take place. Manager review, Internal Appeal review, Tax Court Review.
In-Person Audit Resolution Steps
A minority of IRS Audits are “in-person” office or field audits. These types of audits are usually conducted by a local IRS officer and are more serious and often more detailed than an IRS Mail Audit. The following are steps the taxpayer can take to help arrive at the best outcome.
REVIEW THE IRS CORRESPONDENCE CLOSELY - The auditor should supply a list of the year(s) and items being audited. This initial correspondence should also contain deadline(s) that should be followed if possible.
SUPPLYING INFORMATION - Once it's clear which items from the return are being audited it's best to do the following:
Reconcile Income - The income on the IRS records, from bank statements and what is on the return should be “reconciled” in writing. This allows the taxpayer to provide a clear breakdown of it for the auditor and it also allows for any problems to be spotted ahead of the audit interview.
Gather proof re other items - It's best to have as much information as possible for purposes of proving deductions and expenses. If a category in a schedule C for instance shows that the taxpayer paid 14,543.00 in advertising expenses for the year, it's best to not only locate those expenses in the bank statement that add up to that number, and make a list with dates/amounts and payee, but it's also best to locate the coordinating proof of each expense, invoices, receipts, etc. and make a list of those items as well.
PREPARE FOR INITIAL AUDIT MEETING - It's important to have all of the income and expense information that has been specifically requested, organized and ready to be reviewed with the auditor in person. Questions about discrepancies should be considered and the taxpayer should be prepared to provide a truthful explanation.
Evidence Reconstruction Note - When no evidence exists, the taxpayer can list the items that make up the expense and provide an explanation/overview about how the number was calculated based on those items. It often helps to locate records from business', insurance companies, and any other source that can provide any history related to the expense. It helps to provide information/proof about comparable business' in a schedule C audit and the expenses that comparable business' in the taxpayer's industry have as a percentage of income.
Note Re: Hiring Help - Many office/field IRS audits are handled by the taxpayer's attorney, CPA, or enrolled agent as it can help to have experience and an objective eye in putting evidence together, spotting issues, presenting evidence etc. The cost is usually far outweighed by the costs and headaches related to an audit that results in disallowance of expenses that were actually paid, overstatement of taxable income and other issues.
AUDIT MEETING - In-person audits and field audits are again, face to face. The auditor will review the issues, ask questions, review documents, and contemplate penalty assessment. The auditor may ask for more information, another meeting, or the auditor may finalize the audit and issue a report.
CLOSE AUDIT AND APPEAL - Once the auditor feels that the relevant issues are resolved and the audit report is issued, the taxpayer can ask for a meeting with the auditor and the auditor's manager. If no satisfactory agreement is reached, the taxpayer will have a chance to file an appeal with the IRS appeals office and then a petition to Tax Court.