IRS Audit Overview
ESSENTIAL ELEMENTS OF THE IRS EXAMINATION
Most taxpayers are far from happy upon receiving a tax audit notice from the IRS. However, you can get relief through retaining IRS tax audit representation services in all states. Whether you’re self-employed, a small business or corporate owner, you have a right to representation in tax-related matters.
IRS auditors sift through tax returns to ensure accuracy. If red flags are identified in your tax return, they can demand documentation supporting your claim. Without tax audit representation, you may pay additional taxes in addition to interest and penalties which can add up quickly.
What is the difference between an IRS examination vs audit?
Many taxpayers use the words IRS examination and audit interchangeably, but there are differences. While both require positive assurance and independence, they differ from one another.
The IRS tax examination involves evaluating a company or an individual’s non-historical information on finances. An audit focuses on historical financial information required to verify information on tax returns. Furthermore, tax examinations undergo Standards for Attestation Engagements.
For example, the commissioner compares information, samples them randomly, or goes through a discriminant function system to determine which taxpayers to audit. The discriminant system is the Internal Revenue Service’s computerized method for scoring tax returns for individuals.
If your score rating is high, your documents go through a manual review by an examination agent to determine the need for an audit. You may get a letter of invitation to visit the local IRS office for another review after this process.
Remember that the audit’s nature determines the tax examination location while you get a notice specifying areas that require verification. Bank deposit records, financial statements, and total income are likely areas the IRS wants to examine for discrepancies.
If there is a red flag in your documentation, the commissioner may scrutinize you during the examination. The commission has three years to decide the number of mistakes in your documents, and if discrepancies exceed 25%, the IRS can examine your return for six years.
Opening conference
An audit begins with a contact letter from the IRS scheduling an opening conference. At the outset of the examination, the IRS will issue three IDRs asking for three things: general books and records; disclosure of any tax shelter transactions; and any transfer pricing studies you may have performed. From there, the IRS will determine the scope of the audit, the time frame and which issues they will look at.
In the contact letter, the IRS agent handling your case will propose a time for an opening conference. This meeting will include the lead revenue agent, team manager and any IRS specialists involved. It’s an important point in the process during which you will be able to set expectations and develop a working relationship with the IRS team. You can expect these officials to discuss what to expect: the procedures for conducting the examination, expectations on the exchange of information, target dates for completing the field examination and the issuance of any Notice of Proposed adjustments. For your part, be prepared to present an overview of your business operations and to discuss the timing of the audit.
Before the opening conference, review the return in question to identify any issues that might be conceded in order to avoid a penalty. At the outset of the examination, the IRS will generally permit taxpayers to provide the IRS with agreed adjustments. Under Rev. Proc. 94-69, you have a short window to square these up—things like computational errors—without triggering the accuracy-related penalty.
Information document requests
Before the opening conference, the IRS will issue preliminary IDRs requesting basic financial information, transfer pricing documentation (if applicable) and answers about any reportable transactions you may have entered into. The responses to these IDRs should be ready by the time of the opening conference.
After analyzing the preliminary data, the IRS will shift to so-called “issue focused IDRs” which each pertain to a specific issue. New IRS procedures require the examiner to issue an IDR in draft form first. This allows you to discuss it with the agent, gather the proper documentation and agree on a timeline for your response.
Once the details have been squared away, you will be required to stick to the agreed-upon schedule. Failure to respond in a timely fashion can trigger enforcement procedures.
Proposed adjustments
Once the revenue agent handling your case has completed their field examination, each potential issue they have found will be presented to you in what is called a Notice of Proposed Adjustment, or Form 5701. It details the applicable legal authorities under which the action is proceeding, the IRS rationale for the proposed adjustment and the taxpayer’s position, if known. You’ll be given three choices:
- Agree with the proposed adjustment
- Disagree with the proposed adjustment
- Present additional information that might help resolve the issue
The Notice of Proposed Adjustment can be quite helpful as it provides the IRS’s view of the facts and its analysis of the issue. With this information, you can prepare a tight, focused response to correct any misunderstandings of the facts, explain your position and present any additional legal authorities to support your case.
Resolution options
Even if you find yourself and the IRS at loggerheads, there are still several ways to move your case toward a resolution.
Industry practice groups
The IRS has established industry practice groups (IPGs) that informally advise IRS examiners on industry-specific issues. Getting an IPG to bring in IRS personnel who are familiar with the industry and the issue involved may help.
Technical advice
For issues involving a technical interpretation of a rule or regulation, you can ask that the issue be considered by IRS Chief Counsel through the technical advice process. Technical advice is at the discretion of the IRS, but for purely technical (not factual) issues, the IRS examiner may be inclined to go this route.
Fast Track Settlement
The IRS has instituted a dispute resolution technique called Fast Track Settlement (FTS), which tries to resolve cases at the examination level when there are a limited number of issues. If you request that your case be fast tracked, an IRS appeals officer will be assigned to act as a mediator
between you and the IRS exam team to try to resolve the issues. It can save a lot of time; most FTS cases are resolved within 120 days.
30-day letter
If a case can’t be resolved at the examination level, taxpayers have the option of escalating to IRS Office of Appeals (Appeals). The examiner will issue a 30-day letter detailing the IRS’s position and will propose a tax deficiency. You will then have 30 days to protest the IRS position, in writing, and request Appeals’ consideration.
Settlement consideration
Deciding to settle or contest the IRS examination results requires strategy as well as resources. For example, a recurring issue such as depreciation may be something needing to be addressed in a closing agreement. An issue that involves accounting methods may be reserved for IRS Appeals, which has greater flexibility to fashion a settlement.
Any settlement of the IRS examination will have ramifications for both state tax liability and the filing of amended returns. Thus, state tax filings play an important role in the strategy and timing of a settlement. Once an IRS exam is settled, there’s a limited period during which you may file amended state returns reflecting the agreed adjustments. By settling some issues related to the IRS exam now, and settling some later, you may be saddled with having to file two sets of amended state returns.