So You’re Being Audited, Now What?

A primary concern that all individuals and owners of closely-held businesses share is the fear of having an audit on their tax returns by a governmental authority, especially Internal Revenue Service.  This article will highlight some of the major do’s and don’ts in connection with preparing for and going through a federal tax audit.  There has been much written lately about the reduction of manpower and resources at IRS and that the possibility of having your return selected for audit is very small.  This may be true.

However, if tax files and corresponding tax returns are prepared with the expectation that they will be audited, then any qualified person can review the files, know what the sources of income and deductions are, review the underlying documents supporting those items, and read about any questionable points in the return and the reference sources used to resolve those matters. The files should be set up in the same format as the tax returns so that accessing data and reviewing the files at a later date can be accomplished easily.

Reasons for Tax Audit

Having given you the broad strokes of how to maintain a tax working paper file, let’s take a step back.  You are in the office and receive a frantic phone call from your client that a letter from IRS was received and the client’s tax return has been selected for audit.  What do you do?

• First, maintain your cool. The client has called you and is in a tense state of mind.  Your first inclination has to be to calm the client and explain that IRS has various criteria for selecting a return for audit.  A copy of the audit letter should be sent to you so it can be read and then properly explained to the client as to what IRS is requesting.
• Secondly, explain that returns are selected for audit for various reasons. These may include, but are not be limited to, the following:

1. There may be a discrepancy in the information the IRS received and what was reported on the tax return.  For example, the components of interest income listed on the tax return  may not agree with the information the IRS has with respect to your account.  It may be missing one or more Forms 1099INT or interest income reported on one or more Schedules K-1 from an estate or trust of which you are the beneficiary or from a partnership in which you are invested.
2.   The client may have reported an uncommon transaction and IRS has decided it wants to audit the transaction and the supporting documentation. An example of such a situation is when the taxpayer is involved in a bargain sale of property to a recognized charity for less than the property’s fair market value.  The IRS may be looking at the computation of the adjusted basis of the property sold to determine it was proper; or that the valuation of the property’s fair market value is supported by a properly prepared appraisal (if the complete appraisal was not included with the return); or to determine that the allocation as between the sale and the contribution is proper.
3. The taxpayer may have reported income and expenses as self-employment income on Schedule C of the income tax return and IRS may want to audit the expenses that were deducted. 

Types of Audits by IRS

Once you have received the audit letter and read it, determine what type of audit is being done.  Audits can be divided into three categories and the type of audit the client will be subjected to should be properly explained.

1. Mail Audit- In this type of audit the taxpayer is requested to submit substantiation for  one or a group of items (specific income and/or expenses) as indicated in the audit letter.
2. Office Audit-This is not too dissimilar to a mail audit in that the taxpayer (or his representative) brings documentation relating to some specific item(s) listed in the IRS audit letter.  However the audit is done on the IRS premises rather than by mail or at the office of the taxpayer’s representative.
3. Field Audit-An agent will be assigned to handle the examination either at the taxpayer’s residence or office.  The audit letter will indicate that all supporting records should be made available for review.

Kovel Letter

If the client contacted the attorney, the chances are less frequent that the lawyer had any involvement in preparing the tax return.  The obvious question is, “Why are you calling the attorney instead of your accountant who prepared your return and is most familiar with its contents?”  The answers may include, but not be limited to, any of the following:

1. The client has discontinued his association with the accountant.
2. The attorney-client privilege is stronger and more widespread regarding what the client may say to the attorney.  If the client makes statements or provides documents to the accountant, he may be compelled to divulge them no matter how incriminating.
3. The client did not tell the accountant about certain foreign transactions for that year.

If the attorney knows the accountant and is confident in the latter’s abilities, the client may be placated by having a Kovel letter executed between the attorney and the accountant.  This action results in the attorney hiring the accountant to prepare the files and respond to the tax audit.  A properly executed Kovel letter extends the attorney-client privilege to the accountant’s working papers and communications.  The accountant must remember that the attorney, not the person whose return is being audited, is now the primary client.

Response to Audit Letter

There are some basic steps that should be completed once an audit letter is received:

• While some practitioners may choose to delay responding to the audit letter and contacting the agent, a prompt reply and submitting a properly executed power of attorney helps smooth the initial contact the representative has with the agent. If a rapport can be established with the agent at an early stage it can help in learning things like why the client’s return was selected for audit, what the agent may be looking for-i.e. does the agent have information that is not in the accountant’s working paper file.

• If the representative ascertains that there is a large amount of unreported income that is in question delay may work against the client in terms of additional tax, interest and penalties that may be due. The representative will want to work quickly with the client to determine whether the agent is correct.
• Subject to getting answers for the first two points the representative will be able to better judge how much time will be needed to prepare the necessary files to respond to the agent. That determination will be the basis for finding a mutually convenient date for the field audit to commence.

Preparing the Files for Review by the Agent and Conducting the Audit

How should the files be prepared for the agent?  There are some practitioners who will present a hodgepodge of documents to the agent in the hope that it will be overwhelming. It is preferable to present the files in an orderly manner, following the way the items are presented on the tax return.  Never provide original documents to the agent.  Always make copies with the underlying assumption that the agent will want to have copies of the taxpayer’s records for future reference.  If it turns out that requested files are missing, you can either try to extend the time for commencement of the audit until the files have been located or let the agent know what is missing and that they will be provided when found.

Just as the tax preparer interprets the rules to favor the client, the agent is there to confirm that the tax law has been properly applied in the preparation of the return.  If there is more than one interpretation and you, the preparer, chose the alternative method, present your thesis in a clear, orderly manner.   Agents are not the ogres the politicians portray them to be.  They are intelligent and appreciative if you teach them something that is applicable to the case but was not covered in their training programs. At the same time do not be effusive in your answers.  Stay on point.  Provide answers in the most concise way you can and if you must expand an explanation keep it brief and limit the reply to the facts that are necessary to clarify your point.

Conduct the audit in your office not at the taxpayer’s home or office.  Since the client executed a power of attorney you are authorized to speak for your client. Having the client at the audit cannot help you because of the possibility the individual will make a comment that will compromise the strategy you may be using to defend a tax position.  It also makes it easier for the agent to potentially ask the client a question and get a response before you can stop your client from speaking.

These foregoing pointers are not all-inclusive.  Today taxpayers file their returns electronically.  Some taxpayers have a preference to paper-file their returns or to file pursuant to an extension because they heard that the chances of being audited were less if the returns were filed using one of those alternatives.  This is not necessarily true.  If returns are filed pursuant to an extension, the full payment of any balance of tax is due with the extension.  The extension is not a delay in paying the tax; it is only a deferral of time to file the tax return.

Be aware of your rights when representing a client at an audit.  If you are inexperienced review the Taxpayer Bill of Rights prior to the audit.  If there is a question that has been raised by the agent for which you are unsure of how to respond, don’t answer at the moment but put it on a list to follow up with the client or a colleague and then reply to the agent at a second meeting, either by phone or in writing (if exhibits are required).

Conclusion

Don’t argue the tax because that is the result of the matters that have been disallowed.  Focus on the issues and defending your positions.  Lastly, if you seem not to be able to come to an agreement, you can always request a meeting with the agent’s supervisor to determine if a compromise can be reached.  The last resort, which is strictly a financial decision and is generally used when significant amounts of money are involved, is whether to go to Tax Court.  That is a step not to be done without consulting with your client and, potentially, your legal and tax counsel(s).

 

 

Biography:  I. Jay Safier, CPA,CGMA, CFF is a professional mediator and the owner of Safier Mediation Center, LLC.  He is an R.1:40 qualified mediator on the New Jersey Superior Court’s Roster of Mediators for Civil, General Equity and  Probate Cases and a member of the New Jersey Association of Professional Mediators.

He can be contacted either through his website or by e-mail as follows:

Website:  www.safiermediation.com

E-mail:  jay@safiermediation.com