Audit Representation During Audit

By: Robert E. McKenzie ©2011

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SEE ALSO  THE IRS AUDIT SYSTEM & WHO GETS AUDITED BY THE IRS

2.10 Preparation is essential to successfully representing your client during audit. The better you prepare for an audit the better the ultimate result for your client..

2.20 Generally, any attorney or CPA may represent clients before the IRS. Individuals who are not CPA’s may apply to the IRS for “enrolled” status (enrolled agents) which also enables them to practice before the IRS.

Establishing Representation

2.30 The initial contact with a prospective client will often determine whether or not you will be hired. A prospective client can be quite upset that the IRS intends to conduct an audit and looks to a professional such as yourself who can defend his interests. To many taxpayers, the IRS is feared rather than respected, and the client will often need the assurance that should come from a professional. Your goal during the initial contact should be to gain the taxpayer’s confidence and to make an appointment as quickly as possible for an initial interview prior to the audit.

Initial Interview
2.40
Many tax controversies are better resolved sooner rather than later. Accordingly, it is often to your client’s advantage for you to begin work on the case promptly. Your first goal should be to accurately gather the necessary information. You must control this information gathering process. Otherwise, the client will often inundate you with reams of useless information while neglecting to hand over truly important documents. The initial interview with the client is an important step in your preparation for audit.

What Client Should Provide Prior to Interview
2.50
You should ask the client to provide the following items before your interview:

1. All correspondence, notices, reports, etc., from the IRS to your client;

2. Tax returns for the relevant years, generally the year in question and the two prior years;

3. All correspondence, etc., from the taxpayer or previous representative to the IRS. Be sure to ask for correspondence concerning prior tax years if the issues are similar.

4. Issue-related documentation such as receipts, books and records.

Examining correspondence from the IRS enables you to spot the important issues facing your client. You can use that information to do some preliminary research before the interview. You should determine whether the matter is in audit (correspondence, office or field), appeals, Tax Court or collection. One of the most significant pieces of information on some IRS correspondence is the name of the IRS employee handling the file. It is always preferable to deal with a human as opposed to the error-prone IRS computer system or the IRS telephone system. IRS correspondence can also alert you to important time deadlines such as a 30-day letter, 90-day letter, or a Notice of Intent to Levy. Tax returns are, of course, absolutely necessary. In most field audits, the examiner will have looked at the tax return at issue as well as the two prior years. To avoid surprises, you should do the same. In some cases, the taxpayer has an unsigned copy of the return, but no evidence of when the return was actually filed. Reviewing prior correspondence with the IRS is another way to avoid nasty surprises such as unknown concessions, admissions, or stipulations by the taxpayer. Prior correspondence is also sometimes useful in persuading the IRS to abate penalties. Finally, you must ask for specific documents which relate to the taxpayer’s audit issues. For example, if the issue is unreported income in a restaurant, you will want the cash register receipts and waiter checks.

PRACTICE TIP

Many tax controversies have been won or lost depending upon the documents uncovered by a taxpayer’s representative. You want to be in control of the documents.

What You Should Discuss with Your Client

2.60 While the client is likely to complain about the IRS during your interview, other items for discussion might not come up unless you initiate the topic. These issues include:

* Scope of representation;
* The merits of your client’s position and audit strategy;
* Fees for your services;
* Contingent fees;
* Power of Attorney or Declaration of Representative;
* Burden of proof
* Additional documents you should obtain;
* Document retention and destruction systems; and,
* Contact between your client and the IRS.

Scope of Representation

2.70 You should agree with the client exactly concerning what services you will provide. You should specify the type of tax or penalty involved and the tax year involved. Make it clear that you are not yet representing the client in other matters.

PRACTICE TIP

Malpractice suits against enrolled agents, accountants, lawyers and other professionals are at an all time high. Protect yourself and your client from mistakes by carefully agreeing as to the scope of representation. Always follow up with an engagement letter.

Merits of Your Client’s Position and Audit Strategy

2.80 Rule No. 1: Be honest with your clients! They already understand that they are in trouble. Don’t compound their disappointment by giving them false hope of success. The client will appreciate an honest (and accurate) appraisal. Rule No. 2: Don’t be rushed! If the situation will require some research and thought before you can give an appraisal, tell them so! Admitting that you are uncertain doesn’t demonstrate weakness but is actually the mark of a professional. You should also discuss with your client the audit strategies which may be pursued. Some possibilities include:

* Cooperative: Provide what the Agent wants and attempt to control the audit;

* Confrontational: Battle the Agent at every step, requiring summonses and frequently appealing the Agent’s decisions to the IRS Group Manager;

* Reactive: A wait-and-see approach; and

* Proactive: Aggressively proposing settlements and advocating positions to the Agent.

Most practitioners avoid the confrontational strategy until other approaches are exhausted.

Power of Attorney or Declaration of Representative

2.90 At the initial interview, you should get the client to sign a Form 2848, Power of Attorney or Declaration of Representative. The Power of Attorney allows you to contact the IRS on the taxpayer’s behalf. When received, the IRS enters the Power of Attorney into its nationwide computer system. IRS personnel are instructed not to talk to you about a client unless a Power of Attorney is on file. In addition, with a Power of Attorney on file, you can instruct the IRS examiner not to talk to your client without your permission. The IRS must honor this request, unless the representative is so uncooperative that the IRS successfully adopts the representative by-pass procedure (quite rare) or issues an administrative summonses. Even if an administrative summonses is issued, you still have the right to appear with your client.

PRACTICE TIP

To avoid delays, always send a copy of the Power of Attorney to each IRS employee during your first contact with that person. Otherwise, the Power of Attorney may not have been entered into the computer properly and you may be delayed several days before you can mail a new copy to the appropriate IRS official.

Burden of Proof

2.100 Under prior law, there is a rebuttable presumption that IRS’s determination of tax liability is correct, and therefore (with some exceptions such as fraud), the burden of proof is on the taxpayer to show that the IRS’s determination was wrong, and to show the merit of his or her claims by a preponderance of evidence. RRA ‘98 provides that the Secretary shall have the burden of proof in any court proceeding with respect to a factual issue related to income, estate, gift, and generation-skipping transfer taxes if the taxpayer introduces credible evidence relevant to ascertaining the taxpayer’s income tax liability. To be eligible, the taxpayer must prove that he or she:

* has complied with present-law statutory and regulatory substantiation requirements of any item,

* has met present-law record-keeping requirements;

* has cooperated with reasonable IRS requests for meetings, interviews, witnesses, documents, and information; and

* met the net worth limitations if not an individual, (i.e., qualifies under net worth limitations for awarding attorneys’ fees such as a corporation, trust, or partnership, whose net worth does not exceed $7 million). Therefore, corporations, trusts, and partnerships whose net worth exceeds $7 million aren’t eligible to shift the burden of proof (Act §3001(a); Code §7491(a)).

Additional Documents You Should Obtain

2.110 One advantage of reviewing the client’s documents prior to your interview is that it enables you to locate the gaps in the records. For example, if the client produces a shoebox full of receipts for Schedule A itemized deductions but no mortgage interest statement is found, you will be able to ask your client to obtain one from her bank. Similarly, W-2′s and other information statements can be obtained from the employer. Audit reports, Revenue Agent Reports, Tax Returns, Information Document Requests and Notices of Deficiency can be obtained from the IRS Agent, employee or Compliance Center if the taxpayer failed to keep copies. All of these documents can contain vital information which you should examine thoroughly.

Document Retention and Destruction Systems

2.120 Most taxpayers destroy tax documents after a few years. Larger corporations establish document retention and destruction systems to regulate this process. Taxpayers with assets in excess of $10 million are required by (and some taxpayers with assets under $10 million which keep certain records only on a computer) Revenue Procedure 91-59 to retain all relevant machine-sensible files, and to keep such files and computer records available for the IRS in a useful way {Rev Proc 91-59, 1991-2CB 841]. Alternatively, the taxpayer may enter into a record retention agreement with the IRS. Whether or not your client has such a system, you should sternly advise your client to immediately recover and retain any documents which might be even remotely relevant. For example, one corporation failed to retain accounting work papers which documented certain multi-million dollar items on its returns. Without proof as to the method of calculation, the point was eventually conceded to the IRS. It is your professional duty at an early stage to ensure that the client retains all potentially relevant documents.

Contact Between Your Client and IRS

2.130 Often the IRS will attempt to get information from your client even after a Power of Attorney is filed. This is improper and may damage your client’s case severely. Advise your client to simply refer the IRS to you and to volunteer nothing. You should decide if and when the IRS can interview your client. Under the Taxpayers Bill of Rights, the taxpayer need not appear unless a summons is issued [IRC Sec. 7521 (c)]. If an IRS employee continues to contact your client directly, call his manager to report the improper conduct.

PRACTICE TIP

You should take every step to ensure that there is no unsupervised contact between the IRS examiner and your client. Unless the IRS examiner uses the representative by-pass procedure (very rare), you are the gatekeeper to the client.

Requesting Documents from IRS

2.140 The IRS possesses numerous documents which might be useful to your client. Your client might have been audited in prior years, or you may have been hired after the audit is already underway. Documents which you should obtain include:

* Tax returns or refund claims;
* The Initial Notice of Audit;
* Information Document Requests (IDRs) or Administrative Summonses;
* Notices of Proposed Adjustments;
* Agent work papers;
* Audit letters, Audit Reports or Revenue Agents Reports (30-day letter);
* Field Service Advice;
* Any relevant audit guidelines;
* Notices of Deficiency (90-day letter);
* Tax Court petitions, documents or decisions; and
* Tax account information.

Finding Out What They Really Want

2.150 One primary goal of your pre-audit investigation is to find out what the IRS is looking for. This will help you prepare more effectively and will save your time and your client’s money. If the case is a simple one–a single-issue mail audit, for example–you don’t need to prepare for a full-blown audit. Conversely, you don’t want to be under prepared and surprised when the Agent arrives.

Preparing for Audit Interview

2.160 Even though you have identified likely audit issues and have assembled the relevant records, you are not yet ready for the audit. Before the audit begins you should:

* Prepare document summaries;
* Examine the statute of limitations;
* Research the applicable law;
* Evaluation of the client’s position; and
* Discuss settlement with the client.

2.170 If the case involves a large number of documents, it is often advantageous to prepare summaries. For example, you can transform the proverbial shoebox of receipts into a legible schedule of itemized expenses. These summaries often help you to understand the strengths and weaknesses of your client’s case. In certain circumstances, you might want to provide these summaries to the IRS.

PRACTICE TIP

Be very careful about providing summaries to the IRS. You don’t want to provide a road map for the Agent’s audit. On the other hand, a well done summary could secure an early victory.

Examine Statute of Limitations

2.180 Generally, the IRS cannot assess a tax after three years have elapsed from the later of the due date of the return or the date the return was actually filed. Absent fraud, failure to file, substantial omissions or other similar circumstances, the IRS cannot assess tax after the three-year statute of limitations has expired. An example might be helpful.

EXAMPLE 1. Lackluster Video accounts on a fiscal year ending September 30. The tax return is due two-and one-half months later, or December 15. Lackluster filed its 1999 tax return after a six-month extension, on June 15, 200. The statute of limitations for assessment of income tax expires on June 15, 2003.

If the statute of limitations has expired, inform the Agent and in most cases the audit will be over once the fact is confirmed. If the statute is expiring soon, you are under no obligation to warn the Agent. If the Agent discovers the problem, he will request an extension of the statute of limitations.

Research Applicable Law

2.190 Once you have identified the likely audit issues, you can research the law. The Internal Revenue Code and Regulations are always good places to start, followed by one or more of the tax services (Mertens, CCH, RIA, or BNA Portfolios). Articles in various tax magazines might also prove useful. These sources can be used to identify leading cases and IRS pronouncements which discuss your issues.

PRACTICE TIP

Mistakes are often made when non-lawyers attempt legal research, just as lawyers who review financial statements can overlook important points. A tax professional should not hesitate to week appropriate advice when extensive legal research is required.

Suspension of Interest and Certain Penalties Where IRS Fails to Contact Individual Taxpayer

2.200 Under prior law, interest and penalties on unpaid taxes generally accrued whether or not the taxpayer was aware that any tax was due. The IRS Restructuring Act suspends the accrual of penalties and interest after one year (18 months for taxable years beginning before January 1, 2004) if the IRS fails to send to the taxpayer, who timely files the return, a notice of deficiency within one year (or 18 months) beginning on the later of: (1) the original due date of the return, or (2) the date on which the individual taxpayer filed the return. Interest and penalties resume 21 days after the IRS sends a notice and demand for payment to the taxpayer. The subsection applies separately for each item or adjustment. It does not apply if the taxpayer has self-assessed the tax (§3305; new Code §6404(g); effective for taxable years ending after July 22, 1998).

Using the Internal Revenue Manual

2.210 The Internal Revenue Manual (the “IRM”) is thousands of pages long.. The IRM describes many policies, procedures and guidelines which must be followed by the IRS. While the IRM may not be binding upon the IRS in court proceedings, as a practical matter, if you can point to a favorable provision of the IRM (and the Agent a copy), the Agent will in all probability conform to the IRM. If not, a gentle nod towards the Agent’s group manager will probably do the trick. Of course, this strategy requires a little research into one of the most dense and difficult documents ever written: “The Internal Revenue Manual.”

Evaluate Client’s Case

2.220 Weighing all the possibilities, what are the client’s chances of success? This evaluative skill comes mainly with experience, but there are some steps which can aid in the process:

* Determine dollar values for each issue in the case;
* Determine a percentage chance of success on each issue;
* Consider the costs and risks of contesting each issue; and
* Consider which issues the IRS is likely to concede.

With these considerations in mind, you can come to a reasoned judgment as to the probability of success of each issue facing your client and your client can determine whether the issue is worth fighting, given the costs and risks involved.

Discuss Settlement Possibilities With Client

2.230 You should discuss the probabilities of success on each issue with your client so that he will be inclined to settle certain issues if the need arises. Once you have settlement authority on an issue, you can negotiate appropriately with the IRS.

The Audit

2.240 The Agent will Schedule a time and place for the audit. If the time or place is inconvenient, or if your preparations are incomplete, try to reschedule as soon as possible. The Agent will usually accommodate a reasonable request.

Where Should the Audit Be

2.250 One major theme of the Economic Reality training for IRS examiners is that the audit should take place at the taxpayer’s place of business. The IRS wants to be able to look around (some would say snoop); talk to other people at the client’s place at business; look at signs of unreported income; and generally develop first-hand of the situation and documents. Anything the IRS examiner finds can lead to additional taxes owed by your client. The IRS examiner will accept an audit at the representative’s business if you can demonstrate some of the following:

* The records are not available at the taxpayer’s place of business;
* You have first-hand knowledge of the business and all of the relevant documents in your office; and
* Some hardship will occur if the audit is at the taxpayer’s place of business (i.e., no air conditioned office is available; the taxpayer is out of town; etc.). According to the Economic Reality training materials, the IRS examiner will need a supervisor’s approval to hold a field audit in any location other than the taxpayer’s place of business.

Should Taxpayer Be at Audit

2.260 Generally, no. The taxpayer is quite likely to volunteer additional information that you may or may not want to disclose. The Taxpayer Bill of Rights generally allows a taxpayer to send a representative to an audit in his place. If the IRS issues an Administrative Summons, the taxpayer must appear. In some situations, you will want to make your client available to the IRS to answer some questions. The new Economic Reality training recently received by all IRS examiners emphasizes actual contact with the taxpayer. In order to keep the taxpayer out of the examiner’s presence, you must have detailed knowledge of the relevant facts and business records. If the representative is unable to answer important questions based upon lack of knowledge, the IRS examiner will push for a personal interview, using the administrative summons if necessary.

Your Role in Audit

2.270 Your goal is to get your client through the audit process with the least possible cost. Any legitimate means to achieve that end should be considered. Your role is to coordinate the audit and to provide the necessary information to the Agent to achieve that goal. Your conduct during the audit is more a matter of personal style–some prefer a laid-back approach, passively responding to the Agents’ questions. Others prefer an aggressive approach, persuasively arguing with the Agent the merits of your client’s position. The details hardly matter, as long as you choose a style which is natural and effective for you.

Establishing Trust and Competence

2.280 If the Agent trusts your integrity and believes you to be competent in your knowledge of taxes, then he is more likely to settle issues in the case in a mutually satisfactory manner. Facts should be carefully and honestly stated. Misrepresentations will earn the wrath of the Agent–a very dangerous proposition! Competence can be demonstrated by appropriate discussions of the legal and account requirements of the tax laws. Your goal is not to impress the Agent, but rather to establish yourself as a peer–a competent, honest tax professional.

Identification of Audit Issues

2.290 The Agent will often identify the audit issues. The author prefers to generally allow the Agent to identify the issues. Otherwise, your might unwittingly disclose a new issue to the Agent. The only exception to this rule is when you are aware of an issue which will entitle your client to a refund. In that case, you must highlight this issue as a bargaining chip during the negotiation process.

Referral to Another Professional

2.300 At some point, you might need to refer the case to another professional, either a CPA firm with more experience in the field or a law firm with specialists in tax litigation. Either way you should place your client’s interest above your own short-term success. Understanding your limits and referring cases in appropriate situations will only enhance your professional reputation.

Settlement of Audit Issues

2.310 Your should attempt to settle audit issues whether or not you believe the settlement will succeed. Basis for settlements at audit include factual and legal disputes. The Agent is not authorized to settle audit issues based upon collectability and hazards of litigation. The IRS has also developed several mediation programs which could be explored as a possible route to settlement.

Initiating Settlement Discussions

2.320 Generally, you must initiate settlement discussions. IRS employees will usually wait for you to bring up the subject.

Settlement Methods

2.330 The actual method of settlement can vary. The simplest is issue-trading: The IRS concedes one issue while you concede another. The IRS often concedes penalties in this manner. A second method is a percentage settlement, whereby the IRS concedes a percentage of an issue while you concede the remainder. When a multiple-year audit is being conducted, sometimes the same issue can be settled differently in separate years. Finally, settlement may simply stipulate the tax owed by the taxpayer without further explanation.

Settlement Offers

2.340 Once you or the IRS have mentioned a settlement offer, you have established a settlement range. Try to get the IRS Agent to make a settlement offer first–that way, you won’t offer less than the IRS is willing to accept.

Standard Settlements

2.350 In some cases, notably tax shelters, the IRS has devised standard settlements. The Agent cannot depart from this standard, absent unusual circumstances. The typical tax shelter settlement is for the IRS to waive some penalties and allow the taxpayer a deduction only for out-of-pocket expenditures. If you wish to challenge a standard settlement, do not expect much cooperation from the IRS. Your case will end up in Tax Court.

Settlement Agreements

2.360 Settlement of docketed Tax Court cases is reflected in a written stipulation of the parties, which then must be accepted by a Tax Court Judge. If it is signed and filed by the Judge, it becomes the judgment of the Tax Court. Non-docketed case settlements, however, must be reflected in one of two IRS forms which the taxpayer is asked to sign: Form 870 or 870-AD.

Form 870

2.370 Form 870 is a waiver of restrictions on assessment. It is also used to accept over-assessments. The intended effect of Form 870 is to allow the taxpayer to pay the deficiency, stop the running of interest, and give up the right to go to Tax Court. It is not, by definition, a binding Closing Agreement. As a result, the IRS can assert further deficiencies and/or the taxpayer can file a refund suit even when Form 870 is used. The language of Form 870 permits reopening of issues, by either the taxpayer or the IRS. Therefore, if a taxpayer requests to sign a Form 870, the IRS is on notice that finality is not contemplated. Form 870 is intended to be an informal settlement and is rarely reversed. It is really a “gentleman’s agreement” which lets the statute of limitations run out on refund claims or further deficiencies.

Form 870-AD

2.380 Form 870-AD is practically a closing agreement. The Regulations and Form 870-AD try to make settlement final by providing for the taxpayer’s prompt payment of the deficiency, and an agreement not to file suit for a refund or to make an offer in compromise. Additionally, Form 870-AD omits any statement that the government can assert further deficiencies. And while the Form 870 becomes effective when it is received, Form 870-AD must be accepted by or on behalf of the Commissioner before it becomes effective. The 870-AD also says the taxpayer will sign a closing agreement (which is binding) if asked to, and that the IRS will not reopen the case unless there is fraud, misrepresentation of a material fact or malfeasance.

2.390 While it appears that the Form 870-AD is a final agreement., there is a split in the Courts on the matter. The Ninth Court in 1987 held that Form 870-AD is not a binding settlement agreement. The Third, Sixth, Seventh and Eighth Circuits, however, allow subsequent refund claims to be filed, even after Form 870-AD has been signed and accepted. The Second, Tenth and Federal Circuits take a different approach and only allow closing agreements for settlement of tax controversies.

Closing Agreements

2.400 Taxpayers seeking finality in their settlement agreements with the IRS should attempt to use a closing agreement. While both Form 870 and Form 870-AD are administrative devices, the closing agreement is expressly provided for by statute in IRC § 7121. As such, closing agreements are the only agreements the Code recognizes as binding on the IRS, absent fraud or misrepresentation.

Characteristics of Closing Agreements; Finality

2.410 Basically, the closing agreement is a statutory agreement between the taxpayer (or a person acting for the taxpayer) and the IRS which fixes liability and prevents the re-opening of a settlement with respect to part or all of the liability in a particular matter. It is not governed by contract law. Even the parties themselves may not cancel or rescind it. Agreements on particular matters as to taxable years ending prior to or at the date of the closing agreement are not affected by subsequent retroactive legislation, if the legislation is silent as to the effect on closing agreements. The closing agreement only determines matters which are stated in it. For example, a closing agreement which only determines tax liability does not also by implication determine the taxpayer’s stated gross income for the same taxable year.

When Closing Agreements May Be Used

2.420 Taxpayers who insist on the finality of a closing agreement need to persuade the Appeals Officer that the government will sustain no disadvantage if a closing agreement is used and must show good and sufficient reasons for the agreement. Closing agreements may be requested by the IRS or the taxpayer in a ruling situation. Alternatively, they may be used to clear up a tax matter where a non-tax consideration hinges on the tax consequence of it (for example, a taxpayer wants to complete a sale of stock). In the Appeals situation, a valid reason for entering into a closing agreement is simply the taxpayer’s wish to conclusively clear up a controversy he or she has with the IRS.

Closing Agreement Forms

2.430 There are three closing agreement forms: Form 866, Form 906, and the combined agreement. Either the taxpayer and his representative or the IRS will draft the closing agreement.

Form 866

2.440 Form 866 is entitled “Agreement as to Final Determination of Tax Liability”. This form determines the tax and liability for each period and type of tax listed in the agreement.

Form 906

2.450 Form 906 is entitled “Closing Agreement on Final Determination Covering Specific Matters”. This form would be used, for example, where the parties are unable to agree on an unqualified liability figure and may want to resort to a determination of taxable income only.

Combined Agreement

2.460 When the parties seek to set forth their agreement on both liability and specific matters, they do so in a combined agreement.

Contents of Closing Agreements

2.470 Every closing agreement must contain an identification of the parties, introductory clauses, the agreed determination, an ending clause and the signatures of the parties. Any misrepresentation of material fact in a closing agreement will cause the IRS not to be bound to it, so care must be taken in drafting the agreement. The determination of tax should be clearly and unambiguously stated in statutory terms, if necessary. Closing agreements are always signed by or on behalf of the taxpayer first, since it represents an offer by the taxpayer. If the holder of a power of attorney will be signing the closing agreement for the taxpayer, the power of attorney instrument must expressly provide the authority to sign a closing agreement.

IRS Position on Closing Agreements

2.480 While in some cases the IRS encourages the use of closing agreements, the IRS discourages its use as a matter of practice. Because of the closing agreement’s finality, a large volume of requests for them would be difficult to process and the IRS will carefully consider whether to enter into a closing agreement. The decision is truly theirs, because the Code permits, but does not require the IRS to enter into closing agreements. As a result, the decision is discretionary with the IRS. Additionally, the procedure for obtaining a closing agreement is burdensome and involves layers of approval, culminating in execution only by relatively high ranking IRS officials. Furthermore, the Internal Revenue Manual encourages Appeals Officers to persuade taxpayers seeking finality to utilize Form 870 or 870-AD [IRM 8815, MT 8-27].

Agreed and Partially Agreed Cases

2.490 On the RAR, the Agent will denote whether the taxpayer agreed, disagreed or partially agreed with the proposed adjustment. These notations should reflect whatever settlement you have negotiated on behalf of your client. It is important to realize that issues conceded by the IRS are often dropped forever while the taxpayer can contest continuing audit issues at a later date such as in Tax Court.

PRACTICE TIP

An alternative to a closing agreement is to pay the tax shown on the RAR, wait almost two years ( the length of the statue of limitations for refund) and then file a refund claim on the appropriate form. The statute of limitations for the IRS to assess new taxes would have expired, and yet the taxpayer is still able to file for a refund of the taxes paid on the issues he conceded. The refund will be limited in most cases to the amount of taxes paid within the last two years. If the IRS fails to allow the refund claim, a refund suit must be filed by an attorney in a federal district court or the United States Claims Court. If this procedure is followed, the taxpayer should not be liable for additional taxes for that year, gaining most of the advantages of a closing agreement with none of its disadvantages.

Group Manager’s Conference

2.500 After the Agent has made his final decision regarding an issue or the entire audit, you may request a conference with the Manger of his audit group. You may use this forum to appeal some of the adjustments which you feel are unfair. Be prepared to present detailed facts as to why the Group Manager should alter the Agent’s adjustments. The conference is requested by letter or telephone call to the Agent’s Group Manager before the RAR is completed.

Revenue Agent’s Report (RAR)

2.510 The RAR is the final report of an Agent after the audit. The length and detail of the RAR varies with the complexity of the case the skills of the Agent. The RAR is also known as the “30-day letter” because you can appeal the findings to the Appeals Division of the IRS within 30 days after the issuance of the letter. In almost every case, an appeal would benefit your client. The Appeals Division rarely increases the taxes owed but in many cases reduces the adjustments made by the RAR. Furthermore, an appeal is necessary if you wish to file for professional fees from the IRS.

Extending And Suspending Statute of Limitations

2.520 The IRS will sometimes ask you to sign a Form 872 or Form 872-A(C) to extend or waive the statute of limitations for assessment of tax. You should not grant this request without careful consideration.

Extensions v. Waivers

2.530 An extension of the statute of limitations sets a fixed time limit within which the IRS must either: (a) issue a notice of deficiency; (b) decide not to assess tax; or (c) negotiate a new extension. Form 872 is used to extend the statute of limitations. Special versions of Form 872 have been designed for partnerships, S corporations and certain excise taxes.

Waivers (Form 872-A(C))

2.540 A waiver of the statute of limitations is much broader. Form 872-A(C) is usually the form used for waiver. A waiver is effective until the taxpayer gives the IRS proper notice on Form 872-T or another appropriate form that the taxpayer is revoking the waiver. The issuance of a 90-day letter by the IRS also acts as a termination.

Extensions (Form 872)

2.550 Practitioners generally prefer an extension on Form 872 rather than 872-A(C) because it puts the IRS on a definite schedule which requires them to act relatively promptly. In some cases where a Form 872-A(C) is signed, the audit is still going on (and the statute is still open) 12 years later!

PRACTICE TIP

The authors do not recommend granting an extension or waiver of the statute of limitations if it merely allows the Agent to continue the audit. Extensions or waivers may be advisable if they allow review of the audit at the Appeals Division. Also consider a restricted consent, limited to a single issue. This protects your client from new issues being raised by the IRS.

When to Extend Statute of Limitations

2.560
The statute of limitations should be extended only when it is to your advantage to give the IRS extra time to audit your client. As you can imagine, this should be a relatively rare circumstance. Form 872s are routinely signed by taxpayers when it is really not in their best interest to do so. Remember that you are doing the IRS a favor by extending the statute, so be sure that you are getting something valuable in return. One oft-cited benefit of extending the statue of limitations is that the IRS won’t be forced to issue a hasty notice of deficiency which might be more detrimental than a carefully negotiated RAR. On the other hand, with more time the Agent might uncover new issues which damage your client.

When Not to Extend Statute of Limitations

2.570 The IRS has failed to discover potentially damaging issues, or if the IRS has not been diligent in its audit, you should seriously consider refusing to extend the statute of limitations. The Agent will issue a notice of deficiency but you can contest that finding before the Appeals Division and the Tax Court. If you plan not to extend the statute of limitations, let the Agent know as soon as possible so that the cannot claim to have been misled. You will also get a fairer RAR in the process.

Calculating Beginning of Statute of Limitations Period

2.580 The statute of limitations for assessment begins on the later of:

* the due date of the return; or
* the date the return was actually filed.

The due date of the return is the statute due date, without regard to extensions of time to file. The best evidence of the date the return was actually filed is the date the IRS stamps “FILED” on the original return. You will find the original return in the Agent’s administrative file.

Length of Period

2.590 The statute of limitations for assessment is three years. The three years is calculated exclusive of the starting date and inclusive of the ending date. Thus, if a 1988 return was filed on April 15, 1989, the period would run from April 16, 1989 to April 15, 1992. Assessments for tax year 1988 made on or after April 16, 1992 would be invalid.

What Happens Once Period Has Run

2.600 If the statute of limitations for assessment has been completed and the IRS has not assessed any tax against your client, the IRS legally cannot attempt to collect the tax.

Exceptions

2.610 Several exceptions to this rule should be noted. First, some events temporarily suspend the statute of limitations, such as the issuance of a Notice of Deficiency, bankruptcy proceedings, a lawsuit involving the issuance or enforcement of an administrative summons, or if the taxpayer is out of the country for an extended period. Second, the taxpayer could have agreed to suspend or modify the statute of limitations. Third, a longer statute applies if the taxpayer understated 25% or more of his gross income. Fourth, no statute of limitations applies to fraudulent returns, willful attempts to evade tax or failure to file returns . Finally, some penalties do not need to be assessed, typically penalties for failure to file information returns.

Preserving Audit Records for Appeal or Litigation

2.620 You must act as soon as you are aware of a client’s tax controversy to retain relevant documents and to prevent their destruction. Innumerable tax cases have been needlessly lost at the audit, appeals or Tax Court stages due to inadequate retention of critical documents.

PRACTICE TIP

If you are in doubt as to the usefulness of retaining some documents, err on the safe side and keep the documents.

Taxpayers with assets in excess of $10 million (and some taxpayers with assets under $10 million which keep certain records only on computer) are required to maintain machine-sensible records used in their accounting function All taxpayers are generally required to retain relevant tax records for IRS audit and review.

Privileged Documents

2.630 Some documents do not need to be returned to the IRS. These documents are referred to as privileged documents. Examples of documents which might be privileged include communication between a client and her attorney concerning tax litigation. Although some accountants and enrolled agents have attempted to assert an accountant-client privilege, the IRS and most courts have rejected that approach. In its Economic Reality training materials, the IRS restated its acceptance of the attorney-client privilege as well as the limited situation in which an accountant’s work may be privileged: if the accountant was hired solely by the attorney to prepare the attorney for litigation. One recent article suggested that accountants in tax practice may be able to assert privilege in a fashion similar to the attorney-client privilege.

Withholding Privileged Documents

2.640 Before the IRS arrives, you should examine the files which the IRS will examine and extract any privileged document. You must record each extracted document on a privilege log, recording the author, date, recipient, a brief description, and indicate which file the document was taken from. You should give the privilege log to the Agent when he arrives. This allows the Agent to challenge your assertion of privilege over the documents. In most cases, an attorney should be involved in the process of preparing a privilege log.

PRACTICE TIP

You cannot just remove documents from the files. That act might be criminal tax fraud. If you remove a document, it must be arguably privileged and you must give the IRS a privilege log identifying the document.

Confidential Documents

2.650 Confidential documents contain trade secrets, business plans and the like. You must turn these over to the IRS if requested to do so, although you can ask for the copies to be returned in order to protect your client’s secrets. Generally, the IRS is very good about not revealing confidential documents to outsiders.

CPA/EA Confidentiality Privilege

2.660 Generally, the most common time when a tax preparer and client wish to have privileged communication is when the client seeks tax advice in planning a transaction, structuring the purchase or sale of a business, discussing tax opportunities, or estate planning. Extending the traditional attorney-client privilege to federally authorized tax practitioners (FAT practitioners) may potentially be one of the most treacherous and misinterpreted, albeit over-hyped, provisions included in the Internal Revenue Service Restructuring and Reform Act of 1998 (P.L.105-206). Misunderstandings of the provisions in IRC §7525 are certain, and the consequences for affected practitioners and their clients mistakenly thought to be covered by the privilege may be devastating! This statutory privilege burden could be stated as follows:

1. When “tax” advice is sought,
2. from a FAT practitioner in his/her capacity as such,
3. the communications relating to that purpose,
4. made in confidence,
5. by the client,
6. are at the client’s instance permanently protected,
7. from disclosure by himself or by the FAT practitioner,
8. unless the protection is waived.

Warning: The burden of establishing that all eight points have been met is on the client and the same limitations that apply to the attorney-client privilege will apply to this expanded privilege. As most FAT practitioners are not familiar with these limitations, the purpose of this paper is to discuss the privilege’s probable impact on the practice of tax preparation and some potential problems.

Taxpayer Profile

2.670 A taxpayer profile begins with the examiner collecting data concerning the taxpayer’s standard of living. The starting point is the Standard of Living data published by the Bureau of Labor Statistics, adjusted for local factors. To this is added the taxpayer’s accumulated wealth (investments, cars, boats, houses and jewelry); the taxpayer’s economic history; the business environment particular to the taxpayer; and the potential assertion by the taxpayer of non-taxable receipts, such as gifts. The examiner will also collect industry data on profitability and at least 3 years of tax returns. All of this data is used to prepare a preliminary “Cash T” account.

The Cash T Account

2.680 The Cash T account is simply a two column attempt to reconcile Cash In (the left column) with Cash Out (the right column). An example taken from the IRS training materials will prove helpful.

Cash Transaction (T) Account

Cash In Cash Out

Wages

$ 2,680

Schedule C

Interest

499

Purchases

Exp. (less dep.)

$ 114,337

11,847

Tax Refunds

342

Schedule E

Exp. (Less depr.)

5,191

Pension

2,389

Tax Withholding

792

Schedule C

Gross Rec.

127,385

Personal Living Exp. (Note 1)

38,808

Schedule E

Rent Rec.

3,947

Total

137,242

Understatement

33,733

Balance

$170,975

$ 170,975

Note 1. Personal Living expenses were arrived at using the Bureau of Labor Statistics data for a typical area of the United States. The Bureau of Labor Statistics figures should be adjusted to reflect the geographic location of the taxpayer (if available).

You will notice that the IRS is assuming here that all of the difference between Cash In and Cash Out is understated income. Another incredible assumption is that the family in question spent exactly the BLS “typical” amount for an average American family! A family which is more frugal than most will appear to have unreported income, while a spendthrift family will show less of an understatement. While the Note 1 makes the reasonable suggestion that the BLS data be adjusted for geographic region due to cost of living, no adjustment is suggested for family living and spending styles.

PRACTICE TIP

Ask the examiner for a copy of the Cash T, and attempt to document any overstatement of expenses in the Cash Out column or understatement of cash in the Cash In column. Examples of understatements in the Cash In column would include loans, withdrawals from savings accounts, gifts or inheritances from relatives, or amounts received this year but taxed in a different year.

The Personal Living Expenses (PLE) Form

2.690 The IRS examiner may ask the taxpayer to fill out a Personal Living Expenses (PLE) form. The PLE form is used to gather data for detecting under reported income on the Cash T account. This form should be filled out as carefully as a tax schedule, with as much documentation as possible.

PRACTICE TIP

The taxpayer does not have to fill out a PLE form. The IRS training materials concede that while specific records may be summoned, “no specific authority exists to require the taxpayer to fill out a PLE.” However, the IRS will document in the file the refusal, and may then proceed with what data is available, including the BLS averages.

In the process of filling out the PLE, the IRS examiner is encouraged to answer the following questions:

1. What Is the Standard of Living of the Taxpayer?

1. What does the taxpayer and dependent family consume?
2. How much does it cost to maintain this consumption pattern?
3. Is reported net income sufficient to support the standard of living?

2. What Is the Accumulated Wealth of the Taxpayer?

1. How much has the taxpayer expended in the acquisition of capital assets?
2. When and how was this wealth accumulated?
3. Has reported income been sufficient to fund the accumulation?

3. What Is the Economic History of the Taxpayer?

1. What is the long term pattern of profits and return on investment in the reported activity?
2. Is the taxpayer’s business expanding or contracting?
3. Does the reported business history match with the changes in the taxpayer’s standard of living and wealth accumulation?

4. What Is The Business Environment?

1. What is “typical” profitability and return on investment for the taxpayer’s market segment and locality?
2. What are typical patterns of non-compliance in the taxpayer’s market segment?
3. What are the competitive pressures and economic health of the market segment within which the taxpayer operates?

5. Has the Taxpayer Made Assertions to Receipts of Funds Which Were Considered to Be Non-Taxable?

1. Do claims of non-taxable sources of support make economic sense?
2. How credit worthy is the taxpayer in view of the taxpayer’s assertion that funding was secured from loans?
3. In situations where the taxpayer has asserted that funds were received from other than conventional lending institutions, what was the lender’s source of fund?

IRS Interview Questions

2.700 The IRS Economic Reality training has changed the focus of the examiners’ interview of the taxpayer. Instead of sticking to questions exclusively geared to the tax return, the examiners are also encouraged to delve into the lifestyle of the taxpayer. The following nine points were used to train all IRS examiners in the Economic Reality model:

1. General questions toward imbalance in Cash T.
2. Identify nontaxable sources of income.
3. How are asset acquisitions funded?
4. Were any assets sold?
5. Were there any extraordinary events? (This may lead into weddings of the taxpayer or taxpayer’s children, deaths, inheritances, etc.)
6. Level of education of the taxpayer.
7. Business expertise of the taxpayer.
8. Has the taxpayer prepared a financial statement or balance sheet for a loan, home mortgage, or business mortgage?
9. Are Schedule C’s a sham?

Getting Information from Third Parties

2.710 Third parties may be a gold mine for IRS examiners using Economic Reality methods. A classic example is the taxpayer who understates his income on the tax return, but shows income accurately on a home mortgage application. IRS examiners are now encouraged to review third party documents like home mortgage applications in order to prepare the Cash T. Pity the poor taxpayer who correctly reported income for tax purposes but overstated income on the home mortgage application.

IRS May Not Contact Third Parties Without Taxpayer Notification

2.720 The Bill requires the IRS to notify the taxpayer before contacting third parties regarding examination or collection activities (including summonses) with respect to the taxpayer. Notification is not required in criminal cases, in jeopardy collection situations, or in cases where the taxpayer has authorized the contact (Act §3417; Code §7602; effective for contacts made 180 days after July 22, 1998).

2.730 Third parties will be contacted directly for information. Many of them will volunteer information without the use of a third party summons (discussed in Chapter 7). Third party targets in Economic Reality audits may include:

* Vendors;
* Customers;
* Parties to transactions;
* Banks;
* Brokerage houses;
* Credit card companies;
* Insurance agents;
* Attorneys;
* Accountants;
* Anyone who may have tax-related information; and
* Loan files and credit reports.

2.740 Other sources of information will include Form 8300′s (Cash or cash equivalent transactions over $10,000); Currency Transaction Reports (Bank transactions involving over $10,000 in cash or cash equivalents); Vehicle registrations (automobiles, boats); Property records (houses, vacation homes); any other public or government records.

Copyright 2005

07/15/2009

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