IRS Audit - an Introduction
It can be quite unnerving to be contacted by the Internal Revenue Service (IRS) regarding a potential tax issue. How should you react if you are contacted by the IRS? NOTE - If you're being audited, the IRS will reach out via mail. An email, phone call, or text is almost certainly a scam. This article provides a high-level overview on how to handle one of the most serious types of tax notices: the IRS audit.
There are a number of basics procedures and references that should be used in handling a tax audit in order to achieve the most favorable outcome. Most people assume that they’re being audited because there might be a significant issue with their returns. The truth is, that the IRS may audit you for several reasons, and it’s not always because they think you’re cheating on your taxes. A computer program is used to score tax returns based on comparisons with other, similar returns. Returns are selected for audit because of a number of reasons. It might be audited based on the aforementioned computer scores, or a discrepancy in the return with information returns reported on forms like Form 1099s or you may be the unlucky one who was chosen for an audit as a “random sample”. No matter why you are chosen, the proper handling of the audit is the key to a favorable outcome. You should not fear the IRS audit process, no matter what type of audit is being conducted. With proper representation and preparation, you can expect that your audit will not become a tax nightmare. As we have preached many times before, documentation at the time of preparing the tax return is essential and definitely pays-off in an audit.
Resources Available to Help Understand an Audit
There are a couple of resources available which can help one understand the audit process. However, they are voluminous and are specific for the type of issue and/or business being audited. Farming/ranching has its own section. The Internal Revenue Manual (IRM) is essentially the IRS employee handbook and the IRS's Audit Technique Guides (ATGs) help agents prepare, plan and conduct audits. The IRM contains instructions on how to carry out all administrative and procedural matters, such as how to audit specific tax returns, collect taxes, process returns, or assess penalties. The ATG’s provide insight into issues unique to a specific type of taxpayer, like a rancher, or to a specific industry issue like international transactions. The current ATG section for farmers/ranchers is not available at the time of the writing of this article because it is being edited to incorporate the Tax Cuts and Jobs Act. The old one farm ATG is dated 2006.
These IRS documents shed light on how income will be examined, what interview questions will likely be asked, how evidence will be evaluated, etc. Preparation is critical for success in an audit. The IRM and the ATGs allow practitioners to anticipate what they might need to prepare during the audit. These IRS reference/instructional documents used by the auditors are the IRS’s interpretation of the law and may not reflect the actual current case law. This is why it is recommended to have an experienced tax audit professional handle your responses to any tax auditor.
Types of Audits
Correspondence Audit
The correspondence audit is by far the most common of all IRS audits which is used mainly on smaller tax payers. The correspondence audit usually only requires the taxpayer to submit some extra verification regarding certain aspects of their tax returns. The IRS will indicate in their correspondence, usually a “CP2000 - Notice of Underreported Income”, what aspects of the return require verification or further support, and then you should timely respond within 30 days via mail with the appropriate requested documentation. You will want to consult with an experienced tax professional before submitting your response, particularly if you do not readily have the exact documentation requested.
Office Audit
An office audit is when the IRS requests that you actually come to an IRS field office where an auditor will conduct an interview with you to verify certain items from your tax returns. The IRS will tell you when you need to come to the office, and what supporting documentation you will need to bring with you. Usually, this type of audit will examine and verify specific aspects of your return. Generally, the IRS can complete this type of audit in one day. Again, you should take your tax advisor with you to advise you so you do not give the IRS more information than necessary. An office audit usually occurs if the results from a correspondence audit were not sufficient, or if there are more complex issues with your return which would not be effectively answered by mail.
Field Audit
This is the most serious type of audit, but it is also the least common. Field audits are usually handled by a single auditor. However, if the return is in excess of $10 million, it may be subject to the Large Business and International (LB&I) Division which uses a team audit process. In a field audit, the IRS will have an auditor(s) come to your home, place of business, or your tax professional’s office. This audit will be comprehensive, analyzing just about every aspect of your returns. Generally, the IRS will conduct a field audit if there is a serious issue for which they are trying to uncover more evidence, or in situations where there are issues surrounding a high-income return. They will use the IRM and ATG’s to plan and do the audit. Chances are they will not know your ranching business and will simply follow the refence guidance which may include audit procedures for hobby losses, cash businesses and farming. This process usually results in many irrelevant questions being asked. More than any other form of audit, you should always have a knowledgeable tax professional present to represent you during an IRS field audit.
Audit Completion
Once any of these three types of audits are completed, the IRS will mail you an examination report that will detail the findings of the audit and any changes that are to be made to your returns and the impact to your tax liability. This is called a 30 day letter notice. At this point, you have 30 days to approve or disapprove of the findings. If you agree with the audit findings and approve, you may need to take action to fulfill the adjustments to your taxes, such as paying additional tax liability and penalties. If you disapprove of the findings, then your tax professional can assist you in taking action such as filing a timely appeal. Remember you only have 30 days to reply.
Understanding what is considered a 30-day letter can be important to preserve your appeal rights. A 30-day letter is any letter from the IRS that proposes adjustments to a taxpayer's liability. There are a number of different letters that the IRS uses that are considered 30 day letters. The “Letter 525 – General 30 Day Letter” is the common one used at a close of an audit but there are others depending on if it is an agreed or disagreed proposed adjustment. The letter, for example, CP2000, Notice of Underreported Income, serves as a 30-day letter. Upon receiving any of these letters, a taxpayer has three options: (1) pay the proposed tax liability, (2) contest the findings with the IRS Appeals Division, or (3) do nothing and wait to receive a Statutory Notice of Deficiency (a 90-day letter). If the taxpayer does nothing and receives the Statutory Notice of Deficiency, he or she has lost the right to go through the IRS Appeals office to resolve the dispute. The taxpayer must then file a petition in Tax Court to address the issue.
Appeals option should be used when possible since it gives a second bite of the apply towards a lower settlement. The Tax Court is still available if an agreement at appeals is not possible. There is a fast track option under the appeals process. This option can reduce the time to reach a settlement which could lower interest and penalties if they are applicable. The appeals agents are held accountable on the number and types of settlements they produce so they are motivated to get a reasonable settlement. They can consider the hazards of litigation which is usually a driving force to a compromised settlement on any questionable tax position.
Note, if you want to contests the proposed changes in a CP2000 letter, you should not only indicate on the response form that you are in disagreement with some or all of the changes and document why, you should also state in your response, "If you disagree with all or part of the information contained in this letter, the taxpayer requests a conference with the IRS Office of Appeals."
Summary
Contact your tax advisor immediately upon receipt of IRS correspondence. Your tax advisor should understand your operation and have agriculture tax audit defense experience. You should not fear the IRS audit process. However, timely and honest responses for each information document request must be made to the auditor. Maintain good timely communication with the auditor, preferably via you tax advisor. Do not give more information to the auditor then is requested. Listen to your tax advisor to avoid the dreaded Hobby Loss trap. Protect your appeals rights. If your entity files a state tax return, the result of an audit may also impact your state return. Amend your state return as soon as possible to limit fees and penalties. This is one area where a rancher should not do it alone. That would be like trying to “AI” your cows because you spent the prior night in the local Holiday Inn?? Counting on the Holiday Inn experience will not be good for your cows or your tax liability.