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Taxing, Briefly: The IRS Examination Process

Like Ten Thousand Spoons When All You Need is a Knife

Do you feel like you are cursed to forever draw the short straw in life? Is Alanis Morrisette’s Ironic more of a personal anthem than an indictment of the Canadian educational system’s failure to properly differentiate between irony and unfortunate occurrences?

In this post, we will assume that, in addition to the black fly in your chardonnay, you were greeted with a care package in your mailbox from the IRS stating, in short, that your returns had been weighed, measured, and found wanting. Shock and denial set in, followed by pain and anguish, then anger, then bargaining, and, as you are halfway through the second tub of Cherry Garcia in the day, you finally you call your tax attorney to talk about the IRS examination process.

Why is the IRS Picking on You?

Your first question very well might be, “why me?” This is a valid question.  Why does the IRS select certain returns for exam, while others escape its administrative attention?

The most common reason a return is picked up for examination is known as “information matching.” Though admittedly archaic,[1] the IRS’s computers are very good at comparing the amount of income reported on a taxpayer’s return and the amount reported to the IRS by an employer or a bank (or another third party) on Forms W-2 or 1099. If these numbers don’t match, the IRS’s computer system will automatically issue a notice to the taxpayer (generally in the form of a “Notice CP2000”).

The IRS’s computers also “score” returns based on similar returns.  Using an apples-to-apples approach, the IRS determines the taxpayer’s income tax bracket, size of family, location, and other demographic data and then compares the taxpayer’s return to other similarly situated taxpayers.  For example, if an unmarried young taxpayer making $60,000 per year takes deductions that would only make sense if she were making $300,000 per year, the IRS may flag this return for closer inspection. The specifics of the program are as shrouded in secrecy as the basements in Area 51, but it is generally believed that the program scores on a sort of cost/benefit test.  Thus, higher scores are given to those returns that may yield the highest return (i.e., additional audit revenue).

Returns may be selected for examination (audit) when they involve issues or transactions with other taxpayers.  Thus, if Cousin Jethro is under exam, and his return reports forgiveness of a $100,000 loan to you, the IRS will likely look at your return to ensure that you picked up this $100,000 as cancellation of indebtedness income.  Related examinations are especially common when a partnership is being audited.  Often the IRS will look to the individual partners’ returns to confirm that amounts reported on the partnership’s Form 1065 (Partnership Return) matches the information on the partner’s individual Schedule K-1 (Partner’s Share of Income, Deductions, and Credits). The IRS examines many large partnership and corporate returns on an annual basis.

Finally, when the IRS has received information that a group of individuals are potential participants in a tax shelter or other verboten transaction, their returns will be picked up faster than a five-dollar bill on a busy sidewalk.

So, Your Return has Been Picked up for Audit…

Though it may feel like the world is crashing in around you, the mere notice that a particular return is being examined does not mean that the taxpayer definitely will owe money to the IRS.  An examination may be conducted by the IRS’s examination division (Exam) by mail (a correspondence exam) or through an in-person interview by the revenue agent (the individual responsible for the examination), and the RA’s review of the taxpayer’s records, whether at the IRS office or “in the field,” meeting at the taxpayer’s home, office, or representative’s office. It’s likely that the IRS will ask for records to verify the figures on the return. Provide them. Failure to supply such records is the single best way to ensure that tax, interest, and perhaps even penalties will be assessed against you. Though it may feel like knuckling under to the class bully, cooperation is key in audits.

Once the examination of the return is completed, if the RA believes that changes ought to be made to the amounts shown on the return, he will communicate these changes to the taxpayer.  If the taxpayer and the RA disagree on the changes, the taxpayer may request a meeting with the RA’s manager. This is an optional step, but it is often a prudent one.

Whether or not the taxpayer meets with the RA’s manager, examination concludes when the RA prepares a revenue agent’s report (Form 4549) and issues a “30-day letter” to the taxpayer, which notifies the taxpayer of the changes proposed, as well as the taxpayer’s rights to appeal the proposed changes within 30 days. If the taxpayer does not respond to the 30-day letter, the IRS will send a 90-day letter, better known as a Notice of Deficiency. Once the notice of deficiency is issued, the taxpayer has 90 days to file a petition with the Tax Court. If the taxpayer does not file a petition, the IRS will assess the tax (and any penalties or interest) and send the taxpayer a bill.  We discuss assessment and collection in this post.

Appealing Proposed Changes

The appeals process allows the taxpayer another opportunity to resolve its issues. The Appeals division (more formally referred to as the Independent Office of Appeals) reviews the return from scratch. There are rules in place that limit communications between Appeals and Exam, with the intent that Appeals will reach their conclusions independently and reach a “fair and impartial resolution” of the case.

The appeals process is initiated when the taxpayer files a formal protest with the Appeals within the 30-day period after the receipt of the 30-day letter.[2] The protest must include the following:

  • The taxpayer’s name and contact information;
  • A statement that the taxpayer wants to appeal the IRS’s findings to Appeals;
  • A copy of the 30-day letter;
  • The tax periods involved;
  • A list of the changes that the taxpayer disagrees with, and reasons for why the taxpayer disagrees;
  • The facts supporting the taxpayer’s position regarding each issue;
  • Any law or authority on which the taxpayer relies; and
  • A signature made under penalties of perjury (or a statement by the taxpayer’s representative that the facts stated are true and correct).

Important Note Regarding Underlying Liability

If you disagree that you are liable for the tax or penalties—it is critical that you challenge the “underlying liability” at this stage.  Once the tax and penalties are assessed, although the taxpayer may challenge collection actions through a second type of appeal—discussed here—if you received notice of deficiency, or if you otherwise had the ability to challenge the liability, and you fail to do so, you will not get a second chance, whether in an appeal of the collection action or in your petition to the Tax Court.

Petitioning the Tax Court

If you do not appeal the proposed changes, or your appeal is unsuccessful, you have one last remedy.  Once you receive the notice of deficiency, you may file a petition with the Tax Court.  You have 90 days from the date of the notice to ask the Tax Court to “redetermine” the alleged deficiency.  As explained above, if you don’t file a petition, the IRS will sally forth, assess the tax, and issue the taxpayer a bill for the tax, as well as penalties and interest.

Collection

In our next post, we discuss the collection process, which is essentially what comes after the IRS assesses a liability and politely asks you to pay up or else

Footnotes:

[1] Like, Cuban missile crisis archaic.

[2] Alternatively, an individual taxpayer may make a small case request if the total amount of tax, penalties, and interest for each tax period involved is $25,000 or less, and a formal protest is not specifically required.

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