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IRS Audit Strategy: Seeing the Playing Field

IRS Audit Strategy - Introduction

A favorite saying of mine when it comes to audits is that I like to see the playing field in order to know all the issues and the potential issues that could arise during the course of representation. Upon initial receipt of the audit letter from the Internal Revenue Service, you will have an idea of the areas that are being called into question. However, this is often only the starting point for the areas that may be examined during the course of the audit. When I first approach an audit, I do a through review of the return to look for other unknown and potentially dangerous issues with the underlying return. Specifically, I am looking for items that may either be misreported, overstated, or will likely need to be explained to the auditor in greater detail during the examination process. By getting a sense of these issues, as well as any potential issues on tax returns in the preceding and succeeding years (which may also be audited), I start to formulate a strategy can determine the best way to approach the audit.

Taxpayer returns are generally audited by the IRS because of either their participation in questionable tax avoidance transactions or because of their likelihood that an audit will yield a change in favor of the government. This potential for change is quantified into one of two computerized scores, the Discriminant Function System (DIF) score and the Unreported Income DIF (UIDIF). The DIF score calculates the probability that an examination will yield additional tax liability whereas the UIDIF calculates the probability that there is unreported income on a return. Those returns that yield high scores are then forwarded to examination personnel, who select which returns will be audited.

IRS Audit Strategy - Before the Audit Begins

Contrary to popular belief, most audits begin prior to the initial meeting with the taxpayer or their representative. Auditors generally conduct a full pre-audit investigation, which involves conducting both asset searches (reviewing Department of Motor Vehicles, property records, and other public information) as well as income searches (reviewing past and present sources of income reported on taxpayer returns, pulling IRS transcripts, reviewing information submitted by third parties). As a result, the taxpayer and their representatives must consider the possibility that the auditor knows much more about the taxpayer than they let on in their initial meeting. As such, representatives are going to want to be vigilant with respect to any representations that they make about the taxpayer’s assets and sources of income to avoid making potentially false statements to the auditor and subjecting the taxpayer to additional civil/potentially criminal liability.

IRS Audit Strategy - Limit the Scope

The principal objective of any representative, other than to ensure there is little or no examination change, is to limit the scope of the audit from the outset. Although auditors begin with one tax year, it is not uncommon for them to open up as many as three years. Limiting the scope of the audit to one year will significantly reduce the overall effort involved on the part of the taxpayer (and their representative).

In addition, skilled representatives may be able to narrow the scope of information requested for a particular tax year. Often auditors will send out a generic list of items that are generally required, rather than a specific list of the categories or items that they are interested in examining. By limiting the first meeting to a few select items and proving up these items to the satisfaction of the auditor, the audit may be closed fairly quickly with minimal effort expended on the part of the taxpayer.

IRS Audit Strategy - Income Issues

Although many audits begin by questioning expenses or deductions taken on the return, often the auditor will also challenge the amount of income being claimed. This is often the case with business owners, especially those own businesses that deal with large amounts of cash (retail stores, restaurants, gas stations, etc…). As such, a thorough review of a client’s bank statements, general ledgers, and other financial information in connection with the return in question may be necessary to ensure that gross receipts were accurately reported. For clients who have comingled business and personal expenses on their bank accounts, it is necessary to separate out any personal deposits or expenses. These reconciliations may also be helpful during the initial meeting, as your attorney may be able to resolve preliminary matters with the auditor and further streamline the audit.

IRS Audit Strategy - Other Points to Consider

Two other points that should be noted. First, although the auditor will request performing the audit at the taxpayer’s home or place of business, it is unadvisable to do so and the audit should be conducted at a neutral location. This is because the auditor may use outside information, such as their observations about their locations or their conversations with the taxpayer’s employees against them in the audit. Second, it is important to review applicable audit procedures and guidelines for auditors issued under the Market Segment Specialization Program. These are specialized guides issued by the IRS, which discuss protocol and guidelines for field agents when conducting an audit. Often, they are divided by industry segment or by technical issue, and can be helpful for insight into where the auditor will be looking. Knowing what areas the auditor is going to examine leads to better preparation and faster resolution of the audit.

While not nearly as frightening as many taxpayers imagine, IRS audits are nevertheless serious matters that require attentiveness to the issues and potential issues at hand. The longer an audit continues, the more likely it is to expose the taxpayer to hefty examination changes and the more expense the taxpayer will accrue in defending themselves in the audit. Those who prepare for the audit in advance and who are able to control the scope of the audit and flow of the information that the auditor receives will likely encounter better success during their audit meetings. In this case, better preparation yields better results.

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