Surviving an Audit: Tips & Tactics
In my practice, I have successfully resolved dozens of Audits and am pleased to share some common takeaways. There are two basic types of Audits – computer generated letters and the more serious kind assigned to an IRS Agent. Both types require your immediate, full attention and a strategy to successfully resolve the inquiry.
Stay cool and don’t over-react to computer-generated letters from the IRS. Do read the letter carefully and respond with the exact information requested. Make sure to include a cover letter and your tax id on all correspondence. It is preferred to fax your request, especially in light of the coronavirus pandemic, make sure to follow up within 30 days and make certain the IRS has your correct address. Keep in mind the IRS issues millions of inquiry letters with little human oversight and mistakes do happen. Specifically, your IRS letter saying you owe money may be completely wrong! How can they do this….Well if you read the letter’s fine print it states that this is Not a Bill and that you should review this proposed adjustment, which has not been charged.
This type of Notice – commonly called a CP2000 seeks to reconcile information reported by third parties to the IRS and the information you reported on your tax return. If there is a mismatch of income over a certain threshold, the IRS will automatically generate a letter to taxpayer’s last know address. The Letter can be very intimidating and humbling as it points out all the mistakes you made on your tax return and then asks for money to resolve it – often including penalties and interest charges to boot. The letter must be correct and I should just pay it, right? Not so fast…
The key to resolving these letters successfully (with the minimum additional tax liability), is to read the letter fully and carefully. If you do, you may discover that by filling out another tax form and including some additional previously neglected information, the balance can be reduced dramatically. For example, let’s say you sold some securities and neglected to report the transaction. Though the IRS knows the sales price reported by the custodian, it may not necessarily know your cost basis and the IRS does not do your homework for you. By reporting the transaction, the proposed gain may actually be a capital loss. Quite a reversal!
Audits Requesting an Interview
These types of Audits are more serious as they are assigned to an IRS Revenue Agent and usually are requesting an interview with the taxpayer either by phone or in person. These inquires may be intended to be informational in nature and random, or be targeted on a specific issue that has been flagged with your tax return, for example verifying the income and expenses deducted on your Schedule C. These audits are distinguishable in that you are dealing with an actual human at the IRS (personalities will vary), so careful attention and planning should be paid to these audits. It is advisable to hire a tax attorney to deal with these situations (from the onset) as the taxpayer may lack expertise in this area and significant money may be at stake.
These audits typically focus on whether you have reported all the income on your tax return and whether you have sufficient back up documentation and records to support all deductions. The IRS letter will include a laundry list document request that can be quite overwhelming, particularly as many years have passed. It may be worth a shot to contact the Agent in advance of your interview to see if you can narrow down the list in efforts to limit scope. Be prepared to provide all copies of bank statements and you may need to order statements, deposit slips and checks. The Agent will perform a deposit analysis to ensure all income is reported on your tax return. Be prepared to explain deposits that are not taxable, for example gifts and reimbursements received. All deposits are not necessarily taxable, however don’t expect an Agent to reclassify anything that isn’t an obvious transfer between accounts without supporting proof.
Next, the Agent will seek to verify that all expenses have proper support. Business owners are responsible for keeping accurate records and penalties may apply if you cannot produce them upon request. A credit card statement is proof of payment, but only the actual receipt will suffice to prove the write off, so it is necessary to keep receipts in addition to statements. Similarly, a check is proof of payment, but only an invoice can support a deduction. Keep in mind, your tax preparer does not require records and for the most part will take your word that you have them. Some records should be summarized for the Agent for ease of use, for example, creating a travel log summary based on your day calendar. The key with records is to package your presentation in professionally organized workpapers to make the Agent’s job easier to review.
How to Settle for Less
As you are nearing the end of the audit, there will likely be a sticking point that will prevent closing of the case. If you cannot come to an agreement on this final issue, it may be a good idea to ask to speak to the auditor supervisor for their perspective. The audit process can be very expensive and time consuming for both the government and taxpayer, and the taxpayer has many layers of appeal including going to court. At this stage, both parties may have significant motivation to come to a resolution and this is where some good negotiation can come into play.