2-1 REPRESENTING CLIENTS BEFORE IRS
2-1.10 Preparation is essential to successfully representing your client during audit. Particular attention must be given to the new "Economic Reality" training received by all IRS examiners in fiscal year 1995. This training has already resulted in more intrusive audits, focused upon discovering unreported income. So intrusive, in fact, that the IRS head of examinations, Lou Carlow, has told examiners to ease up a little by exercising more judgment in how deeply they audit using the Economic Reality methods [Wall Street Journal, Sept. 27, 1995, p. 1]. In 1996, the IRS announced that it was curtailing the most abusive aspects of the Economic Reality audits.2-1.20 Generally, any attorney or CPA may represent clients before the IRS.(1) 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.(2)
2-2 ESTABLISHING REPRESENTATION
2-2.10 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
2-2.20 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
2-2.30 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.
How "Economic Reality" Affects Location of Your Interview
2-2.35 In Fiscal Year 1995, the IRS launched an ambitious program to train all of its examiners in the concept of "Economic Reality" [See Section 2-11]. This week-long training is designed to make the IRS agent much more aggressive and effective, especially in discovering unreported income. The IRS examiners are strongly urged to conduct the audit at the taxpayer's place of business, and to snoop around for evidence while there. You should discover any such "evidence" before the IRS does. This is the only way to prepare the client effectively for the audit and to prepare yourself for issues the examiner may raise. You should insist that the audit take place at your office.
PRACTICE TIP
Since the Economic Reality training will force the IRS examiner to try to audit at the taxpayer's place of business, you should "audit" the premises first, asking the questions discussed below.
What You Should Discuss with Your Client
2-2.40 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;
Additional documents you should obtain;
Document retention and destruction systems; and,
Contact between your client and the IRS.
Scope of Representation
2-2.50 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
2-2.60 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.
Fees for Your Services
2-2.70 You must initiate the matter of fees. Most clients will be relieved if you broach the subject first. The client has the right to know the basis of your fees before you begin work. Several options are available:
Hourly rates for work done, plus disbursements;
Fixed prices for standard services;
Minimum and maximum fees; and
Contingent fees.
Hourly rates are most commonly used. You can adjust the hourly billing rate to reflect the expertise of the personnel performing the work. Hourly billing also protects you from grossly underestimating the amount of time a matter will take to resolve. If you agree to a fixed price, you may end up losing money on a case which takes longer than expected. Clients, however, often prefer a fixed price.
PRACTICE TIP
Give the client a "ball park" estimate of your fees and get this amount as a retainer but charge off your time on an hourly basis.
Contingent Fees
2-2.80 In refund suits and some other tax controversies, a contingent fee might be appropriate. Circular 230 was recently revised to eliminate restrictions on contingent fee arrangements in practice before the IRS (as opposed to contingent fees for tax return preparation, which is a different matter altogether), although the IRS continues to be "deeply troubled" by contingent fees for return preparation.(3)
Power of Attorney or Declaration of Representative
2-2.90 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.
Additional Documents You Should Obtain
2-2.100 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 Service 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
2-2.110 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 workpapers 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
2-2.120 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.
2-3 ENGAGEMENT LETTER
2-3.10 An engagement letter describes the terms and conditions of your representation. Some professionals prefer not to use an engagement letter, hoping that the client will just look to them for all matters. While this practice is common, an engagement letter is recommended for several reasons. First, it memorialized the scope of your representation, the fees for your services and how billing will be done. Both the professional and the client should benefit from "spelling out" these matters before any dispute or problems arises.
PRACTICE TIP
Doctors, enrolled agents, lawyers and professionals of all kinds are discovering that the best defense against malpractice suits is good client relationships. If you keep the client well-informed, then win, lose or draw, the client is likely to be pleased by yours efforts.
2-4 CONTACTING IRS
Need for Power of Attorney
2-4.10 No IRS employee should communicate with you about a taxpayer's situation unless a Power of Attorney is on file with the IRS. It is generally a waste of time to appear at a conference with the IRS without a Power of Attorney on file or in hand.
Requesting Documents from IRS
2-4.20 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 workpapers;
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.
Administrative File
2-4.30 If your case is in Audit, Appeals or Tax Court, the Agent will usually have most of these documents, if they exist, in the administrative file. You can ask the Agent for copies of these documents, which will usually be provided. If the Agent withholds a critical document such as a tax return, speak to his manager and emphasize the importance of the document to your preparation of the client's records for audit.
PRACTICE TIP
In one case a practitioner was able to secure an abatement of a late-filing penalty after he examined the original tax return in the administrative file. The return was clearly marked "FILED" on the proper date by the IRS.
Service Center
2-4.40 You should also formally request relevant documents from the Service Center where the taxpayer filed his returns. This should be done as soon as possible since it may take months for the Service Center to copy the documents. You should also routinely request the other documents from the IRS Service Center with a letter. When you request documents, remember that the IRS is probably the largest information-gathering agency in the country. If they know something about your client that you don't, you may be at a severe disadvantage. Even if you are fully informed, it pays to know what the IRS knows or does not know.
Tax Returns or Refunds Claims
2-4.50 Obviously, these are necessary documents in most tax controversies. Taxpayers have sometimes lost their copy or have kept only an unsigned draft copy. If at all possible, you should obtain a signed copy with the IRS date stamp indicating "FILED." This date stamp is necessary in order to determine when the statute of limitations expires and whether certain penalties are appropriate.
Initial Notice of Audit
2-4.60 The initial audit correspondence between the IRS and your client might be useful in determining the goal of the audit. For example, a computer-generated letter from the Service Center document matching program usually results in a single-issue mail audit. A letter personally signed by a Revenue Officer or an Agent from the Criminal Investigation Division is a much more serious matter. The initial letter might also disclose whether this is a DIF audit or a full-blown, no-holds-barred TCMP audit.
IDRs or Administrative Summons
2-4.70 When an Agent wants specific information about the taxpayer, it can be to your advantage to request an IDR. The IDR will specify the information the Agent seeks and might alert you to the issues being investigated. The advantage of requesting an IDR is that you control the flow of information to the Agent. If you do not respond to an IDR, the Agent may have an Administrative Summons issued. Under most circumstances, you must comply with a summons.
Notice of Proposed Adjustment
2-4.80 When the Agent has made a tentative decision on an issue, he may issue a notice of proposed adjustment. An Agent is sometimes willing to change his mind on these notices if you provide an alternative in a timely fashion. For example, in one case the Agent proposed an adjustment to a loan arrangement between consolidated corporations and then calculated the tax effect among the consolidated group. Upon examination, the practitioner agreed that the loan adjustment was correct, but determined that the allocation and effect of the adjustment among the consolidated group was erroneous. The practitioner conceded the adjustment, proposed a new allocation in writing to the Agent, and ultimately prevailed on 95% of the taxes raised in the original notice.
Agent Workpapers
2-4.90 If a prior audit took place, the Agent's workpapers will allow you to see the positions and goals of the IRS. Contrary to popular opinion, these papers are often obtainable, either after audit or in the Tax Court.
Audit Letter, Audit Reports and Revenue Agents' Reports (RARs)
2-4.100 When the Agent has reached a definite conclusion, an audit report is issued. Depending upon the case, the client may receive anything from a simple letter to a very large RAR with numerous exhibits. These documents are also referred to as "30-day letters" since they grant the client 30 days in which to appeal the findings to the IRS Appeals Division.
Notices of Deficiency
2-4.110 If you do not appeal the 30-day letter, or if the appeal is unsuccessful, the IRS will issue a Notice of Deficiency. The Notice is also known as the 90-day letter, since it grants the client 90 days (150 days for taxpayers abroad) to file a petition in the Tax Court [IRC Sec. 6213(a)]. Otherwise, the IRS will assess the tax at the end of 90 days and will attempt collection. The 90-day letter contains a description of the issues, but is not usually as complete as the RAR. You cannot file a Tax Court petition without attaching a Notice of Deficiency [TC Rule 34].
Tax Court Documents
2-4.120 These include petitions, briefs, stipulations and decisions. If your client has been involved in prior Tax Court litigation on the same or similar issues, you should obtain these documents from the Tax Court. You might also consider requesting documents from other Tax Court cases involving the same issues. They could alert you to the government's strategy and provide other useful information.
PRACTICE TIP
Before writing the Tax Court, get the name of the case or document number from your client. Call the Docket Clerk of the Tax Court at (202)606-8764 and ask for the docket sheet for the case. They will send this to you free of charge. The docket sheet will help you identify the other important documents to request. A copying fee will be charged for these other documents. Tax Court Petitions are available on-line via computer modem from Tax Analysts, Inc. on the LEXIS, Dialog and Tax RIA electronic services. For more information, call Tax Analysts at (800) 634-2430. Actual copies of the Tax Court documents can be ordered at (800) 955-3444.
Tax Account Information
2-4.130 In order to determine what taxes the client has paid and what taxes, interest or penalties are due, you need tax account information. The Agent should be able to provide you with a copy for the relevant years. Sometimes checks are posted to the wrong accounts or in the wrong amounts. The tax account can help locate those errors. If you cannot obtain the information from an Agent, write a letter to the appropriate Service Center.
Oral or Written Communications
2-4.140 Generally, frequent oral communication with the IRS employee handling the case is recommended. You will have many opportunities to get acquainted with the Agent and to understand the audit objectives. You can answer some questions or provide information quickly and informally. Many issues can be disposed of informally in this manner. Some issues will be incapable of oral settlement. In these cases the Agent may require documents to be provided. A cover letter should be sent with the documents, with a copy kept in your files. That way, you know exactly what information has been provided to the IRS.
PRACTICE TIP
You cannot rely in a court on the oral statements of an IRS employee. Advice by the IRS in binding only if it is in writing and certain other requirements are met [IRC Sec. 6404 (f)]. Nevertheless, most IRS agents will uphold any oral agreements which they personally have made.
Finding Out What They Really Want
2-4.150 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.
2-5 PREPARING FOR AUDIT INTERVIEW
2-5.10 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.
2-5.20 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
2-5.30 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.(4) 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.(5) (The taxpayer can also agree to extend the period. This choice is discussed in Section 2-8.) 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 1995 tax return after a six-month extension, on June 15, 1996. The statute of limitations for assessment of income tax expires on June 15, 1999.
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. Whether you should consent to the extension is discussed in Section 2-8.
Research Applicable Law
2-5.40 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,(6) CCH,(7) RIA,(8) Prentice Hall,(9) or BNA Portfolios(10)). Articles in various tax magazines might also prove useful.(11) 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.
Using the Internal Revenue Manual
2-5.45 The Internal Revenue Manual (the "IRM") is thousands of pages long. CCH publishes an abridged version. A complete CD-ROM version is also available. 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
2-5.50 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
2-5.60 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.
2-6 THE AUDIT
2-6.10 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
2-6.15 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.
PRACTICE TIP
Another way to keep the interview away from the taxpayer's place of business is to request an audio tape of the interview under the Taxpayer Bill of Rights. Current IRS rules require that "the recording takes place in a suitable location, ordinarily in an Internal Revenue Service office where equipment is available to produce the Service's recording . . . " [Notice 89-51,1989-1 CB 691].
Should Taxpayer Be at Audit
2-6.20 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
2-6.30 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
2-6.40 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
2-6.50 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.
Retaining Experts
Assistance In Fighting IRS
2-6.60 Some cases are so complex that experts need to be retained during the audit. For example, actuaries are often called in to examine the adequacy of insurance reserves during audits. Other issues which may require experts include valuation, depreciation, "ordinary and necessary" expenses, and legal terms derived from business practice. Experts are more commonly retained at the litigation stage, but in some cases an expert's opinion during audit could settle an important issue.
Referral to Another Professional
2-6.70 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.
2-7 SETTLEMENT OF AUDIT ISSUES
2-7.10 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
2-7.20 Generally, you must initiate settlement discussions. IRS employees will usually wait for you to bring up the subject.
Settlement Methods
2-7.30 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
2-7.40 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
2-7.50 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.
Agreed and Partially Agreed Cases
2-7.60 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
On an issue which you might want to litigate before the Tax Court, your might "agree to disagree" with the Agent. Allow the Agent to write up the issue, attempt to extract concessions on other issues, but prepare the issue for Tax Court. Experienced Agents are familiar with this process and should cooperate.
Closing Agreements
2-7.70 Any settlement of an audit issue does not legally bind either the taxpayer or the IRS unless a closing agreement is signed. Both the IRS and the taxpayer can raise "settled" issues in Tax Court and in refund suits. In most cases, however, the IRS does not do so. Nevertheless, the only sure way of foreclosing the possibility is a closing agreement. Closing agreements may be made on either Form 866 or Form 906. The procedure is cumbersome and time-consuming, but be appropriate in certain cases. Absent fraud or misrepresentation of a material fact, closing agreements are absolute binding upon both the IRS and the taxpayer.(12)
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
2-7.80 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)
2-7.90 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.(13)
2-8 EXTENDING AND SUSPENDING STATUTE OF LIMITATIONS
2-8.10 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
2-8.20 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))
2-8.30 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)
2-8.40 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
2-8.50 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
2-8.60 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
2-8.70 The statute of limitations for assessment begins on the later of:
(1) the due date of the return;(14) or
(2) the date the return was actually filed.(15)
The due date of the return is the statutory due date, without regard to extensions of time to file.(16) 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
2-8.80 The statute of limitations for assessment is three years.(17) 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
.90 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
2-8.100 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(18), bankruptcy proceedings(19), a lawsuit involving the issuance or enforcement of an administrative summons(20), or if the taxpayer is out of the country for an extended period(21). 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(22). Fourth, no statute of limitations applies to fraudulent returns, willful attempts to evade tax or failure to file returns (23). Finally, some penalties do not need to be assessed, typically penalties for failure to file information returns(24).
Discovering Assessment Date
2-8.110 The assessment date is found on Form 4340, Certificate of Assessments and Payments, which you should request from the Agent if you want to find out the taxes your client has paid or if you want to see if and when the IRS has assessed taxes.
PRACTICING TIP
The assessment date is also known as the "23c date" in IRS jargon.
2.9 TRANSFERRING AUDIT
2-9.10 In some cases, especially in mail audits, the Agent is at a great distance from the taxpayer. Even if the distance is not that great, you should consider an audit transfer.
When to Make Conditional Requests for Transfer
2-9.20 During a mail audit with a Service Center, practitioners will often negotiate with the Agent over the telephone and submit written comments. One case involved substantial penalties levied upon a mortgage service company for failure to file magnetic medial returns. A request for penalty abatement was filed. The practitioner asked the Agent for his tentative conclusion after all of the information was provided. The Agent was told that if his tentative answer was not to abate the penalties in full, that the taxpayer would request a transfer of the case from the Kansas City Service Center to the Chicago District Office in order to appeal personally. The Agent abated the penalty. The advantage of this procedure is that you get two chances to convince an Agent of the merits of your clients' position.
2-9.30 Another possible reason for requesting a conditional transfer is to get the file transferred to a local IRS District Office which is viewed (correctly or incorrectly) as being more sympathetic to or experienced with certain types of taxpayer.
PRACTICE TIP
Conditional requests should be handled over the telephone. If the proposed adjustment is not favorable, request a transfer in writing and take a second bite of the apple.
When Not to Request Transfer
2-9.40 A transfer request will often take months to complete and will cost the client additional money. In addition, you may not want the case in your local IRS District Office for various reasons. In any case, if the facts and law in your client's situation are relatively clear, a transfer is unlikely to be of much benefit.
2-10 PRESERVING AUDIT RECORDS FOR APPEAL OR LITIGATION
Retain Relevant Documents
2-10.10 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 [See section 2-2.110]. All taxpayers are generally required to retain relevant tax records for IRS audit and review(25).
Privileged Documents
2-10.20 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 ligation. One recent article suggested that accountants in tax practice may be able to assert privilege in a fashion similar to the attorney-client privilege.(26)
Withholding Privileged Documents
2-10.30 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
2-10.40 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.
Non-Responsive Documents
2-10.50 When the IRS requests certain documents, the taxpayer could give the Agent access to all files and let the Agent find it himself. This is usually a terrible idea because while Agents are fishing through the files they often discover other audit issues as well. The proper alternative is for you to go through the files and to collect all documents which respond to the Agent's request. All other documents (non-responsive documents) are left in the files. The Agent is provided with only the responsive documents. No log similar to a privilege log need be maintained or provided. When you are determining whether a particular document is responsive or not, it is your duty to interpret the Agent's request fairly and consistently. Remember that the Agent can later expand the request. If it later is discovered that you withheld a requested document, then you have lost the confidence of the Agent and may face other serious consequences.
2-11 THE NEW 'ECONOMIC REALITY" TRAINING IN THE IRS
New Training Program
2-11.10 Beginning in fiscal year 1995, the IRS embarked upon an ambitious training program entitled "Examining for Economic Reality" now known as "Financial Status". The program requires one week to complete, and will be taught to every IRS auditor and all Revenue Agents (GS-12 and below). The program:
Requires the examiner to prepare a profile of the taxpayer, looking for unreported income. The "Cash T" account is a primary tool;
Teaches them ways to be more skeptical concerning the taxpayer's return as filed and the role of the representative;
Develops investigation techniques, emphasizing visits to the taxpayer's place of business and extensive use of third-party records; and
Encourages further development along market specializations by teams of IRS examiners.
Each of these areas will be examined in turn.
Strong Public Outrage
2-11.14 The first year of the Economic Reality audits provoked strong public reaction in the press and in Congress. At first, the IRS claimed that Economic Reality was not really a new program at all. Those statements didn't fool anyone, and the pressure increased. Even the ordinarily staid New York Times ran a negative article. Finally, the IRS issued an internal memorandum dated March 25, 1996 which told Agents to respect the Client's representative and to not embark upon an Economic Reality audit as a fishing expedition. The memo requires only "reasonable indications of unreported income" before using Economic Reality audit techniques. The IRS stopped short of adopting the standard suggested by the AICPA, which was to use the Economic Reality audit only if there is a "documentable fact which backs up a reasonable suspicion of unreported income".
A New Name: Financial Status Audit
2-11.18 In May of 1996, IRS assistant commissioner (examination) Thomas Smith opined that the "Financial Status Audit" (the new name of the Economic Reality Audit) was not new, and that Agents were always trained to find unreported income. In short, the IRS is committed to the technique, whatever it is called, although they do intend to restrict to use to "appropriate" cases, rather than routine application.
Taxpayer Profile
2-11.20 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
2-11.30 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
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
2-11.40 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?
a. What does the taxpayer and dependent family consume?
b. How much does it cost to maintain this consumption pattern?
c. Is reported net income sufficient to support the standard of living?
2. What Is the Accumulated Wealth of the Taxpayer?
a. How much has the taxpayer expended in the acquisition of capital assets?
b. When and how was this wealth accumulated?
c. Has reported income been sufficient to fund the accumulation?
3. What Is the Economic History of the Taxpayer?
a. What is the long term pattern of profits and return on investment in the reported activity?
b. Is the taxpayer's business expanding or contracting?
c. 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?
a. What is "typical" profitability and return on investment for the taxpayer's market segment and locality?
b. What are typical patterns of non-compliance in the taxpayer's market segment?
c. 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?
a. Do claims of non-taxable sources of support make economic sense?
b. How credit worthy is the taxpayer in view of the taxpayer's assertion that funding was secured from loans?
c. 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?
A More Skeptical IRS
2-11.50 The Economic Reality training materials are full of motivational "war stories" in which an aggressive IRS examiner keeps digging until the taxpayer confesses to skimming the cash off the business and keeping a second set of books. While somewhat humorous, it does reflect a growing IRS attitude that taxpayers--especially cash businesses--are routinely under-reporting income. Examiners receive Economic Reality training in the following techniques:
Using humor or appropriate small talk to relax the taxpayer before popping damaging questions;
Expressing appreciation for the taxpayer's help in order to gain access to more information;
Working to establish rapport and trust;
Acting dumb in order to learn more information; and How to contain excitement when the taxpayer is telling the examiner something important.
PRACTICE TIP
Read that list to your client before they meet with the IRS examiner for the first time.
IRS Interview Questions
2-11.60 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?
The taxpayer should also be prepared to answer questions concerning all of his personal bank accounts, especially regarding the source of funds flowing into those accounts; who makes out the business deposit slips; what are the internal controls and sales recording procedures in the business; what are the inventory procedures; and "relevant information to address taxpayer's financial lifestyle".
2-11.70 Apparently, the IRS feels that some taxpayer representatives are too successful in shielding their clients from IRS examiners. The Economic Reality training materials acknowledge that taxpayers' representatives will attempt to steer the audit to some location other than the taxpayer's place of business. The materials also agree that the Taxpayer Bill of Rights allows the representative to appear without the taxpayer in the normal course of an examination. A major focus of the Economic Reality materials is training examiners to get past the representative legally.
2-11.80 The first method is to demonstrate the representative's lack of first-hand knowledge of the taxpayer's business and personal expenditures. This information forms the basis of a request to move the audit to the taxpayer's place of business and to question the taxpayer directly (with the representative present).
PRACTICE TIP
A well prepared representative will know the answers to the IRS examiner's questions about how the business runs. A little preparation here before the examination begins might keep the audit off the taxpayer's premises.
2-11.90 The second method is to emphasize the authority of the IRS examiner to meet with the taxpayer. The Economic Reality training materials identify three lines of authority for the examiner:
1. The Taxpayer Bill of Rights, which allows meetings with the taxpayer's representative, so long as the representative has sufficient knowledge or can provide the information in a timely fashion. The IRS examiner will try to emphasize the representative's lack of knowledge.
2. By-pass authority [IRC 7521(c)], a rarely used provision that allows the IRS to by-pass an extremely uncooperative representative after written warning; and
Market Segment Specialization
2-11.130 As discussed in Chapter 4, the IRS is training its examiners to develop more expertise in particular industries or businesses, called "market segments" by the IRS. The Economic Reality training reinforces this trend because it develops particular questions to uncover unreported income in different market segments: one set of questions for an auto repair shop; a quite different set for restaurants. If the IRS has published an Audit Techniques Guide for your client's business, you should have a copy on your desk before an audit begins.