Articles
First Steps in Responding to Tax Audit Notices
By Michael P. Duffy on July 26, 2021One of the most frightening letters a person can get from the government is a notice that their taxes are going to be audited. But even though an audit can be an exhausting experience and result in real financial pain, taxpayers can implement basic strategies to improve outcomes in almost all circumstances.
Stonewalling Is a Losing Strategy
One common response to receiving an initial audit notice is for the taxpayer to simply ignore the request for information. In other cases, the taxpayer may forward the notice to their return preparer or accountant, who initially reaches out to the IRS, but then drops out of communication when problems are discovered with the underlying return.
In most audits, the odds are stacked against the taxpayer. Taxpayers have the burden to show that the deductions and credits taken on their returns are valid, which often means coming up with receipts and supporting documentation. A taxpayer will also have the burden to rebut or explain items of apparent income reported to the IRS by third parties.
For these reasons, stonewalling is rarely an effective strategy. For example, an auditor who does not receive anything from the taxpayer to substantiate travel expenses has the authority to simply disallow the entire line item. Although a taxpayer may be aware there are problems with the amount of travel expenses they actually deducted on their return, by not actively engaging with the auditor they substitute a known quantity of exposure for the auditor’s worst-case scenario.
In instances when the IRS may not have a complete picture to make an assessment, taxpayers may attempt to stonewall on the basis that they don’t have an obligation to provide anything to the IRS from a Fifth Amendment perspective. Stonewalling from an evidentiary standpoint is usually a losing proposition in tax cases. The Fifth Amendment almost never protects business and financial records used to compute a taxpayer’s liability from discovery. This is because the documents themselves are very rarely considered Fifth Amendment protected testimonial statements. Further, a taxpayer’s failure to cooperate may motivate the auditor to reach out to third parties and obtain the same records in another manner.
Cooperating Opens Up Opportunities
It is always advisable at the outset to cooperate with an auditor by acknowledging calls and written correspondence, and then negotiating a timeline for responding to information requests. Establishing this baseline rapport creates opportunities for negotiations at a later date.
Being able to keep the lines of communication open is key. For example, under something called the Cohan rule, a taxpayer can overcome missing documentation by coming up with reasonably reliable estimates to support the premise that some portion of deductible business expenses must have been incurred. Inherently, using the Cohan rule is a persuasive exercise; the taxpayer needs to be in a position where they can demonstrate their representations are accurate and truthful in order to get the auditor to agree with the proposal. This is simply not possible if the relationship is completely adversarial.
Cooperating does not mean agreeing with the auditor or rolling over on every contested issue. Taxpayers do not have an affirmative obligation to disclose noncompliance, and frequently it is not in their interests to give up more information than is absolutely necessary to respond to specific information requests. Furthermore, a taxpayer should never respond to auditors with false or misleading information, as this exposes them to increased civil penalties and potential criminal tax liability. On the other hand, a taxpayer may want to make a voluntary disclosure in certain circumstances to prevent an inquiry from spiraling out of control and leading to more serious charges. This is often advisable if the discovery of damaging information by the government is inevitable.
Strategy Is Key
The hard part for many taxpayers is not knowing what strategy to employ, and whom to turn to for help. Taxpayers frequently will reach out to their return preparers for assistance in responding to audit requests. Oftentimes, a return preparer will be the party best suited to know the ins and outs of the taxpayer’s return. In other cases, however, the return preparer may have simply been engaged to type numbers from forms and documents provided by the client into tax prep software. In the latter case, engaging that same preparer to assist with the audit will not add value because they will not have the requisite level of knowledge to be able to explain the numbers as they relate to the taxpayer’s actual business.
Where taxpayers are under audit and there is concern that there could be a significant assessment for any reason, it is advisable that they seek competent legal counsel immediately. Although accountants and CPAs may have the technical skills to handle most complex tax matters, communications with these professionals concerning many routine disputes are not protected by any sort of accountant-client privilege. In my professional experience, this distinction can and does block frank communications between the taxpayer and their service providers in a way that does not happen when an attorney is retained.
Hiring tax counsel does not foreclose using an accountant, either. Counsel has the option of retaining accountants with respect to client matters through something called a Kovel arrangement. Because the accountant retained under the Kovel arrangement is an agent of the attorney and not an agent of the client, communications may be made between the client, accountant, and counsel without the loss of attorney-client privilege.
The right strategy also takes into consideration the taxpayer’s ability to deal with the aftermath of a potential assessment, including whether penalties may be negotiated down. Sometimes fighting a proposed assessment may not be worthwhile at all when the taxpayer is insolvent or is no longer able to generate significant income due to disability or other hardships. A taxpayer’s resources in these cases may be better spent dealing with the matter from a collections standpoint. Although the taxpayer may legally owe a significant amount of money, the ability of the IRS to actually collect from the taxpayer is not unlimited. Bankruptcy may alternatively be a viable option to discharge income tax debt, although the rules for discharging this type of liability are complicated. We always advise that taxpayers considering bankruptcy seek an individual with expertise in both bankruptcy and tax matters.
Closing
Taxpayers need to be cognizant when they are selected for audit as to what their real risks are and act accordingly. Typically, when an initial information and document request is received, the taxpayer should have some idea as to what areas the IRS wants to focus its examination on. This can be total gross receipts, particular expense types, particular transactions, or other discrete items reported – or not reported – on a tax return. This is the ideal point where the taxpayer needs to commit to some sort of strategy. If they know scrutiny could reveal significant compliance problems, they should reach out to counsel first in developing an appropriate response.
©2021. This material is intended to offer general information to clients and potential clients of the firm, which information is current to the best of our knowledge on the date indicated below. The information is general and should not be treated as specific legal advice applicable to a particular situation. Fletcher Tilton PC assumes no responsibility for any individual’s reliance on the information disseminated unless, of course, that reliance is as a result of the firm’s specific recommendation made to a client as part of our representation of the client. Please note that changes in the law occur and that information contained herein may need to be reverified from time to time to ensure it is still current. This information was last updated July 2021.
Stonewalling Is a Losing Strategy
One common response to receiving an initial audit notice is for the taxpayer to simply ignore the request for information. In other cases, the taxpayer may forward the notice to their return preparer or accountant, who initially reaches out to the IRS, but then drops out of communication when problems are discovered with the underlying return.In most audits, the odds are stacked against the taxpayer. Taxpayers have the burden to show that the deductions and credits taken on their returns are valid, which often means coming up with receipts and supporting documentation. A taxpayer will also have the burden to rebut or explain items of apparent income reported to the IRS by third parties.
For these reasons, stonewalling is rarely an effective strategy. For example, an auditor who does not receive anything from the taxpayer to substantiate travel expenses has the authority to simply disallow the entire line item. Although a taxpayer may be aware there are problems with the amount of travel expenses they actually deducted on their return, by not actively engaging with the auditor they substitute a known quantity of exposure for the auditor’s worst-case scenario.
In instances when the IRS may not have a complete picture to make an assessment, taxpayers may attempt to stonewall on the basis that they don’t have an obligation to provide anything to the IRS from a Fifth Amendment perspective. Stonewalling from an evidentiary standpoint is usually a losing proposition in tax cases. The Fifth Amendment almost never protects business and financial records used to compute a taxpayer’s liability from discovery. This is because the documents themselves are very rarely considered Fifth Amendment protected testimonial statements. Further, a taxpayer’s failure to cooperate may motivate the auditor to reach out to third parties and obtain the same records in another manner.
Cooperating Opens Up Opportunities
It is always advisable at the outset to cooperate with an auditor by acknowledging calls and written correspondence, and then negotiating a timeline for responding to information requests. Establishing this baseline rapport creates opportunities for negotiations at a later date.Being able to keep the lines of communication open is key. For example, under something called the Cohan rule, a taxpayer can overcome missing documentation by coming up with reasonably reliable estimates to support the premise that some portion of deductible business expenses must have been incurred. Inherently, using the Cohan rule is a persuasive exercise; the taxpayer needs to be in a position where they can demonstrate their representations are accurate and truthful in order to get the auditor to agree with the proposal. This is simply not possible if the relationship is completely adversarial.
Cooperating does not mean agreeing with the auditor or rolling over on every contested issue. Taxpayers do not have an affirmative obligation to disclose noncompliance, and frequently it is not in their interests to give up more information than is absolutely necessary to respond to specific information requests. Furthermore, a taxpayer should never respond to auditors with false or misleading information, as this exposes them to increased civil penalties and potential criminal tax liability. On the other hand, a taxpayer may want to make a voluntary disclosure in certain circumstances to prevent an inquiry from spiraling out of control and leading to more serious charges. This is often advisable if the discovery of damaging information by the government is inevitable.
Strategy Is Key
The hard part for many taxpayers is not knowing what strategy to employ, and whom to turn to for help. Taxpayers frequently will reach out to their return preparers for assistance in responding to audit requests. Oftentimes, a return preparer will be the party best suited to know the ins and outs of the taxpayer’s return. In other cases, however, the return preparer may have simply been engaged to type numbers from forms and documents provided by the client into tax prep software. In the latter case, engaging that same preparer to assist with the audit will not add value because they will not have the requisite level of knowledge to be able to explain the numbers as they relate to the taxpayer’s actual business.Where taxpayers are under audit and there is concern that there could be a significant assessment for any reason, it is advisable that they seek competent legal counsel immediately. Although accountants and CPAs may have the technical skills to handle most complex tax matters, communications with these professionals concerning many routine disputes are not protected by any sort of accountant-client privilege. In my professional experience, this distinction can and does block frank communications between the taxpayer and their service providers in a way that does not happen when an attorney is retained.
Hiring tax counsel does not foreclose using an accountant, either. Counsel has the option of retaining accountants with respect to client matters through something called a Kovel arrangement. Because the accountant retained under the Kovel arrangement is an agent of the attorney and not an agent of the client, communications may be made between the client, accountant, and counsel without the loss of attorney-client privilege.
The right strategy also takes into consideration the taxpayer’s ability to deal with the aftermath of a potential assessment, including whether penalties may be negotiated down. Sometimes fighting a proposed assessment may not be worthwhile at all when the taxpayer is insolvent or is no longer able to generate significant income due to disability or other hardships. A taxpayer’s resources in these cases may be better spent dealing with the matter from a collections standpoint. Although the taxpayer may legally owe a significant amount of money, the ability of the IRS to actually collect from the taxpayer is not unlimited. Bankruptcy may alternatively be a viable option to discharge income tax debt, although the rules for discharging this type of liability are complicated. We always advise that taxpayers considering bankruptcy seek an individual with expertise in both bankruptcy and tax matters.
Closing
Taxpayers need to be cognizant when they are selected for audit as to what their real risks are and act accordingly. Typically, when an initial information and document request is received, the taxpayer should have some idea as to what areas the IRS wants to focus its examination on. This can be total gross receipts, particular expense types, particular transactions, or other discrete items reported – or not reported – on a tax return. This is the ideal point where the taxpayer needs to commit to some sort of strategy. If they know scrutiny could reveal significant compliance problems, they should reach out to counsel first in developing an appropriate response.©2021. This material is intended to offer general information to clients and potential clients of the firm, which information is current to the best of our knowledge on the date indicated below. The information is general and should not be treated as specific legal advice applicable to a particular situation. Fletcher Tilton PC assumes no responsibility for any individual’s reliance on the information disseminated unless, of course, that reliance is as a result of the firm’s specific recommendation made to a client as part of our representation of the client. Please note that changes in the law occur and that information contained herein may need to be reverified from time to time to ensure it is still current. This information was last updated July 2021.
