CHAPTER 33
Handling Audits with the IRS
The word “audit” sends shivers up the spine of a small business owner, and for good reason. Tangling with the IRS diverts the owner's attention from running the business now to hashing over old taxes. An audit may also wind up costing the owner hefty professional fees for representation and additional taxes, penalties, and interest. The good news is that audit rates for most types of businesses are down and not expected to grow anytime soon (see Chapter 1 for audit statistics). Still, if you are selected for examination by the IRS, these statistics are little comfort to you. When you receive a letter from the IRS stating that you are under examination, you need understand what it means and what you can or should do.
This chapter is intended to give you only an overview of the audit process and your options for dealing with it. For further information about tax audits, see IRS Publication 1, Your Rights as a Taxpayer; IRS Publication 556, Examination of Returns, Appeals Rights, and Claims for Refund; IRS Publication 3498, The Examination Process; and IRS Publication 3498-A, The Examination Process (Audits by Mail).
Types of Audits
The IRS is the tax collector for the federal government. If the IRS thinks you have underreported your income or made other errors that caused an underpayment of taxes, it will seek recovery. To do this, it must audit you. IRS audits are conducted by mail or in person (never online). Audits can be:
Examinations by mail (correspondence audits)
Office audits conducted in IRS offices
Field audits conducted in a taxpayer's home or at a place of business
Correspondence Audits
The most common type of audit is by mail. According to the 2015 IRS Data Book, almost 73% of all examinations conducted in the government's 2015 fiscal year were correspondence audits. This type of examination typically is a request for additional information about items shown on a return (e.g., substantiation for a charitable contribution of $250 or more claimed). In some cases, it may be a request for additional taxes resulting from an omission of income that was reported to the IRS on an information return. For example, say Form 1099-MISC was issued to an independent contractor, showing $1,000 of nonemployee compensation, but such amount was not on the taxpayer's return. The letter may adjust the contractor's taxes to take the $1,000 into account.
Depending on the letter received, you may want to handle it yourself or turn to a tax professional, such as the CPA who prepared your return, or a tax attorney. If you checked the box on your return saying that the IRS may discuss the return with the preparer listed on the return, the preparer may talk to the IRS on your behalf about return processing issues, such as missing information, math errors, or payments and refunds. If you want to use a different professional than the one who prepared your return or if you have issues beyond return processing issues, you must complete Form 2848, Power of Attorney and Declaration of Representative, so the IRS can speak with your representative.
Office Audits
The letter inviting you to an IRS office for an examination usually focuses on specific matters from your return. The letter lays out what additional documentation the IRS is seeking; you need to bring this with you when you appear.
Make sure you understand how an office audit works, and your rights during the process. It is usually a good idea to have a professional with you or representing you so you don't say anything or show anything that can induce the IRS to expand its audit focus.
Field Audits
This type of audit is the most invasive because of its location. When the IRS does an in-person audit of a self-employed person, usually it is a field audit. While the IRS usually is looking at specific issues on a return, it may expand its focus after observing your operation.
You should have professional representation during a field audit.
Appeals
At the end of an examination, you can agree with any adjustment that the IRS proposes to make to your tax bill. If so, you pay up or arrange for payment and the matter is closed. If you don't agree with the proposed adjustment, you can take your case to the IRS Appeals Office. Here you have the opportunity to explain your position to a different IRS agent, who may be persuaded to agree with you.
Litigation
If you've exhausted your administrative options, you can go to court.
Tax Court allows you to argue your case without having to pay what is in dispute up front. If the taxes, penalties, and interest are less than $50,000, you can use a small case procedure in Tax Court. This is more expeditious and may be less expensive, but if you lose, there is no appeal from a small case decision.
U.S. District Court may hear your case, but only after you pay what the IRS says you owe and you then sue for a refund.
Federal Claims Court is another federal court option, which also requires payment so that you are suing for a refund.
Mediation
This is a process in which both parties agree to work out their differences using a skilled third party, called a mediator. The results are not binding on the parties, but usually they are adopted.
The IRS offers mediation for tax matters for small businesses and self-employed individuals. The Fast Track Settlement Program at www.irs.gov/Individuals/Fast-Track-Settlement-Small-Business-Self-Employed can produce a settlement within 60 days. The mediator is a trained IRS professional. If you want to use an outsider, you'll have to pay for it, and the IRS must agree to it.
Opting for mediation does not eliminate your other rights, such as going to IRS Appeals or having a conference with an IRS manager. You can still pursue litigation if you can't resolve your issues.
If you want to use this program, you must apply and be accepted. Use Form 14017, Application for Fast Track Mediation. Attach to it your own statement explaining your position on issues in dispute. You cannot use mediation for collection cases, frivolous issues, and certain other matters.
Taxpayer Bill of Rights
By law, as a taxpayer you have certain rights. Many of these rights relate to audits. These rights are:
The right to be informed
The right to quality service
The right to pay no more than the correct amount of tax
The right to challenge the IRS's position and be heard
The right to appeal an IRS decision in an independent forum
The right to finality
The right to privacy
The right to confidentiality
The right to retain representation
The right to a fair and just tax system
Taxpayer Advocate Service
If you have an ongoing issue with the IRS that you've been unable to resolve and need immediate help, contact the National Advocate Service. For example, if the IRS has placed a lien on property that is causing you a hardship and you can't wait to address the issue through normal processes, the National Advocate Service may be able to help.
You can contact the National Advocate Service by calling 877-777-4778 or filing Form 911, Request for Taxpayer Advocate Service Assistance. Find more information at www.irs.gov/Advocate.
If you need more time to file with the IRS, extensions are no longer automatic. You can request a 30-day extension by submitting Form 8809, Application for Extension of Time to File Information Returns. You must give a reason why you need more time to file. The IRS will grant an extension only in extraordinary circumstances or catastrophe.