As a public service to Colorado taxpayers, the Tax Section of the Colorado Bar Association has prepared this and other brochures intended to help individual taxpayers better understand how the IRS and the Colorado Revenue Department determine and collect taxes. This brochure will help you understand how the federal and state tax agencies carry out their personal income tax audit missions. In question and answer format, this brochure also provides useful tips and general advice on how to prepare for and deal with audits.
DEALING WITH THE I.R.S. NOTICE OF EXAMINATION
A significant percentage of taxpaying citizens have the experience of being audited (IRS uses the term "examination") at some point during their lives. The IRS examines individual taxpayers in essentially three ways. First, returns are examined at IRS Service Centers (Ogden, Utah if you are a Colorado resident). Routine errors, such as math errors, missing schedules, and the like, are usually dealt with by correspondence. Returns with more complex issues, or that meet other criteria, may be forwarded to the IRS local District Office for further screening. Returns that warrant further examination will be assigned for either an "office examination," or "field examination." Office examinations are conducted by agents who do not leave the IRS premises to do their job. Field examinations are carried out by more experienced agents who usually go to the taxpayer's place of business or residence.
The most complex returns, such as those involving high income schedule C (sole proprietor) businesses, are generally assigned for field examination. However, the majority of examinations will be handled by office examination. While many of the issues discussed in following pages are common to both office and field examinations, the balance of this brochure will focus specifically on a typical office examination situation, since that is how a large majority of audits are handled.
In any case, knowing what to expect, and how to respond, can make things easier! Here are some of the most common questions about how the IRS conducts audits, and what rights and obligations taxpayers have in the course of that process:
Q. I (or my spouse and I) have received a letter from IRS telling me that my tax return for a previous year is being examined. I'm a conscientious taxpayer, and I understand only a very small percentage of returns are audited. Why am I being singled out?
A. The IRS rarely singles out a taxpayer based on who the taxpayer is, or because IRS thinks the taxpayer has done anything wrong. More than 95% of personal tax audits occur as a result of entirely objective statistical reviews of filed returns. Through a complex system known as "DIF" scores, IRS looks for particular items in returns that it has found from statistical analysis to indicate a higher than average chance of tax understatement. Returns showing very large gross incomes, and those having Schedule Cs (sole proprietorships) are frequently picked, often based on the amount of deductions claimed in relation to gross business income. Persons who have significant capital gain transactions reported on Schedule D are also more likely to be audited, since asset "tax basis" issues often arise and result in adjustments.
Taxpayers who fail to report all items of income, improperly report items, or omit required W-2s and other return schedules, are more likely to attract attention. Most simple issues, such as computational errors and missing documents and schedules, are resolved by "correspondence audit" from the Service Center. Merely sending in the requested information or schedule will usually bring these return reviews to a quick and trouble-free conclusion. Other returns with more extensive or complicated issues may be headed for a more personal and detailed office (or field) examination.
The point is, no taxpayer should ever feel or assume they are being audited for "personal" reasons. In the vast majority of cases, there is no need to be worried or upset. There is simply a small chance each year of having IRS select your return for examination for one reason or another. Unless your returns are very simple and invariably accurate, the chances of at least one audit during a lifetime are fairly high.
Q. My examination notice says I am to appear for an appointment at the IRS offices, and that I need to bring certain records and items with me. Is there anything else I need to think about or bring to the audit?
A. Some examinations are conducted entirely by mail, with no required personal appearance. In other cases, the taxpayer will receive a notice listing the information that is needed, and setting a time for the taxpayer to appear at one of the IRS office locations. Except for special circumstances as discussed later on, the best approach to an IRS examination is to promptly and fully cooperate from the outset. An examiner's mission is to quickly and efficiently complete each assigned case, so prompt cooperation may improve the chances of a quick and satisfactory conclusion. If an appointment is scheduled, try to make it if possible. If you can't, call the examiner's office right away and re-schedule. The best policy is to bring only those items or records that are specifically referred to in the notice letter. Don't risk opening issues unnecessarily by volunteering information that was not requested.
Q. The notice we received pertains to a joint return between me and my spouse. Do we both have to attend the meeting with the agent?
A. No. In most cases, either party can attend the meeting. The only exception might be if the issues being examined would require answers and information from each spouse.
Q. I am afraid of IRS and the power they seem to have. Can I, and should I, take a CPA or attorney with me? Will IRS think I am hiding something if I do?
A. You have every right to be represented during an audit. IRS employees are used to dealing with taxpayer representatives. No reasonably experienced IRS agent will assume or presume that you have anything to hide just because you chose to be represented. You can hire a CPA, attorney or IRS Enrolled Agent to represent you, or the paid preparer of your return can represent you. Representation can be expensive, so you need to consider the nature of the issues, and the amount of tax you believe IRS could or may determine you owe. If you have good books and records, and you are fairly sure that you can substantiate any items in your return, you may not need or benefit from representation. While a few IRS examiners may be unduly aggressive, most are fair and reasonable. Their job is to determine if the entries on your return are accurate and supportable. If they are, the return will be "no-changed" and you will be in and out quickly. There could even be a refund, if you discover in the process that you had deductions that you failed to claim.
On the other hand, if you anticipate that there will be significant issues that could result in substantial tax liability, and certainly if you know you filed an inaccurate return (more on this later), it may be wise to consult with an experienced and knowledgeable tax professional before the examination begins. Even if you think you know what the areas of concern might be, an experienced tax professional may be able to look at your return and tell you what items or schedules are likely to draw the examining agent's attention. This may help you prepare, and it will also help you decide whether you want and need ongoing representation during the audit process.
Q. If I hire a representative, can I avoid having to meet face-to-face with the examining agent?
A. In most cases, yes. You can give a qualified representative your power of attorney (using IRS form 2848), and he or she can appear for you. Your representative can handle any or all aspects of the audit, including signing final agreement forms. If your own time is very valuable, it may be worth the cost to have representation. But, such representation can be expensive, and it can have the effect of prolonging the audit process. An audit may move faster and more efficiently if the IRS examiner can deal directly with you. Items that need explanation can be dealt with quickly, without having to go through an intermediary. In some cases, examiners desire to see and question the taxpayer directly, perhaps to evaluate the taxpayer's credibility in connection with issues that are marginal. Unless there are compelling reasons why you do not want to participate directly in the audit, it may serve your best interests to do so. Indeed, the examiner might be persuaded to allow a deduction based upon the sincerity and believability of the taxpayer, whereas he or she would have refused to allow the item in the absence of the taxpayer's testimony.
You should also know and appreciate that, while IRS agents must generally respect a power of attorney, they do have the right and authority to command the taxpayer's presence at an audit by way of an "administrative summons." This can happen if the examiner is not getting complete cooperation and information from the taxpayer's representative. It can also happen if the examiner has suspicions about the entries on the return. If you elect to hire a representative, be sure he or she is qualified and has the time to be attentive so that needed information is gathered and submitted to the examiner in a timely fashion.
A representative is also highly advisable in any case where a taxpayer has knowingly filed a return that contains false information. There are costly civil penalties for tax understatements and inaccuracies, and if willfulness can be shown, a criminal investigation can result. If you know you filed an inaccurate return, and/or you know you cannot substantiate material items in your return, you should see an attorney with experience in handling criminal (or potentially criminal) tax cases. In such cases, it can be extremely important to have a representative dealing directly with IRS on your behalf. If there are questions you would hate to have to answer on the spur of the moment, it is better to have those questions routed through a representative. If in doubt, get professional advice!
SPECIAL NOTE: Never succumb to the temptation to fabricate receipts or other records to support invalid deductions that you have claimed, and don't lie to the examiner about income or any other items. More than a few taxpayers have been prosecuted for giving false records or statements in cases where the best course would have been to simply give up the deduction and pay the tax! Underlying tax evasion is generally difficult for the government to prove. On the other hand, false statements or fraudulent records made in an effort to cover his/her tracks are more often a taxpayer's undoing!
Q. If I agree with the amount of tax the examiner proposes, when and how will I have to pay it?
A. First, you should understand that any proposed tax deficiency will also include statutory interest at 9% per annum from the date the return in question was due to the date you pay the tax amount. The interest is compounded daily, so it can become a very significant factor in the total bill! The examiner will generally prepare an audit report showing the additional tax, any penalties and the accrued interest amounts. If the "bottom line" is acceptable, you will be asked to sign the audit report, which also contains a provision by which you allow IRS to immediately assess the amount shown. By signing the form, you will waive further administrative appeal rights, and the right to go to Tax Court. It will take the IRS Service Center anywhere from three to eight weeks to process the file, assess the tax and send you a final bill. Interest stops for 21 days after the bill is issued (if the deficiency is less than $100,000). If you pay within that time, there is no additional interest.
If you are worried about accruing interest, you can make a payment immediately, even before the examination is completed or a bill is sent from the Service Center. This will cut off further interest accruals on the amount paid. Such payments can be made in two ways. First, you can pay part of the tax that you anticipate you will owe. Note clearly on your check that the payment is for 1040 taxes for the year in question, and be sure to include your Social Security # on the check! The payment can be made at the cashier counter in the local IRS District Office, or you can send it directly to the Service Center in Ogden.
Another option is to make a "tax deposit" rather than a tax payment. If you wish to stop all accruing interest, the only way to do so is to deposit the full amount of the tax and accrued interest to the date of payment. A partial tax payment, or full or partial deposit, will not deprive you of your right to an appeal or to go to Tax Court. Care must be taken, however, to not fully pay a proposed deficiency, since that can terminate your appeal and Tax Court rights. If you are considering making a payment under either of these options, you may want to consult with a qualified professional who can assist you in deciding whether and how to make a payment. Advice from a professional is especially wise if you anticipate that you will want to appeal the examiner's decision, and/or petition the Tax Court.
SPECIAL NOTE: You should always bear in mind that whenever IRS assesses additional tax for any year, you have a legal obligation to report the changes to the Colorado Department of Revenue. Even if you don't voluntarily
report the changes, Colorado will almost always pick them up pursuant to an information sharing arrangement between the taxing authorities. So, in deciding whether to agree to an adjustment on your federal tax return, don't forget the additional Colorado tax and interest that will have to be paid!
Q. If the examiner determines that I owe tax and I don't agree, what are my options?
A. There are various options available to you if IRS says you owe more tax. The most important thing to remember is that you do not have to agree (or disagree) with an examiner at the time of the audit interview. IRS office examiners are encouraged by their group managers to get examinations closed quickly, preferably right at the conclusion of the first audit interview. In most office examination situations, examiners will tell the taxpayer what they think he or she owes, based on the examiner's assessment of the taxpayer's records and substantiation. The examiner may encourage you to sign a computer generated audit report at the end of the audit interview, which as noted above, allows IRS to immediately assess the additional tax.
If you are not entirely comfortable with the amount of additional tax the examiner says you owe, do not sign anything, and do not indicate whether you agree or disagree. The best approach is to have the examiner run an audit report for you showing the additional tax, penalties and interest that he/she is proposing. You should tell the examiner that you will get back to them after you have a chance to study the report and consult with your advisors.
When deciding whether to agree to additional tax, always remember that, in addition to the tax, you will owe statutory interest from the due date of the return. Also, make sure you understand whether the examiner is proposing any penalties, such as late filing or accuracy penalties. These can be substantial in amount, and they too bear interest from the due date of the return. The audit report should reflect all of these items, and will give you the "bottom line" number. Also, you should be alert to the possibility that a subsequent year return may contain the same issues, and could make you vulnerable to another audit. Thus, it is wise to carefully consider all the effects and risks of agreeing to any proposed tax deficiency.
If you disagree with the examiner's findings, you have the right to an administrative appeal. If you feel the examiner was being unreasonable on any issue or issues, you can first request a meeting with the examiner and his/her group manager. Managers will sometimes reverse the examiner if circumstances warrant. If that avenue fails, or you feel it would not be helpful, the next step is to advise the examiner that you will not agree with the proposed adjustments. Examiners usually try to persuade taxpayers to do "partial agreements" in which the taxpayer agrees to those adjustments that he or she does not dispute. Only the disputed items are then written up as "unagreed." Partial agreements can make sense in many cases by simplifying the issues. On the other hand, by agreeing to some issues that are marginal, you may be giving up some measure of "leverage" in an appeal. Here again, professional advice can be helpful.
If the case will be fully or partially "unagreed," the IRS will then issue what is commonly called a "thirty-day letter." This letter will set out the proposed changes and tax liability, as well as explaining your appeal rights. It will tell you that you must file a protest (and/or request a hearing before the Regional Director of Appeals) within thirty days. By filing a protest, you will insure your right to have the Appeals Division consider your case.
The Appeals division is staffed by experienced IRS agents who are charged with the responsibility to review your case, and to determine if there is a basis upon which your case can be compromised and settled. Don't expect Appeals to give away or settle issues that you could not support or substantiate in the audit. But, if the issues are not entirely clear, are close-calls, or legally debatable, Appeals Officers, unlike an examining agent, have settlement authority. A large majority of cases submitted to Appeals are settled. However, the process can take anywhere from four to eighteen months (or more) to complete. Meanwhile, interest continues to run on whatever tax liability is finally settled upon. You may want to consider making at least a partial payment to reduce interest accruals. Doing so will not adversely affect your opportunity to get a fair hearing in the Appeals Division.
Q. Will I need an attorney or CPA to represent me in Appeals?
A. As with the audit phase, you have a right to have a qualified representative handle your appeal. Again, the costs can be substantial, so you need to weigh the issues and the amount of dollars at stake. Proposed deficiencies of less than $10,000 can make representation relatively uneconomical, and there is a simplified procedure for appealing a case involving that amount or less. Appeals officers are, for the most part, well qualified and conscientious individuals. They will generally give every taxpayer a fair and impartial hearing, and they will not demand much in the way of formality in the process. But, if the amount at issue is substantial, and particularly if subsequent years returns may contain the same issue, it might be wise to get some advice and assistance from a qualified professional.
Q. Do I have to go through the Appeals process before I can go to Tax Court? What if Appeals is not willing to settle my case in a manner that I think is fair?
A. A taxpayer can waive Appeals consideration and proceed directly to Tax Court. This is not generally advisable. Also, even those cases that are directly docketed in Tax Court will be routed back to Appeals to see if the case can be settled. In almost all cases, particularly those involving modest amounts of proposed tax ($10,000 or less), it is best to try to get the matter resolved in Appeals. In complex and/or high dollar cases, professional advice should be obtained before deciding how to proceed.
If you go to Appeals but do not obtain a settlement proposal that you feel is fair, your next option is to petition the United States Tax Court. Once you tell the Appeals Officer that you will not agree, a "90-day Letter" will be issued. This is a letter in which Tax Court rights are explained. The letter will also provide instructions on how to file a petition within the 90 day petition period. The Tax Court holds varying numbers of sessions in Denver and other IRS Districts. It can take anywhere from six months to two years to get a case heard in Tax Court. Fortunately, most cases that are petitioned in the Tax Court are ultimately settled by Appeals Officers or IRS District Counsel attorneys. In those rare cases that cannot be settled, the Tax Court judge will make the final decision.
Again, costs must be considered before deciding to petition a case in Tax Court. It is possible to follow instructions and petition your own case. Tax Court judges will make every effort to give a taxpayer a chance to present his or her case. But, much more so than with the Appeals Division, it may be unwise and even counter-productive to enter the Tax Court arena without qualified legal counsel. The amount at issue must, of course, justify the cost, and beware of ever accruing (and non-deductible!) interest. Advance payments of some portion of the tax may be advisable.
With rare exceptions, a Tax Court judge's decision will end the matter. An appeal can be taken to higher federal courts from an adverse Tax Court ruling, but the costs and complexities of doing so are formidable. It is also possible, and in some cases advisable, to take a tax controversy to federal district court rather than to Tax Court. This option requires advance payment of the entire tax amount at issue, and legal counsel is virtually indispensable. These issues are beyond the scope of this brochure, but if your case involves significant dollars, you may want to discuss the options with a qualified tax attorney.
SPECIAL NOTE: If you need help with an appeal or Tax Court petition (or any tax litigation), but the amount at issue is small, or you cannot afford to hire a lawyer, there may be other resources available to you. For example, the Tax Advocacy Clinic at the University of Denver College of Law will provide assistance with selected cases at no charge. The Clinic phone number can be obtained by calling 871-6000. Also, low income taxpayers may be able to qualify for assistance from the County Legal Services Department. Check you phone book listings.
Q. It took the IRS many months to get around to auditing my return, and the audit itself took a lot of time. Is there any way to get IRS to reduce the interest I have to pay on the additional taxes I owe?
A. Generally speaking, a tax deficiency assessment will always include statutory interest, regardless of how long the audit and assessment process takes. Recent law changes have made it easier to get a reduction of interest in certain limited circumstances. If the IRS has caused a delay in processing your case once you were notified of an audit, you can request a reduction of at least a portion of the interest. Only certain administrative processing errors (so called "ministerial errors") on IRS's part can be used as a basis to reduce interest. The fact that the examiner was slow or inefficient is not such an error!
A request for an interest adjustment must be made by way of a claim for refund (using IRS form 843) after the Service Center has billed you for the deficiency that you have agreed to. The examiner will not be able to consider your request for interest reduction. The IRS has generally been very reluctant to grant interest adjustments. The only recourse if the decision is negative is to petition the Tax Court to review the interest issue. Unless the amount of interest at issue is quite substantial, it is probably not worth pursuing.
Q. If I cannot afford to pay the taxes the examiner says I owe, what are my options?
A. Taxpayers usually haven't budgeted for unexpected tax deficiencies, so this can be a real problem. If you are inclined to agree to the deficiency, but can't afford to pay the full amount due, speak with the examiner. The examiner is authorized to consider a payment plan as part of the examination process. You may need to complete a simple IRS financial statement, although this is not required if the amount of tax is $10,000 or less. An installment payment plan fee of $43 is charged, and interest at the statutory rate (as well as up to 1% per month in "failure to pay penalty") will be running on any balance due, so the IRS "carrying charges" can be extremely high. Check out all other sources of funds before you take this route!
Aside from making an installment payment agreement, there are other options, including an offer in compromise. Another CBA Tax Section brochure deals specifically with offers in compromise and other tax collection issues, so please refer to that item.
Q. Since I am experiencing a federal income tax audit, will Colorado audit the same returns?
A. No. The Colorado Department of Revenue relies almost entirely on the federal system. It performs almost no independent individual audits of underlying tax return information. Once IRS makes changes to your returns, you have a duty under the law to amend your Colorado returns for those years, or to at least provide Colorado with a copy of the federal audit report. Regardless of whether you notify Colorado, the IRS will furnish the audit information and results to Colorado on magnetic tape. Colorado will then make corresponding adjustments to the state returns and bill you for the additional tax. Colorado will also assess interest on any deficiency (currently at a minimum "discount rate" of 9%). There is no procedure for obtaining a reduction or elimination of Colorado interest, but prompt payment insures getting the lowest rate.
Q. Having been audited for a given year, what are my risks of being audited again on future returns?
A. This is a common but difficult question to answer. Obviously, if the same issue that triggered an audit in year 1 appears in a tax return for year 2, the chances of another audit are fairly good. In fact, examiners will usually ask to see copies of filed subsequent years' returns to see if the same issues appear. The examiner has the discretion to initiate an examination (or to extend the current examination) to the subsequent years. However, for the most part, examiners will look only at one or two years and that will be the end of it. Just because you were audited for a given year will definitely not, in and of itself, cause you to be audited in future years. The only exception to this would be certain cases where the taxpayer has "inadequate records" which make the examination difficult to perform. In certain circumstances, the IRS may issue a special notice of inadequate records. This usually does result in annual follow up contact to insure that the inadequacy is being corrected.
The best way to get through an audit, and the best way to ward off additional audits, is to maintain good records! Most unpleasant audit experiences come from having improperly prepared returns and/or having inadequate records. And, be sure to keep your records for at least three years!