IRS audits have more than doubled in the past decade. The number of taxpayers targeted is likely to continue to increase in the years ahead as the federal government tries to boost tax revenues to close its huge budget deficit.
High earners, small-business owners, the self-employed and those with offshore accounts face the greatest risks — but an audit can happen to anyone.
Most audits are simple “correspondence exams” — an IRS computer identifies a math error… mismatched data… a missing form… or some other straightforward mistake. Once you are contacted by the IRS, you mail in the additional payment or information requested and the matter often is resolved without further fuss.
You face a much more significant audit if the IRS requests a meeting. Although many taxpayers choose to handle this on their own, it is best to hire an experienced tax attorney, certified public accountant (CPA) or enrolled agent (who is required to pass a test to represent taxpayers in dealing with the IRS). This could cost from a few hundred to a few thousand dollars, depending on the experience level of the professional you hire, the complexity of the audit and where you live. Costs could climb even higher if there are appeals or the case goes to court.
Helpful: If you can’t afford to hire representation, ask local law schools if they have a free or low-cost tax clinic that can provide representation.
Whether you work with a representative or go it alone, it pays to be aware of IRS agents’ latest tactics… and the often-overlooked tools available to you.
The surprise phone call. Prior to 2009, audit notifications almost always were sent through the mail. Now IRS agents sometimes contact taxpayers by telephone out of the blue to tell them that they are being audited. The shock of this call may cause a taxpayer to say more than he/she should.
What to do: If you receive such a call, take down the IRS agent’s contact information, say that you are represented by a tax preparer or tax lawyer (or that you may hire one) and that this representative will be in contact. Say nothing else — you have a legal right to consult a tax adviser before responding to IRS questions. And be aware that in some cases, the caller could be a scammer posing as an IRS agent in hopes of obtaining sensitive data, so don’t supply personal information.
Inflexible deadline. The IRS requires taxpayers to respond to most audit notices within just 15 or 30 days. Those deadlines have become increasingly inflexible in recent years.
Example: Fail to respond to a correspondence exam notice within 30 days, and the disputed amount becomes a final assessment to be handled by the collection department, making it very difficult and expensive to challenge the IRS’s position — even if you can prove that the IRS is wrong.
What to do: Always contact the IRS by the deadline on the notice, and ask what in particular the IRS wants to cover. Do so by certified mail so that you have proof of when your reply was received. If you intend to hire a representative, do this as soon as possible so that your rep has time to respond.
Casual chitchat. Anything you say to an IRS agent can be used against you, and agents increasingly are trained to get taxpayers to say things they shouldn’t.
Example: An auditor swapped fishing stories with the owner of a part-time boat charter business, then asked whether the business ever was likely to make money. The owner jokingly replied that he loved fishing so much that he didn’t really care if it did. The agent said this quip showed that the business was just a hobby, and the owner’s tax losses were disallowed.
What to do: If you work with a representative, politely refer all questions from the IRS to your tax pro — even questions that seem innocuous. Let your representative meet with the IRS without you unless the representative specifically advises you to accompany him. If you do not hire a representative, politely avoid small talk. Respond to financial queries by writing down the questions and promising to provide the requested information as soon as possible. Supply these answers in writing to reduce the possibility of misspeaking or saying too much, and keep a copy.
It isn’t easy to take on the IRS, but taxpayers and their representatives do have some tools at their disposal…
Ask to speak with a manager — twice. If you can’t see eye-to-eye with the agent handling your audit, you have the right to speak with the agent’s “team manager.” Unfortunately, team managers generally stand behind their agents’ rulings. If this happens, ask to speak with the team manager’s manager — the “territory manager.” Territory managers tend to be more reasonable and flexible than lower-level IRS employees and sometimes overrule low-level agents’ decisions.
Turn the IRS’s strict deadlines against the IRS. Send certified letters to the agent handling your audit. These letters might ask questions about your audit or provide information requested by the auditor. If 30 days pass without any reply to your letter — as often happens — you have the right to request the free assistance of the IRS Taxpayer Advocate Service (877-777-4778, www.irs.gov/advocate). The Advocate Service can spur the IRS to action when it is dragging its feet or stand up for taxpayers when the IRS is not following its own rules. Most important, enlisting the Advocate Service’s help encourages IRS agents to treat you kindly — agents typically tread with caution when this watchdog is looking over their shoulders.
Request a Fast-Track Settlement (FTS) if your audit involves a gray area of tax law. The FTS option lets you enter the IRS appeals process even before the initial audit has ended. That could work in your favor if your audit involves a gray area of tax law. Why? An agent who handles an initial audit typically rules against the taxpayer if there is any chance that the taxpayer owes money… but IRS appeals officers take into account the odds that the IRS may lose if the case goes to court. Thus appeals officers are much more likely to back down or compromise when it’s unclear which side the tax law favors.
Example: An IRS agent questions whether you “actively participated” in a business. What constitutes active participation is a legal gray area.
You could wait until after the initial audit to appeal, but that likely would leave the audit hanging over your head for many months and inflate your representative’s bill if you hire one. A tax pro should be able to advise you as to which issues fall into legal gray areas.
Warning: If an FTS makes sense in your case, request it as soon as the agent handling your audit indicates that he/she intends to pursue what seems like a gray-area tax issue. A new IRS policy makes this fast-track process unavailable once the agent handling the initial audit sends a 30-day notice officially ruling on an issue.
Request a face-to-face penalty-reduction meeting. The IRS attempts to impose penalties almost every time it concludes that a taxpayer has underpaid his taxes. In most cases, those penalties are unjustified. Penalties generally are called for only when taxpayers knowingly fail to pay taxes, not when they make honest mistakes.
Agents who specifically handle penalty abatements are far more likely to reduce or eliminate penalties when they have looked the taxpayer — or the taxpayer’s representative — in the eye and heard in person an explanation of how the underpayment was accidental.
