Tips On Surviving A Tax AuditI had just left our Scarsdale, N.Y., headquarters on a business trip a couple of years ago when anInternal Revenue Service collections officer named Celeste Green stormed in, waving a "Notice ofIntent to Levy" and demanding that we pay the IRS $25,000 by the end of that month.Since I was not present, Green directed her brusque comments to our perplexed receptionist, whoknew nothing about our business taxes, and to our equally perplexed administrative manager,Pascale Bocchino, who did. Pascale keeps our books and has worked out many snafus involvingpayroll, property and sales taxes over the years. We are diligent about complying with the tax laws -we are in the business, after all - and problems typically involve paperwork that was mishandled,most of the time on the governments end.But Green was not the sort of helpful customer service agent Pascale usually deals with. A collectionsofficer gets involved only after the IRS has repeatedly tried to get a taxpayer to remit money that thegovernment believes it is owed but which the taxpayer has neither paid nor properly challenged. We,on the other hand, had no idea that the IRS thought it had a problem with us. Green offered nodocumentation for why we supposedly owed all that money, and she was not particularly helpful whenPascale asked.After some stonewalling, she told Pascale that a recent income tax deposit of $268 (representingwithholding taxes for an employees maternity leave disability pay) was not timely because it was paidby check rather than electronically. That, said Green, resulted in penalties that brought the bill to$25,000. She told Pascale to pay up. Pascale told Green we would get back to her.After talking to me, Pascale turned the problem over to Rebecca Pavese, who manages our firmwidetax practice from our Atlanta office and who had, coincidentally, just wrapped up an unrelated audit ofone of my personal returns. Rebecca and I both knew that, though some of our tax laws are prettystrange, nobody ends up owing $25,000 because he or she makes a $268 payment by check.Rebecca got to the root of the problem the next day. A few months earlier, the IRS processing centerin Cincinnati had failed to enter data from our quarterly payroll tax return showing the various dateson which we had paid our employees. The data demonstrated that all of our withholding taxes werepaid on time, but since it was missing, the IRS computers concluded that our payments were late.The processing center should have sent several letters alerting us to the problem. We never receivedany. Eventually, the computers referred the matter to collections.An IRS customer service representative in Cincinnati canceled the liability as soon as Rebeccaresubmitted the information. Rebecca notified Green, the collections officer.Green was furious that Rebecca had contacted the processing center, which no longer had authorityover the matter. The collections officer said she knew all along what the problem was. Then shereversed the IRS representatives adjustment and put our nonexistent liability back on the books.This forced Rebecca to interrupt her other work to immediately prepare IRS Form 12153, "Requestfor a Collection Due Process or Equivalent Hearing." This submission prevented the collections officerfrom commanding our bank to hand over our money to satisfy a debt we did not owe. Though she
took her sweet time about it, Green eventually got around to closing the case on her own.This is not how the tax enforcement process is supposed to work. It is not how it usually works. Auditsand collection procedures are not supposed to trick or bully taxpayers into paying fictitious taxes orincorrect penalties. Tax administrators are supposed to try to determine the proper tax, no more andno less, and see that it is paid. Taxpayers and tax practitioners such as those at my firm have thesame obligation.I got into the tax business 25 years ago, and for the most part, the revenue agents I haveencountered were not out to victimize innocent citizens. They were just doing their jobs. Those whostaff the IRS service centers, in particular, frequently try their best to sort out the foul-ups thatbyzantine laws and antiquated information systems regularly create.Still, a quarter-century of representing other taxpayers and of running my own business has made melook at each tax audit as a minefield that contains a relatively safe path surrounded by hiddendangers. Here are my survival tips, and some of the war stories about how I learned them.1. Dont assume that the tax authorities are correct. Federal and state tax offices send out hugenumbers of notices advising taxpayers that they owe money. If you carefully gathered your taxinformation and had someone competent prepare your return, there is a good chance such a notice isincorrect. But a lot of people just pay the bill. Check the facts, or ask your tax preparer to take a look.In a more complex field audit, the revenue agents primary job is to gather facts. He or she has toknow how to apply the law to those facts, but very often, in our experience, the agent does notunderstand the law, or sometimes even the facts.The audit of my personal return that Rebecca handled for me was a good example. I had beenexpecting an audit, because my business income and expenses are mostly reported on the Form1040 I file jointly with my wife, and my business has become much bigger than most similar soleproprietorships. So it was no surprise when an auditor asked for extensive detail about my businessreceipts, all of our business and personal banking transactions, and the three largest expense itemsreported for the business. He was probing to see if I might be skimming cash or otherwise hidingincome, and whether I had records to support the expenses I claimed. This was all standardprocedure.The agent was polite and professional, but he had trouble digesting the information we presented. Hecalculated that the money the business distributed to me exceeded the taxable income I reported thatyear, and asserted that I must have had "unreported cash receipts" equaling tens of thousands ofdollars. But he had looked at all of the bank statements and saw that all our receipts were properlyrecorded. Moreover, we never receive cash in our business, so I could not have had any unreportedcash receipts. Our clients pay us hundreds or thousands of dollars at a time, always by check, creditcard or bank transfer. The auditor had already signed off on this.Rebecca explained that there are a lot of reasons the business could distribute more money than itreported as income in a given year. The business did not start the year with zero in the bank. It coulddraw on credit lines. The owner could contribute capital that would not be included in taxable income.It could receive cash distributions from partnerships whose income is reported separately. Some
expenses, such as profit-sharing contributions, would be deducted in the current year but not actuallypaid until the next year. Other business expenses were paid by me from personal funds and werelater reimbursed by the business. All of these reasons applied to us.Still, the agent persisted in a ludicrous argument that I had "constructively received" income frommyself. Rebecca told him to write up his assessment and send the case to the IRS Appeals office,where we would take it up with an independent reviewer. But first, the agent asked Rebecca to join aconference call with him and two supervisors. They tried to pressure her to agree to his assessment.When she held her ground, the trio muted the phone for a private conversation, then came back onthe line and conceded the case.The same auditor told Rebecca that the holiday gratuities we pay our buildings superintendent andgarage staff could not be deducted beyond $25. We have never heard of such a limit, and the agentcould not point to anything supporting it. His supervisors conceded that point, too.We often find that field agents lack a detailed knowledge of the law, or seem to simply make up rulesthat are not in the tax code or regulations. In part, this is because field agents are some of the leastexperienced and least trained personnel in the enforcement staff. Those with greater knowledge tendto be promoted to appeals or other review-level positions. Educating the agent is part of our job whenwe represent a taxpayer, but what about individuals who represent themselves and who know evenless about the tax laws than the auditor? They are vulnerable to pulled-out-of-thin-air declarationssuch as my agents $25 gratuity limit.2. Do not represent yourself. I have dealt with many IRS agents over the years, but in these twocases that involved me personally, I never spoke with either one. My wife and I gave Rebecca ourpower of attorney and she handled everything. The audit process works best when it is professionaland limited just to the issues that the auditor raises. The taxpayers presence invites incomplete orincorrect off-the-cuff answers to the auditors questions. An effective taxpayer representative (usuallya CPA, attorney or IRS-authorized enrolled agent) will find out what the auditor wants to know, gatherthe information and present it clearly and concisely without triggering collateral issues.The downside to hiring a representative, of course, is cost. Skilled professional representation isexpensive, and your representative does not control how many hours the audit will consume - theauditor does. Auditors do not care how much they cost you in professional fees. In some instances, Ihave had the impression that tax authorities have a pretty good idea how much it will cost a taxpayerto appeal or litigate a dispute, and they offer to settle for about the same amount. It may be worthaccepting such an offer if the auditor raises a valid point.Once you hire a representative, get out of the way. Dont go to meetings with the auditor. Dont speakdirectly with the auditor (other than a polite hello if the auditor comes to your home or business). Ifyour representative is good, you have nothing to gain by participating in the process.3. Do not extend the statute of limitations. You have a few months after the end of the year to fileyour tax return. The authorities generally have three years thereafter to examine it and ask anythingthey want. Auditors have heavy caseloads, however, and they like to manage them by askingtaxpayers and their representatives to waive the three-year limit. Taxpayers usually grant such
requests. I think this is a mistake.Waiving the statute is almost never in the taxpayers interest. It allows the agent to drag out theprocess, inflating the taxpayers cost for representation and increasing the exposure to any potentialinterest and penalty charges. It gives the agent more time to raise more issues. It lets the agent raiseadditional issues if new legislation, regulatory pronouncements or court decisions provide support.The taxpayer, who is entitled to compute and pay his taxes and get on with life, gets no benefit.Taxpayers who represent themselves may not want to upset an agent who seems to want to be theirfriend. Professional representatives, I suspect, feel the same way, but they ought to know better. Theauditor is not there to be anyones friend. Yet auditors sometimes react so negatively when wedecline to extend the deadline that I am convinced that they almost never experience such rejection.In one such case, a New York state tax agent sought to determine how much time one of our WestCoast clients spent in New York in 2006. He asked for information in February 2009 - 20 monthsbefore the limitations expired - and Paul Jacobs, one of our client service managers, sent it to him afew weeks later.Paul heard nothing from the auditor until December 2009, when the agent said he would soon getaround to reviewing the file. Then there was no contact until August 2010. With two months to gobefore the deadline, the agent wanted more information - and an extension.Paul promised to get the data to the auditor in a few days, but said we would not grant an extension.The auditor, who had been congenial to that point, then turned threatening and promised to makethings difficult for our client by launching a broader examination of 2007s return and by immediatelyassessing $70,000 in taxes that our client did not owe.Paul put the auditors comments into a letter to the auditor, asked for a reasonable amount of time toprovide the information he had belatedly requested, and told the auditor we wanted to complete theexamination within the statutory period. This documentation of the auditors threats immediatelychanged his attitude. He accepted the data when Paul sent it to him, dropped his demand for anextension, and closed the case without assessing any tax.4. Do not be bullied or intimidated. Most agents will not threaten, yell at or otherwise mistreat ataxpayer, but an occasional miscreant will. Pauls approach of documenting the misconduct so thatthe agents supervisor or an appeals officer might learn about it is one way to handle this situation.Another is to simply ask to speak with the agents supervisor.Some years back, an agent who was examining a clients gift tax return wanted to come to my officeto review voluminous documentation with me. It would have taken hours and cost my client a lot ofmoney needlessly. I told the agent I would compile the information, send it to him, and we could thentalk on the phone and discuss whether a meeting was necessary.He began to scream at me, mostly along the lines that he, not I, was going to control the audit. Whenhe paused to catch his breath, I calmly told him I would speak with his supervisor before having anyfurther dealings with him. He gave me the supervisors name, and the supervisor quickly assignedanother agent to the case. That agent let me send her the documents and then came to the office fora brief, to-the-point meeting.
5. Keep excellent records. This is the best tax advice I can give you. If you can demonstrate thatyour tax return is correct and complete, and that the positions you have taken comply with the law,you should have no problems if you are audited.You might have to rely on professionals such as my colleagues for the compliance part, because thelaws are just too convoluted for anyone else, except maybe someone whose financial affairs are verybasic, to be expected to understand. But even the best-informed tax professionals must work with theinformation you give them. If you dont have a system to efficiently maintain the records you need,your tax adviser can help you set one up, and maybe even maintain the records for you. It can bemoney very well spent.Your goal in an audit should be to respond to questions quickly, accurately and completely, withoutgetting bogged down with extraneous information. The auditors job is to build a good file showing thatthe taxpayers return is correct, or that it is not. You will get the best results by helping the auditor dohis or her job well, by offering information that is credible, responsive and well organized.6. Pay what you owe, promptly. Interest and penalties, including penalties for late payment, add upquickly. If you have the money to pay what you owe, pay it. Yes, it is possible to get installment plansand even compromises on tax debts, but the tax authorities are not cutting wholesale deals forsolvent taxpayers. Do not kid yourself.If an auditor raises an issue in which you clearly are wrong, concede the point. Owning up buildscredibility and shows the agent (and any appeals officer who reviews the case) that you are making agood-faith effort to comply with the law. That credibility might earn you the benefit of the doubt onsome other issues, such as minor gaps in your records.Though tax enforcement is theoretically about collecting the correct tax rather than more tax, revenueagents do, of course, care about revenue. If they are not going to find a lot of money by auditing you,they want to move on to a more productive assignment as soon as possible.Your goal in an audit should be to show the auditor that it is time to move on. Thats the quickest,safest route I have found through the audit minefield.cpa exam review courses