Each year, the IRS conducts more than 525,000 field examinations. These examinations are the most intrusive of IRS audits and often result in significant additional taxes and penalties. Field examinations can also take up unnecessary time, which drives up your client’s fees and anxiety through what seems to be a never-ending process.
Much of the problem stems from an influx of new IRS agents learning how to conduct examinations. Consider this: Field examinations have increased 120% in the post-1998 Taxpayer Bill of Rights era, from 239,243 in 1999 to 525,389 in 2011. The number of revenue agents has also increased, from 11,513 in 2003 to 13,761 at the end of 2011, many of whom are new to audits. In 2011, more than 2,200 senior IRS employees were offered buyouts because of the agency’s $304 million budget cut for 2012. The increase in revenue agent hiring and examinations is the IRS’s attempt to help close the $376 billion a year tax gap, which is mostly due to underreporting of tax.
Your client is especially likely to have an inexperienced IRS agent if the field audit involves a small business, which the IRS has pinpointed as an area with the highest noncompliance.
Agents face time pressure
IRS agents have a tough, time-sensitive job. In 2007, the Taxpayer Advocate Service (TAS) reported that agents spend an average of 30 hours per field audit, per return. The agent has 30 hours to complete a difficult project, which entails the following:
- Determine the information to request to understand your client’s business and its history, recordkeeping, finances, and tax return positions.
- Learn the unique aspects of your client’s business, including ratios, operations, accounting methods, and business issues.
- Reconcile financial information on the return against your client’s financial records, bank accounts, and third-party evidence.
- Gather and understand information on technical issues particular to your client’s industry or profession.
- Determine which issues to pursue, which may or may not be evident on the return, and develop these issues by requesting relevant information pertaining to your client and the industry.
- Identify and scrutinize related returns for accuracy, such as shareholder, payroll, and information returns.
- Propose issues in writing, solicit agreement, and, if it’s an unagreed examination, prepare the facts, law, and government’s position for IRS appeals.
The above list is not exhaustive. The agent must determine the accuracy of your client’s return, which is often filed more than once a year before the audit begins. Add to that a complex Tax Code, and the agent faces an almost impossible task to perform effectively in a short time.
Inexperienced IRS agents and time pressure lead to a dilemma and an opportunity for tax professionals representing their clients. CPAs are becoming facilitators in audits, often guiding the audit and educating the agent every step of the way. This requires that CPAs become familiar with the IRS audit process through personal experience, CPE courses, and consulting with other tax professionals experienced in audit logistics.
Increase your tax audit due diligence
To effectively facilitate an audit, you must plan. With some extra due diligence, you can prepare for most of what will arise in an audit and avoid prolonged examinations. Your clients may have more upfront fees, but your planning will save them much more in the long term.
Take these nine steps to prepare for your client’s audit:
- Explain the big picture clearly and concisely. For example, if your client is in the real estate business, be prepared to use data to explain how the economic downturn has affected your client and his or her business. The agent will appreciate the insight. Refer to the data constantly throughout the examination to explain income and losses.
- Identify potential issues and prepare to clearly explain your position. Good starting points are large, unusual, and questionable items; ratios that are not in line with industry norms; wide variances from prior and subsequent year returns; losses; and related-party transactions. If you prepared the return, you will know the sensitive areas. Be prepared to present your position clearly and definitively.
- Create a roadmap of your client’s business records and reconcile the records to the return. Be prepared to explain how the return reconciles to different financial systems and how your final trial balance and tax return workpapers are reliable. A written flowchart will avoid many misconceptions.
- Explain significant differences in “cash in” vs. “cash out.” A tax return that shows much more “going out” than “coming in” will need a well-prepared and well-documented early explanation. If not, be prepared for a long, in-depth inquiry from a suspicious agent. Even the most inexperienced agent is trained to test this first.
- Perform a bank deposits analysis. The agent will add all the deposits and ask questions about discrepancies between amounts of specific deposits. Be prepared with answers. If your client has commingled funds, reconcile business and personal accounts.
- Review all Forms 1099, vendor files, and accounts payable for possible worker classification issues and required but unfiled Form 1099s. The agent is required to look at these areas. Be prepared with explanations, especially with your position on the treatment of workers as independent contractors. If you find unfiled Form 1099s, be prepared to correct these filings. Intentional disregard of these filing rules carries a much higher penalty than voluntarily filing.
- Review your client’s online presence. Google your client. Be prepared to explain property findings, professional designations, additional product or service offerings, and any other activity that may be revealed about your client and your client’s business. Use archive.org to view your client’s website for the years under examination.
- Review any audit techniques guides that are relevant to your client. Audit techniques guides (ATGs) provide the blueprint for how the IRS will conduct the audit based on your client’s industry or profession. There are more than 50 ATGs published on the IRS website that provide insight into exam steps for various industries and issues, including cash-intensive businesses, executive compensation, and partnerships. This is mandatory preparation before an audit.
- Request your client’s wage and income transcripts and reconcile them to the return. This is an easy but often overlooked step for individual taxpayers. Request your client’s wage and income information (Forms 1099, W-2, 5498, 1098, etc) and reconcile them to the return. Be prepared to explain discrepancies and own any errors. Failing to reconcile the information on returns without explanation is a sign of return preparation errors for the agent.
Take the lead
Being passive to an IRS audit is risky in today’s environment. The increase in new IRS agents and the complexity of the Tax Code have led to inefficiency in IRS examinations. In fact, since 2006 (with a small exception in 2009), return on investment (ROI) for IRS field audits has steadily decreased. As the IRS stretches to close the tax gap from underreporting, it is imperative that CPAs take the lead in IRS examinations, as facilitators for IRS agents and advocates for their clients.
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Jim Buttonow, CPA/CITP, is the co-founder of New River Innovation and creator of its flagship product Beyond415. He has more than 24 years of experience in IRS practice and procedure.