For the average taxpayer, getting a notice in the mail from the IRS stating that their return has been selected for audit, or selected for “examination,” as the IRS calls it, can be a daunting experience. Returns are selected for examination for a number of reasons. Some are randomly selected. Just because the IRS wants to audit your return doesn’t mean that it’s time to panic; but it is time to prepare.
Returns are typically selected by the IRS for examination a year or two after they’re filed (the IRS generally has 3 years from the date a return is filed to select it for examination, but certain circumstances can extend this period out to six or more years). This means that successfully defending an IRS audit typically entails compiling the necessary supporting documentation to back-up the figures claimed on your return. If the records are available and the return was completed accurately, an IRS examination can be a relatively painless process. However, that’s often not the case.
An IRS examination typically begins with an interview between the taxpayer and the Revenue Agent assigned to the examination, where the IRS will question the taxpayer regarding sources of income, accounting practices, etc. These interviews are typically a formality, but it is still helpful to prepare ahead of the interview in order to anticipate any issues that might arise during the course of the examination that could have the impact of expanding the scope of an audit otherwise limited to one year or a certain set of issues.
Following the interview (and sometimes preceding the interview), the IRS Revenue Agent will typically issue an Information Document Request (aka an “IDR”) on Form 4564 that will listed the specific items on the return that are under exam and the documentation the IRS is requesting in order to verify the accuracy of the return as filed.In the context of personal income tax returns, the items that are most often scrutinized by the IRS tend to be income and, particularly, expense items claimed on Schedule C by self-employed individuals. Most tax payers that are self-employed will compile a profit and loss statement and provide it to their tax preparer to be entered onto the return. Often times, very little vetting is done of the income and expense items claimed on the Profit and Loss statement past the initial bookkeeping stage. Generally speaking, the IRS will request primary-source supporting documentation for items of expense claimed on Schedule C, meaning bank statements, receipts, and cancelled checks. If you’re self-employed and your return is selected for examination, the first step is typically to obtain whatever financial records can support the expenses claimed on the return and begin to tie out the financial records to the figures claimed on the return.
Now, oftentimes taxpayers under exam will simply dump the supporting documentation on the Revenue Agent assigned to review the return and allow the IRS to comb through the records to determine the accuracy of the figures claimed on the returns. While this can shift a large portion of the labor burden involved in an IRS examination to the IRS, it isn’t always the best strategy for successfully negotiating an examination. Having an IRS employee comb through financial records line by line can often result in additional issues being uncovered and the scope of the examination increasing.
In my experience, the best way to achieve a favorable result from an IRS audit is to do the IRS Agent’s work for them: compile the supporting documentation in an organized, clear way and provide summary sheets tying out income and expense items to the various supporting documentation provided. Doing so allows the IRS Agent to confirm the accuracy of the specific items under scrutiny on the return, while minimizing the time the Agent spends actually going through the records. Additionally, going through the records prior to providing them to the IRS enables a taxpayer to recognize potential issues and address them proactively. It also gives the taxpayer the opportunity to identify issues under exam that may impact returns for other years that have not been selected for examination yet. This affords the taxpayer the opportunity to prepare and file amended returns for other years to correct issues before the IRS expands the scope of the examination to include those additional years. While doing so might increase the tax owing for the years outside the scope of the audit, at a minimum, proactively filing amended returns can avoid costly accuracy-related penalties that could be added to the return were it to be selected for examination.
What if I no longer have supporting documents to verify items listed on the return?
Even if you no longer have the supporting documentation necessary to verify the exact amounts reported on the return, not all hope is lost. While the IRS’s default position will typically be to propose a wholesale disallowance of deductions and expenses that cannot be verified, a federal court decision from 1930, “Cohan v. Commissioner of Internal Revenue, 39 F.2d 540 (2d Cir. 1930)” created what’s come to be known as the Cohan Rule. The Cohan Rule refers to the now firmly-established principle that even where a taxpayer cannot substantiate the exact amount of the expense or deduction claimed on the return, so long as the taxpayer can demonstrate that expenses of that type were incurred, the Service should allow a reasonable estimation of the expenses incurred.
In the absence of specific documentation, the IRS will generally want to err on the side of a lower-end estimate of the expenses being claimed, however there is still a lot of room to argue for an estimate of the liability. However, effective advocacy can result in a large portion of the claimed expenses being allowed, even where substantiating documentation is not available. For example, if a taxpayer reports contract labor expenses, but did not issue 1099s and made payments in cash, the IRS may be inclined to disallow the contracting expenses. However, published industry statistics can be used to argue for an allowance that approximates the average contracting cost as a percentage of revenues for the specific industry-type and company size. This can make a huge difference in the total amount of additional tax assessed during an examination.
It is worth mentioning that there are certain expense categories (such as travel and car and truck expenses) which are specifically carved out of the Cohan Rule, and generally require exacting documentation. Even so, one can typically argue for an allowance for car and truck expenses where an exact mileage log was not kept, either by recreating a work-related travel log based on available records or by using available mileage records from oil and tire changes. It is important to bear in mind that an IRS examination is not a zero sum game, and it’s worthwhile to argue for any allowance you can, even if it requires elevating the case to IRS Appeals.
Appealing an Adverse Examination Determination:
After the IRS Revenue Agent reviews available records, they will issue an initial report of their findings, typically a Form 4549 that provides an overview of the specific changes affecting tax owing on the year in question along with a Form 886-A, which provides more detailed explanations of the items being changed. Once a taxpayer receives this report from the IRS, they can either agree to the proposed changes or file an appeal. Generally speaking, an appeal of an IRS examination should focus only on items contained within the initial Form 4549 that the taxpayer disagrees with. In this way, there’s usually very little risk to appealing an adverse examination determination, and IRS Appeals generally has much broader leeway in allowing non-conventional arguments for allowances, including estimates in the absence of records. Whereas many taxpayers will simply accept the initial findings of the IRS Examiner, having experienced counsel on your side can result not only in a more favorable determination during the initial examination process, but also lay the groundwork for a successful determination in Appeals.
My audit was closed, but I was able to find additional information that would help my case. What are my options?
Even if the examination of your return has been finalized and resulted in an additional assessment of tax (plus penalties and interest), there are still avenues whereby a taxpayer can request the IRS make additional changes to the return in the future. The IRS calls the process of doing so an “Audit Reconsideration.” As long as there is still a balance owed on the account for the year that was under examination, the taxpayer has the option to provide the IRS with additional documentation which the IRS will generally review to determine if additional adjustments to the return are appropriate. Even if the resulting audit assessment has been paid in full, so long as there is still time remaining on the Refund Statute Expiration Date on that year, the IRS will generally agree to process a request for audit reconsideration. It bears mentioning that the IRS has sole discretion to reconsider an examination that has already been closed out, however as long as the taxpayer can provide compelling information that would indicate the original audit assessment was incorrect, the IRS will generally have no problem processing the request and making adjustments to the audit assessment.
As a successful audit reconsideration will generally result in a direct reduction of the taxes assessed on a particular year, as well as a rollback of the concomitant penalties and interest assessed on the account, requesting an audit reconsideration can actually be a powerful tool in resolving income tax liabilities, though audit reconsiderations generally take quite a while for the IRS to process (sometimes over a year), so negotiating a temporary resolution can sometimes be helpful in keeping the IRS at bay while they review the request and make the necessary adjustments to your account. If you’re currently under examination and don’t want to go it alone, please reach out to us to discuss your specific situation. Our audit representation services can give you the peace of mind to know your audit will be handled by an expert and result in the lowest assessment possible. If you’ve been audited by the IRS in the past and believe the examination resulted in an over-assessment, we can review the audit results against the originally-filed return and available supporting documentation to determine whether an audit reconsideration can reduce or even eliminate the taxes the IRS believes you owe.