The IRS has emphasized its scrutiny of affluent taxpayers in the past few years. The U.S. Treasury’s inspector general for tax administration stated in July 2006 that the examination coverage rate of high-income taxpayers increased from 0.86 percent in fiscal year 2002 to 1.53 percent in FY 2005. Moreover, the examination rate for high-income tax returns based on 1040 forms filed with Schedule C rose from 1.45 percent to 3.52 percent.

Why should an audit notice cause such fear? Generally speaking, an audit is a process whereby a taxing authority merely seeks to verify the accuracy of a filed return to determine that the correct amount of tax was paid or refunded. However this process also allows an auditor to rake through the details of one’s financial (and sometimes personal) life.

The procedure ranges from cursory information requests to in-depth interviews and, in extreme cases, a field visit by an auditor to a taxpayer’s business. Depending on the level of involvement and what the examiner discovers during the audit, the end result can lead to a tax refund, or, more likely, a tax increase, penalties, interest and, in the worst cases, criminal investigation, prosecution and prison.

The IRS closely guards the secrets that can trigger an audit. Some investigations are prompted when a taxpayer claims a deduction outside of a standard range for similar taxpayers. Sometimes one is triggered by a discrepancy between tax-year filings or even a tip from an informant. The taxpayer normally becomes aware that he is the subject of an audit with an opening letter from the taxing authority containing an Information Document Request (IDR).

Get By With a Little Help
Now what do you do? In our collective 32 years of experience at the IRS, we have come to appreciate the wisdom in the old saying that the lawyer who represents himself has a fool for a client. The same applies to the naïve taxpayer.

A number of clients who began the process without competent representation were so distracted that business suffered.

An audit can seriously impact your business activities, and it can also be a stressful experience that drains your personal life. A number of clients who began the auditing process without first obtaining competent representation have later stated that, once they realized how demanding and detailed the audit process is, they were so distracted that business suffered. Some felt a tremendous impact on their personal lives, which was reflected in strained relationships at home.

When you receive an IDR, your first action should be to identify an authorized and competent tax practitioner to represent you. Initially, go back to your tax preparer and find out if that person is sanctioned to represent clients before the IRS. Three categories of professionals meet this standard: enrolled agents, certified public accountants and tax attorneys. A quick meeting will either provide you with confidence, inspired by having a knowledgeable ally with an interest in your situation, or quickly convince you of the need to seek new, independent representation, because your ultimate goals may conflict with those of your original preparer.

If you decide to seek independent representation, you should consider referrals from your trusted advisors to professionals with experience in actual IRS audits and familiarity with the issues represented on your return. If the bulk of your income comes from a specialty area such as oil and gas, for example, you should seek a representative well versed in those investments.

You must also decide whether to seek out an accountant or tax attorney to represent you. An accountant may suffice to convince an auditor of your return’s veracity early in the audit process, before problems occur. But you should also consider hiring a tax attorney if the transactions in question appear to have either a questionable legal precedent or an unduly contentious nature.

After you pick your representative, you must file an executed power of attorney (POA) with the auditing agency for the tax years and entities under review. This gives your representative the authority to act legally on your behalf regarding all matters stated in the POA. Be certain that the scope of the POA is sufficient to enable the representative to act on your behalf for those matters in the audit, but is not unnecessarily broad.

Keeping Secrets Secret
When you have established a professional, fiduciary relationship, you must be completely honest with your representative concerning how your tax returns were prepared and any omissions that may have been made. To facilitate free-flowing communication between you and your representative, the IRS offers confidentiality privileges for communications between taxpayers and federally authorized tax practitioners (in noncriminal matters). A taxpayer should take immediate advantage of this privilege when faced with an audit to ensure the most favorable outcome possible.

Taxpayers do have rights, and sometimes must take this ultimate recourse to halt IRS fishing expeditions.

Your representative’s next step will be to review all communications received from the taxing authority in order to determine the initial scope of the audit. The tax advisor will also need to evaluate the tax returns filed and all of the supporting documents for the issues under examination. If there were nonfiled returns and/or omissions on filed returns, the representative will need to assess all documentation relating to these in order to present your information properly and successfully.

After completing these reviews, your representative will craft a plan for moving forward, specific to the scope of the audit and the facts presented. The advisor will contact and communicate with the auditor and begin the process of responding to the auditor’s requests. This method involves sharing information and negotiating with the IRS to resolve any issues that may arise during the course of the review.

The IRS does not require taxpayers to appear for audits. In fact, taxpayers typically do not appear. If your representative cannot answer certain questions, he will request that they be made in writing and responded to accordingly. This process helps reduce the chance of miscommunications or misunderstandings. During the audit process, the taxpayer only needs to provide the taxing authority with information needed to substantiate the income, deductions and/or tax position taken on a return. Occasionally, the government requests information that appears to be irrelevant, such as customer lists. If your representative cannot convince the taxing authority to retract these requests, he may have to seek an injunction to quash these demands in order to protect your confidentiality. Taxpayers do have rights, and sometimes must take this ultimate recourse to halt IRS fishing expeditions.

Upon the audit’s conclusion, the auditor prepares a report of his results. The report includes recommendations to change the return and specify the tax consequences of the proposed changes. Before the auditor issues the report, a supervisor reviews it to ensure that it complies with IRS policies. If the report proposes additional tax, penalties or interest, the government issues a 30-day letter outlining its position and its proposed resolution of the audited transactions. If the auditor proposes no changes, the case is closed.

If the taxpayer agrees with the proposed adjustments in the letter, he signs the agreement and pays the assessment. Alternatively, the taxpayer may dispute all or part of the adjustments. He has the right to pay only those adjustments with which he agrees and to request a review by an appeals officer within 30 days. When the case moves to the IRS Appeals Division, your representative will present information to support your position. He will generally use information not considered by the government in its final report. If you lose your appeal, your next recourse, unfortunately, is tax court.

Nemo Perera and Doug Rogers are executives with Risk Capital Partners, a risk-consulting firm with offices in Los Angeles and New York. Rogers formerly served as director of penalties and interest for the IRS.

Flying Solo: An Expensive Lesson

One of our clients confessed that he had been skimming funds off cash receipts that represented 30 percent of his gross profit. He initially entered the audit representing himself, having full confidence in his ability to handle the auditor’s questions and hoping to avoid having to tell anyone of his skimming activity. His confidence was short-lived. During the initial interview, the auditor asked for all supporting documents to substantiate the claimed cost of the goods he sold. The client produced his records, but an analysis of the data showed that the invoices for purchases, minus returns and allowances, resulted in a much greater cost of goods sold than was reported on the return. When the auditor began to follow up on this issue, the client’s world started to cave in and he finally sought help.

In the end, the client’s audit expanded to three years, and, when the questionable funds were included in his earnings, his net profit increased by 30 to 40 percent for each year in question. The net tax increase ranged from $150,000 to $250,000. The IRS also added a civil fraud penalty amounting to 75 percent of the tax adjustment for each year. By employing a professional from the outset, the taxpayer could well have lessened the final tax adjustment by identifying the under-reporting prior to sharing his records with the IRS. Then he could have provided corrections to the agent with an explanation of what was not reported, how he identified it and actions he took to eliminate future under-reporting. This may have led to the assessment of an accuracy-related penalty: 20 percent in lieu of 75 percent for civil fraud.

The advisor may also have won a smaller penalty by removing any bias that might have developed during the taxpayer’s initial interactions with the auditor, allowing a more objective and fair assessment of the actual tax due. While no professional will help an individual defraud the government, an advisor can help ensure that a questionable situation is resolved so that the amount of tax paid is assessed fairly and that punitive penalties are limited or avoided if the taxpayer demonstrates good-faith efforts to ameliorate the disputed transactions—rather than a belligerent attitude that may become evident if a taxpayer attempts to negotiate the matter himself. The IRS wields latitude in assessing punitive penalties. A professional can present a taxpayer’s case in an objective light that can often remove any rancor that may have grown between an auditor and a taxpayer.