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TaxMama’s
Audit Secrets
Or...
How to Survive an Audit With
No Changes
By Eva Rosenberg, MBA, EA
copyright © Eva Rosenberg 2006
800-5-WHY TAX
TaxAnxiety, Inc.
P.O. Box 280549
Northridge, CA 91328
www.TaxMama.com
No portion may be reproduced without the written consent of the author,
except, naturally, for IRS forms, which are public domain.
The worksheets, if any, may be reproduced for internal use only.
The mandatory legal disclaimer thing: This material is for education purposes. It’s designed to provide a
guideline only. Things change. Laws change. Please do not rely on this as the ultimate authority on all
things. I am not engaged in rendering legal, accounting or other professional advice or service via this
publication. If you need advice on a specific issue - get it for that issue from an appropriate source.
Copyright © Eva Rosenberg, 2003
AUDITS
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About The Author
Eva Rosenberg, known as TaxMama for both her warmth and her nagging, is an
enrolled agent, hostess of www.TaxMama.com and author of the weekly, syndicated
Ask TaxMama column and the daily audio podcast TaxMama’s Tax Quips. The
TaxMama.com site is a free resource, warmly welcoming all taxpayers and tax
professionals. Through the site, Eva provides articles, IRS news, links to tax forms and
free answers to visitors' tax questions . . . along with her own twist on pending and
current legislation. Go to www.TaxMama.com for your free subscription and access to a
continuing stream of tax advice, news, and tips -- and plenty of jokes and inspiration,
too!
You'll find her quoted in publications as diverse as the Wall Street Journal, Chicago
Tribune, New York Times, Los Angeles Times, USA Today, Glamour and Woman's
Day. Her tips appear regularly in banking publications, including those of Wells Fargo,
Guaranty Bank, and BankRate.com.
Her recent book, Small Business Taxes Made Easy was named one of the top tax
books of 2005 by Entrepreneur Magazine.
http://www.taxmama.com/AskTaxMama/book/
She has co-authored a series of three business e-books with popular tax author Wayne
Davies. The first book is called THE TAXTICAL GUIDE TO INCORPORATION
SECRETS. http://suchasuccess.net/
Eva's frankness, sense of humor, and casual, stand-up tax delivery make her a popular
talk show guest and speaker around the country. Her MarketWatch.com tax columns
are eagerly anticipated by readers, wondering just what IRS button she's going to push
next.
Copyright © Eva Rosenberg, 2003
AUDITS
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Staying Out of Audit in
the First Place
Some History
I started preparing tax returns on my own in
1979. Sometime around 1990, after listening to
other tax professionals discuss their client s
audits, I began to notice that few, if any of my
clients were getting audited. It s a bit hard
getting experience doing audits if you aren t
generating any. I just didn t know any better.
Audits through 1979
- 1990:
Individuals:
1 office in home;
1 person who omitted
$100K in 1099 income (he
never gave me the 1099's);
Another person who
omitted $30K interest income,
he never received the 1099
with the various preparer penalties, we face
tremendous new burdens to ensure that the data
on the tax returns we prepare is reasonable and
correct. And with all the hoopla about Enron and
Anderson, when it comes to certified audits, the
world’s eyes are on us, more than ever.
We've developed
TaxMama’s Philosophy:
forms,
engagement
Unless a client can afford
letters,
disclaimers, etc.
to (and is willing to) give
to protect
me enough money to live
ourselves from
for the rest of my life in the
clients'
manner to which I would
non-disclosures.
like to become
But, if too many of
accustomed,
our clients start
facing audits with
NO WAY!
major examination
changes, it stands to reason that our work will be
under scrutiny and our ability to earn a living will
be jeopardized.
Anticipating an Audit. Laying
the Groundwork:
Knowing there is an audit is simple - they get an
audit notice and come to see you.
But, when preparing the return, how can you
predict when an audit or scrutiny is likely?
Real Estate Partnerships:
One third of the
buildings burned down 2 weeks
after purchase – and they
reported the major casualty loss;
Donated $1,000,000
building to religious school
It seems that my basic nature was responsible
for my failure to generate more audits.
Fundamentally, I have an adventurous,
risk-taking personality. However, when it comes
to my clients, I am extremely conservative.
While I will take advantage of any gray areas the
law allows, I will not knowingly prepare a false or
fraudulent return.
1) You are dealing with a non-filer and
preparing two year’s or more returns.
2) You are dealing with non-filers and a
Revenue Agent has knocked on their
door.
3) You are dealing with non-filers who
have a Revenue Officer on the case due
to SFR (Substitute For Return)
assessments or other unpaid issues.
4) A member of a targeted MSSP class,
related to working/for someone being
audited.
5) They are a member of an entity that
is/has been/is about to be audited.
6) They have a lot of "red-flag" issues on
their tax return, although legitimately.
Too many clients come to us with information
that clearly bears no relationship to reality. Then
we have those clients who complain to us about
friends who are getting away without paying
taxes and living well - so, why can't they?
As tax professionals, under Circular 230 and
Copyright © Eva Rosenberg, 2003
AUDITS
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You know the return will be scrutinized. What will
the IRS look for?
1) Financial lifestyle
2) Standards of living and
reasonableness of business
operations costs
3) Spending habits and new purchases
(conspicuous consumption)
4) Bank deposits
5) 1099/W-2 reports with their ID #
If these factors don't match the tax return (or
industry practices), the IRS will suspect
unreported income, inflated expenses, or worse,
though client s source of funds may simply be
non-taxable income.
The IRS is the nation's tax collectors. They know
that some people will do anything they can to
reduce their taxes - even illegally.IRS’s main
focus is no longer just on substantiating
expenses. They are serious about picking up
unreported income and making their audits
profitable.
They have so many electronic tools and
information sorting technology at their fingertips,
that’s become really easy to do select the right
tax returns for audit.
If you aren’t seeing a higher rate of taxes billed
as a result of audits, you will be.
There’s no longer a reason for IRS to perform
audits strictly at random. (Yes, they have that
National Research Program running – but it
impacts very few people.) Now, IRS can sort for
common errors or for tax preparers whose
returns consistently fall into certain patterns.
So, if they can find returns they know will be
wrong, why waste energy on no-changes?
Mark my words, you’ll see more solid audits
come up in the next many years.
So, how will IRS know if our clients are lying?
Inside Info
W-2s
1099s
Tax Returns
Collections
Prior Audit(s)
Prior Examiners
Market Segment Spec Prog (MSSP)
Copyright © Eva Rosenberg, 2003
AUDITS
National Research Program (NRP)
Audits of other people’s returns
Audits of Related or Pass-Through Entities
IRP ( Information Returns Program)
Currency & Banking Retrieval System (CBRS)
- Customs
- Casinos
- CTR's (Currency Transact. Reports)
- F-Bar (Report-Foreign Bank Accts)
- Forms 8300
Outside Data
Agencies
Bureau of Labor Statistics (BLS)
Social Security Admin (SSA)
U.S. Post Office (USPS)
Dept of Motor Vehicles (DMV)
Law Enforcement
Dept of Social Svcs (DSS)
Dept of Agriculture (DOA)
OSHA - Occupation Health &
Dept of Social Svcs (DSS)
Small Business Admin (SBA)
Dept of Transport (DOT)
Fictitious Name Register
Permits
Better Business Bureau (BBB)
Court Records (Amount/Holder)
Divorces
Mortgages
Liens
Bankruptcies
Probate
Property Records
City and State Information
Permits
Licenses
Sales Tax
Employment/Unemployment
Other
Trade Associations
Corporations (charters, etc)
City Directory
Public Utilities
Credit Applications/Reports Suppliers
Employer s Personnel Records
Banks/S&Ls/Credit Unions
Insurance Providers
Dun & Bradstreet
Legal Databases
Former Personal Contacts/Relationships
Landlord
Employer
- Employees/Contractors
- Ex-Spouse/Children
- Neighbors
Third Party Contacts - Various
Newspaper Articles
Informants
Internet Searches
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Remember, the IRS is the arm of the US
government that caught Al Capone, Darryl
Strawberry and Heidi Fleiss. They have access
to substantial internal and external resources
about people - especially in today's computer
age
How do you overcome this?
Know as much about your client as the IRS
knows. You never want to walk into an audit and
learn:
The IRS has
communications from
the client on file of
which you are
ignorant.
They know about
income or bank
accounts that you
don't.
Your most important tools these days are the
proof of cash and the Cash T. Auditors should
be using them. Do it first. (I haven’t seen one
done in an audit. But then, I’ve always had my
own to hand them.)
Get copies of ALL the bank statements on all
accounts, personal and business, checking,
savings, CD and Money Market.
The next most important line of defense? Redo
the tax return from scratch, using all the
supporting information you gather from the
client.
Make it VERY clear to your client that s/he must
disclose all IRS-related interactions to you. All
income sources must be disclosed. Be clever
and ask very detailed questions about the
client's finances and lifestyle. Ask to see a credit
report.
If you feel that the client has many unexplained
or suspicious transactions you may want to
remove yourself from the case. (Note: The new
Tax Pro client privilege does not extend to
knowledge about criminal actions.)
Have the client sign all the appropriate
engagement letters. If they think criminal
charges are a consideration, bring in an attorney
and be retained under that umbrella.
Keep in mind: Your reputation and credibility with
the IRS is your best asset if you want to build an
audit practice. If a client lies to you, will the IRS
believe you didn't know.
Tip: Document the date, time and
substance of all conversations with your
client or auditor.
Copyright © Eva Rosenberg, 2003
If your client tells you that there is unreported
income, explain the consequences and potential
tax liability to your client, preferably in writing. Do
your best to determine the full magnitude of the
problem before you go to the IRS. Having the
facts in hand and good reasons for the actions
may help you negotiate away fraud and other
penalties.
AUDITS
Although you may not find the auditor performing
these tasks, it’s wise for you to do them.
For each bank account, do a
proof of cash :
Please note: Regardless of the non-income
sources of funds your client tells you about, if
they are not deposited to any of the accounts in
questions, those funds will NOT reduce the
income resulting from the proof of cash. The
Cash T is a more detailed version of the old
proof of cash.
There is nothing to prevent the auditor from
looking at all your taxable and non-taxable
income, beginning bank balances and loan
balances, partnership/S-Corp/LLP distributions
and all other sources of deposits you have
identified. If they do, the auditor will deduct all
visible expenses. If you refuse to (or cannot)
provide The client’s living expenses, the IRS
may use Bureau of Labor Statistics (BLS) data
figures.
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In ideal situations, the client will have a Profit
and Loss and a Balance Sheet, along with a
Detail General Ledger printout.
Add up all the deposits on all the bank
statements for ALL 12 months
Deduct:
All personal loans
Gifts (document them) deposited to
the account
Credit card advances deposited to the
account
Bank loans
Refinancing proceeds deposited to
the account
SS Income
Other non-taxable income (federal
tax refunds, etc.)
Find transfers into this account from
another of the client's accounts
Fundamentally, the difference should be
your income.
Since the audit is brief (about two hours are
allotted for the typical office audit), during the
meeting, the auditor is likely to try to come to
some ball-park estimations of reasonableness.
It’s up to you to do enough homework to make
sure the information is reasonable - or be
prepared to explain any discrepancies.
If there are more expenditures than sources of
income, the IRS will consider any unsupported
difference as unreported income. It is our job, as
tax professionals to know about this difference,
in advance – and to minimize this difference.
Frankly, your average honest taxpayer will have
probably come out just fine. This stringent tool is
designed to ferret out the tax outlaws. (And keep
us from looking like clowns at audit.)
We’ve got the deposits explained...now let’s
move on.
Deposits are Sorted out?
Time to Work on Expenses.
Copyright © Eva Rosenberg, 2003
AUDITS
In reality, if you're lucky, they'll come in with an
accordion file with all the receipts neatly
arranged into categories - you won't realize there
is a problem until you later notice that there are
no adding machine tapes, the totals don't come
close to the expenses shown on the return, and
you have checks written to another bank account
he forget to tell you about.
Oh yes, back to reality. What now?
Frankly, the simplest method I've found to work
my way through audit schedules is to use an
accounting program like QuickBooks. Many
people prefer spreadsheet programs. Whatever
software you use, make sure it's one that doesn't
require you to POST or CLOSE each month
or year. I prefer a program that does not force
me to make journal entries to correct my data.
(I really have to leave an audit trail every time an
entry in a check register is different from the
canceled check.) Try to find one that let's you
enter receipts and checks in any order and any
year, but places them into check number &/or
date order for you. Make sure it will produce
detail general ledger reports as well as account
detail and detailed reports on groups of
accounts. You will find that this saves
substantial filing/sorting time.
Prepare all your entries and compare the results
to the tax return. If you are way off, ask the client
for credit card statements for ALL his/her
accounts and all cash-paid receipts. Don't
hesitate to ask if they used someone else's
credit cards for their business expenses. This
practice is becoming more prevalent than you
realize. Get copies of the friend's credit card
statements and the canceled checks
reimbursing the friend. (Prime candidates –
people who have filed bankruptcy, gotten
divorced recently or are non-filers afraid to open
bank accounts.)
For expenses where the IRS permits you to use
standard amounts (auto/mileage, meals and
travel per diems) compare the actual with the
standard rates. Too often, I have been able to
bypass a detailed scrutiny of the expenses via
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one of these methods. You’ll find links to all of
these things at TaxMama’s Tax Resource Page.
We're going to walk through some real audits.
Naturally, the names have been removed.
When preparing for an audit, use every tool at
your disposal - Tax Code, Master Tax Guide,
Research Disks/libraries, Regs, Tax Court
Cases, industry behavior (newsletters, articles,
guides, etc.), wiser minds. Call a college tax
department for help. Call one of us!
Negotiating:
You can negotiate, to some extent on all levels.
You need to have a basis for your request.
They won't do it just because you ask.
In another case, concluded on July 18, 1996,
(not presented here) I was able to negotiate with
an office auditor. They generally don't have the
authority to reduce the tax liability once the audit
has been concluded - so don't ask for that.
However, the office auditor does have the
discretion to decide what documentation is
acceptable. In this case, I could prove that there
were loans, but couldn't trace them into the
bank. I could convince her that the client most
likely had auto insurance, but since the
insurance agent was gone (deceased) and the
client had used his mother's money to pay for it
we couldn't prove the cost. I could prove there
was a second vehicle, couldn't prove how many
miles it had been driven (business or
otherwise). I had no bank statements at all for
one of the years, but I had detailed QuickBooks
schedules covering all the checks in the check
register, the credit card entries and all the cash
expenses.
TaxMama’s 3 Basic
Rules of Tax
Negotiating
1.
Know before you start
negotiating exactly what it is you want
to accomplish. (They don’t need to
know that - but it’s critical that you
have it defined in your own mind.)
2.
Have something to give up.
(Do your audit preparation so
thoroughly that you find the expenses
your client overlooked. Look at missed
itemized deductions - always a good
source of errors in your favor!)
Although I did not have a mileage log, I had a list
of all the jobs and how often he had been there. I
had the client reconstruct his sales calls
(mileage to potential work) and the approximate
number of shopping trips for materials and
supplies.
3.
Give the auditor/Appeals
Officer something tangible to put into
the file to support your position. It
saves them time and makes them look
good to their superiors on review.
In other words, I gave the office auditor an
excuse to accept my position on the
questionable expenses.
In Case Study 1, although I couldn't prove the
last $133,000 of deposits were transfers, I was
able to prove that there was a consistent pattern
of behavior. I was able to provide enough
paperwork to give the auditor an excuse to
support my position that perhaps the deposits
were not income after all.
Copyright © Eva Rosenberg, 2003
Looking at Case Study 2, I made sure that I had
enough extra expenses to be able to give up
some without losing much. When the auditor
started to waver about the garments, I quickly
offered him a lower percentage of the office in
home. The garments were important to Al in
order to establish a precedent. The office in
home no longer mattered because he wasn t
living there - and now, he really was selfemployed. So I knew that we were giving up
nothing in the long run.
AUDITS
Tip:
Make an extra set of copies of all the
schedules and workpapers for the auditor's
file. It provides documentation and makes
him/her look better upon review.
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Result: Instead of the $10,000 additional taxable
income I expected, we ended up owing only
$987.00.
Copyright © Eva Rosenberg, 2003
AUDITS
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Audit Reconsiderations,
Appeals & Tax Court, some
Brief Words
You can get audit reconsiderations. Try any or
all of the following:
Should we use Appeals only a
Last Resort?
Some practitioners find that the Appeals process
is sometimes easier to deal with that the
auditors. While all auditors must have college
degrees, the degree does not necessarily have
to be in accounting or taxation. So, sometimes
they are not as well-trained as we would like.
1) If you are working with a
revenue officer, ask him/her
for help.
2) Ask the local audit group
manager.
3) Write to the branch chief.
4) Contact the Practitioner
Priority Service they have
Form 3410-Request for
Audit Reconsideration ask
them to give you Forms
3411 & 3412 ( copies
enclosed).
5) Contact the Taxpayer s
Advocate (formerly,
Problem Resolution Officer)
6) Make an appointment for an
IRS Problem Solving Day (if
they still have them)
7) Contact the Small
Business/Self-Employed
Operating Division
8) Contact the Deputy Director,
Compliance Field
Operations
9) Contact the Director of the
IRS
10) Call TaxMama for help
However, by the time IRS agents get to the
Appeals level, they have extensive field
experience, education. Training and the ability to
use and understand tax research and the
research tools.
You are dealing with a seasoned professional
who has more decision authority than the office
auditor and many field auditors.
The purpose of Appeals is to settle cases
without litigation. They will evaluate your case's
strengths and weaknesses with an eye to how
your case will stand up in court. They will have
pulled the relevant court cases, decisions and
precedents. (Or at least the items they think are
relevant.) Feel free to ask them for their citations
when you meet. But, most importantly, have your
research ready. If you give them a copy of your
cases (not just the citations to cases) with your
points highlighted, it will enhance their
willingness to cooperate with you. You've done a
big part of their job and they have objective
documentation, in your favor, to put into your
client's file.
When you ask for the reconsideration, you'd
better have at least 80% of your material ready.
You won't generally get another chance to
present your case.
You can also get an auditor removed from a
case and get a replacement if things get
completely out of hand. (I did that for one
entertainment industry audit this year, where the
office auditor spent our entire two hours getting
terminology defined!)
Copyright © Eva Rosenberg, 2003
Are Appeals More Appealing or
Frightening Than Audit?
AUDITS
Remember, generally, Appeals is not about
supporting expenses. It is about tax law and
precedents. However, if deductions were not
substantiated during audit, expect the appeals
officer to require supporting documents.
Most tax professionals use Appeals to their
advantage. When confronted with a particularly
troublesome auditor and a group manager who
will not intervene, the tax pro simply calls a halt
to the whole process. Let the IRS post their
adjustments and the pro walks away.
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They wait for the audit determination letter
(30-day letter). When it comes, it tells you right
on it that you can request an Appeals hearing.
Do it. Write a letter requesting the hearing.
Include specific areas where the auditor is
incorrect and briefly describe what
documentation you have to add for this hearing.
And be sure to include the office where you d
like the case heard. In an area like Southern
California, we have several duty stations for
Appeals Officers. If you know that one group has
a particular attitude pro or con your issue, take
that into account. (If you don t know, ask your
colleagues who ve done appeals cases in the
area - or call TaxMama)
we had. But, oops, the Appeals Officer s
requests for documentation were making more
and more sense - and Bob was missing crucial
information. By this time, Bob had come to
realize that his position is much weaker than he
thought. In fact, the more material that came to
light, the worse his case kept getting. (Potential
recapture of K-1 losses on all the closed
partnerships, potential gains from cancellation of
indebtedness...were the interest deductions even
valid - after all, he bankrupted those debts...on
and on...it kept getting worse). The case finally
closed with a negotiated balance of $50,000.
(Then, he waited another couple of years and
bankrupted that again - but that s another
story!)
DO NOT include a harangue of the auditor's bad
qualities, what's wrong with the IRS or the
System.
Meanwhile, get all your documentation together.
This will include all the support for the
unresolved income/expense issues. It will also
require that you do some in-depth research on
the tax law issues involved. Besides the legal
issues, you may have to get background
information relating to your client and his/her
business, plans, intentions.
Intentions are critical. However, they must be
documented. Was the intent of the expenditure
for Business, for Investment, simply a Personal
loan?
One case I had was about whether a building
developer, Bob, was an employee of his various
corporations or self-employed (in the business of
being a developer). While we could gather
substantial legal authority to demonstrate a
precedent for this concept, we couldn't prove
that it applied to him. Bob had no evidence that
he had ever received compensation, wages or
profits from any of the entities. He had taken
substantial deductions on Schedule C for the
legal and interest costs to close down his various
operations. However, none of the corporate or
partnership returns for the income-making years
were available.
On audit, Bob was assessed about $300,000
(taxes and penalties) for 1990-1992. We thought
we were ready for Appeals with all the research
Copyright © Eva Rosenberg, 2003
AUDITS
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Tax Court - Must You Take the Tax Court Exam to Appear in Tax
Court?
Yes and no. A while back, I had lunch with one of the name partners of a major tax law firm in
Los Angeles. He stated his solid opinion that only trained attorneys should practice in Tax
Court. He scoffed at the idea that EA's could simply take an exam and be free to represent cases.
I asked him how often his firm took cases to Tax Court? He replied that while they file hundreds of Tax Court
Petitions, they rarely ever end up in Court.
Have you ever looked at the Tax Court decisions. Don't you wonder why they ever ended up
in Tax Court at all? Couldn't you have settled half of them in AUDIT, much less Appeals?
Getting into Tax Court:
If you've missed your opportunity to go to Appeals after the 30-day letter, wait for the
90-day letter (Notice of Deficiency). Then use the forms provided in the Appendix to file
a Tax Court petition.
Strategy: Use as much of the 90 days to get your records as ready as possible. Send your
petition in about 10 days before the end of the 90 days. Send it with $60.00 ?? to:
The United States Tax Court
400 Second Street, N.W.
Washington, DC 20217-0002
Copyright © Eva Rosenberg, 2003
AUDITS
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TaxMama’s Typical Year’s Score:
•
Academy-Award Winning Designer – over $25,000 of employee business expenses –
approved. Would have been ‘no change’ except auditor discovered AMT error and issued
$2200 refund.
•
Consultant – HOH issue. He couldn’t be bothered to come up with costs, so IRS could
verify that he paid more for support of son than wife did. (Both claimed the same son as a
dependent – her 1040, with her new husband showed over $1 million in income.) – IRS
accepted HOH and EIC, but not dependent.
•
Insurance Broker – Big Schedule C audit, and unreported income issue (he inherited
Mother’s estate in six figures) with 20 bank accounts to do Proof of Cash on. - No
Change.
•
Estate of Tony Award Winning Producer – Accepted as filed
•
Estate of Academy Award Winning Composer and Conductor (2000) – Accepted as filed
•
Several that really had me losing sleep – all ‘no change’.
•
That’s all I could remember right now.
One Case’s Timetable:
I filed on June 24, 1997. Got a Docket number on July 1, 1997.
Heard from Appeals on September 16, 1997. (This is the fastest Tax Court response I ever had.) Handled
it by mail.
Learned from the client that he didn t have the documentation, so it took a bit longer than I had planned.
Settled it on Christmas eve - by phone. His report is dated December 27, 1997.
We got the first version of the Notice of Settlement from IRS Counsel, dated April 8th. Re-did it twice First time, the judge would not accept his signature using a black felt pen - it looked too much like a copy.
Second time, they had misplaced the re-signed documents.
On May 12, 1998, the judge agreed to accept the signed documents.
And the change notice from Fresno arrived on June 22, 1998. And the refund, soon after.
Total time – about one year.
As you can see, filing a Tax Court Petition gets you right back to Appeals.
We’ve filed several cases since then. They all go about the same way.
Copyright © Eva Rosenberg, 2003
AUDITS
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CASE STUDY - AUDIT 1 –
The Real Estate Mogul
The Sad Tale:
No records. What now? The Los Angeles client had
limited records. One bank had been
bought out, the other's records were destroyed in
the "Rodney King" riots.
This taxpayer was referred to me in November
1995 by an EA. who specializes in collections
issues. The client had an IRS levy for $177,270,
resulting from an audit report on a 1989 tax return,
dated 9/03/93 assessing additional taxes of nearly
$73,000 and penalties of over
$33,000. With interest, the balance due in
September of 1993 was $143, 495.57. By
November 1995, we were talking about over
$177,000.
The auditor had disallowed a minor amount of
interest expense and over $42,000 worth of
rental loss (the rental loss reported was only
$35,000??). The auditor had picked up over
$20,000 of unreported interest and dividend income
(from 1099s) AND also imputed nearly $300,000 in
additional rent receipts!
The taxpayer was adamant that this was simply not
true. He had not had any profits, in fact, he had
some serious losses that year. Can't we get it
re-opened? Along the way, we learned there
had already been one audit reconsideration. The
same preparer had handled both the audit and
the reconsideration. He brought little or no
documentation to either meeting. Got minor
changes.
Getting Started:
I believed the client. I gave him a list of things to
get for me:
Letters to and from all his banks and/or
their successors requesting bank
statements
Or... written explanations about why they
could not provide them
All available bank statements from ALL
accounts
Copyright © Eva Rosenberg, 2006
AUDITS
Reconstructed rent rolls on all his rental
properties (about 20 of them)
Escrow closing statements on all
mortgages and refinancing on his real
estate.
We had a conference with the revenue officer (RO).
We brought her some of the escrow closing
statements showing loans of about $200,000.(Not
sure how much had been deposited into this bank
account?) We had some of the bank statements
showing that there were savings that might have
been transferred. She agreed that it there was a
good chance that the taxpayer's income might have
been overstated by the auditor.
The RO agreed that if we could provide her with
some tangible evidence that these loans, savings
and other funds had been deposited into the
primary operating account (the auditor had based
his determination on the deposits to a specific
account), she would try to get us an audit
reconsideration. [Lesson - some senior RO's will
work towards the truth and have enough of an audit
background to understand the problem.)
Procedure:
• Got FOIA data on the audit and audit
workpapers, 1099's, 1098's etc. Wrote to
Disclosure Office.
• Traced specific deposits from two savings
accounts to the operating account using
worksheet.
• Identified all NSF's redeposited
• Had them recreate the rent rolls, compared
them to the 1099's issued for subsidized
housing.
• Analyzed his rental report and cleared up or
got explanations for the discrepancies substantial vacancies due to
vandalism/gang activity - get photographs
of those properties to put into the record.
• Identified all bank loans/mortgages and
traced the deposits to the operating
account.
• Used FOIA information to identify other
accounts (the add'l interest income was
correct)
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It gave me had room to negotiate and agree to
increase the rental income by about $100,000
The interest income reported on 1099's was for
without adverse consequences to my client.
earnings on 2 or 3 Certificates of Deposit.
Based on the year end balance of the CD’s and
using a reasonable interest rate for that year,
Result Case Study #1 (not including
the interest earnings indicated that the CD’s had
been intact all year. None of them had been cashed accrued interest) :
in. So the client’s contention that he got money from
his CD’s made no sense.
Original tax liability + Penalty:
$ 105,464.18
(After first audit recon)
Oh, I forgot to mention, the taxpayer was elderly
corrected Tax Liability
$ 2,981.00
and sometimes was slow to remember
or be able to pinpoint things.
Net Reduction:
$ 102,483.18
When we got done with all the sources, we were
still way off on the deposits. There was still well over ===========
$175,000 unaccounted for.
And since the IRS had previously collected/kept
$3,000 of his subsequent refunds, he didn't even
owe the $2,981.00! They sent him a refund.
Listen!
Important step: I conversed with the client and the
banking officer about his borrowing habits
We learned that he pulled mortgage loans on the
property. Then he bought CD's. Then, he borrowed
against the CD's!
Aha! He had been doing this for so long that he
took it for granted and NEVER explained this
to anyone. He just kept saying that he had
deposited the CD money into the account we had
been analyzing - and we couldn't find any decrease
in the CD balances based on the 1099-Int. We got
this practice confirmed in writing from the banking
officer. She was quite happy to comply.
Take Nothing For Granted:
One other important thing I did. (Don't assume that
the original return has been correctly computed just
because someone used a computer program to
prepare it. Passive loss issues
and carryovers are often wrong!) I reviewed the
computations on the original tax return - and
re-entered the whole return from scratch into my
program. I learned that although the original 1989
return showed a rental loss of about $35,000, the
total rental loss was over $85,000. (Coincidentally,
this unused rental loss had not been carried over to
the 1990 return. ) So it
turned out that we had a lot of room to absorb
additional rental income without a tax effect.
Copyright © Eva Rosenberg, 2006
AUDITS
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CASE STUDY - AUDIT 2 The Designer
Here we have a case of a young man, in his
twenties, who has been repeatedly audited.
In 1993, his tax return called him a “cutter.” In fact,
he was a designer of garments. He had recently
graduated from Los Angeles Trade Technical
College, where they have a special
program for the garment industry. But, considering
that it’s a City College, with limited funds,
the programs are not strong enough for a careerbase. Graduates could expect to earn little
more than minimum wage. Yet in 1993, his gross
wages were over $50,000.
How did this 20-some year old achieve this? By
learning on his own. He went to the designer shops
and bought garments having quality he admired. He
studied the fabrics, the stitching, the cut, the bias,
etc. He took the garments apart and used them to
learn to create a sleeve or a
back or a hem or a vest or a crotch. And he spent
over $10,000 buying them. After a
battle with Appeals and Tax Court, his attorney got
IRS Counsel to grant her $3,492 worth of
the garments. (She got some other expenses
accepted and the negligence penalties waived.)
But, with such a large part of the garments
disallowed, it was not encouraging for the next
year’s audit. (1993 was settled on June 22, 1998.
The original audit report was dated 1/10/96.)
In the next year’s audit, essentially, the issue has
been the same one - Is he entitled to a business
deduction for those garments? And while we’re at it,
we’ll look at the entire miscellaneous deduction
issue. I was the lucky one who got the 1994 audit. It
was scheduled for July 10, 1997 and I was
prepared.
Before going into the audit, I asked the Hotline to
run a printout of his 1994 W-2s & 1099's.
We discovered that he had not reported the
California refund, and some 1099 income and
had over-estimated some wages. We were going to
start this audit with $7,401 worth of
additional income before I even walked in the door!
By the time we got done, concessions and all - the
IRS assessed him for only $5,940 additional
income. And that was after I made some
concessions. How did I do it?
My Preparation Technique:
Getting Started:
I.
Get copies of all bank statements, canceled
checks and credit card statements
II.
Get all receipts for cash expenditures and
large ticket items
III. Get a schematic drawing of all the places he
lived (for office in home)
IV. Have him mark all the business only usage
areas and the mixed use areas
V.
Get his calendar for the year. (If none reconstruct based on deposits/purchases)
Procedure:
The printouts with the additional income had already
arrived, so I knew that I was looking for more
expenses than were originally on the return.
I entered all the checks and expenses into
QuickBooks - let the computer sort them into date
and category order. Once all the expenses were
entered, I could print out detailed reports on each
expense category.
Issues to ponder:
1. No 2106 or detail - only a line entry
on Schedule A (no detail)
2. Garments - $13,819
3. Auto (gross expenses $5,317) Net
Finding over $13,000 worth of purchases, I had him
to 2106 = $3,999
write a one-page report for each purchase. It was to
4. Schedule C - Office in Home
contain:
$4,401 (using 59.48% of residence)
5. Not really an employee - he worked
freelance, from home, but was paid
on W-2 for simplicity’s sake.
Copyright © Eva Rosenberg, 2006
AUDITS
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•
•
•
•
•
Description - what was bought
Cost
Job or Client he used it for
What he learned from it
How he used it
possible in order to avoid/reduce the selfemployment tax assessment.
We put the whole package together, including a
summary of his educational intent for these
purchases, pictures, calendars, industry wages,
detailed workpapers - and I went into the
audit with great confidence. (Except for the $4,401 worth
of office in home.)
Upon asking him if the items he bought were things
he could wear for personal use,
Al just laughed. Then he explained that a) many of
the clothes were women’s wear, and
b) they were average sizes, while he was small and The Audit
slender and built like a boy. (I had never
met him. We handled all transactions by telephone.) First, the auditor took her time coming out. While
we were walking in, she told me
So I asked him to have someone take photographs that the only reason she hadn’t left yet was because
of him wearing the some of the men’s garments.
of this audit appointment. Otherwise
They were so far too large on him, you could see
she’d have gone home. She had a bad cold. Well,
the pants legs trailing the ground
so did I, so I thought we could commiserate.
in front of him, or the waist big enough for two . And Nope - she was downright hostile. And she wasn’t
the sleeves draped alluringly past
interested in anything I had prepared.
his fingertips.
She wanted it all re-done. It’s been a long time (at
least three years) since I’ve run into anyone so
I also wanted pictures of how he cut the garments
unprofessional in an IRS office audit unit.
apart and the sequence he followed to create a new
garment.
Well, we did what we could for her. She took her
While we were at it, I wanted to prove that he was
earning far more than the industry average.
So Al went to a couple of sources and got industry
earnings statistics. We added his resume and
career history. (Yes, I go overboard.)
Next, using the blank 1994 month-a-glance
calendar pages I gave him, Al recreated his
activities
and computed his total mileage, business mileage
and personal mileage. We used actual expenses
and no depreciation. (It was a very old car and had
been more than fully depreciated in the past.)
Recap:
With all the information gathered, I redid the whole
return. It was stamped AMENDED and
I brought it along as my proposed revision. By the
time I got through with my version, Al owed only
$140.00. We both knew it was optimistic.
sweet time writing the report. Knowing that
she would disallow everything, I was prepared to go
to Appeals so I could deal with a professional.
Nevertheless, when I got her report sometime
around October or November,
I called to try to discuss it with her. She was no
longer there - and no explanation was provided.
The total assessment, including negligence &
delinquency penalties and interest was $11,300.00.
The case had been assigned to someone else who only wanted to close it. I explained the
situation and wrote him a detailed letter outlining
why these expenses were legitimate. By this
time the Tax Court case had been settled. It wasn’t
solid enough for me to use to convince
him, but I felt that it was leverage. (I knew if I had to
go to Tax Court, I would win.)
So, he looked at the file again. And changed little or
nothing. But, by the time his report was issued in
late December, the assessment had risen to about
$11,600.00, including interest.
The one area we were a bit weak on was the
employee vs independent contractor (re: W-2
income). I knew it would be difficult to prove that his
office in home was justified. (Now that
we had $6,080.00 worth of 1099 income, I wanted
to offset that with as many expenses as
Copyright © Eva Rosenberg, 2006
AUDITS
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Options for a Disputed Audit:
1) We could ask for a supervisor’s review, but that
didn’t seem encouraging.
2) We could request an Appeal. That would be
costly to client AND we could be turned down.
3) We could wait for the 90-day letter and file a Tax
Court petition - we’d get into Appeals for sure.
4) We could let it post, set up a minimal installment
agreement and then bankrupt the whole thing.
NEW: IRS has a Fast-Track Mediation Program.
That might be a good alternative these days. It does
work. Ask for it!
Decision:
I tried option #1, but the group was in between
supervisors. Oh well...
Al decided to wait it out. We’d file the Tax Court
petition.
So we waited. One fine day in March, I received a
call from a woman who wanted to know if
we were going to just let this post unagreed? Upon
inquiry, she admitted to being the group’s interim
supervisor. So, I took a shot - I explained the
circumstances and told her that I was sure I would
be able to get a fair hearing in Appeals. I was very
confident in my case. But I would much prefer to
settle it at her level if she’d look at it again.
the delinquency penalty (taxpayer did file late).
By the time we got done, the assessment was only
$2,315.00 plus interest.
Remember, the additional income we started with?
If I had gotten a no-change on all the expenses, Al
would have ended up owing about $2,100 from
these omissions alone.
Result Case Study #2 (not
including accrued interest) :
Original tax liability + Penalty:
(After first audit report)
Corrected Tax Liability
(penalties removed!)
Net Reduction:
$
9,176.00
$
2,315.00
$ 7,401.00
===========
More important than the reduction of the audit
assessment: We established, for the record, that
his expenses for garments are legitimate. Next
time he gets audited, that won’t be an issue - only
verifying the costs of the purchases. This is
extremely important for two reasons: first, since I
firmly believed they were legitimate, I went ahead
and took those deductions in the years when I
prepared his returns. And 2) He had gotten an audit
notice for 1996.
That’s how the audit bounces!
I admitted that the circumstances were unusual.
(Actually, not really. I find that many people doing
audit representation just aren’t as creative about
interpreting a person’s career or
business activities as I am. ) We talked for over an
hour. She agreed to reassign the case (but
wouldn’t tell me what happened to the first auditor)
and have it reviewed in her group. Well,
it went back to the same man who had brushed it
off in December!
Fuming quietly, I patiently explained my contentions
to him and asked him to look the case over in that
light. After three more conversations and some
negotiations, we came to an agreement.
He gave me ALL the garment expenses. I lost a
little bit of the auto on Form 2106, and most of
the office in home (the item was expecting to lose
entirely!). He removed the negligence penalty and
Copyright © Eva Rosenberg, 2006
AUDITS
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BONUS – Questions asked
of IRS in October 2002
(data is still current)
b) Will the random audits go into more depth
(Like the old TCMP, line-by-line audits)
c) Are there any ways to get out of the audit, if
your client is selected?
Answer:
Trends in Audit
•
Question 1:
Many professionals are complaining that their
clients are getting audit letters, listing specific
criteria for the audit. But when the audit takes
place, the examiner is going outside the scope
of the contact letter – even before seeing the
taxpayer’s records.
a. Is this deliberate? (It’s happening much
more often)
b. Is it a new policy?
c. What should the Tax Pro do, without
antagonizing the examiner?
Answer:
a. The contact letter and accompanying
information request should normally contain the
initial scope of the examiner’s audit. Additional
items may be examined based on initial
interview responses or other facts that present
themselves during the audit.
b. This is not a new policy. Examiners have
always had the authority to expand the audit
with managerial approval based on the facts
and circumstances of the case.
c. The practitioner is responsible for full
representation of the taxpayer, even if they do
not prepare the taxpayer’s return. The
practitioner should feel free to contact the
group manager, If any disagreement should
arise during the audit process. Any ambiguities
regarding documents can be resolved by calling
the group prior to the appointment.
•
•
•
a. How will you know if you were selected
for an NRP audit – the contact letter sent
to the Taxpayer will specify that this is
an NRP examination.
b. Depth of Audit – unlike TCMP audits, the
NRP examiner’s judgment determines
the depth, substantiation and
verification needed for each classified
issue. Please note, that there will only
be approximately 2,000 line-by-line
audits.
c. Exclusions - Ways to get out of Audit –
in limited instances a taxpayer will be
excluded from an NRP examination:
•
•
•
•
Question 2:
In July IRS announced the return of the random
audit. I know, they’re random, but what are the
search criteria, and which returns are excluded
from the population?
a) How can you know if your audit is part of
the random selection or for cause?
Copyright © Eva Rosenberg, 2006
AUDITS
NRPs will consist of approximately
50,000 randomly selected filed 1040
returns.
Approximately 2,000 audits will be lineby-line as part of a calibration sample.
Will represent most 1040 filers.
Some NRP audits, after classification,
will be accepted as filed. Some NRP
audits will be conducted through
correspondence, other by examination
in person.
•
•
•
•
•
Affected by Terrorists Acts of 9/11/01.
KITA – killed as a result of a terrorist
action.
Stationed in a combat zone.
Disaster relief – excluded if taxpayer
suffered from disaster and is unable to
produce records as a result of the
disaster.
Illness.
Incompetence.
Death –if executor can not be located.
Outside of U.S. – and unable to provide
adequate documentation in sufficient
time.
Systemic Exclusions – taxpayers
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audited under the 1988 TCMP and EITC
Compliance Study Audits.
Copyright © Eva Rosenberg, 2006
AUDITS
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Question 3:
Question 4:
With the restructuring of the Service, how
are the various audit functions affected?
Can you tell us of changes in procedure we
should know about for all audit categories?
a)
b)
c)
d)
e)
Office audits
Field audits
Large Cases
Appeals
Did I miss any?
Answer:
The major change is that organizationally,
Tax Compliance Officers (Tax Auditors) and
Revenue Agents now work in compliance rather
than Exam.
With regard to the Small Business/SelfEmployed (SB/SE) Operating Division, there
have not been major changes in the audit
procedures as a result of our restructuring that
would impact the taxpayer or tax practitioner.
With regard to Large Cases, now under Large
and Mid-Size Business (LMSB) Operating
Division, there has been increased focus on
industry specialization, and LMSB territories are
aligned around specific industries rather than a
geographic location.
This realignment resulted in some territory
managers being located in other cities or states.
The basic function of Appeals remains much
the same, which is to rule on the tax law
decisions made at the group level, not to
perform an audit or examination. If Appeals
determines that an examination or audit needs
to be further developed, the case will be
returned to the Examination group.
Copyright © Eva Rosenberg, 2006
AUDITS
Conflicted audits. Without going to Appeals
or filing a Tax Court petition, when there is a
complete conflict between examiner and
practitioner (personality of either, auditor is
not familiar with the industry, etc.),
a) How can we get the case re-assigned to
someone who understands the issues?
b) At what point should we get the supervisor
involved?
c) What MUST the supervisor do if a complaint
is registered?
d) Who else should we contact in the chain of
command
Answer:
It is the auditor’s responsibility to gain
professional competence in an industry – we
have several mechanisms (i.e., audit technique
guides for specific industries, coaches,
managers) to help the auditor gain this
competence.
a. To request an auditor be re-assigned,
the tax professional should contact the
group manager and explain the facts of
this case.
b. The supervisor should become involved
as soon as an impasse is reached or the
audit becomes unnecessarily delayed.
c. The supervisor’s responsibility is to
evaluate the facts and take actions if
appropriate. In most territories the
manager is encouraged to accompany
the examiner on the next visit.
d. The chain of command is: group
manager, territory manager, area
director.
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