The IRS Doesn’t Really “Audit” Tax Returns

By Gary A. Hensley, MBA, EApicture004

It is a misnomer to label IRS “examinations” as “audits.”

I am not sure how the terminology evolved over the years as it relates to Internal Revenue Service (IRS) examinations—perhaps it helped build the fear factor regarding the dreaded IRS examination. The process of completing a certified financial audit (performed in the United States by Certified Public Accountants) involve standards and principles of financial reporting and accounting promulgated by the Financial Accounting Standards Board (FASB), generally accepted auditing standards (GAAS), and generally accepted accounting principles (GAAP). IRS examinations are guided by the Internal Revenue Code [IRC] as passed by Congress (which it has constantly amended [tweaked] for economic and social policy reasons).

For example, the majority of deductions allowed on Schedule A of the personal income tax return (Form 1040) are based on social policy considerations. Property taxes on your home and home mortgage interest are allowed deductions because Congress has historically used the IRC to “promote” home ownership as good social policy. Once a deduction is allowed by the IRC, powerful lobbyists do all they can to make sure they never get removed; only enhanced. Several taxpayer-friendly sections of the IRC expired at the end of 2013; however, a bill to extend these provisions is already in the making so that they will once again be available for 2014 and beyond. They will be superficially knocked around and debated on both sides of the political aisle but, in the end, they will be renewed with slight modifications at best. In contrast, certified financial audit standards use guidelines that evolve slowly over time and the baseline attest functions and standards are not modified without great debate and review by nongovernmental bodies.

Most IRS revenue agents are not trained “financial” auditors; they are IRS-trained tax compliance agents. Many come straight out of college with an accounting major (which may or may not have included one class on traditional financial auditing). There is no requirement for prerequisite auditing experience with a CPA firm prior to coming on board with the IRS as a revenue agent. Revenue agents are the front-line employees that do the face-to-face field examinations in the taxpayer’s home or business for the IRS. Unfortunately, many of the group managers that supervise the revenue agents also lack this traditional financial audit experience. There are IRS revenue agents that have the CPA credential (a plus for any taxpayer who has them as an examiner) and others, like myself, who had Enrolled Agent (EA) status and extensive national and local CPA firm audit experience before entering employment with the IRS as a revenue agent. Senior agents will quickly identify the significant issues (or determine there really aren’t any) and move the examination toward closure. And, believe it or not, some examinations do end up with the taxpayer receiving a refund for overpayment of taxes.

The IRS has compliance “procedures” that are used on examinations. It’s no secret that from year-to-year more examinations are conducted on higher income taxpayers, specific professions, and industries. The Audit Guides used by revenue agents are available for review by the public (which is sort of like sending your playbook to the opposing team). Many of the procedures are the “check the box” type. The IRS examination goal is to determine that the taxpayer is in “substantial” compliance with the IRC—not absolute compliance. IRS examinations are targeted to one or more areas to test for tax compliance depending on the nature of the return being examined (more on this later). A standard field examination starts with the selected examination year but may be expanded to prior and subsequent years if significant tax errors appear to follow a pattern.

In my opinion, IRS revenue agents with prior traditional financial auditing experience have a significant advantage in developing civil and criminal fraud examination cases because they: (1) are more likely to pick up anomalies during the initial and subsequent taxpayer interviews (the Lt. Columbo technique is a favorite); and (2) generally have more experience with forensic accounting techniques (connecting the financial dots to flush out missing information). The taxpayer (or his or her representative) should engage the examiner about his or her prior experience and training and ask for a business card.

During examinations, it is important to remember this; the burden of proof for unreported income is on the IRS: the burden of proof for deductions is on the taxpayer. No proof (substantiation); no deduction (although the Cohan rule can be helpful).

What is your examination risk?

Your individual IRS examination risk is determined by a number of factors including the areas the IRS may have under increased review. Last year’s examination rate of 0.96% for individuals was the lowest since 2005. This means the IRS examined just one out of every 104 filed returns. However, this figure includes correspondence examinations…exams by mail that typically question a limited number of items on the tax return, such as missing income from interest, dividends, royalties and earnings from self-employment. Last year, they represented over 1.06 million of the 1.4 million examinations that the IRS did. The number of face-to-face examinations by revenue agents was much lower…0.24% or 1 out of every 417 returns. Examination rates for partnerships, S corporations and regular corporations of all sizes fell in 2013 and are projected to decline in 2014 as well.

Tax returns are typically “scored” against a computer database to determine examination potential. Those passing a certain threshold are then reviewed by senior IRS agents who determine whether or not the return should be sent to field offices for examination. A final review is made by the group manager in the field office before an examination is actually scheduled by a revenue agent.

The Initial Contact

The initial contact for a field audit (in your home or business) will contain a letter asking you to confirm an appointment date, a publication that reviews your rights during the examination, and an Information Document Request (IDR) form that will give you the initial examination blueprint (or “heads up”) on the income and/or expenses the examiner intends to review. Business and/or personal bank statements will always be reviewed for the initial examination period. The IDR is a significant piece of information for the taxpayer as, again, it outlines the areas the IRS feels the need to review. The taxpayer does have the “right” to be represented during the examination. If you feel you want or need professional assistance during the examination, it would be best to obtain that representation before the first face-to-face visit (or any telephone calls from the agent). Attorneys, CPA’s, and Enrolled Agents (EA’s) are allowed to represent you during an IRS examination.

One tip: if, during the review of your tax return, prior to your first appointment, you discover any honest mistakes, errors or omissions, bring it up early in the examination process. Part of every agent’s job is to assess your credibility as a taxpayer. Bringing up honest mistakes will score points for you with the agent and he or she will be more likely to accept your verbal explanations regarding other matters that arise.

© 2014 by Gary A. Hensley

Surprise IRS Victory in IRA Rollover Case

Recent Tax Court Decision

In fact, the surprise victory is in direct conflict with IRS Publication 590, the bible for Individual Retirement Accounts (IRAs). Here it is, in a nutshell: starting in 2015, no matter how many IRA accounts you have, you will only be allowed one rollover per year (no longer one rollover per year per account) [Bobrow v. Commissioner, T.C. Memo. 2014-21, filed January 28, 2014].

“Industry leaders, financial advisers, and everyone else who handles IRAs are stunned,” said Denise Appleby, the editor and publisher of The IRA Authority.
According to Appleby, there are two ways to move money between IRAs:

1. Transfers, which are not reported to the IRS and not reported on a tax return. The IRA owner never touches the money. You can do this as often as you like, whenever you like, Appleby said.
2. And rollovers. With this method, the IRA owner takes the money as a distribution and they have 60-days to rollover (put back) the amount in an IRA. And this, you can do only once per 12-month period, said Appleby.

According to Appleby, the IRS, through their publications and regulations, has said for at least 20 years that the rollover method applies on a “per-IRA” basis. In other words, if you have 12 IRAs, you can do 12 rollovers for the year (12-month period) as long as each IRA does it only once.

In 2008, Alvan Bobrow, who had a few IRAs, rolled over two distributions from his IRAs and took the position that the rollovers were valid because they were done in a timely manner, and involved different IRAs, Appleby wrote in her analysis of the court case. His position was that he had not broken any rules, as explained by the IRS in their publication for the past 20 years.

The IRS disagreed and determined that only one of the two rollovers was valid. So, the IRS and the Bobrows went to court. And the Tax Court—much to the amazement of all IRA experts—agreed with the IRS.

The mistake cost the Bobrows an additional $51,298 in income tax and a penalty of $10,260.

Per the Tax Court, only one of the Bobrow’s distributions was eligible for rollover during the 12-month period. The Tax Court concluded that the Internal Revenue Code Section 408(d)(3)(B) limitation—the relevant section of the federal tax code—applies to all of a taxpayer’s retirement accounts and that regardless of how many IRAs he or she maintains, a taxpayer may make only one nontaxable rollover contribution within each one-year period.

The Bobrow case highlights, according to Appleby, an important rule that we sometimes overlook: “If conflicting information is provided in multiple sources, one must consider the hierarchy and reliability of such sources. In this case, Publication 590 is not authoritative and is not considered official guidance. The Tax Code is the more authoritative, and supersedes any other guidance in the event of conflict.”

What Now?
Well, according to Appleby, the IRS will be changing its publications, changing what they have been saying for 20-plus years. The IRS will implement this change for everyone, everyone except the Bobrows who still have to pay the tax and penalty, starting January 1, 2015.

Appleby said individuals should start moving money via transfers and not rollovers. “There are too many pitfalls with rollovers and none with transfers,” she said.

Starting in 2015, make sure you only do one rollover per year.

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Click here for Reference:  IRS Announcement 2014-15