By Gary A. Hensley, MBA, EA
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