Basics of an IRS Audit
When a taxpayer is notified by the IRS for a tax return audit, the first reaction may be panic or fear. Understanding the audit process can help alleviate some of these concerns.
The IRS defines an audit as a review or examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct. The fact that a taxpayer’s return was selected for an audit doesn’t suggest that there is a problem. There are various methods the IRS uses for audit selection, which include:
- Random selection
- Related examination—business partners/investors returns are audited and the entity return is audited as well
- Discriminant Inventory Function (DIF) Score—a formula identifying items which may be a cause for concern, such as unusually high deductions outside the average for a similarly situated taxpayer
The audit process is started once a taxpayer receives an official notice from the IRS. The notice will provide instructions related to how to contact the examining agent and the time period in which a response is required. It is recommended that, upon receipt of an audit notice, the taxpayer contact their CPA to discuss the audit process and make a determination if they would like representation during the audit. If the CPA will be representing the taxpayer, a Form 2848 Power of Attorney and Declaration of Representative is completed which allows the CPA to communicate with the auditor.
Typically, the initial contact with the auditor is by phone to discuss the main point of contact, initial information needed by the auditor, and the timing. The auditor requests information from the taxpayer by issuing a Document Request (IDR, Form 4564), a document listing all information requests and due dates. As the audit progresses, additional IDRs will be issued. In some cases the IRS brings in specialists to handle certain areas of the audit. For example, an IRS engineer may be assigned to the audit to review research credits, or an IRS transfer pricing specialist will be assigned to review transfer pricing documentation. If the auditor identifies an issue that may cause an adjustment to the taxpayer’s return, the taxpayer has an opportunity to provide evidence/support for their position.
After the agent finishes review the documents received, the audit can be concluded in one of three ways:
- No change: you have provided all support requested and there are no changes
- Agreed: the IRS has proposed changes and you understand and agree with the changes
- Disagreed: the IRS has proposed changes that you do not agree with
A taxpayer usually has 30 days to decide whether they agree or disagree with the IRS changes. If they agree with the findings and result of the audit, they are required to sign the examination report and mail the signed copy to the IRS with additional tax payment (if applicable) within 30 days of the notice date. If they disagree with the changes, they can do the following:
- Request conference with an IRS manager
- Go through mediation—an informal, confidential, and flexible dispute resolution process
- File an appeal
The time involved going through the audit process varies depending on various factors including: type of audit, complexity of the issues, the availability of information requested, the availability of both parties for scheduling meetings, and the taxpayer’s agreement or disagreement with the findings. Generally there is a three year statute of limitations after a return is filed for the IRS to propose adjustments. In special circumstances the time period is extended to seven years. If the audit will not be completed within the statute of limitations, the auditor will request that the taxpayer agree to extend the statute limitations in order to provide enough time to complete the audit.
As mentioned above, taxpayers can ask for tax or legal representation during an audit. A professional helps minimize distractions from a taxpayer’s day-to-day business while allowing time to review and respond to IRS questions. In addition, the professional will organize and present information in a manner that the IRS wants to see, and can help in the negotiation of IDR scope and appeal process.
As a taxpayer, rights include:
- Professional and courteous treatment by IRS agents
- Privacy and confidentiality
- The right to know why the information is asked, how they will use it, and what will happen if the requested information is not provided
- The right to representation, by oneself or an authorized representative
- The right to appeal disagreements, both within the IRS and before the courts
Typical Audit Areas
- Meals & entertainment
- Personal use of company vehicles, condos, and employee reimbursements
- Transfer pricing—the IRS is usually concerned about the pricing if the related parties are cross border.
- Section 263(A)—provides comprehensive capitalization rules to all direct costs and a portion of indirect costs incurred in the production of real or tangible personal property which are allocable to that property.
- Repair and maintenance—any items being expensed that should be capitalized
- Earnings stripping—interest expense deductions of multinational corporations being limited in accordance with the thin capitalization rules
Any taxpayer could be selected for an IRS audit at any time. Actions that taxpayer’s can take to facilitate a smooth audit include: keeping good records, understanding the tax positions being taking on returns when they are filed, and having professional representation.
If you need assistance with an IRS audit, contact Clayton & McKervey.