Rules of the Road.
- It is crucial that the client’s team understand the new rules of engagement introduced by the IRS recently. Stonewalling, delaying or obstructing the examination is more likely than not to backfire on the client, particularly in light of the IRS’ new expedited examination process. Your advocate should know both the tax law applicable to your exam as well as current IRS guidelines on your industry and procedural matters to guide the IRS agent toward resolution.
Likewise, if two Revenue Agents turn up at a field exam you should determine immediately whether one of the agents is a Criminal Agent.
If the Agent disappears from the case for an extended period of time without explanation, there is a possibility that the case has been referred to Criminal Investigation Division (CID).
Why Me? Usually in the case of an examination of a tax return, the examination may have been initiated due to mistakes made in the preparation of the return, or the IRS is challenging a particular item or issue on the tax return that may be a gray area. In addition, you exam may be part of an industry specific examination. If the exam is based on either a mistake in preparing the return or lack of experience with the challenged tax issue, the tax return preparers’ objectivity may be compromised and another tax professional might be a better choice.
Initial Preparation for the Exam with the Client.
- The representative and each taxpayer should execute a Form 2848 Power of Attorney for the tax years in question in order to communicate with the IRS.
- The representative and the taxpayer should carefully go over the details of the tax returns and ancillary issues to define and prioritize the goals of the client.
- The client should also provide, under the attorney client privilege, any information pertinent to the taxpayer’s return of a sensitive nature. Should the client reveal sensitive information, the client needs to be apprised of the noncompliance, omission or error and consequences of such noncompliance, omission or error.
- The initial preparation provides the tax representative the information for the initial interview with the IRS Agent.
- Under no circumstances should the IRS directly interview the client. The IRS can insist on this if they issue a summons to interview the taxpayer under Section 7521(c). If the taxpayer is summoned, you may consider requesting in advance to the IRS that the interview be recorded and transcribed. The taxpayer must pay for this. This can prevent a he said/she said situation.
- Tax Exposure Items. If the tax preparer has knowledge regarding one or more issues that the taxpayer may not want disclosed, another advocate should be engaged to avoid exposing the tax preparer to perjury or penalties.
Types of Examinations
- Correspondence Exam. Letters will be issued by Service Centers, usually for mathematical errors, mismatches regarding items of income reported by the taxpayer and the reported to the IRS. These exams have the highest rate of no response and assessments made due to lack of response.
- Office Exam. A taxpayer in an office exam will be asked to report to the nearest IRS office for an interview and to bring certain records in support of specific items on the return. The scope of the examination is generally limited to the items on the classification checklist. Individuals are selected for office examinations when the present issue requires more than verification of records. Business returns may be selected because of the complex issues involved. These exams typically have a limited number of issues.
- Field Exam. A field exam will typically take place on the taxpayer’s premises, at the location where the taxpayer’s books, records and source documents pertinent to the examination are maintained. A Revenue Agent will examine the taxpayer’s books and records to determine the correct taxpayer income or correct tax liability. Agents are aware that the tax return has been selected and assigned to them because there is a higher probability for a tax change. Therefore, the agents will be prepared to find mistakes and make corrections. This is applicable to everyone from individuals to large and international businesses alike for all types of issues and sizes.
Why are Returns selected for Examination?
- Discriminant Index Function (DIF). DIF is a mathematical technique to classify income tax returns by assigning weight to certain return characteristics to obtain a composite score. The higher the score the more likely chance of a significant tax change.
- Whistle blower/ informant cases
- Return preparer projects
- Related returns
- National Research Projects
- Once returns are pulled for potential examination, they are classified as to whether they are reviewed in Office exam or Field exam or accepted as filed.
What to Expect.
- Initial Contact. For an office interview, the IRS will notify the taxpayer via mail correspondence asking the taxpayer to schedule an appointment. For a field exam, revenue agents will typically call the taxpayer to make an appointment. If the taxpayer is a corporation, agents will contact an executive connected with the preparation of the return.
Minimum Income Probe. IRM 188.8.131.52. The IRS will:
- Prepare a financial status analysis.
- Test internal controls.
- Interview the taxpayer.
- Reconcile income taxable income to Book income.
- Analyze personal. business and financial accounts.
- Tie gross receipts to original sources.
- Prepare analysis of business ratios
- Determine whether the taxpayer derives income from e-commerce and the internet.
- Tour the business location and review the website.
Additionally. if the taxpayer is a business:
- Analyze the Balance Sheet and Schedule M-1. M-2 and M-3.
- Review tax returns of shareholders.
IRS Examination Lead sheets.
- Review prior and subsequent tax returns
- Large. unusual and questionable items
- Other forms filed. e.g. employment. excise
- Was FBAR necessary to be filed?
Information Document Request (IDR) and verification
- Responding timely. IDRs will always have a deadline for information to be received. The date listed on the IDR should provide the organization a reasonable amount of time to gather and provide the information, generally between two and four weeks.
The change between IDRs issued during examinations in the past and now:
- The time to respond is much quicker;
- The result of not providing complete information now is that the information may be disregarded if not provided in a timely manner.
- If new information is provided in Appeals, the Appeals office is instructed to send the information to the Revenue Agent to consider, so you cannot get away from the Revenue Agent.
Circular 230 Section 10.20 provides that a tax practitioner must, on proper and lawful request by a duly authorized officer, promptly submit records or information in any matter before the IRS.
Privilege Exception. If the practitioner believes, in good faith and on reasonable grounds, that the records or information is privileged.
- Attorney client privilege. Attorney client privilege protects confidential communication with counsel for the purpose of obtaining legal advice that has not been waived and is asserted. It does not protect the intention to create a criminal act nor in furtherance of a future or ongoing crime or fraud.
- Tax practitioner client privilege. Section 7525 provides common law protection in noncriminal federal tax proceedings in Federal Court and does not apply to written communication in connection with the promotion of a corporate tax shelter.
- Fifth Amendment privilege with respect to the act of producing records.
- Civil cases. US v. Chen No. 12-10973 ( D. Mass. July 3. 2013)
- Criminal cases
- In re Grand Jury MH. 648 F3rd 1067 ( 9th Cir 2011)
- Kovel doctrine. Accountants hired by attorney extends attorney client privilege to non-lawyers performing menial or ministerial responsibility that involves relating communications with an attorney
- Documents prepared in connection with preparation of tax return
- Communications related to traditional accounting work and tax preparation work.
- Privilege waived on matters disclosed in the tax return
- Communications related to not privileged personal, financial and business advice
- Communications related to transactions where attorney acts as escrow agent.
Narrowing the scope of IDRs.
- All IDRs must be issue focused. It must state and identify the issue that has led the examiner to request the information in the IDR.
- The IDRs must be discussed with the taxpayer or taxpayer representative before being issued.
- The taxpayer and the agent need to discuss an appropriate deadline for the request.
Delinquent or incomplete responses
- Delinquency Notice. If the taxpayer does not provide complete information, or does not respond to the IDR by the deadline, the examiner will issue a delinquency notice. The taxpayer is generally given 10 business days from the receipt of the delinquency notice to supplement the incomplete information to the IDR.
- Pre-Summons Letter. If the taxpayer does not provide complete information to the delinquency notice before the deadline. the examiner will issue a pre-summons letter. The taxpayer is generally given 10 business days from the receipt of the Pre-summons letter to supplement the incomplete information to the IDR.
Summons. Section 7601 and 7602. If the taxpayer has not provided complete information to the pre-summons letter. the IRS may proceed with its general summoning procedures. Summons can be used at Examination. Collection and Criminal Investigation. The IRS may enforce the summons on anyone connected with the company through enforcement through the proper federal court.
The use of summons depends on:
- the tax liability involved
- the time and expense to obtain the records
- the likelihood of resorting to court action
- the adverse effect on tax compliance if not used
- is a criminal case pending
The taxpayer can bring an action to quash the summons. Information must be relevant. not a fishing expedition.
Failure to follow Powell requirements:
- Must be for legitimate purpose; Information not already in possession of IRS
- Must be relevant
- Must follow administrative steps ( slender reed here)
- Must be in possession or control
- Privileged: attorney client
- Work product prepared in contemplation of trial
- Work product has sometimes been extended to work papers
- Fifth amendment against self-incrimination normally applies to testimony.
- However the gov’t has been using required records doctrine for foreign documents. such as Bank accounts. given that they are required to maintained under FBAR
- See Summons Enforcement Manual page 30 for objections and responses.
In the case of the taxpayer with foreign accounts or hidden accounts the question is whether the IRS will be able to identify the source of the bank accounts or potential revenue sources.
The taxpayer cannot be compelled to produce documents that are not already in existence.
The IRS can summon third parties to be interviewed pursuant to Section 7609. These parties have the right to counsel and the right to move to quash the summons. The taxpayer and his representative cannot attend the interview unless the third party consents and even then the IRS can exclude them from the interview.
Agents can reduce the "scope" of exams. Agents have the power to resolve disputes over factual issues.
Agents cannot "settle" exams. Revenue agents do not have the power to settle any cases. However. as a practical matter on issues that occur during the examination an agent is more likely to be able to dispose of an issue if it is factual.
The Office of Appeals is "the only administrative function of the Service with the authority to consider settlements of tax controversies. and as such has the primary responsibility to resolve these disputes without litigation to the maximum extent possible."
Examination of Facts and Tax Law
- Fully developing the Facts
- Issue Resolution
- Raising defenses to Penalties
- Avoid sandbagging a difficult Agent by providing new information or facts to Appeals because Appeals will refer the case back to Examination to be more fully developed. Exam may take the position that that issue will no longer be Appealable. since you submitted your appeal previously.
- Industry Specific examination techniques
- Tax Methods and Tax Accounting
- IRS Manual guidelines
- Training Guides
- Chief Counsel Memorandum
- Defenses to Accuracy Penalties
Resolving the Case: Notice of Proposed Adjustment at Examination.
If the revenue agent does not agree with the taxpayer’s original position on the tax return. and proposes tentative adjustments to the taxpayer. The taxpayer may proceed in one of the four following ways:
- First. the taxpayer can agree and consent to the revenue agents position. This will end the examination. and the taxpayer will receive a bill for the discrepancy. If the taxpayer chooses. he may file a refund claim in the appropriate federal district court or claims court.
- The taxpayer can submit a written response and provide additional substantiation to the Revenue Agent.
Request technical advice memorandum from the IRS.
- The request is made by a field office when it has determined that the application of law to the facts involved is unclear.
- The question presented must relate to "the interpretation and proper application of tax laws. treaties. regulations. revenue rulings. notices. or other precedents to a specific set of facts that concerns the treatment of an item in a period under examination or appeal.
Proceedings before the Service" include:
- an examination of the taxpayer's return;
- consideration of the taxpayer's claim for refund;
- A technical advice memorandum request does not include a case that is currently docketed in court. unless the issue that is the subject of the request is not part of that litigation.
The Service will not issue a technical advice memorandum with respect to the following matters:
- alcohol. tobacco. and firearm taxes;
- certain issues concerning tax-exempt and government entities and farmers' cooperatives;
- requests for relief under Regulations Section 301.9100;
- frivolous arguments; and
- collection issues.
Technical advice is useful to a taxpayer because of its effect on the administrative action concerning the disputed issue.
If the technical advice is favorable to the taxpayer. field offices have no choice but to resolve a dispute on a legal issue in the taxpayer's favor.
- Technical advice adverse to the taxpayer has the opposite effect; that is. it forecloses the possibility that the taxpayer's position will be accepted by the field office.
- Appeals. on the other hand. may rule in favor of the taxpayer under its existing settlement notwithstanding an adverse technical advice memorandum.
- While adverse technical advice does not have the same preclusive effect in Appeals as it does at the field level. it may significantly decrease the possibility that Appeals will accept the taxpayer's position. Additionally. settlement in Appeals on a basis favorable to the taxpayer is unusual as a practical matter once the National Office has issued an adverse technical advice memorandum. Thus. before a taxpayer initiates a request for technical advice. careful consideration must be given to whether the National Office will issue a favorable conclusion on the issue involved.
- The taxpayer or the field office may initiate a request for technical advice.
- In determining whether to request technical advice. the field office first considers whether another form of guidance would be more appropriate.
- The field office also must seek assistance and a recommendation from field counsel before submitting a technical advice memorandum request to the National Office.
- If the field office disagrees with the field counsel's recommendation. the field office must elevate the issue up through their respective supervisors. Ultimately. any request for technical advice must be approved in writing by a Director.
- A taxpayer may initiate a TAM request that the issue be referred to the National Office.
- If the field office denies the request the taxpayer has the right to challenge that denial within thirty days by submitting a memorandum outlining its position. the relevant facts and law. and the particular need for technical advice. The taxpayer's memorandum. along with the field office's reasons for not wanting the issue referred. will be sent to the Territory Manager for resolution.
- If the taxpayer is unsuccessful at that level. the taxpayer can seek additional review with the Director of the office having jurisdiction over the taxpayer's case. but may not appeal the adverse decision.
- The person responsible for review may consult with the Associate office. if appropriate. and will notify the field office as to whether the proposed denial of the taxpayer's request is approved or denied within forty-five days of receiving all information.
The Field agent may also request a taxpayer specific guidance known as a "Chief Counsel Advice Memoranda." Unfortunately. the taxpayer under audit does not participate in the process and such advice can be used by field personnel as a substitute for requesting technical advice memoranda above.
Propose a settlement.
Closing Agreements. The taxpayer and the IRS can enter into a closing agreements. Closing agreements are legally binding. Treasury Regulation Section 301.7121-1(a) Closing agreements are generally reflected on Form 866. Agreement As to Final Determination of Tax Liability or Form 906. Closing Agreement on Final Determination Covering Specific Matters.
- Form 866.Agreement as to Final Determination of Tax Liability —establishes the final tax liability. In a form 866 closing agreement. a deficiency notice is not necessary. Both sides agree to a final liability and. therefore. there is no need to provide an opportunity for the taxpayer to request a court review.
- Form 906. Closing Agreement on Final Determination Covering Specific Matters. makes a determination on only those items specifically listed on the form. Other items still can be adjusted by the IRS in subsequent actions. These agreements are binding on both sides absent fraud. malfeasance or misrepresentation of material fact. With form 906. all unstated items are left open for future review. If the IRS adjusts any of these items. the taxpayer has the right to request court review. Therefore. the IRS must issue a deficiency notice before attempting to collect.
Form 2504. Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment. is the agreement form to be used in two situations: In employment tax examinations where any worker classification issue was examined and accepted and other non-IRC 7436 issues are adjusted. (i.e.. fringe benefits). The non-IRC 7436 issues are reflected on the Form 2504. and the identity of the worker job classification that was accepted in the exam should be notated in the "Other Information" section of the Form 4666.
- If the taxpayer does not agree with the adjustment. the IRS will give the taxpayer 30 days to reconsider. The taxpayer can file a protest within this 30 day period to request a hearing before the Appeals Office.
- The taxpayer can bypass Appeal Office. wait until the 30 day statutory notice of deficiency. and within the 90 day period file a petition in the U.S. Tax Court. If the taxpayer chooses this route. he is not required to pay the proposed deficiency unless and until the Tax Court renders an adverse decision that becomes final.
- The taxpayer can bypass administrative appeal and Tax Court review by not filing either a protest or a Tax Court petition. If the taxpayer pursues this course of action. he will be sent a bill in due course. After payment. the taxpayer can file a claim for refund and obtain judicial review by filing a refund suit in the appropriate federal district court or claims court within the statutory period.