The Audit Trail

In most cases, an IRS income tax audit is nothing to fear. The keys are to keep calm and make sure you’re accompanied by an accounting professional.

The Audit Trail

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Within the past few weeks, you’ve gone through the ordeal of filing your tax returns. Now that you’ve finished, there’s a momentary sigh of relief. But that relief can be short-lived if a follow-up call from the Internal Revenue Service is forthcoming.

A visit from the tax man is the stuff of grim jokes and horror stories. When makers of the movie Seven Pounds wanted Will Smith’s character to come off as thoroughly unlikeable, they made him an IRS agent.

That’s fiction. The facts are something else. If you get one of those letters from Uncle Sam announcing it’s your turn for an IRS examination, Lesson No. 1 is: Don’t panic. Easier said than done, perhaps, which is why there’s Lesson No. 2: Call a professional, ideally your certified public accountant or the tax attorney who helped you prepare your returns.


No Drama

There are two reasons for having professional help: expertise and detachment. “They have experience in dealing with the IRS, and they know what the hot buttons are and what are not,” says Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants. “Second, and almost as important, it takes the emotion out of the issue.”

When the agent challenges a particular deduction, it’s easy for the emotionally invested business owner to get his dander up and get in a shouting match, Ochsenschlager says. A professional can hear the same challenge, stay cool, and calmly point out why the deduction is legitimate.

Besides yourself, only a CPA, an attorney, or an Enrolled Agent — a technical expert formally authorized to represent you by the IRS — can handle your case. Representing yourself is as ill-advised as being your own lawyer or your own surgeon. “A taxpayer should never represent himself before the IRS,” Ochsenschlager says.

Expert help can head off unnecessary inquiries. In his years of helping clients with the IRS, Ochsenschlager observes, “I recall several instances where it looked like the agent was headed toward a particular issue and was asking for certain information, but I could approach the agent and say, ‘I know what angle you’re looking at, and let me tell you why that’s not a valid argument.’ Sometimes these things can be nipped in the bud if you have a professional involved on the front end.”


The Right Information

The most common mistakes audit subjects make is with the information they give the examiner — too little, too much or the wrong kind. It’s not because they’re trying to deceive, but because they don’t understand what’s being asked of them.

“In one extreme they send too much information — stuff the agent didn’t ask for. That sets the agent off on a tangent” and may raise red flags, Ochsenschlager says.

The other extreme is failing to provide the asked for information, perhaps simply because the business owner didn’t understand the request. “They send something they think is responsive, but it’s not what the agent was looking for,” Ochsenschlager says.

The agent shows up on the appointed day for the audit, doesn’t receive the information requested, and everyone gets frustrated. “You get in these sort of cat and dog fights over something that was very preventable on the front end, if you’d understood their terminology and the way the IRS works,” says Ochsenschlager.

Often, these conflicts arise when the audit subject doesn’t understand the information request. Take a business owner who donates property to a charity, such as a church. Such a donation earns a deduction for the property’s fair market value.

But to uphold it, the donor needs documentation of the donation itself — a receipt, for instance — as well as documentation of the property’s value and an acknowledgement from the church that the company didn’t get something of value for the property. Faced with the request from the IRS to document the deal, an uninformed donor might respond, “OK, I’ll show you the deed.” But that doesn’t address the questions at all.


No Thugs Here

Alarmists love to depict IRS agents as police-state thugs out to nail even the innocent, but Ochsenschlager insists that’s really not fair.

“The greatest misperception is that the IRS is intimidating and that therefore they collect a lot more money than they really deserve,” he says. “I’ve had situations where, during the audit, the taxpayer actually got a refund.” Agents are professionals, and they don’t work on commission, so they have no incentive to misrepresent the law.

But they’re not perfect. “Generally they’re technically knowledgeable, but they can’t know everything,” Ochsenschlager says. “That’s why it’s wise to have an expert.”

An expert can also steer you through IRS appeals processes. The first step is requesting a technical advice memorandum. Suppose your advisor understands that a particular deduction is permitted in your industry, even if it’s normally not allowed, and the agent doesn’t believe you.

You can request a technical advice memorandum on the issue from an IRS internal expert, who may be more familiar with the details of the law than the agent. If the law and rules support you, the IRS expert won’t hesitate to side with the taxpayer. “I’ve often found that just the suggestion of going for technical advice would kill the issue,” Ochsenschlager says.

The agency also has a formal appeals process. But wait, you ask. Isn’t that going to be stacked in favor of the agency? Won’t they just back up their own people?

“Probably most people think that, but it’s not true,” Ochsenschlager says. “In my experience, close to 75 percent of the time we win at the appellate level.” (That reflects the likelihood that most cases appealed probably were wrongly decided at the audit.)


Ounce of Prevention

There’s no guaranteed way to avoid an IRS audit. Ochsenschlager says many business cases are first flagged by computers programmed to analyze returns and compare them with norms for the industry. But again, that’s a reason to make sure you have a relationship with a competent professional who knows your business.

That way, you can get advice not only to keep you on the right side of the tax law, but also on how your costs, expenses and margins compare with others in your industry, and how you can catch up if you’re behind. Then, at least, when the IRS sends you that letter, you may find yourself breathing more easily.


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