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August, 2007


In the May 2007 Tax Newsletter we discussed the ramifications of petitioning the
United States Tax Court (USTC) as a result of legitimate tax disputes with the IRS.  
The first item listed as a requisite ground to petition the USTC was a Notice of
Deficiency (NOD).  NODs are most often the result of tax audits.  We’ll take a look
now at the legal and tax aspects of tax audits and the related appeals process.

Which tax returns are selected for audit?

The IRS (also called “the Service”) uses a number of methods to choose which tax
returns to audit, including computerized indices by profession, zip code and other
determinants to pull certain tax returns for desk review.  Tax returns that are computer
selected are sent to an Audit Classification Section to determine audit potential.  A
classification checklist is used by these personnel.

One of these computerized indices is called the Discriminant Function System (DIF),
which scores tax returns for potential audits.  The Service’s computerized systems
also identify any number of discrepancies between what you report and what is
reported to the IRS by someone else using its Information Reporting Program (IRP).  
Reported items of income on W-2s, Form 1099 and other information statements, e.
g. K-1s are examples of matched items of income.  

Deductions are reviewed for similar matching and for reasonableness by the IRS.  
Certain deductions get the attention of the IRS quicker than others, e.g. auto
expenses coupled with high business usage ratios.  The IRS has for a number of
years now placed heightened focus on offshore credit card users; high-risk, high-
income taxpayers; high-income non-filers, and self-employed individuals.  

The Service also uses a Taxpayer Compliance Measurement Program (TCMP) in
conjunction with its audits to evaluate comprehensive compliance with the tax laws.  
Although the Service says the use of the TCMP is random, there are instances when it
has used this methodology on specifically selected tax returns.  Finally, the Service
may audit a taxpayer based upon a “tip” received from an informant through its tax
informant reward program, or it may do so based upon information provided to it by
law enforcement.  The IRS and the FBI work very closely together in the wake of 911.

What do you do if you are selected for audit?

First thing you must realize if you are notified you are being audited is that you have
rights as a taxpayer.  Those rights are contained in tax law and generically referred to
as “The Taxpayer’s Bill of Rights.”  These rights include, but are not limited to, your
right to:

    Courteous and considerate treatment
    Complain about the IRS treatment of your case
    Representation
    Record any interview with the IRS
    Pay only the tax required of you by the law
    Appeal audit findings

The next thing you must do is to prepare for the audit.

How do you prepare for an audit?

There are several things you should do to prepare for an audit:

    Locate all records that support tax items shown on the questioned tax returns
    Identify problems backing up income sources or expense deduction (the IRS       
    will usually indicate in its notice which areas of the tax return are being
    Organize your records in a manner that coincides with the items being questioned
    Contact your tax professional for advice and possible representation regarding
    the audit

Under the following pointers may be helpful...

    Gather bank statements, cancelled checks, receipts, and all other financial
    records that are relevant to your tax return for the year audited.  
    Keep the information you provide limited to that which the auditor is entitled and
    nothing more.  The Service often requests that you bring prior and subsequent tax
    returns filed by you.  Generally, do not provide information for other tax years.  
    Doing so may result in an audit of more of your tax returns.
    Contact  your CPA or Tax Attorney and execute a Power of Attorney (IRS Form 2848
    and FTB Form 3520) with him or her, so that he or she may then contact the IRS to
    schedule an appointment at a convenient time for the audit.
    Try to schedule the appointment in the afternoon for most matters as IRS auditors
    do not like to work past normal working hours and they will try to resolve audit
    issues in time to leave at the normal quitting time.

Why are small businesses often selected for audit?

The Service has an Industry Specialization Program (ISP).  It has dedicated audit
personnel for all major industries.  Moreover, the IRS has both identified certain
industries that are prone to tax errors or abuse and have historically audited more self-
employed individuals and business tax returns than wage earner returns.  As a
business owner, there are several items you should immediately find and organize
as noted herein above:

    Bank statements, canceled checks, and receipts
    Electronic records
    Accounting books and ledgers
    Appointment books, logs, and diaries
    Auto records
    Travel & entertainment records
    Expenses for renting
    Records which support the acquisition of assets (whether purchased with money,
    credit or by note)

Under the following pointers may be helpful...

    Keep all business related canceled checks, invoices, or sales slips for five (5)
    years (from the date of the filing of the tax return). If you paid some expenses with
    cash keep the paperwork supporting the payments.
    Keep all debit and credit card statements for five (5) years also.  Payments by
    them are deductible in lieu of checks or cash according to proof of payment.  They
    must show the name of the payee, the date, the amount, and you should be ready
    to show the business purpose of the payments.
    If you maintain accounting records or “books” for your business, you should keep
    both “hard” and “soft” copies of them for five (5) years as well.  The tax code
    doesn't require small businesses to keep a formal set of books per se.  Records
    must be sufficient to support income and deductions on the returns filed.  If you do
    maintain accounting books and ledgers, you must be prepared to reconcile them
    to the tax return items for your business.  Checkbook and cash register tapes are
    acceptable forms of recordkeeping for small businesses. A profit and loss
    statement and a balance sheet generally demonstrate that the business has
    a good system of accounting, while supporting schedules may be helpful in
    supporting specific line items.
    Diaries, appointment books, travel ledgers, vehicle odometer readings and gas
    purchase records are particularly important in supporting the business use of
    vehicles that are available for off-duty, non-business use.  
    By law, out-of-town business travel and entertainment expenses require greater
    recordkeeping than most other expenses.  You must have a written record of the
    specific business purpose of the travel or entertainment expense, as well as a
    receipt for it.  The same applies to business meals, which include meals during
    business trips and those with business related individuals, e.g. customers,
    clients, suppliers and partners.

How does California’s audit process differ?

California’s Franchise Tax Board (FTB) performs audits on a limited basis, because it
has an information sharing agreement with the IRS and relies heavily on the IRS to do
the “heavy lifting.”  Once an IRS issues a NOD, the FTB will issue a Notice of
Proposed Assessment (NPA).  You have sixty (60) days from the mailing of the NPA
within which to file a “Protest” to the NPA or it becomes final, assessed and sent to

When you disagree with audit findings can you appeal?

You have the right to appeal when you think the auditor made errors or was unfair.  
However, before you appeal it is sometimes helpful to ask for a conference with the
group manager to discuss the audit findings and possibly to make a settlement offer.  
If that does not help to resolve your concerns, the audit findings will be finalized and
you will receive an examination report, sometimes referred to as a Revenue
Adjustment Report (RAR) or Income Examination Changes (Form 4549).  If you do not
agree to the audit findings within thirty (30) days of receipt of the examination report,
the proposed changes become final and a NOD will be issued.  During this 30 day
period, you can appeal your case to the IRS’s Appeals Division. California appeals
are made to the State Board of Equalization and must be made 30 days from
receiving the FTB’s Notice of Assessment (NOA).  You may also seek the assistance
of the Taxpayer Advocate Office (TAO), even if you are represented by a CPA or tax
attorney.  The TAO will investigate your claim, report findings, and help to achieve an
equitable settlement.  Both the IRS and the FTB have TAOs.  After the appeals
decision is made, you will receive a letter(NOD) in the mail from the IRS that will give
you 90 days to either agree to payment of the increased tax assessed or to file a
petition with the U.S. Tax Court if you still feel the IRS made errors, misinterpreted the
law, or was otherwise unfair.


Being audited by the IRS can be a major inconvenience for most people and
businesses.  Obviously, good tax planning and return preparation is the first line of
defense.  The dilemma can be exacerbated when the Service sends revenue agents
to the place of business to conduct the audit (usually when you cannot offer them an
alternative venue for their audit).  While most individuals are audited at the IRS’s
offices, corporations, partnerships, limited liability companies, and self-employed
individuals, e.g. real estate professionals, attorneys, doctors, and others, are often
audited at their place of business because of the volume of records and easy access
to them.  In those cases, it is imperative that the taxpayer engage the services of a
competent CPA and/or tax attorney.  That way, the audit can be conducted at the CPA’s
or the attorney’s office instead of the place of business.  

Moreover, the tax laws are complex and intricate in many areas.  Taxpayers rarely
have a comprehensive knowledge of the Internal Revenue Code, Treasury
Regulations, the legislative history, tax cases, the Internal Revenue Manual, Revenue
Rulings, Revenue Procedures and Private Letter Rulings.  Yet, these are the “tools of
the trade” for tax practitioners and the IRS.  Hence, in most cases it behooves the
taxpayer to seek professional assistance during tax audits.  

Tax preparers are not able to represent taxpayers before the Audit Division of the IRS.  
Representation is limited to CPAs, Enrolled Agents and Attorneys.  And that is so for
good reason.  Obviously, a taxpayer must consider the cost versus benefit of
engaging a tax professional for audit representation.  If the cost of engaging a tax
professional is less than the estimated benefit contemplated (i.e. the reduction in
potential tax exposure and liability), then it is both prudent and sensible to engage a
tax professional.  If the Service’s course of action is wrong or unfair, current tax law
allows taxpayers to recover legal fees in pursuing their tax rights under certain
circumstances.  Finally, some CPAs and Attorneys will take your tax audit on a
contingency fee basis.  In certain cases, this may be a feasible and an economic way
to handle your tax audit.

As always, our offices are available to defend your taxpayer rights and to assist you in
your tax matters from start to finish; all the way from tax planning and preparation to
tax court litigation.  We offer free tax return “physicals” to ascertain the propriety of your
return preparation, as well as missed or possible tax planning opportunities.