Preparing for and Beating the I.R.S.:
Audits and other Tax Matters
By David Goldstein, Ph.D.
Copyright © 2011 David Goldstein,
All Rights Reserved
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Preface: Disclaimer from the Publisher and Author
The author will not be responsible for any damages resulting from applying the information contained herein. This book presents the author’s opinions based upon research on and experience with the tax process. This book is for educational purposes and should not be considered professional accounting or legal advice. If professional assistance is required then competent accounting or legal services should be sought.
The legal, accounting and tax principles of the United States are constantly in flux so the reader bears responsibility to ensure that any laws, publications or principles mentioned herein are current before applying them.
Prologue
Dealing with I.R.S. notices and audits can be a harrowing experience. The first few times I received notices I panicked. Having many businesses over two decades I have learned a lot from dealing with “the service.” This book describes the lessons learned with concrete examples on my letters and conversations to help you get satisfactory results from investigations and audits.
I am a computer consultant by trade, not a lawyer or accountant. I am not particularly organized: when I had employees I hired bookkeepers. No book is a substitute for a tax accountant or lawyer. However, not every case requires a C.P.A., tax lawyer, enrolled agent or even a bookkeeper. This book will help you address mundane issues that you can likely handle yourself. This book also addresses special circumstances, like getting the service to absolve tax debt. When I needed advice, I considered accountants, lawyers and enrolled agents. Over time I learned to handle notices and audits on my own and have advised others on these matters. This book will help you address simple issues and make informed decisions on assistance for more complex issues.
If you worry about dealing with tax notices, audits and debt then this book is for you.
Chapter 1: Introduction
Overview
Filling tax forms can seem overwhelming – more overwhelming than paying the actual taxes. There are numerous types of taxes and many things can go wrong in the payment process. If you worry about having problems with the Internal Revenue Service (I.R.S.) or already have had issues risen by the service then this book is for you.
This book assumes some knowledge of the tax process. If you have questions at any point in reading this chapter you may want to jump ahead to “Types of Taxes” and come back to what you were reading.
Purpose
Dealing with the I.R.S. presents useful strategies for handling tax issues at various stages. This book does not focus on minimizing taxes. This book is not about avoiding taxes. This book covers time-tested mechanisms for avoiding problems with submitted returns. This book is for getting the decisions you want from tax processes if problems have already been noted.
This book briefly examines numerous mechanisms on reducing the tax burden. These mechanisms are covered in concentrated sections and in the indices. Why does the book separate tax-saving mechanisms from mechanisms on dealing with the service? The tax savings mechanisms are temporary, often for a single year – the methods for dealing with the service are often timeless.
Another thing distinguishing this book from others is this book assumes you can afford your tax burden. We discuss negotiating with the I.R.S. under “Meeting with the I.R.S.”. However, many books and infomercials claim that you can negotiate tax debt like you can a car. We discuss rare cases where the I.R.S. will consider debt “uncollectable” but stress an approach minimizing penalties and interest and – more importantly – keeps you out of jail.
Audience
This is a book written by ordinary citizens who have dealt with the I.R.S. for people who have to deal with the I.R.S. This book is not by tax professionals for tax professionals. One of the many subjects in this book is finding the right tax-related professionals to help you.
If your taxes involve keeping significant records, this book is for you.
If you want to protect against audits, this book is for you.
If you have received notices from the I.R.S., this book is for you.
If you have been audited, this book is for you.
If you want to take the I.R.S. to court, this book is for you.
Our goal is not to describe avoiding taxes, finding specific deduction or minimizing taxes. Our goal is to resolve problems with the service without any penalties assessed and minimizing any interest involved.
You may also not need this book. Just as the reasons above show why to buy this book, this books does not address every possible topic.
Ignoring taxes. Some people believe there is no constitutional provision for income taxes. Even celebrities that take this stance, such as Wesley Snipes and Richard Hatch, are jailed for tax evasion.
Deliberate tax avoidance. Most people have tax deductions, some people use tax credits, and then there are people with “strategies” for avoiding taxes. Many clever strategies for avoiding taxes are illegal mechanisms given legal sounding names. Some of these are extremely popular, such as the “Slavery Reparations Scam” detailed on the I.R.S. web site under http://www.I.R.S.gov/pub/I.R.S.-news/ir-02-08.pdf. Any such attempt is subject to (current) $5,000 penalty for filing a frivolous tax return.
Types of Taxes
A critical aspect of discussing taxes is defining the types of taxes we cover. There are hundreds or thousands of types of taxes. Here we discuss a few, very general types of taxes that affect nearly everyone and every business in the United States.
Income taxes cover your earnings from employment. Most Americans realize that their W-2 form for reported wages leads to a 1040 (or one of its variants for income tax.)
A person’s income tax is also affected by other sources of income. Most individuals have other sources of income, such as interest, capital gains, property sales, business income. These sources of income are reported via forms such as variants of the 1099 and are included in income taxes.
Businesses file and – sometimes – pay business taxes. Only some businesses pay business taxes because many businesses that have a small number of interested parties have income that directly flows through to the parties.
Each of the above types of income has books of related regulations, instructions and forms. The above types of income generally are summarized in a yearly tax obligation: you file a 2020 personal income tax return that includes capital gains distributions in 2020 from Google reflecting Google’s 2020 business tax filing. Delving into the specific forms is unnecessary at this time but we want to distinguish such taxes from taxes that have more stringent deadlines and a greater sense of urgency to the I.R.S., such as payroll taxes.
Payroll taxes, such as those reflected in each taxpayer’s withholdings can be due in ranges from a single day to a yearly obligation. The sense of urgency for such taxes is also much greater: while a dispute over personal income taxes may involve simply letter sending for years, I have had I.R.S. agents come to my door with filled out forms that they needed to clear up my accounts.
Important Tax Concepts
Thousands of concepts are important in tax professionals’ filing tax forms. However, only a few basic concepts are essential for our discussion of resolving issues with the service while minimizing any amount atop the tax due.
A critical concept in tax law is differentiating between credits and deductions. Deductions offset income and indirectly reduce the taxes owed; if you have less income, you owe less tax. Credits offset taxes directly: a $1000 tax credit reduces your tax burden by $1000.
Credits are a powerful concept: with enough credits anyone can owe $0 of taxes. Conversely, many credits are temporary in nature, involve significant paperwork and the service knows they are ripe for abuse. If you seek tax credits ensure that “the t’s are crossed and the i's are dotted.”
An attractive current credit is a maximum $13,170 credit for adopting a child. Most credits have a significant paper trail involved and the I.R.S. has a backlog of internal investigations holding up returns with this credit; with each credit offsetting tens of thousands of dollars of income, the American public does not want to see a lot of millionaires paying no taxes on fictitious adopted children. Thus, the credit involves Qualified Adoption Expenses (form 8839) as well as documentation of the adoption expenses occurred.
Another important concept that must be considered is “tax year.” Individuals generally follow calendar years as tax years but businesses can set – and revise – their tax year. Tax year is important because income, deductions and credits are based upon tax years specified or derived from legislation.
Let’s extend our use of the adoption credit example. The Form 8839 discusses carrying forward credits and expenses from one tax year to the next. Some deductions and credits, such as those involving depreciation, can affect returns for dozens of years. In theory, capital gains expenses may need to be tracked for centuries!
The tax year concept brings us to another topic: record keeping. Good records are essential to any discussion with the I.R.S. Depending upon the complexity of your taxes these records can easily involve thousands of pages of documentation – and any credits will require top quality documentation. We devote a whole chapter to record keeping.
Another concept that underlies almost every type of tax is a relevance threshold. There are thresholds for minimum taxable income, taxable interest reporting, bank transaction reporting and virtually every other aspect of taxes. Some of these thresholds are relatively complex. For example, in the adoption credit above a taxpayer’s Modified Adjusted Gross Income – not even just their Adjusted Gross Income – must be examined to see if the taxpayer qualifies.
Two final, and often misunderstood, tax topics are “uncollectable debt” and “bankruptcy.” These related topics provide for reducing or eliminating assessed tax due to hardship. Many commercials, books and enrolled agents oversell the value of these. However, due to interest and relevance, whole sections on these are included under “Tax Issues” (what these are), “Record Keeping”(how to substantiate them) and “Getting Professional Help” (ensuring the desired outcome.)
I hope to make clear that there are ways of reducing taxes – such as credits – which can be complicated to handle properly. This book’s goals include giving you methods to ensure that if the I.R.S. questions your filings that you can minimize any penalties, interest, and effort in resolving misunderstandings.
Organization
This book concentrates on handling issues with the I.R.S. to minimize your effort in dealing with them while also avoiding fines and – where possible – interest. The next chapter covers common tax issues. That chapter frames questions like what problems can arise in filing taxes, what to expect in the dispute process, and how tax issues can be resolved
The next chapter discusses record keeping. Accurate, complete records are critical in resolving disputes in your behavior. The chapter discusses ways to keep records, how to minimize the effort for record keeping and what to do when records are not available.
A chapter on professional help follows. Most people have heard of bookkeepers, certified professional accounts, lawyers and other types of help available: the chapter delves into what they can do for you at what cost.
Communicating with the I.R.S. may be the most detailed chapter of this book. The chapter offers very detailed advice and samples on how to read, react and respond to I.R.S. notices. This is the chapter to read when you get a letter from the I.R.S. – even if the letter includes a check.
The last dedicated chapter covers visiting the I.R.S. There are many inconsequential reasons to visit the service: you may need a form, qualify for free taxpayer assistance, etc. Since the service videotapes your visits and you cannot (legally) record your perspective it’s important to protect your rights if the visit could have consequences.
Summary
Taxes are an eventuality of life. While minimizing taxes owed is important, many of the articles, books and investment advisors offer strategies that are often outdated, difficult to follow or event illegal. We stress methods for interacting with the service are timeless. Our methods are time-tested, presented with examples, and can quickly save thousands or millions of dollars when disputing tax assessments.
Chapter 2: Tax Issues
Essential to discussing taxes is ensuring we are talking about the same process. This chapter discusses the tax process and then the various things that can go wrong or cause the Internal Revenue Service to examine your return. We first examine how things should go right in order to see how things can go wrong
Normal Tax Process
Anyone holding a job employed by another likely starts the tax process either during the interview process or on the first day of a job, by filing a W-4 and an I-4, providing their number of exemptions and identifying their ability to work in the United States. Persons working for themselves or as a business often file similar documents so that 1099 payments from one company to another (resulting in business income) can be tracked by the service.
Even the process of being hired can cause tax issues. The government administers a nationwide service using taxpayer identifying documents to ensure employability. The process of even placing funds into banks involves a process for ensuring identity. These processes can (and should) raise flags in protecting against identity theft and related issues, such as terrorism.
The hiring process is also often key for establishing deductions from income and credits that could eventually foster dramatic tax reductions. Many specialized credits are often in place for specific populations, such as minorities, veterans, and prison inmates. Any business that hires employees should verify the applicability of credits – often with state agencies – before applying for them.
Your specifying deductions also allows you to raise or lower your taxes withheld, affecting how much you owe or get back at the end of the year. Both alternatives can be used advantageously: if you expect delays in processing, even minimal overpaying can result in interest payments by the I.R.S. much higher than currently available if the service delays in returning overpayments.
Another, common tax issue from the hiring process is benefits, such as insurance and pensions. In general such benefits offer you untaxed potential rewards. However, consider your income and the benefits themselves when you get them: at high levels of income – or benefit – they can be taxed as income.
Virtually every potential income source provides documentation to you and to the I.R.S. Interest payers, insurance companies and even on-line auction sites may provide documentation on possible sources of income. Your return should reflect any source that is reported to the I.R.S. There are very few cases where you can defend not reporting a source:
if the source sends you multiple sets of documentation the I.R.S. expects you to defend them all. For example, I regularly get several 1099-INT forms from an individual bank, one for each account.
If the source sends the I.R.S. documentation and sends you none, the service expects you to report on the forms you didn’t see.
If the source sends you late documentation it still must be included.
I have personally encountered all three of these cases, so as the tax year progresses I will suggest additional steps to take to ensure that you are not penalized for what seem to be others’ mistakes.
Another event in the yearly tax process is estimated tax payments. The I.R.S. expects you to estimate all taxes owed from all sources in a timely manner. If you have difficulty estimating your income the easy way to avoid penalties here is to pay just over what you owed in the previous year. However, if you simply avoid paying for a source, you will owe penalties and interest.
January of each year often provides you W-2’s for working with your tax return. March 15th then generally closes the books for most businesses and their K-1’s, which specify how much income you might have from business interests. If you are a partner in a business or own stock in a company you might receive K-1’s. These and other forms lead to the all-important 1040.
It is with the filing of 1040’s (or their variants) where this book really becomes valuable.
Avoiding Major Issues
The tax process is records driven so maintaining good records, obtaining accurate records from others, and ensuring that these agree with the government are key to avoiding penalties.
Major issues occur after taxes are filed – or when taxes are never filed – and discrepancies are detected. Prior to submitting your taxes you should account for all possible sources. After submitting your taxes, you can verify your records against the I.R.S.’s records by requesting a transcript.
Discrepancies in taxes, especially missing forms, cause automated notices to be generated by the I.R.S. You can often detect discrepancies before the I.R.S. would post notices, thereby avoiding penalties since no discrepancy has been detected.
I routinely get many 1099’s. Some banks refuse to provide written 1099’s because they want to save money on postage and processing. Some businesses may do this and employers can provide electronic W-2’s. Thus, the I.R.S. may easily have forms that you have never seen.
Another factor that can work in your favor is the I.R.S. has long, but often legally mandated, date windows for getting forms processed. Thus you can always request an transcript over the phone or at an office to see the I.R.S.’s view of your income and return. Sometimes, during I.R.S. conversations, you can learn of pending notices before they are sent – allowing you to “beat them to the punch.”
The dates of notices, checks, etc., are also important: if the I.R.S. delays processing then they owe you interest.
How Issues Proceed
Any I.R.S. investigation starts with sending notices. Businesses can get many, many notices a year. Private individuals should get almost none. A notice may have almost no consequence or could be involve huge sums of money.
The first, critical step when you receive a notice is to not panic and open it. Almost every notice that is not informational is time sensitive. You may have only thirty days to respond from the date that the letter was “written”, so time is of the essence – where “written” is the date given in the letter (even though the letter was not likely generated on that date.).
The next step in handling a notice is analyzing its exact meaning. Many notices are several pages. A four-page notice may have only one or two sentences of any real value. Having consulted to the I.R.S. and many large financial firms, organizations expect and sometimes rely upon people being overwhelmed by standardized text (called boiler plate.) Legal disclaimers, excessive details, irrelevant payment addresses are often included. Find what is important and assess its impact (see Figure: Informational Notice.)
Figure: Informational Notice
Some notices are sent just to inform taxpayers.
A note of almost any consequence requires a reply. Determine if you are the best person to write a reply or if you need help. If the I.R.S. is asking a business to send in a form, these forms are often involve zero balances but are important to the service. You can write a reply and send or deliver it. If the notice is about tax court, you should seek counsel. Several later chapters cover acquiring external assistance for responding to the I.R.S.
Once you have assessed the important of a notice and determined if you should respond personally, respond in a timely manner. Virtually every notice will have a time limit for responses. The chapter “Communicating with the I.R.S.” covers writing, calling and faxing the I.R.S.
An analogous issue is how to deliver the response. Each method has its advantages and disadvantages. Phone calls let you learn more about a situation before you provide a written response. In-person visits, on rare occasions, let you get written feedback on your problem; written instructions from the I.R.S. are extremely rare because it is can bind the I.R.S. and so agents are trained to not offer things in writing. If you hand-deliver a response the service will also give you a photocopy of your response with a distinctive I.R.S. time-stamped, acknowledgement that shows where and when you submitted the response.
Chapter 7 discusses the common forms of bankruptcy (Figure: Trade-offs of Special Circumstances). Most Chapter 7 bankruptcies take approximately four to six months to be completed. In addition to taxes, typical debts eliminated in a Chapter 7 bankruptcy include credit cards and medical bills. Some debts cannot be eliminated in a Chapter 7 bankruptcy such as child support and student loans.
Taxes can be eliminated in a Chapter 7 bankruptcy if they are income tax liabilities or non-trust fund employment taxes and meet all the timing rules previously reviewed.
Chapter 7 bankruptcy is most appropriate for a client who cannot afford to make monthly payments on his tax liability after deducting reasonable living expenses. It is generally for the client with minimal or no cash flow. In that regard, qualifying for a Chapter 7 bankruptcy is somewhat analogous to having a “currently not-collectible status.” A Chapter 7 bankruptcy is best where the client has no assets that could be seized, trading the tax debt for a bankruptcy notice on the client’s credit rating for seven year (as opposed to uncollectable debt status, where ten years of the status with the taxpayer having no ability to pay the debt causes the debt to be ignored.) A client with consistent cash flow or significant assets would most likely file a Chapter 13 repayment plan to try to keep valued assets while paying a portion of the debt.
Typical bankruptcy exemptions would permit someone emerging from a Chapter 7 bankruptcy to keep all their household goods; retirement plans; cash on hand and in a bank account up to $800, up to $1,000 of equity in a car, and up to $5,000 of equity in a personal residence.
Chapter 13 bankruptcy also provides a mechanism for individuals to prevent foreclosures and repossessions. Arrearages on cars and houses can be repaid in a Chapter 13 so that the property is not lost to a creditor.
An important aspect of a Chapter 13 bankruptcy is that the amount repaid to the I.R.S. can range from one percent to 100% of what is owed. The lowering of the amount actually repaid to creditors is commonly referred to as a “cramdown.”
In addition to taxes, debts such as credit cards and medical bills can be repaid at substantially lower rates than what is actually owed. Interest also stops running on most I.R.S. claims, a feature that is impossible to obtain directly from the I.R.S. Penalties also stop accruing after a Chapter 13 is filed.
Taxes are repaid and classified in a Chapter 13 filing in the following three ways:
1. The value of any tax lien the I.R.S. has filed must be repaid at 100% plus continually accruing interest while the bankruptcy is pending.
This rule operates regardless of which type of tax is involved or how old it is. This feature is referred to as a “secured claim.”
A claim is secured if the I.R.S. has filed a tax lien before your client files for bankruptcy. In that event, the value of your client’s property subject to the lien must be repaid. Your client must have sufficient cash flow to pay back at least the value of the tax lien to the I.R.S. during the course of the Chapter 13 repayment.
There is also an unsecured part to most tax liens. The unsecured part is the amount of the taxes, interest, and penalties owed on the lien that are in excess of the value of your client’s property.
2. Unsecured priority claims are the income taxes (and the accrued interest on those taxes) that are not yet old enough under the timing rules.
These “newer” claims must be fully repaid in a Chapter 13 filing. They are unsecured but bankruptcy law prioritizes them. Trust fund employment taxes and sales taxes are also fully paid as priority claims. The penalties on unsecured priority claims have a lower classification as unsecured general claims.
No interest runs on most priority claims while they are being paid in a Chapter 13.
3. General unsecured claims are repaid at the “cramdown” rate that can be afforded by your client with whatever cash flow is left after paying the secured part of a tax lien and the unsecured priority claims.
No additional interest or penalties will accrue on most general unsecured claims during the bankruptcy. And the penalties that already accrued before the bankruptcy was filed are subject to cramdown.
Figure: Trade-offs of Special Circumstances
Each special mechanism for reducing tax has specific characteristics beyond requiring that the taxpayer might not have the ability to repay the debt. Some mechanisms would likely fail if the taxpayer has bank accounts, recorded assets or a well-paying, above board (legally noted) job. Recognizable but unsubstantiated assets, i.e., lifestyle assets, would undermine some mechanisms. Some mechanisms are contingent upon I.R.S. actions. Different mechanisms also affect longer time periods, years after the tax period.
Notices
Virtually all actions taken by the I.R.S. begin with a notice. A notice can cover any of a wide range of possibilities. Notices are often even sent for informational purposes, such as a line or form missing from your tax form whose assumed value does not affect your liability. However, because notices are sent for virtually all matters – including time-sensitive matters with large tax liability implications – it is critical that all notices are read and considered.
Receiving a notice can be unnerving, but ignoring a notice is a bad decision. The service generally uses return receipts for initiating audits and other serious matters. An organization with accounting or legal assistance on staff thus might ensure that registered or certified correspondence is automatically examined by accounting or legal representation. However, all notices should be examined in a timely manner so that a reply can be formulated and given to the service. Do not delay in responding to the service; a thirty-day time limit for a response can pass quickly.
The chapter “Communicating with the I.R.S.” discusses how to respond to notices in more detail and with specific examples. A telephone response can often delay any I.R.S. action for months, so may often be your best choice when deadlines are tight.
Audits
One of the scariest things to most Americans is an I.R.S. audit. Unresolved notices can lead to an audit. Many notices are mundane, require no response, or may involve a small owed some. However, some notices announce “investigations” which are the first step in an audit. Here we provide what you might expect from an audit.
The I.R.S. largely uses statistical measures to select audit candidates. Most decisions on examining taxpayers are automated – there is rarely “someone out to get you”. The exception would be if the investigation stems from another criminal probe – where that probe is “out to get you.”
The statistical measures use for triggering audits vary over time as the I.R.S. targets types of taxpayers specific types of abuses to examine. A few common measures include the following.
1. Non-payment of taxes. An irksome myth the service deals with is that income taxes are unconstitutional. Steadfastly denying that you are not required to pay taxes is a reliable way to end up in jail.
2. Large amounts of credits. Credits have a large impact on taxes owed. Credits submitted without the help of professionals are often based upon incorrect or missing paperwork. Unsubstantiated credits will generally be denied by the I.R.S. and pursuing them often leads to audits.
3. Foreign bank accounts. Foreign bank accounts that unnecessarily complicate businesses and personal needs are viewed as indicators at attempts to avoid declaring income.
4. Cash transactions. Significant cash transactions are also often viewed as a mechanism for hiding income or - worse – supporting terrorism. The government has a keen interest in monitoring financial transactions, especially tracking cash transactions in businesses that have customers normally engaging in credit card transactions.
A key trait here is that the service consistently looks for tax evasion and underpayment. The tax code is complex so agents know that people make mistakes.
5. Exceeding thresholds. The I.R.S. collects data on expected deductions, income and profit for various types of businesses. Even compliant individuals and businesses may have years that are substantially outside the expected results. These deviations can trigger the auditing programs to select your return. Such audits can easily be the service not realizing a change in your lifestyle, business, etc.
There are four types of audits, each with varying expectations, time frames, and need for assistance.
Correspondence audit. A correspondence audit questions individual items on a return asking for documentation. This type of audit may be conducted solely by mail. For small, simple returns, its limited scope may make it seem like a notice simply requiring a response. As long as you do not violate the guidelines presented below a correspondence audit should be brief.
Office audit. An office audit questions specific items on your return. This type of audit is initiated by U.S., mail and is typically used for small businesses and sole proprietors with annual sales under
$500,000. Providing complete documentation for these in an organized manner resolves an office audit. Bringing an intermediary, such as a certified public accountant who has gone over your records, helps resolve the issue without letting the audit expand in scope.
Field audit. A field audit generally involves only businesses and is where the I.R.S. agent calls the business representative to arrange the audit at the primary place of business with its principals. The intent here is for the service to first under stand your business and its business conditions to then determine what items should be placed under more scrutiny. Large organizations may be readily able to accommodate such an audit, often having areas already arranged for audits by various government agencies. As always, following our audit guidelines can hone the scope of the audit.
TCMP audit. A Taxpayer Compliance Measurement Program, or TCMP, audit used to update the data used in selecting audit candidates. A TCMP audit examines every part of the return where each line must be substantiated by documentation. This type of audit is the most time-consuming type of audit.
Audits can be difficult and are nearly always stressful: even my firms that were audited yearly by the Department of Defense needed additional (re)organization of records for I.R.S. auditing. We mention a few general guidelines here that should foster better results and save time during audits.
1. Try to have the scope of the audit clarified. If the auditor wants to examine “everything” you may need professional assistance (see below). Outside parties will often prevent an audit that should be about a small amount of records from becoming a multi-year “fishing expedition.
2. Try to determine what is considered “material.” Auditors are not generally stupid and recognize that there is a cost in maintaining records. Auditors cannot tell you how to run your business. Thus records of transactions are important but actual copies of numerous tiny receipts often need not be provided as long as there seems to be no systematic attempt to misstate facts. Alternatively stated, no one wants to spend $30 of time recording or verifying the purchase of 60 cents of stamps.
3. Be organized. Anyone who is naturally very organized can provide a mechanism for appropriately organizing records for traceability. Traceability is key in any audit: how an item leads to credit card receipts, to credit card statements, to payment of credit card bills to an asset, supply or other expense. Organized, traceable records indicate transparency and, in turn, honesty. If auditors have confidence in your business an audit may involve much less effort than expected.
4. Engage outside help where needed. Enrolled agents, certified public accountants and tax attorneys can all work on your behalf. They will likely move any meeting to their site and act as intermediaries. They are not emotionally attached so can often assess the situation better than you can and – as intermediaries – add a recognized overhead that both you and the government recognize. The chapter “Getting Professional Help” discusses what you might expect from different types of assistance. The earlier a conflict is resolved the less help – and less expensive help - that would likely be required.
5. Realize how the agent is graded, the size of their case load, and how this can be used to your advantage. Agents want to ensure that procedures are followed. Auditors want to ensure favorable settlements for the government. However, auditors with bigger cases are expected to prioritize their time to maximize government income. Auditors never want to see their results protested which could overturn their findings (in your favor) or - worse – lead to a tax court case that could affect the entire I.R.S. The promise of resolving an audit in a manner that avoids appeal while auditor look good is your best leverage.
With well-organized documentation an audit can be resolved quickly probably to your satisfaction. Penalties can often be waived and interest altered once the situation is resolved; our methods and communication techniques should help you do this while keeping your sanity.
An auditor’s decision can be appealed. One method for altering the assessment itself is tax court. This section is not meant to be comprehensive, but an overview – the tax court procedures themselves may encompass thousands of pages.
Notices after audits will include where and how to file an appeal as well as to petition a tax court case. The taxpayer pays a minimal fee to file the petition.
Many elements of the tax process seem stacked against “resourceful” taxpayers; disputing I.R.S. findings where you actually have the ability to pay often seems impossible. Thus I.R.S. agents and auditors have been criticized for being rude and intimidating – a problem routinely voiced to Congress. Conversely, tax court involves tax lawyers which is expensive both to the I.R.S. and to the taxpayer (if you hire one, see below.)
Audit Appeals
The conclusion of an audit includes a letter by mail that describes changes to your tax obligation and describes your write to appeal.
The appeal of an audit varies significantly from the audit itself in that auditors look at items on your return as being allowable or not. In contrast, I.R.S. Appeals Officers can compromise on issues after considering evidence as it might be viewed in tax court, i.e., the "hazards of litigation"; if the I.R.S. might lose tax precedent could be established that dramatically hurts the services collection ability. The great majority of cases that reach the Appeals Division are settled there and never go to court.
Tax Court
The first decision you face in filing for tax court is whether to hire a lawyer or not (see “Hiring Professional Help.”) The I.R.S. has tax lawyers assigned to each case so most individuals hire tax lawyers. The service incurs significant risk in tax court, so I have felt far more leverage in tax court, after hiring a tax attorney, than in any other step of the process.
Several aspects of tax court pose significant risk to the government; there is no possibility of bad outcome from the government’s perspective in notices, audits, etc. However, in court cases not only can your tax burden be reduced or eliminated but:
1. The service can be held responsible for your legal fees.
2. Simply going to court can cost the government tens of thousands of dollars.
3. Worst of all, court cases set tax law precedent. Thus, if the court agrees that a person’s living in a green house waives his tax liability, then all persons’ living in green houses deserve no tax liability.
Keeping in mind that your penalties have been set already, interest is at a preset rate, and that your tax lawyer may be taken as a deduction for professional services. One can see why the service would like cases to be settled out of court.
An important step that determines which I.R.S. lawyers and agents are involved is venue assignment. The case would be heard in some court, convenient to either the taxpayer or his lawyers. This venue can be changed, upon request, given a substantial change in the parties.
If your job takes you across the country, the venue can be moved to across the country. That move would likely increase your legal costs, but also the services costs.
Another important step in the process of any trial is discovery. The relevant tax forms, receipts, credit card statements, etc. will be supplemented with statements covering any missing records or other items affecting the case (often via depositions, subpoenas). The service’s lawyers would likely work with a tax agent and you (or your representatives) to reduce the focus of the case.
A tax case proceeds almost in the opposite manner of an audit. I.R.S. lawyers often accept items with credible substantiation: I.R.S. lawyers often have large case loads, their time is considered far more valuable than lower-level service employees, and the damage to the service of going to court can be substantial.
Case will often be settled with a written agreement between the service and the taxpayer, especially where taxpayer has enlisted legal help. The decision to settle vs. go to trial can be modeled based upon costs such as:
1. cost of legal representation for preparing the case for the service and taxpayer,
2. cost of legal representation of each day in court
3. cost of preparing legal briefs,
4. cost of additional accounting services,
5. opportunity cost of taxpayer engaging in the court case,
6. opportunity cost of government not addressing other cases,
7. dollar amount of your taxes affected,
8. probability of the taxpayer winning the case,
9. probability of the taxpayer losing the case but restricting the tax law, and
10. dollar amount of taxes eventually affected by tax law changes.
Some of these costs illustrate why a case might be settled out of court. For example, cost (3) is a more than $10,000 cost for the government in labor – so their settling a case involving $5,000 in differences is obviously in the government’s best interest. If the there is any probability of (8) or (9) occurring, the risk to the government in the dollars from (10) tends to be huge. Thus if a tax law change has even a slight chance of occurring, the government should settle. Conversely, taxpayers arguing their own cases almost never win. A tax lawyer handling your case should know if there is a reasonable chance of winning, most notable by a settlement with the government.
Cases that are not settled out of court go to trial before a judge. Continuances are possible which can delay resolution. But, given the costs involved, most cases seem to be either very short or very long – depending upon the resources of the taxpayer.
Much of the process described above is ignored when taxpayers argue their own cases. Most taxpayers understand tax law poorly and so such taxpayers rarely win cases. Conversely, an I.R.S. lawyer loosing such a case would likely be humiliated so should take any chance of settling a case with any doubt.
One element adding substantial cost to both parties in the case – and so further dissuading I.R.S. attorneys from court are pleadings. Any trial that occurs requires pleadings to be submitted. The paperwork of proceeding with a case, by itself, costs the service $10,000 - $20,000 just for the lawyers. These costs imply that any taxes gained from going to court should exceed these amounts; the service does not want to cost taxpayers more money to collect than the amounts it collects.
One final aspect of the tax court process worth discussing is claiming costs. If the service loses a court case the taxpayer can ask the court for legal expenses up to some maximum per hour threshold. This is yet another motivation for tax lawyers to settle over proceeding to court.
Bankruptcy, Hardship and Negotiated Offers
Three more options can reduce the actual amount paid to the government for a tax burden. The first option is having your account placed in uncollectable status for long enough that the debt is taken off the I.R.S.’ books. The second is using bankruptcy as a tool to have the courts erase or reduce the debt – along with other types of debt simultaneously. The third is a limited set of circumstances that indicate potential error or hardship that could negate some of the debt. We discuss these briefly here and in more detail in later chapters (Figure: Special Circumstance Checklist).
Figure: Special Circumstance Checklist