Although this is toward the end of the Audit, it is a very crucial aspect of the Audit process. The reason is that if done correctly, it can save you from considerable probable financial loss. There are a number of steps you can take to make this happen. Before this, it is important to make yourself aware of the kind of penalties involved. Below, we will discuss them in detail. At this point, you really want to try and negotiate with the auditor in a reasonable manner and with consensus. The goal is to help the auditor show empathy, and thereby, allow us to avoid the penalties as much as possible.
Try to Negotiate Penalties
The IRS often proposes that penalties be assessed, if they propose adjustments. If penalties have been proposed, you may want to try to negotiate with the IRS to remove penalties before the audit closes. The auditor may be willing to do this, if you agree to some or all of the proposed adjustments.
The accuracy penalty applies, if your return has a substantial misstatement. It can include omitted income or overstated tax deductions or tax credits. This penalty is usually 20% of the additional tax that you should have paid. The IRS’s closing paperwork will let you know if this penalty is being proposed by the auditor.
There is a “reasonable cause” defense to this penalty. To get the auditor to remove the penalty, you should negotiate based on the position that you have satisfied “reasonable cause.” Reasonable cause is usually established by showing:
- Reliance on tax advice from a tax advisor
- Serious illness, death, incapacitation of the taxpayer or an immediate family member
- Natural disasters, fire, and similar disturbances
- Failure to access records
If the auditor ends up imposing this penalty, you will need to consider appealing the penalty. The penalty can be appealed, along with the adjustment that gave rise to it.
If the IRS auditor concludes that the underpayment on your return is fraudulent, the auditor may impose a fraud penalty. The fraud penalty is 75% of the unpaid tax.
IRS auditors usually only propose this penalty, if there is clear evidence that you intended to understate your income or take deductions or credits you were not entitled to. The IRS has referred to this as “badges of fraud.”
The IRS auditor’s closing letter will let you know if the IRS will propose this penalty. It will also include the amount of the penalty. You should negotiate with the auditor not to propose this penalty. Verbally, you might ask the auditor to propose the accuracy-related penalty rather than a fraud penalty. You do this by going through each “badge of fraud” and noting that the facts do not establish those badges in your case. If the IRS auditor refuses your verbal request, you should address this topic with the IRS auditor’s manager. The penalty is too high to simply accept it and the “fraud” connotation makes it difficult to settle the case with the IRS appeals officer or attorney later. The IRS auditor’s manager may be willing to impose the accuracy-related penalty to move the case along. If the IRS auditor or manager do agree to remove the fraud penalty, they will likely impose the accuracy-related penalty. You should consider contesting the accuracy-related penalty.
Failure to Pay & Deposit Penalties
The failure to pay and deposit penalties are usually applied as a matter of course. These penalties are computed based on the amount of tax you should have paid. As the IRS audit increases your tax, it also increases the amount of this penalty. The late payment penalty is a 0.5% penalty per month, based on the due tax. The maximum late payment penalty is capped at 25% of the tax you owe.
The IRS auditor’s report may not even include these penalties. They may be computed separately and sent to you after the IRS audit is closed. Regardless, the IRS auditor will usually not remove these penalties. Once the audit is closed, you can submit a penalty abatement letter (and Form 843) asking that these penalties be abated or removed. The same “reasonable cause” arguments noted above apply here. If you have not had these penalties in the prior three years, the IRS may also remove these penalties under its “First Time Abate” policy. You can even call the IRS 800 number after the audit closes and mention the “First Time Abate” policy and the IRS representative will check to see if they can abate the penalty over the phone. If they cannot do so, then you should consider sending in a penalty abatement letter (and Form 843).
Late Filing and Late Payment Penalties
The IRS imposes penalties for late filing and late payment of taxes. As the IRS audit increases your tax, it also increases the amount of this penalty.
The IRS’s revenue agent’s report will usually include a late payment penalty, if proposed. It will also have the amount of the penalty. You should follow the same process noted above for the failure to pay and deposit penalties.
Group Manager Approval
For accuracy-related and fraud penalties, our tax laws generally require the IRS auditor obtain his or her manager’s written approval for imposing penalties. The IRS auditor has to do this before notifying you in writing about the penalty. IRS auditors do not always get this written approval in advance. If you move forward with your case in appeals or in court (both of which are explained later), keep in mind that you may need to raise this issue. You may need to get the IRS’s records to see if manager approval was received. The Freedom of Information Act request allows you to get a copy of the IRS records. We’ll explain how to make this request later in this chapter.
Request Technical Guidance
You do have the ability to request the IRS auditor to obtain technical advice. This type of request is usually made when there is a disagreement as to the law or how the law applies to your facts. If the IRS grants your request, the IRS Office of Chief Counsel (the IRS’s attorneys) will request information and issue a Technical Advice Memorandum (“TAM”). The TAM is the IRS’s final decision for your case. The TAM will eventually be made public, but your name and identifying information will be redacted or removed first. This creates a record that others can cite to, but they cannot rely on, since the TAM is not binding on the IRS for other taxpayers. Our experience is that the IRS auditor or even the IRS attorneys may decline to issue a TAM. They may also use the TAM to gather more information and this could result in a TAM that does not support your position. This can foreclose on the ability to have a fair administrative appeal, since the appeals officer may be hesitant to overturn a position set out in a TAM. Suffice it to say that you may want to discuss this issue with a tax professional, before asking for a TAM in your case.
Request a Group Manager Closing Meeting
You have the right to ask to meet with the auditor’s manager. The IRS refers to these as group manager closing meetings. During this informal meeting, you may be able to convince the manager that the auditor erred. While rare, the manager may even ultimately side with you. They may be willing to compromise the case, if you propose some fact-based argument and method for doing so. They may also be willing to remove penalties or impose a lesser penalty to move the case along. These meetings are usually used to get some concessions from the IRS, before the case is closed to the IRS Office of Appeals. The general rule is get what you can get and then move on with the process, if needed.
Request Fast Track Mediation
IRS auditors generally do not have the power to settle your case. The IRS Office of Appeals, which is covered in the next Chapter, does have this authority. You may not want to wait for Appeals to review the case, however. You may want to try your luck now and then again at Appeals later–getting two bites at the apple. This is where fast track mediation comes in.
You can ask the IRS auditor to participate in fast track mediation. This can be helpful, if the auditor is proposing to adjust your tax return, but they indicate that they are sympathetic to your position. If the IRS auditor is not sympathetic to your position, they will likely deny your request for fast track mediation.
The dispute also has to be capable of being settled easily. For example, fast track would not be capable of resolving a tax dispute over receipts. If the dispute focused on substantiation or recordkeeping, it is not likely something that can be settled easily. For example, say the dispute involves whether the IRS should accept your receipts as sufficient evidence for $20,000 of expenses you deducted on your tax return, but you only have a record showing $10,000 of expenses. Fast track medication will not work in this type of case, since you either have the records or you do not. If you are missing the records because of no fault of your own, such as a house fire or loss due to a natural disaster, fast track mediation may work. The distinction is that there are court cases where the taxpayer was not held to such a high standard, when they lost records due to no fault of their own.
If granted, you and the IRS auditor present a written summary of the issue and the IRS Office of Appeals will assign an employee to work the case. The appeals officer functions as an intermediary to encourage the parties to settle the case. If successful, the IRS Office of Appeals will sign off on the settlement using its authority to settle cases. This is how the process gets around the IRS auditor’s inability to settle cases.
It should be noted that fast track mediation does not preclude you from appealing the audit, if you are not able to reach an agreement. The appeals officer that handles the fast track process will also not share any information with the appeals officer, who later hears the appeal.
Check for Computational Problems
You should check the IRS auditor’s numbers. IRS auditors do make errors in their calculations. This is very common as the IRS uses tax software that is not up to par with the software that is available to the public. You should re-run the numbers using your tax software or tax preparer, given the IRS auditor’s adjustments. If you discover a computational adjustment in your favor that the IRS auditor missed, you should point it out to the IRS auditor. The IRS auditor will usually fix their computational problems voluntarily, once you point them out.
Request a Copy of the IRS Audit File
The IRS auditor closes the audit and sends you the records it wants you to see. It does not send you the entire audit file. You should request a copy of the file.
You can request a copy of the IRS’s audit file, by submitting a Freedom of Information Act (“FOIA”) request. You do this by writing a letter to the IRS and sending it to the IRS Disclosure Office.
The IRS has provided an explanation of the FOIA process and a sample FOIA letter on its website. The explanation and sample letter are included in Appendix 11. The documents you are wanting to request are usually your “entire IRS audit file.” You will also want to list the type of tax at issue, the years, and identify the IRS auditor who likely has the records.
It will take the IRS some time to respond to your request. The IRS will usually send several letters saying that it needs additional time to respond. You should be prepared to wait several months for the response to arrive.
The IRS will usually send the records to you on a compact disc. The compact disc will have one or more PDF files in it. The files are usually not organized in any logical fashion and the IRS Disclosure Office will usually redact or black out information that it feels are exempt from disclosure. You do have the right to dispute and appeal the IRS’s decision to redact information. You should also know that if you move forward with the administrative appeal, the IRS Office of Appeals will usually make these files fully available to you, if you ask to review them. The Taxpayer First Act provides a method for Appeals to send the records to you in a way that is similar to the FOIA request described previously.