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The IRS audit is a process of providing information to the IRS auditor and waiting for the auditor to respond. This information exchange is what the audit is all about. How you respond and what information you provide or do not provide will impact the audit outcome. The outcome will be that you owe more tax or are entitled to a refund or that no change will be made to your tax return. This information exchange starts with the IRS’s audit opening letter.

IRS Audit Opening Letter or Notice

IRS office audits usually start with a letter asking you to bring certain records for a set meeting with the IRS. The auditor may also include a document request with the letter asking for information. The IRS’s opening letter will usually request that you meet with the IRS auditor. It will usually set a date to meet or ask you to call to schedule a date to meet. 

IRS Opening Conference or Meeting

Opening conferences are less common for correspondence and office audits. The auditor may skip the open meeting and start asking for specific information or answers with these types of audits. The auditor may also issue a closing report without any actual audit in a correspondence audit. 

For field audits, the auditor will almost always insist on having an opening conference or meeting. Auditors prefer to meet at your home or, if you own a business, at your business. They do this since they want to get a sense of what lifestyle you live and how active your business is. A driveway full of expensive cars and a governess who answers the door says a lot. A disorganized home or business office does too.

During the opening conference, the auditor will usually go over a few procedural issues related to the audit that include explaining why the tax return was pulled for audit and what they intend to examine during the audit. If this information is not volunteered, you have every right to ask the auditor about it. Most auditors will freely share this information with you.

Providing Information to the Auditor

The auditor will then want to gather information from you, which is the purpose of the opening conference or meeting. In this meeting, the auditor may ask about your income or expenses: what do you do, how long you have been doing it, and how you keep your records. If it is a new auditor, they may even have a list of questions typed out in advance, they may go through each question with you, and they may write down your answers to each question. 

The auditor will usually be courteous and inquisitive. They are trained to be nice at the beginning, since this allows them to gather more information. While you may feel that an auditor is a nice person, they are not here to help you. They are here to audit your return and, likely to increase the amount of tax you owe. It would be best if you always were mindful of this when you talk to the auditor. Do not make any statements that are not in your interest. Do not admit any fault. Do not highlight any deficiencies in your records or recordkeeping. The auditor will note these statements, and you will likely see them repeated in the IRS auditor’s audit report at the end of the audit. The statements will be included as proof or support of the IRS’s position that you owe more tax.

Do not feel compelled to answer or reply to every question the auditor asks. The audit interview is not a deposition. You are not under court order to answer any question if you choose not to do so. To avoid the personal uneasiness that comes in refusing to answer questions, you may want to have a diversion planned out ahead of time. This diversion may be as simple as one or two questions you want to ask the auditor. Have these questions written out before the meeting and keep them in mind during the session. When a question comes up that you do not want to answer, respond by asking your question on a different topic. If this fails, you may also be able to tell the auditor that you will get back to them on that question. The chances are good that the auditor will not get back to the question. 

Providing Records to the Auditor

The auditor may ask for copies of any records that you mention. If the record helps your case, you can mention it. If it does not help your case, you should avoid mentioning it. You should not bring records to the meeting, if you do not want the IRS to have them. You do not need to make the IRS’s case for the auditor. 

Providing the IRS auditor with a copy of your tax returns warrants further consideration. IRS auditors often only have access to computerized summaries of your tax returns. This is why they often ask you, as the taxpayer, to provide a copy of your tax returns. If the auditor asks for a copy of your tax return for the years that are currently being audited, you should comply with that request. If the auditor asks for prior or subsequent periods, you should respectfully decline that request. This type of request is usually an instance of the IRS auditor fishing for evidence, so they can open the other tax year for audit. You should try not to arm the IRS with information to open another tax year for audit. 

Allowing the Auditor to Tour the Business

The auditor may also ask for a business tour for business tax returns, since this is a common practice. Knowing this in advance, you should prepare your employees and tell them to conduct business as usual. Here are a few examples of issues that you might keep in mind:

  1. The auditor may be assessing whether the business income you reported is correct. For a cash business, the auditor may wait outside the business and count the number of customers entering the business. The auditor may then estimate the amount of income the business should report on its tax return. For example, suppose the business has 50 customers a day, and the average sales price is $100. In that case, the auditor may assume that the business is making $1.8 million in revenue (50 customers a day x 365 days a year x $100 per customer). If the tax return reports substantially less than this amount, the auditor may be curious about why that is. 
  2. The auditor may be assessing whether your tax deductions are reasonable. For example, consider a daycare business that feeds some of its students breakfast and lunch each day. The business probably has a significant tax deduction for groceries or meals. The auditor may discover that you have groceries delivered every day, but note that the cupboard where the groceries are stored is tiny, leading the auditor to question whether the tax deduction is overstated. 
  3. The auditor may be assessing whether your business is functioning. If you know that the IRS is coming, you may be tempted to tell your staff to stay home and avoid scheduling client meetings that day. When the IRS tours the business, the auditor may think that the business is not operational, which can be an issue if it has been producing tax losses. The auditor may be inclined to argue that the losses are not allowable under the Hobby Loss rules. These rules allow the IRS to deny deductions for activities that do not rise to the level of being a business.
  4. The auditor may be assessing whether a tax deduction or credit is allowable. Consider the case of a business that takes research tax credits. These credits are not permissible for reverse engineering a competitor’s products. When the IRS tours the business, it may see the competitor’s products in your warehouse in various states of disassembly. The auditor may use this fact to disallow your tax credits.

These are just a few examples of things you might be conscious of when allowing the auditor to tour your business. 

The Auditor’s Plan

Before the initial conference is over, the auditor will likely explain their plan for the audit, including describing how information is provided and the expectations for response times. 

If the auditor does not volunteer the information, you should ask what the audit timeline is. The IRS refers to this date as the “expected close date” or ECD. When does the auditor envision the audit closing? What is the ECD? The auditor can and should share the ECD with you. If the audit timing is a concern, you may be able to negotiate with the auditor for a reasonable audit timeline. 

IRS Information Gathering

The IRS audit is to gather information. It has tools at its disposal to collect information and merely includes asking you to provide information, issuing document requests, making third-party contacts, and issuing administrative summonses. 

Voluntary Disclosures

The IRS auditor may ask you to produce information and records voluntarily. It would help if you voluntarily produced a certain level of information, including background information and records, to show that your tax returns are correct. 

The point is not to produce everything the auditor wants, but the focus should only be on what information the auditor “needs,” not what they “want.” To determine what information is needed, you have to start with your tax returns. The IRS requires information to verify what is listed on the tax returns. 

Keep in mind that you have the burden to prove entitlement to tax deductions and tax credits. You should, therefore, provide all relevant information and records to support tax deductions and tax credits reported on your tax returns. The general rule is that more is often better, when it comes to records for expenses. You do not need to be as thorough in providing information and records about your items of income or your business or finances. You do not have to make the IRS’s case for the auditor voluntarily. 

The IRS agent may “want” and may request information about items that are not listed on the return, such as unreported income, information about your personal assets, etc. You should be hesitant and very careful not to provide this type of information, as it is not relevant to the audit at hand. 

Information Document Requests

The auditor will also issue one or more Forms 4564 or the Information Document Requests (“IDRs”). The IDR is the primary way auditors request information and records. The IDR documents what information and records are needed. You may receive multiple IDRs during the audit. The auditor may only issue one or two IDRs in an individual or small business audit. Several hundred IDRs may be issued in a large business audit.

IDRs can ask for anything and everything. Most IDRs ask for copies of documents, such as bank statements, canceled checks, etc. The IDR can also ask for irrelevant and voluminous documents. You do not have to provide everything that is requested. You are only required to provide records that you have. You do not have to seek out records that others have or filed with the IRS. You do not have to create records you do not have. You also do not have to produce privileged records, including communications to your attorney and tax preparer, spouse, or physicians. Various “privileges protect these records.” 

You may push back against these requests and negotiate with assigned case officers to reduce the number of documents that have to be produced. With that said, as a courtesy, if the records are not harmful and you can obtain them easily, you might provide them to the auditor. 

To sum up, if you have a record that is requested and you do not want to provide it, you can either:

  1. Convince the auditor to re-word the request to exclude that item,
  2. Respond but do not provide the item, and
  3. Respond by identifying the item and saying that it is privileged and will not be provided.

If the auditor believes you have the item and did not provide it, they might just issue a Statutory Notice of Deficiency or Refund Disallowance Letter. We will cover this topic later. For now, just know that these notices are used to close audits. If you do not respond to IDRs, the auditor may simply conclude that you had extra income or were not entitled to deductions and issue one of these notices to close the audit. 

The IRS auditor may also issue administrative summons to obtain the record. The administrative summons requires that you produce the record or, if you do not, it allows the IRS to ask the district court to require that you produce the record. We’ll cover the IRS summons later in this chapter. 

You can also negotiate for the timing and delivery options for IDR responses. It may be as simple as asking for more time, given the nature of the records requested or your staff’s availability, etc. You may also ask if you can provide the records to the auditor electronically or in some other format that is easier for you. 

You should keep a list of all IDRs received and copies of every record you provided to the auditor. The chances are good that you will need these records to defend against any issue raised by the auditor. 

For records sent to the auditor in paper or on thumb drives that are mailed to the IRS, it is good practice to request confirmation that the auditor has received the information. It is also advisable to send the information via U.S. Postal Service with delivery confirmation or similar service, proving that the auditor received the documents requested. 

Taxpayer and Employee Interviews

The IRS auditor will typically request an opportunity to interview the taxpayer. For business entities, this may include interviewing management and the bookkeeper. These interviews help the IRS auditor get a feel for how the records are kept, whether the records may be suspect, and what types of records are available. 

Employee interviews may be conducted in some limited situations. The IRS usually only asks for employee interviews for tax returns that include tax positions based on employee activities. For example, the IRS routinely conducts employee interviews to consider whether the taxpayer is entitled to research tax credits. These credits are computed based on the activities of employees. Absent a tax deduction or credit like this, it is rare for the IRS auditor to request employee interviews. 

This is an area where a tax professional can add value. There is value in the ability to say “I don’t know, I’ll get back to you.” As the taxpayer, you generally cannot get away with this. The IRS auditor is more likely to press you for answers and to react adversely, if they feel that you are not answering their questions honestly. 

As long as you, the taxpayer (or your authorized representative is present), you have the right to record in-person IRS interviews. You have to provide the IRS with written notice that you will record the interview at least ten days in advance of the interview. The IRS auditor will then secure a recording device and will record the interview. 

The request to record interviews will usually not be received well by the IRS auditor. In most cases, it is better to simply have someone attend the interview and take notes. The IRS is not entitled to advance notice of the note taking or entitled to a copy of the notes. It may make sense to send a copy of the notes to the IRS auditor to help document what was said. This can help build the record for an appeal or litigation. 

Third-Party Contacts

The auditor may also gather information by making third-party contacts. The phrase “third-party contacts” refers to the auditor contacting those who may have information about you, including your contractors, vendors, suppliers, banks, and others. 

The auditor can contact third parties, but it generally has to notify you that it will do this before making contact. Section 7602 provides that auditors may not contact third parties without first providing you, the taxpayer under audit, with notice of its intent to do so. The auditor also has to keep records of its third-party contacts, and it has to make these records available to you upon request.

Practically speaking, auditors notify you of their intent to contact third parties in every audit. This requirement is satisfied by the auditor providing you with form letters and publications at the start of the audit. These form letters and publications say that the IRS may make third-party contacts. 

The auditor also has to follow specific protocols in making these third-party contacts, including identifying you, the taxpayer, and that the auditor is an IRS employee working for the IRS. The auditor also has to explain that the contact is being made to determine whether a tax liability exists or collect taxes.

If you have a contractor, vendor, or other third parties that you do not want the auditor to contact, you may wish to discuss this with the auditor upfront. We usually see this with businesses that have discreet relationships with certain vital contractors or vendors. The fear is that the auditor’s contact may lead to the contractors or vendors not wanting to do business with the taxpayer. The auditor may be understanding of this and may agree that they will not contact the third party. Of course, the opposite may be true too. The request may trigger the auditor to wonder whether they should contact the third party, an area that you have to address, given the nature of the auditor’s communications and demeanor that is working your case. 

The IRS Summons

If the auditor cannot get the information they want by issuing an IDR or making a third party contact, they may decide to issue a summons.

The summons is the IRS’s most potent tool for fishing for taxpayer records and information. The IRS’s summons power is broad. The summons can even reach records located in foreign countries.

With limited exceptions, the IRS has the authority to issue a summons without court approval. Like a subpoena issued in a civil lawsuit, the IRS’s summons must be served on the taxpayer or third party. This service is accomplished by hand delivery, leaving a copy at your last abode, or third-party record keepers, by delivery by certified or registered mail.

Once served, you have to act to comply with the IRS’s summons, choose not to comply with the summons, or bring a proceeding to quash the summons. If you fail to comply with the summons, the IRS may seek to have a court enforce the summons. The court may or may not enforce the summons. If the court does not implement the summons, this may provide little relief. The auditor can usually address whatever technical foot fault was made with the summons and just issue another summons.

If you fail to comply with the summons, the IRS could also seek to have an arrest warrant issued. You will then be brought before the judge. The judge can then order punishment or, more commonly, enter an order enforcing the summons and why you should not ignore a summons. If you do not intend to comply with an IRS summons, you should consider filing suit to quash the summons. The case to stop the summons suspends the statute of limitations for assessing tax and criminal liability, giving the auditor a more extended time to conduct the audit. 

If you fail to act after a court has ordered enforcement, the court can and may impose sanctions on you, resulting in possible contempt, allowing the court to order that you be held in jail, until you agree to comply with the court order for the summons. 

Decide What Information to Provide to the IRS

The IRS is not entitled to every piece of information that the auditor may ask for. Just because the IRS asks for information or issues, an IDR, or summons does not mean that you are obligated to provide the information. 

The leading case for this is Powell v. United States, 379 U.S. 48 (1964). In Powell, the IRS issued a summons for information in a year that was outside of the normal three-year audit period. The U.S. Supreme Court set out a four-factor test for determining whether a summons issued by the IRS is valid:

  1. The summons is issued for a legitimate purpose,
  2. The inquiry may be relevant to the legitimate purpose,
  3. The IRS is not already in possession of the information, and
  4. The administrative steps set out in the Code have been followed.

If these factors are met, the courts will force you to comply with the IRS’s summons. These factors provide the general guidelines you should follow when deciding whether to provide information the IRS asks for or that it issues an IDR or summons to obtain. 

With that said, you do not have to create records for the IRS or secure records that you do not already possess. There are times when you may want to do so, however. As a general rule, the IRS has the burden to prove that you underreported your income, and you must establish that you qualify for deductions and credits. Therefore, you can see that you may not want to go out of your way to provide information about your income, but you probably do want to do so to support deductions and credits. 

Do Not File an Amended Tax Return

If the IRS auditor has hit on an issue and you are certain they are going to write the issue up, you may be tempted to provide the IRS auditor with an amended tax return reflecting the adjustment. Do not do this. The IRS auditor will prepare calculations showing his or her adjustments. That is their job.

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