Anatomy of an IRS Audit

As a taxpayer representative and preparer, I’ve recently finished up 3 interesting audit cases with the IRS and would like to share how they went:

1^st Case:

A client of mine was selected for an IRS audit due to a large partnership loss from a K1 that he invested in.  The IRS is currently auditing partnership losses especially for passive activity limitations.  Only issue is that partnership losses in this case are an oil/gas venture that is exempt from passive rules if the investor is considered a general partner bearing full risk for the venture.  IRS agent did not understand this and didn’t want to spend the time to deal with it but instead decided to open up other years going back to 2004 and review other tax returns.  She can examine those but it would be unfair to the taxpayer since the original issues have been identified and addressed and she wants to expand scope.  Revenue agents can look at any returns that the taxpayer controls at least 10% regardless of entity and that can be abused in situations where they have a narrow scope and then move more broadly to review those returns which would not ordinarily be selected for audit.

At this point, it was time to question the agent, talk to her manager and find out why the case was.  We also decided to hire a tax attorney specialized in tax controversy who may know the senior actors at the IRS to increase stakes for the auditor.  Having a tax controversy attorney is invaluable in understanding the players, the process, and the internal politics that are an aspect of every IRS case especially those that the IRS agents are aggressive and have biases against your clientele.  Also this agent was new (within 5 years) and would like to work the cases beyond normal hours (after 7pm), which I thought was unusual

2^nd Case

Another client is a technology partnership that has lost monies for over 5 years (over $1MM).  When I went to see the agent, he mentioned at the last second, I will be also speaking with his manager.  So I knew, this would be challenging and everyone will be putting their best face into the meeting.  Again, a lesson here is the unpredictability of IRS audit environment in each office.  This IRS office is the largest one here in my city of Los Angeles and has relatively sophisticated revenue agents.  They have seen most of the difficult issues and this particular agent was skilled in understanding partnerships.

We faced off on this one challenging issue. Why did the taxpayer continue to lose money and have no revenues.  Well, it was a startup in a new industry with new technology and has struggled to find viable customers, develop technology, and started in one of the worst recessions in US history.  The auditor printed out the website of the client and kept asking questions.  Why is there no revenue when you have an operational website.  I addressed it easily that the website is for marketing purposes and if you tried to buy this product, you couldn’t buy it and there was no inventory to fulfill the order.  His manager kept challenging this and even wanted a list of potential customers, bank account info etc.  All of these I would gladly provide I said.  Another issue is the hobby loss rules but clearly this was a business and the expenses were 90% R&D expenses which can be expensed under Section 174.  This issue surfaced but was quickly put to bed and a no change was issued. The key is addressing head on the worst issue and making sure your case is properly stated.

Again, the IRS has usually one or two issues to address and if you address them properly, they should back-off. There was no more information other than the general audit of bank statement and expenses which can be clearly proven.  The agent has a lot of experience and knew how to close cases and move on.

3^rd Case

Another client, a large distributor of salon products, was audited randomly even though the company reported a healthy profit and paid a lot of taxes.  This auditor wanted to work on the client’s office which the client didn’t like.  We were able to rent an off-site office. This was an amazing opportunity to control the environment without the auditor being nosy at the client’s office.

Basically , the auditor was reduced to ticking and tying out numbers which was fine since the client had decent internal controls.  Another lesson here , if client has good internal controls provide the boxes of information because a human being can only process so much information.  Information overload can be a good approach to handle certain auditors and if the client has good internal controls.  Poor internal control would need another approach and information would need to be selectively given as the auditor requests data.

TAKEAWAYS:

Know the strengths and weaknesses of your tax positions.

1. Control the information workflow. Identify strengths and let IRS push those issues forward (more art than science).  Push back weaknesses
2. War of attrition.  If difficult case, don’t rush to settle as you may lose opportunities to push back with auditor.  They also are limited in time and resources, don’t forget this
3. Prepare, prepare, prepare!  Only you can prepare more than auditors.  Auditors must wash as lot of cars and can only detail very few.  Many posture their power but in the end they can only act on your information.
4. Live to fight another day. If initial agent is difficult to deal with, plan to go to appeals and fight issues there. Appeals agents are paid to settle disputes and prevent cases from going to court.