How does the Internal Revenue Service (hereinafter, “Service”) conduct audits?
The Services utilizes a number of techniques to select tax returns for audit. There are three (3) categories of audits: “correspondence audits,” “office audits,” and “field audits.” I.R.M. 4.1.3., 4.10.3. “Correspondence audits” are conducted by written communications. As such, these audits do not involve face-to-face contact between the taxpayer and the Service.” Discrepancies between information returns (e.g., Forms 1098, 1099, or W-2) submitted by third parties and the taxpayer’s filed return are a common cause for the Service to initiate a correspondence audit.
As the name suggests, office audits are conducted at the local Service office. The taxpayer and/or a representative must appear with the information and records that the Service requested in association with audit.
Field audits are more involved. Such audits require the examiner to travel to the taxpayer’s residence or place of business for the purpose of inspecting the taxpayer’s books and records.
If the Service notifies a taxpayer of a pending audit, what should be the next step taken by the taxpayer?
The taxpayer should gather and organize documentation to support the validity of the return under audit. The information document request (hereinafter, “IDR”) that accompanies the letter notifying the taxpayer about the pending audit will provide details regarding the scope of documentation anticipated to be required. For example, if the scope of the audit includes car and truck expenses, the IDR will likely request the following information: (1) records showing the total mileage for the tax year at issue, (2) records, such as logbooks, supporting business mileage claimed, (3) your calendar or appointment book evidencing business activities for the tax year at issue, (4) documentation to support actual expenses (i.e., gas, tires, oil, repairs, insurance, taxes, interest, and parking fees and tolls.) claimed, and (5) the bill of sale for the vehicle utilized for business purposes. If claimed expenses are related to employment, the IDR likely will request information to ascertain whether reimbursement was available, the manner in which the employer treated any reimbursement for tax purposes, and other information to pertinent to whether the claimed expenses were ordinary and necessary as required by 26 U.S.C. § 162.
Pursuant to 26 U.S.C. § 6001, taxpayers are required to maintain records to support their Federal income tax returns, and the burden of proving entitlement to a claimed deduction lies with taxpayers. Treas. Reg. § 1.6001-1(a), (e); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Nevertheless, in some situations, the burden is somewhat lesser. That is, if a taxpayer is unable to substantiate the precise amount of an established expense that is deductible, courts are generally permitted to estimate the deductible expense provided that the taxpayer provides sufficient evidence for estimation of the expense. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 743 (1985). Certain categories of expenses are excluded from the relief provided by Cohan. That is, with regard to certain categories of expenses including, but not limited to, those related to travel or involving listed property, such as passenger automobiles, 26 U.S.C. § 274(d) supersedes the Cohan doctrine. Sanford v. Commissioner, 50 T.C. 823, 827-828 (1968); 26 U.S.C. § 280F(d)(4). The deductibility of expenses attributable to travel away from home is dependent on the taxpayer establishing the following for each expenditure: (1) amount, (2) time, (3) place, and (4) business purpose. Similarly, in order to be entitled to deduct expenses related to business use of listed property, such as a personal automobile, the taxpayer must establish the following: (1) amount, (2) time, and (3) business purpose. Treas. Reg. § 1.274-5T(b)(2), (b)(6). A taxpayer generally must satisfy each element of the substantiation requirements of § 274(d) or face disallowance of the full deduction. Sanford, 50 T.C. at 827-28; Treas. Reg. § 1.274-5T(a). Consequently, it is vital to compile as much documentation as possible to support entries on your tax return.
As the foregoing discussion illustrates, the taxpayer may desire to contact the tax preparer and/or retain assistance from someone who is authorized to practice before the Service to guide him or her through the audit process and provide representation in the matter. Before the Service will divulge taxpayer information and permit someone to represent a taxpayer, Form 2848, which is readily available at www.irs.gov and simple to complete, must be submitted. Publication 1 provides useful information regarding a taxpayer’s rights; it can be accessed at www.irs.gov/pub/irs-pdf/p1.pdf.
How does the Service assess additional tax liability?
The prerequisites for assessing additional tax liability are the taxpayer’s signature on a waiver or failure to timely petition the Tax Court for review after issuance of a statutory notice of deficiency. I.R.M. 220.127.116.11. The method of assessment is described in 26 U.S.C. § 6203. Section 6203 provides, “The assessment shall be made by recording the liability of the taxpayer in the office of the Secretary in accordance with rules or regulations prescribed by the Secretary.”
Is there a time limitation on the ability of the “Service” to assess additional tax?
In general, the Service must assess additional tax due within three years after the return for the tax year was filed. 26 U.S.C. § 6501(a). This period is extended to six years where there is omission of gross income in excess of twenty-five percent (25%). 26 U.S.C. § 6501(e)(1)(A). Further, there is no limitation on the assessment of additional tax in the following circumstances: (1) the taxpayer has not filed a return for the taxable year at issue; or (2) the taxpayer filed a fraudulent return for the taxable year at issue. 26 U.S.C. § 6501(c)(1)-(3).
If a taxpayer does not agree with the Service’s proposed deficiency, what are the options?
Administrative Appeals: When the Service concludes an audit, it will issue a “thirty-day letter” to the taxpayer. At this stage, one of the taxpayer’s options is to request review by the Service’s Appeals Office. I.R.M. 18.104.22.168. The goal of administrative appeals is to settle the case. In this regard, Treas. Reg. §601.106(f)(2) provides:
Appeals will ordinarily give serious consideration to an offer to settle a tax
controversy on a basis which fairly reflects the relative merits of the opposing
views in the light of the hazards which would exist if the case were litigated.
However, no settlement will be made based upon nuisance value of the case
to either party.
If a settlement is not reached, the Service issues a statutory notice of deficiency.
Tax Court: Before the Service can validly assess additional tax where the taxpayer has not consented to the assessment, 26 U.S.C. § 6212 requires the Service to “send notice of such deficiency to the taxpayer by certified mail or registered mail.” The notice of deficiency provides the taxpayer with an opportunity to petition the United States Tax Court for a redetermination of the deficiency.
With regard to procedures for income tax deficiencies, 26 U.S.C. § 6213 sets forth the deadline for filing a petition with the Tax Court to challenge an assessment. In pertinent part, § 6213(a) provides:
Within 90 days, or 150 days if the notice is addressed to a person outside the
United States, after the notice of deficiency authorized in section 6212 is
mailed (not counting Saturday, Sunday, or a legal holiday in the District of
Columbia as the last day), the taxpayer may file a petition with the Tax Court for
a redetermination of the deficiency . . .
Filing a petition with the Tax Court does not require payment of the proposed deficiency before obtaining court review.
District Court or Court of Federal Claims: In general, federal courts, other than the Tax Court, do not have jurisdiction to determine the correct amount of the tax liability where the taxpayer has not paid the disputed tax. I.R.M. 22.214.171.124. A taxpayer has the option of paying the tax and filing a claim for credit or refund of an overpayment of tax with the Service and, if denied, litigating the issue in federal court. The period of limitation for filing a claim for credit or refund of an overpayment is governed by 26 U.S.C. § 6511. In general, the period of limitation is “3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expire the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.” § 6511(a). If the reviewing revenue agent or tax auditor denies the claim in full or in part, the taxpayer is informed via letter and afforded an opportunity to request a conference with the Appeals Office. If the taxpayer elects not to request review by the Appeals Office, or the Appeals Office affirms the disallowance, the general procedure includes the Service sending the taxpayer a notice of claim disallowance. In general, the date of the notice of claim disallowance is the triggering event that starts the statute of limitations under 26 U.S.C. § 6532, which gives the taxpayer two (2) years to initiate litigation. The general rule regarding commencement of litigation does not apply in certain circumstances. Exceptions are delineated in § 6532(a)(3) and Rev. Rul. 56-381.
What are the options if the taxpayer did not petition for review by the Tax Court within the permitted timeframe?
Audit reconsideration might be an option. Through the audit reconsideration process, the Service “reevaluates the results of a prior audit where additional tax was assessed and remains unpaid, or a tax credit was reversed.” I.R.M. 126.96.36.199. If a taxpayer satisfies the criteria for assistance from the Taxpayer Advocate Service in addition to the criteria for audit reconsideration, the audit reconsideration is expedited. I.R.M. 188.8.131.52. While audit reconsideration is requested for various reasons, it is common for such a request if a taxpayer has new documentation to present and he/she does not agree with an assessment attributable to an audit or his/her tax return. I.R.M. 184.108.40.206. As an initial step, the following requirements must be evaluated: (1) a tax return must have been filed by the taxpayer, (2) the taxpayer must have an outstanding balance resulting from the unpaid assessment attributable to an adjustment, (3) disputed adjustments must be clearly identified, and (4) additional information regarding the adjustments must be provided. I.R.M. 220.127.116.11. The Service cannot accept a reconsideration request in certain circumstances including, but not limited to, the following: (1) “[t]he United States Tax Court has entered a decision that has become final,” and (2) “a District Court or the United States Court of Federal Claims has rendered a judgment on the merits that has become final.” I.R.M. 18.104.22.168. In accordance with 26 U.S.C. § 7459(d), a Tax Court dismissal due to lack of jurisdiction is not considered a decision and is not considered a case dismissed on the merits. In general, reconsideration requests are considered by the Service in the following circumstances: (1) an assessment is improper as a result of a computational or processing error, and (2) a taxpayer has information not previously considered which, if considered, would have resulted in adjustment of the assessment. I.R.M. 22.214.171.124. Collection activity is suspended until the Service concludes the audit reconsideration. I.R.M. 126.96.36.199. After the audit reconsideration is concluded, a taxpayer has an additional opportunity for review by appeals if the “request is disallowed in full or part.” However, a taxpayer is not afforded an opportunity to appeal if he/she does not attend the reconsideration appointment. I.R.M. 188.8.131.52. Alternatively, an aggrieved taxpayer can pay the amount due and file a claim for refund in accordance with 26 U.S.C. § 6511(a). Id.
After a tax liability has been assessed, is there a time limitation on collection?
Yes. In general, the statute of limitations on collection is ten years after the assessment of the tax. During this period, the outstanding tax liability “may be collected by levy or by [initiating] a proceeding in court.” 26 U.S.C. § 6502(a)(1). As such, it is vital to determine the date of the assessment, as it is the starting point for determining when the collection statute of limitations expires. Pursuant to the Internal Revenue Code, a taxpayer’s self-assessment of taxes on a filed return results in automatic assessment of the reported liability, and assessment following examination usually requires a final determination. 26 U.S.C. § 6201(a)(1), (e); I.R.M. 35.9.2. However, a number of other events can suspend or extend the period of limitation incorporated into § 6502(a)(1). Submission of an offer-in-compromise and filing a bankruptcy petition are examples of the multitude of such exceptions. §§ 6503(h); 6331(i)(5), (k)(1).
Is there a way to prevent or challenge enforced collection action?
Installment agreements between taxpayers and the Service permit payment of outstanding balances in monthly installments. If a taxpayer's outstanding balance does not exceed a specified level, these agreements do not require submission of financial information. In the event that the outstanding balance exceeds the threshold levels, the taxpayer must submit detailed financial information to enable the Service to determine whether it should enter an installment agreement. I.R.M. 4.20.4. Depending on your situation, other options, such as submission of an offer-in-compromise, may also be appropriate. Unlike an installment agreement, an offer-in-compromise that is accepted by the Service "settles a tax liability for payment of less than the full amount owed." I.R.M. 184.108.40.206.1. As would be expected, a taxpayer desiring to enter an offer-in-compromise must submit documentation to support the Service's acceptance of the offer-in-compromise. A taxpayer does not have to wait until the Service commences enforced collection to explore these options.
Depending on a taxpayer’s circumstances, there may be number of possible ways to challenge enforced collection action, such as a proposed levy or filing of a tax lien. As a component of the Internal Revenue Service Restructuring and Reform Act of 1998, Pub.L. No. 105-206, Congress enacted 26 U.S.C. §§ 6320 and 6330 that enhance procedural safeguards. Section 6320 requires the IRS to notify a delinquent taxpayer when a lien is filed pursuant to § 6323. This notice must be provided within five business days of the day that the notice of lien is filed, and it must provide the following information: (1) the amount of unpaid tax; (2) the right to request a hearing within the specified thirty-day (30-day) period, (3) legal guidelines for release of liens, and (4) the availability of administrative appeals and procedures related thereto. § 6320(a)(2)-(3). A taxpayer’s right to a hearing under 6320 is not unlimited. In this regard, “[a] person [is] entitled to only one hearing under this section with respect to the taxable period to which the unpaid tax . . . relates."
Subject to a number of exceptions, § 6330 prohibits levy on any person’s property or right to property until there has been written notification of the right to a pre-levy hearing. I.R.M. 5.11.1. The notice can be made in the following ways: (1) given in person, (2) left at the dwelling or usual place of business of such person, or (3) sent by certified or registered mail, return receipt requested, to such person’s last known address. This notice must be provided at least thirty days prior to the day of the initial levy for unpaid tax for the taxable period. § 6330(a), (f). Section 6330 delineates the scope of the hearing process at the administrative level and provides for further review, including judicial review, related to filing of liens and proposed levy action. §§ 6320(c), 6330(c)-(d).
In addition to collection due process hearings as described above, extreme circumstances may warrant commencement of litigation under 26 U.S.C. § 7433.
The options outlined do not represent an exhaustive list of all options that may be available; you should consult with a tax professional to discuss the facts of your situation.