audits of individuals and small business...taxpayer can be . asked. to appear. can only be ....
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Audits of Individuals and Small Business
Victoria Eve Kelly, Esq.Victoria Eve Kelly, LLC
www.vekllc.com | [email protected]: 240-242-9074
Olney, Columbia, Bethesda, Rockville, DCMailing address:
3407 Olney-Laytonsville Rd., Olney, Maryland 20832
Authority to conduct audits:
IRC Sec. 7602 - Examination of books and witnesses
Authorizes the IRS to examine books, papers, records, or other data, and take testimony to determine the correctness of any return, and the liability of any person for tax.
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6 STEPS IN AUDIT PROCESS:
1. PREVENTION: address issues in tax return before the Service does
2. PREPARATION: know what the Service knows
3. DISCOVERY: limit issues and disclosure
4. AUDIT RECONSIDERATION/APPEAL
5. CLOSING AGREEMENT: choose form binding on service
6. REFERRAL TO CRIMINAL DEFENSE ATTORNEY
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Who gets audited?
Lower, middle and upper middle income taxpayers.Returns by Percent of Percent AuditedIncome Total Returns in 2017
All Returns 1.00 0.62No adjusted gross income 0.02 0.03$1 under $25,000 0.36 0.71$25,000 under $50,000 0.23 0.49$50,000 under $75,000 0.13 0.48$75,000 under $100,000 0.09 0.45$100,000 under $200,000 0.12 0.47$200,000 under $500,000 0.04 0.70$500,000 under $1,000,000 0.58 0.02$1,000,000 under $5,000,000 0.26 0.04$5,000,000 under $10,000,000 0.02 0.08$10,000,000 or more 0.01 0.15
IRS Databook 20174
How does the Service select returns for audit?
The Government Accounting Office’s report on IRS RETURN SELECTION, Appendix III: Description of Small Business/Self -
Employed (SB/SE) Selection Methods or Workstreams, GAO-16-103:
Identifies 38 ways of selecting returns for audit
IRS materials on correspondence audits refer to identifying returns “with high potential for a tax adjustment using”:
• Results of prior audits• 3rd party information (data matching)• Entries on the tax return• Referrals from criminal investigation• Preparer/promoter activities• Non-filers
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AUDIT PREVENTION BEGINS WITH THE TAX RETURN.Not just about correct numbers.
Also about addressing issues before the Service does throughDisclosureDocumentation
Step 1: PREVENTION: address issues in tax return before the Service does
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Consider attaching explanatory statements for:
So called “Audit flags”Home Office DeductionReal Estate ProfessionalSchedule C for a high cash business like taxi cab service, convenience
stores, gas stations, (etc.)
Large, unusual, or questionable line itemse.g., Unusually high charitable deductionsSchedule UTP (Form 1120), Uncertain Tax Positions, sets forth line items on
Form 1120, U.S. Corporation Income Tax Return, required for corporations with assets equal or greater than $10 million who’ve recorded a reserve for an uncertain tax position in an audited financial statement, or have not, because they expect to litigate the position.
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Tax Practitioner Guidance: Circular 230, Sec. 10.34, Practitioner Standards
https://www.irs.gov/pub/irs-utl/circular_230_best_practices.pdf
Tax advisors are under no obligation to audit their client’s return.May rely in good faith, without verification, upon information furnished by the client.
BUTTax advisors must advise client of requirements for
adequate disclosure to avoid penalties
Must make reasonable inquiries if information received or assumptions appear incorrect or incomplete
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Hypothetical tax return client: J. Q. Developer (“J.Q.”)
J.Q. tells me he’s a Real Estate Professional pursuant toIRC Sec. 469(c)(7), Reg. Sec. 1.469-9 and 1.469-5T, CCA 201427016
Allows a taxpayer to offset loss from a passive activity, like real estate rentals, against non-passive income.
Requirements are complicated, and an audit flag.
More than one-half of the personal services the taxpayer performs in trades or businesses during the tax year must be in real property trades or businesses
Hours spent in real property trades or businesses exceed 750 per year
Taxpayer must materially participate in income producing rental activities for >500 hours per year
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Services, and approximate hours of services, shown “by any reasonable means”, including:
- Daily time reports- Logs- Calendars- Narrative summaries
Reg. Sec. 1.469-5(f)(4)
Good faith reconstruction of time or expenditures: permitted under the Cohan rule. Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930) **
Bare assertion will not suffice. It must be accompanied by corroborative evidence, Vanicekv. Commissioner, 85 T.C. 731 (1985)*
IRS may or may not consider it sufficiently probative to allow deduction
If insufficient, Service may impose penalty for “negligent record keeping” under IRC Section 6662
* When substantiation requires specific documents, as for the Earned Income Credit, good faith reconstruction likely not accepted. See Form 886-H-EIC (October 2017)
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Guided by Circular 230, I advise hypothetical taxpayer JQ as follows.
1. He has to maintain records of his time, to show:
> ½ is in real property trades and businesses vs. other trades and businesses
> 750 hours in real property trades and businesses
> 500 hours material participation in rental activities
2. If JQ fails to maintain adequate records, and he is audited, the Service may impose penalty for “negligent record keeping” under IRC Sec. 6662.
3. JQ provides a summary of time for each of his activities, and it’s apparently in order. Nothing in his records puts me on inquiry notice, and I’m not required to audit him.
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Hoping to stave off an audit by showing the Service that JQ understands and satisfies the requirements for being a Real Estate Professional, and for material participation, I attach a summary of JQ’s time to his return.
Let’s say it doesn’t satisfy the Service, and they open an audit
We’ll discuss their procedure for doing so a little later.
For now . . . I need to prepare.
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STEP 2: PREPARATION: Know what the Service knows
Obtain from client:
Returns for taxpayer and related entities for year in questionReturns for at least three years to look for repeated errorsNotices and correspondence from tax authorities to taxpayerCorrespondence from taxpayer to tax authoritiesRecord of conversations between tax authorities and taxpayerTaxpayer’s credit report
From IRS:File Form 8821, Tax Information AuthorizationObtain tax, account, wage and income transcripts from IRSPrudent if you’ve never met taxpayer
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Undertake representation by filing Form 2848, Power of Attorney and Declaration of Representative
File request for information under the Freedom of Information Act, U.S.C. 552, as amended
File promptly, since will take time for Service for respondMight not include tax returnsWould include previous examination reports, if any Should contain factual information about taxpayer not exempt from disclosure under the statute, including reports by the Services’ agents, factual information from any studies undertaken by the Service.
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Request 3rd party contact sheet pursuant to IRC Sec. 7602(c)(2)
Other resources:
Dun & Bradstreet
Transunion TLOxp to search personal and employment information, criminal information, bankruptcies, foreclosures, liens, judgments, assets and professional licenses
Google search
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Review Internal Revenue Manual
Generally: IRM 4.10.3 Examination Techniques: https://www.irs.gov/irm/part4/irm_04-010-003
Also includes “Handbooks” for specific types of taxes:Employment, Excise, Estate & Gift, Pass-through Entity Handbook, Employee Plans, Exempt Organizations
IRS Audit Technique Guides for specific industries:https://www.irs.gov/businesses/small-businesses-self-employed/audit-techniques-guides-atgs
From Aerospace to Wine industries
Includes Passive Activity Losses Audit Technique Guide, discussing Real Estate Professionals
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STEP 3: DISCOVERY: Limit issues and disclosure
There are 3 types of audits described in Reg. Sec. 601.105
1. Correspondence Exam
70.8% audits in 2017 https://www.irs.gov/statistics/enforcement-examinationsBy mail or faxLargely automatedResolve limited issues by production of documents
Refundable Tax credits Schedule A, Charitable DeductionsSchedule CNon-filers
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Takes place at local IRS Offices
Might involve more books and records than can be easily handled during correspondence audit
Might involve discussion with taxpayer or representative to ascertain, for example, circumstances surrounding claim or transaction
Service will try to complete the same business day
Service does not keep statistics on number of office audits performed, or the percentage they comprise of all audits.
2. Office exam
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Field exam
At taxpayer’s place of business or representative’s office
Larger businesses
Examiners are usually highly trained
May be accompanied by other IRS personnel with specialized training in finance, engineering, (etc.)
Exams can take months
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Audit begins with a LETTER notifying taxpayer his or her return has been selected for examination
For JQ, our Real Estate Pro, letter might refer to “Schedule E real estate loss after passive limitation”
Letter asks JQ to contact the IRS
IRM 4.10.3 Examination Techniques emphasizes personal contact with taxpayers as a way of gathering evidence
Passive Activity Loss Audit Technique Guide, p. 2-6 Guidance for auditing Real Estate Professional advises during the initial interview, question the Real Estate Pro regarding time spent in all activities (personal, business, civic, family, hobbies, and so forth).
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As a rule, taxpayer should not speak directly to serviceTaxpayer can be asked to appear
Can only be compelled to speak pursuant to a summons, enforced by court (more detail later)
Options as a substitute for personal interview:
Offer documentation or other written response (chart, summary)
Postpone client interview pending review of documentation.
If Service seems determined to summons taxpayer
Negotiate with the Service to reduce the number of interviews and to limit the interviews to certain persons or specific subject areas
Negotiate with the Service to obtain, in advance, the questions that will be asked
Deny the interview request and see whether the Service issues a summons.
If the taxpayer agrees to the interview request, or is summoned, the taxpayer should be informed of what to expect.
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LETTER accompanied by DOCUMENT REQUEST
Audits requesting more complicated information may include an Information Document Request (“IDR”) on Form 4564.
IDRs are informal means of gathering information. Not enforceableIf taxpayer does not respond, the IRS may summons the same information
under IRC Sec. 7602If taxpayer does not respond to summons, IRS may enforce summons by
court order
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Along with letter, Service sends document request asking for JQ’s time logs- to see if JQ qualifies as a Real Estate Professional &- materially participated in his rental activities
Recall that, if both are true, JQ may offset rental losses against non-passive income
Passive Activity Loss Audit Technique Guide, p. 2.6, instructs examiners to “[r]equest and closely examine the taxpayer’s documentation of time utilized for material participation in each activity.
Contemporaneous daily records not required, but may be requested if taxpayer’s participation cannot otherwise be reasonably established
The courts have repeatedly taken a dim view of self-serving guesstimates of time. See Scheiner, Tax Court Memo 1996-554, 72 T.C.M. (CCH) 1532 “We are not bound to accept the unverified, undocumented testimony of taxpayers.” Hradesky v. Commissioner [Dec. 33,461], 65 T.C. 87, 90 (1975), affd. per curiam [76-2 USTC ¶ 9703] 540 F. 2d 821 (5th Cir. 1976)
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For simpler audits, generally:Support numbers on tax return with the documentation needed to persuade Service to accept tax return as filed.
Drafting responses to document requests of any type:Ensure adequate time frame for doing so Discuss with client after receipt Confirm time for response with Service
Track documents submitted Spreadsheets useful Don’t submit original documents If you must, obtain Form 2725, Document Receipt
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Ensure discovery observes appropriate parameters
Communication
After filing Form 2848, Power of Attorney and Declaration of Representative, communication should only be through you as representative
Scope of Audit
From Service’s perspective, IRM 4.10.3.2.1 (02-26-2016):
Goal of examination to determine the "substantially correct" tax liability. Examiner considers facts and circumstances, evaluation of internal controls (in business examinations), use professional
judgment to determine whether scope should be expanded or contracted. Examiners must document reasons for expanding or contracting the examination on Lead Sheet 110 [Revenue Agent
Audit Plan], or workpaper, or Form 9984 [brief summary of actions taken] indexed to Lead Sheet 110.
From Taxpayer’s perspective:
Confirm issues under audit with Service Taxpayer Bill of Rights: Service should not lie or misrepresent See IRC Sec. 7803(3) IRS should provide notice if it expands issues under audit
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Information Document Request (IDR) should not exceed permissible scope of discovery.
IDRs can seek evidence that“may be relevant or material” to issues under audit IRC Section 7602“might . . . throw . . . light upon” the correctness of the return under examination.U.S. v. Arthur Young &Co., 465 U.S. 805, 813 n. 11 (1984)
IDRs may not be overbroad or burdensomeNo fishing expeditions. U.S. v. Richards, 631 F.2d 341, 345 (4th Cir. 1980)e.g., “All emails pertaining to services for the rental activity claimed as a loss”
An IDR concerning charitable donations during the audit of my hypothetical Real Estate Pro should prompt question about whether this is appropriate.
Cannot require creation of new documentsProvide a chart . . .Provide a summary . . .
But consider whether generating the document might address and satisfy issues in a particular instance
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Only 1 exam/year
IRC Sec. 7605 limits exams to 1 per year, and prohibits “unnecessary examinations or investigations”
Unless taxpayer requests otherwise• Requests a private letter ruling
Or Service deems necessary • Circumstances where Service can reopen limited under Regs. Sec. 601.105(j) (discussed later)
Actions the Service does not consider an examination under 4.03 of Revenue Procedure 2005-32.31; Rev. Proc. 2005-32; 2005-1 C.B. 1206.
Contacts and communications with taxpayer that do not involve inspections of books and accountsCorrection of a math errorAdjustment resulting from an information-return matching programVoluntary issue-resolution programs like a technical adviceRecalculation carry-backs and carry-forwards based on adjustments in other years
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Statute of limitations
IRC Sec. 6501, Limitations on assessment and collection •The statute of limitations generally expires three years after the return is filed •Various exceptions for fraud, failure to file a return, omissions from gross income in excess of 25%, failure to report foreign transfers
Not unusual for IRS to request extension if it appears 180 days before statute runs that the audit will not be finished.
IRM 25.6.22.3 (02-09-2018) Notification of Taxpayer's Rights directs examiners to notify the taxpayer that•Taxpayer has the right to refuse•Request the extension be limited to particular issues/•To particular period of time
Information also provided in Publication 1035, Extending Tax Assessment Period28
Other considerations for extending statute:
Has the exam proceeded fairly, suggesting a fair result, or does taxpayer intend to file a protest with appeals?
Do concerning issues remain, that the IRS has not explored?
IRM 25.6.23.6.6. “If the taxpayer does not consent to extend the statute, the examiner will initiate action, as necessary, to issue a statutory notice of deficiency or initiate other means to assess tax deficiencies before the statute expires.”
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Privilege:
Is the material requested by the Service privileged?
Should the privilege be waived?
What are the consequences of waiving privilege?
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Attorney – client privilege
Confidential communication from client to attorney for purpose of obtaining legal advice, or
From attorney to client, containing the client’s confidential information which is the subject of that advice
The privilege does not apply to documents intended to be disclosed to third parties, like a tax return. United States v. Lawless, 709 F.2d 485, 487 (7th Cir. 1983);
Also, tax return regarded as more of an accounting than a legal function. See Olender v. United States, 210 F. 2d 795 (9th Cir. 1954), and cases cited therein.
- But advice relating to a tax return position may be covered -
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IRC Sec. 7525 - Confidentiality privileges relating to taxpayer communications
(tax practitioner privilege)General rule: With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
Significant Limitations:
o Only applies in federal tax proceedings, • not to any proceeding outside the federal tax system
o Does not apply to advice given to promote tax shelters
o Does not apply to criminal proceedings
• Accountants and other consultants offering advice in the context of criminal proceeding may be brought within the ambit of attorney-client privilege if employed by an attorney to assist that attorney in rendering legal services to the client. United States v. Kovel, 296 F.2d 918, 921 (2d Cir. 1961)
• To ensure communications with an accountant will be protected by the privilege, the accountant should be directly retained by the attorney.
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Attorney Work Product Privilege
Codified by Federal Rules of Civil Procedure, Rule 26(b)(3)
Protects “documents and tangible things that are prepared in anticipation of litigation”, or in other words “because of” the prospect of litigation by or for a party or its representative.
Whether an administrative proceeding before the Service that could lead to litigation supports the privilege may vary depending upon jurisdiction.
Privilege can be overcome by sufficient showing.
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5th Amendment privilege against self-incrimination
The privilege granted by the 5th Amendment of our Constitution allowing an individual the right to refuse to answer questions or otherwise give testimony against him- or herself.
Taxpayer must present him or herself for questioning and elect whether to raise the privilege as to each question.
The federal district court may then determine whether, for each question, the claim of self-incrimination is appropriate
In a civil context, the finder of fact is allowed to take a negative inference against the person asserting the privilege
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Acknowledgement of Facts
At the end of discovery in simpler audits, the IRS may send a notice proposing adjustments to the tax return, followed by an “examination report” or other form, and request taxpayer’s signature.
For more complex audits, the Service may seek agreement with the taxpayer on relevant facts before forwarding a notice proposing adjustments.
This may take the form of a Written Acknowledgment of the Facts (AOF) IRM 4.46.4.9 (03-09-2016).
Purpose:
Ensures all relevant facts considered before a notice of a proposed adjustment issues.
Defines issues for appeal.35
Acknowledgement of Facts (continued)Enforceability:
Not enforceable by summons
Recall that IRC Sec. 7602 authorizes the Service to examine books and records, and take testimony to determine the accuracy of a tax return. An AOF is, in effect, document request that doesn’t actually request documents. An AOF is more in the nature of an interrogatory (request for information) under Rule 33 of the Federal Rules of Civil Procedure, or perhaps a Request for Admission under Rule 36.
Response:
Remove misstated facts
Supply relevant and favorable facts
Consider re-writing the facts in a counter-statement
Qualify response for good faith errors, further investigation, changes in law and IRS theories of adjustment, and so forth.
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Conclusion of Audit
NO CHANGE: Service agrees no change is warranted.o Letter issues stating no changes made to the taxpayer’s return.o Audit is closed.
AGREED: Taxpayer accepts changes to the tax return by the Service.o Form issues stating adjustments to the return.o Taxpayer signs form agreeing to assessment of additional tax.
PARTIALLY AGREED: Taxpayer agrees to some, but not all adjustmentso Adjustments agreed to:
Listed on Form 886-A, Explanation of Items Those issues will be closed
o Adjustments not agreed to: 30 day letter issued permitting protest to Office of Appeals If insufficient time for administrative and judicial appeal, and taxpayer has not agreed to extend
statute of limitations, Statutory Notice of Deficiency, known as a 90 day letter, will issue, permitting petition to U.S. Tax Court
Generally, if case not considered by Office of Appeals beforehand, it can be referred for administrative appeal from Tax Court
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STEP 4: AUDIT RECONSIDERATION/APPEAL
Audit Reconsideration, IRM 4.13.1, Pub. 3598
If the taxpayer disagrees with the IRS’ adjustments, may ask for reconsideration under specific circumstances.
Taxpayer has new information not previously considered Taxpayer did not appear for the original audit Taxpayer moved, and did not receive the correspondence from the IRS Taxpayer disagrees with an assessment created under the authority of IRC Sec. 6020(b), Substitute for
Return (SFR). Taxpayer has been denied tax credits such as earned income credit (EITC) claimed, during prior
examination. There was an IRS computational error
Consider this option if retained after audit terminated, particularly if material facts were not presented to the original examiner.
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Appeals
Office of Appeals
If the taxpayer does not agree with one or more adjustments following the exam, the taxpayer may appeal. See Reg. Sec. 601.105(d)(1))
Office of Appeals is part of the IRS, but separate and independent from the division that conducts exams
Goal to resolve disputes without litigation
Success rate said to be about 80%, though IRS does not have numbers
Appeals shorter, more informal, cheaper than formal litigation
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Purview of Appeals Office
Cannot consider criminal cases
Cannot develop issueso If new issues arise, must send back to exams
Can consider hazards of litigation
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Appeals strategies
May settle some issues on appealTake others to court
Can appeal some issues while others still in examo Early referral program under IRC Sec. 7123(a)o Roughly comparable to interlocutory appeal under the FRCP Section 1292o Fast Track Settlement allows expedited appeal of specific issues even while others are still under exam
On appeals, emphasize hazards of litigationo Demonstrate to Appeals that taxpayer’s position is correct ANDo Service is unlikely to prevail on appeal
Necessary to exhaust administrative remedies if taxpayer hopes to get attorneys fees in court under IRC Sec. 7430, IRM 8.7.15.1
If taxpayer seeks a refund, and a significant issue remains unexplored after exam, it may be best to forego administrative appeal, consider paying the disputed tax, and pursuing a refund claim in district court just before the statute of limitations expires
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Timing of appeal30 day letter
Notifies taxpayer of the right to appeal exam within 30 days Accompanied by Publication 5 describing the appeals process
90 day letter, “Notice of Deficiency” Notifies taxpayer of right to file petition in Tax CourtIssued after exam if not enough time to accommodate an administrative appeal and an appeal to Tax Court, andTaxpayer has not agreed to extend statute of limitations by signing Form 872, Consent to Extend the Time to Assess TaxTaxpayer should file the petition with Tax Court
• Generally, if case not before Office of Appeals beforehand, Tax Court will refer to appeals• Taxpayer may also request that the IRS attorney assigned to their Tax Court petition transfer
their case to IRS Appeals
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Form of Appeal
Appeal commenced with “Protest” See Reg. 601.105 (d)(2) and Publication 5
Protest may be short or long depending on complexity issues
Cases under $25,000• File “small case request” on Form 12203, Request for Appeals Review• Or brief letter
Protest for larger dollar amounts requires written letter as described in Publication 5
May file protest meeting minimal requirements and amplify later• If retained late• If new facts/law comes to light
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Discovery (or further discovery) before appeal
FOIA RequestFile promptlyIf need be, file more than one
The Service is under no continuing obligation to update previous responses
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FOIA should request Administrative File
File should include:Correspondence and notifications from IRS
Notice of AuditInformation Document RequestsNotices of proposed adjustments30 day letter90 day letter (Statutory Notice of Deficiency)
Internal IRS documentation
Form 5402, Appeals Transmittal and Case MemoExaminer’s workpapers and notesExaminer’s rebuttal to any protest previously filedInformants’ reportsMemoranda of interviews with taxpayer and third partiesInformation from other taxpayers’ returnsPreviously filed protest/tax court petition
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STEP 5: CLOSING AGREEMENT: choose form binding on service
Service and Taxpayers may enter into so called “closing agreements” under IRC Sec. 7121 and Reg. 301.7121-1(a).
IRC Sec. 7121, Closing Agreements authorizes an agreement with any person or estate as to any type of tax liability.
Reg. 301.7121-1(a) only recommends a closing agreemento “where there appears to be an advantage in having the case permanently and conclusively closed”,
and no disadvantage accrues to the Serviceo “or if good and sufficient reasons are shown by the taxpayer for desiring a closing agreement”
Closing agreements require approval of personnel above examiners.
Using the language of contract law, the statute describes these agreements as: o Finalo Except for fraud, malfeasance, misrepresentation of material fact
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Use the correct form
Form 866, Agreement as to Final Determination of Tax Liability used to close conclusively the total tax liability for a taxable period ending prior to the date of
the agreement. Reg. Sec. 601.202
Form 906, Closing Agreement as to Final Determination Covering Specific Matters finally determines one or more separate items affecting the taxpayer's liability used when agreement has been reached as to the disposition of one or more issues and a
closing agreement is considered necessary to insure consistent treatment of such issues in any other taxable period. Reg. Sec. 601.202
this type of closing agreement does not bar the IRS from subsequently determining that a taxpayer is liable for additions to tax
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Combined Agreement
Neither Form 866 nor Form 906 is specifically designed for closing agreements which determine both tax liability and specific matters.
Instead, typed combined agreement should be used. oFormat described in Rev. Proc. 68-16, Exhibit F.oLast page of combined agreement same as last page of Form 906
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Consequences for not using correct form: Hinkle et al. v. U.S.,No. 1:16-cv-01048 KG/SCY, Consolidated with No. 1:16-cv-01051 KG/SCY, No. 1:16-cv-01052 KG/SCY, United States District Court, D. New Mexico., June 15, 2018
At the conclusion of audit, the IRS sent Form 4549, Income Tax Examination Changes, with a letter stating that, if Plaintiffs signed the form, they would not be assessed an accuracy penalty under IRC Sec. 6222.
IRS later sent written notice that it was considering a penalty under IRC Sec. 6707A for failure to disclose a listed transaction under Reg. 1.6011-4(b((2), referring to transactions the IRS considers consistent with tax avoidance schemes.
Thereafter, Plaintiffs received a Form 4549-A, Income Tax Discrepancy Adjustments assessing a civil penalty under Sec. 6707A
Both before and after receipt of Form 4559-A, Plaintiffs received correspondence from the IRS, including the North Atlantic Area Director, stating that there would be no penalty.
The court held that the Service had waived the penalty under Sec. 6662, but not 6707A. "As a Revenue Officer, Roberts was not authorized to enter into a binding agreement with the Meyers. The Meyers were charged with knowing Roberts' limited authority so they cannot demonstrate that their reliance was reasonable. Since only a private letter ruling or a closing agreement by authorized agents bind the government, and because the Meyers did not obtain such documentation, their estoppel claim fails". Footnote 9
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STEP 6: REFERRAL TO CRIMINAL DEFENSE ATTORNEY
Criminal matters are handled differently than conventional civil audits
Do not cooperate or disclosePrivileges claimedPursuant to summonsValidity of claims decided by federal court
Do not agree to extend statute of limitations
Consequences may include jail
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3 scenarios where question of referral to criminal defense attorney should be evaluated:
1. No substantiation for expenses . . . o Will IRS simply disallow with penalties and interest?o Or see a willful and criminal attempt to evade tax?
2. Non-filers . . . IRS distinguishes non-filers with badges of fraud from non-filers without.
o Pursue voluntary disclosure? IRM 9.5.11.9., Voluntary Disclosure Practiceo Make a “soft disclosure” by filing past due or amending previously filed returns?o Refer to criminal attorney?
3. Signs of fraud/examiner considering referral to criminal division during audit . .
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How to handle these 3 scenarios:
Two fold analysis, based on -
LAW
IRS PRACTICE AND POLICY
Interplay not always straightforward
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Law
Two statutes particularly relevant:
IRS Sec. 7201 - Attempt to evade or defeat taxAny person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.
IRS Sec. 7203 - Willful failure to file return, supply information, or pay taxAny person required under this title to pay any estimated tax or tax, or required by this title or by regulations made under authority thereof to make a return, keep any records, or supply any information, who willfully fails to pay such estimated tax or tax, make such return, keep such records, or supply such information, at the time or times required by law or regulations, shall, in addition to other penalties provided by law, be guilty of a misdemeanor and, upon conviction thereof, shall be fined not more than $25,000 ($100,000 in the case of a corporation), or imprisoned not more than 1 year, or both, together with the costs of prosecution
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Law (Continued)
Case Law:
Was taxpayer’s conduct willful? Cheek v. United States, 498 U.S. 192 (1991)o Willfulness is “an intentional violation of a known legal duty.” o Taxpayer may claim a good faith belief that s/he did not have a legal duty, and belief
need not be objectively reasonable.o“ [C]laimed good-faith belief [need not] . . . be objectively reasonable if it is to be
considered as possibly negating the Government's evidence purporting to show a defendant's awareness of the legal duty at issue.”
o In effect, ignorance of the law is a defense to prosecutions or penalties based on willfulness.
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IRS POLICY
Badges of fraud” as evidence of willfulness
o A consistent pattern over several years of underreporting taxable incomeo False Statements or False Recordso Accounting irregularities o Failure to cooperate with the examinero Concealment of assetso Inadequate records; Dealing in cash
Significant multi-layered review within the Service and Justice Department before bringing criminal proceedings to determine likelihood of:
o Proving defendant guilty beyond a reasonable doubto Significant jail timeo Publicity which will achieve substantial deterrence
Typical targets are educated/financially successful taxpayers with substantial misstatements over several years
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Non-filers:
IRS handles non-filers differently depending on whether if there are “badges of fraud”.
Taxpayers’ representatives should as well.
If fraud, Service will develop case pursuant to guidelines in IRM 25.1.7, Fraud Handbook –Failure to File
If no fraud, Service will solicit returns IRM 4.12.1.7.2.1 (10-05-2010)
Enforcement usually limited to 6 years. Longer or shorter periodsRequires management approval Depends on variety of factors How much tax is due relative to time and effort to collect Badges of fraud Illegal income Taxpayers history of noncompliance/evasion of withholding requirements Special circumstances relating to taxpayer, industry, or type of tax
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Voluntary Disclosure (domestic)https://www.irs.gov/compliance/criminal-investigation/how-to-make-a-domestic-
voluntary-disclosure
Voluntary disclosure for non-filer • If there’s fraud: consider referral to criminal defense counsel
Made by forwarding taxpayer’s identifying information to the IRS criminal division Prior to any enforcement action by IRS Income must be legally obtained
Taxpayer must cooperate with IRS in Determining amount of tax due and Paying it
IRS does not guarantee voluntary disclosure will avoid criminal prosecution, but it typically does
If non-filer has committed further crimes of fraud and evasion Voluntary disclosure may enable them to avoid prison Should be handled by attorney experienced in criminal defense
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“Soft disclosure”
Another option for a nonfiler is “soft disclosure” byForwarding unfiled returnsAmending previously filed returns to report unreported income
Accompany with an explanation why taxpayer’s failure to file or report was not accompanied by badges of fraud
If failure to file or report was accompanied by badges of fraud, consider referral to defense counsel
(Historically, soft disclosure made in the hope that the IRS would accept the returns, and refrain from prosecuting failure to report/file as “willful”. If fraud is present, this procedure exposes taxpayer to the risk of prosecution without protection by defense counsel.)
Conversation with one Taxpayer’s advocate suggests the IRS prefers voluntary disclosureOne would suppose that’s especially the case where there’s no good explanation
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Signs of fraud/possible criminal referral by Service during audit
So called “eggshell audit” Representative knows there’s fraud, but IRS doesn’t Consult experienced criminal defense attorney
o Do so behind the scenes o Refer with discretion
Long period of silence during audit Conventional wisdom: long period of silence where auditor is out of touch and unresponsive may
indicate a referral to criminal division You can consider asking whether such a referral has been made, but risk alerting IRS to possibility it
may not be considering Consider having criminal defense attorney available, but in background, to avoid alerting Service
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-End of review-
6 STEPS IN AUDIT PROCESS:
1. PREVENTION: address issues in tax return before the Service does
2. PREPARATION: know what the Service knows
3. DISCOVERY: limit issues and disclosure
4. AUDIT RECONSIDERATION/APPEAL
5. CLOSING AGREEMENT: choose form binding on service
6. REFERRAL TO CRIMINAL DEFENSE ATTORNEY
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Volunteer for MVLS!
Janice Shih and MVLS network are wonderful to work with.
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