The tax audit environment facing midsize businesses has shifted dramatically and unpredictably in recent years. Facing a revenue shortfall widely believed to be the result of non-compliance by smaller businesses, the Internal Revenue Service has reallocated enforcement resources away from its traditional focus on large companies toward midsize businesses, according to a 2010 report by the Transactional Records Access Clearinghouse, a nonpartisan research group affiliated with Syracuse University. This has resulted in more frequent and increasingly protracted audits for smaller companies.
Because smaller organizations often lack the resources and the audit experience of larger companies, these audits can seriously disrupt daily business, resulting in a loss of revenue as well as other unexpected, unbudgeted expenses.
Fortunately, there are a number of ways CFOs and other officers and managers of midsize businesses can mitigate the negative impact of an IRS audit. Here are five.
1. Identify likely issues.
There are two important steps in preparing for an IRS audit: (1) Review and evaluate any prior audit experiences; (2) Determine whether there are any areas of concern regarding the tax returns covered by the current audit.
Being proactive can help the business reduce costs such as time and resources spent compiling documents in response to an IRS request for information. Ask, for example, what issues arose in the prior audit and what is the likelihood they will resurface? Do any of these prior issues have carryover effects into the current audit? The business should also put policies in place to ensure that tax return positions are adequately documented, and that supporting records are well organized and easily accessible.
In reviewing its return, a business sometimes will discover mistakes in its preparation. In appropriate situations, the business should consider proposing self-audit adjustments for issues that will be discovered by the IRS. For instance, a situation could arise in which the business has inadvertently deducted the same item in two different places on its return. Making affirmative adjustments not only can avoid the imposition of penalties but, more importantly, they can build goodwill and trust with the audit team.
2. Plan for the process.
After the business receives notice of an audit, it should begin discussing its plan. It will be helpful to identify the IRS personnel who will be involved in the audit to identify the potential scope of the examination, the individuals authorized to act on behalf of the business to control the flow of information to the auditors, the audit schedule, the response times required to provide Information and Document Requests (“IDRs”), agreements on whether the statute of limitations will be extended, and certain due dates or time periods for IRS actions.
At, or shortly after the initial conference, the IRS issues an IDR requesting a lengthy list of organizational items from the business. This list generally includes corporate minutes, organizational charts, financial statements, general ledger and trial balance and chart of accounts, and depreciation schedules. Depending on the line of business and audit history, the initial IDR may contain more focused requests related to specific areas (for example, payroll documents, cost of goods sold computations, prior audit reports, and so on). A well-organized document maintenance system will save the business a substantial amount of time and resources during this information gathering period.
If the business does not respond to the IDR in a timely manner, or if it provides responses the IRS deems inadequate, it may receive a summons. The issuance of a summons signals a breakdown in the audit process and can result in public court proceedings. The IRS recently has begun issuing summonses more quickly when taxpayers miss response deadlines.
3. Document significant transactions.
Businesses should, of course, document significant transactions when they occur and be aware of the tax risks surrounding those transactions. Easy access to this documentation will become very important during an audit, especially if the documents substantiate the business purpose of a transaction that the IRS may challenge on tax avoidance grounds. The taxpayer should collect and organize such documents as the events they describe happen, and review them before the audit begins. The review should include the removal of drafts of documents and e-mails the business is not required to retain. The IRS frequently asks for all drafts of documents and all e-mails on a particular subject. Responding to this request can be time-consuming and expensive if several drafts and copies of the same document exist.
4. Respond narrowly.
When a business answers an IDR, it should provide only information specifically requested, resisting the temptation to rely on documents compiled by outside advisors. Such compilations may include both too much and too little information. While it is easier to turn over to the IRS a pre-packaged deal book, doing so may raise issues the IRS was not inquiring about. On the other hand, closing books may not include essential information, such as the business reasons behind transactions. The point is to take care, and carefully consider what you’re turning over to the IRS. Whatever you do cannot be undone.
Businesses should assign one person to deal directly with the IRS agents. A suitable individual will be personable but also discreet and sensitive to any cues given by the agents. The goal should be to have the IRS direct, in writing, all inquiries and IDRs to this person who, in turn, can communicate to others in the organization as needed. The business should attempt to maintain careful control over the IRS’s access to both documents and people. Maintain meticulous records of all IRS requests, deadlines, and copies of everything your business has provided.
The point person should read all document requests carefully and understand the scope of the information sought. If the person finds the requests vague or overly broad, he or she can and should ask for clarification. In general, the business has a duty to provide existing records; it does not have a duty to create new records, although it may want to consider creating new documents in cases where doing so would both satisfy the agent without inviting him or her to look into matters beyond the defined scope of the audit.
5. Retaining outside counsel.
Midsize businesses typically do not retain outside counsel at the outset of an audit, and in some instances engaging counsel might raise IRS suspicions. However, retaining counsel may be prudent in some situations. For example, if an IDR touches on a sensitive issue, counsel can work behind the scenes with the business to prepare an appropriate response and, if necessary, serve as a buffer to preserve a good relationship between the business and an agent. Counsel may also be helpful in preparing a witness for an interview with the IRS, an increasingly popular examination technique.
Midsize businesses need to be prepared for more intrusive examinations into their operations. Understanding the audit process, maintaining adequate and well-organized records to support tax positions, and, if necessary, retaining outside counsel are all essential to successfully navigating the audit and achieving the best possible outcome.
Andrew R. Roberson is a partner and Brad McCormack an associate in the U.S. and International Tax practice group at McDermott Will & Emery LLP. Thomas M. Connolly, counsel at McDermott Will & Emery LLP, also contributed to this article.