Every tax professional understands that Internal Revenue Service audits can often be challenging experiences–and sometimes unpleasant and long-lasting ones. That is particularly true for small and mid-size businesses because such companies’ bookkeeping methods vary widely, which makes it hard and sometimes impossible for them to respond to homogenized, one-size-fits-all IRS audit practices.
But a proactive approach in dealing with the IRS can help executives more effectively manage the audit. Taking preventive action can reduce the burden associated with the audit process for corporations and their CFOs and finance teams as well as for the IRS audit team itself.
What are the best ways to prepare? One way is being knowledgeable about the administrative options and tools available to effectively manage the examination process. Another is to work closely with the IRS examiner to guide his or her actions and keep the process focused. By preparing in those ways, corporations will have less stress and practitioners may secure better outcomes for their clients–both in terms of the final monetary result and in the experience involved in obtaining it.
Senior corporate executives must also be aware that their companies could be at a great disadvantage if their own tax professionals, in contrast, take a passive approach to an IRS audit. After all, while limited engagement by tax professionals (i.e. 20 to 40 hours) may on the surface appear to be sufficient, it is comparatively small when working within the confines of the IRS’s focus on certain tax issues.
To be sure, the IRS tiered system (which classified tax deductions in different ways to address compliance risks) is no longer in place. The IRS now uses a knowledge-based system, which allows for more open communication between the service and taxpayers. With the new system, agents discuss certain positions with IRS subject-matter experts to strategically manage the most important tax-compliance issues. The new approach also provides examiners with clear and timely guidance on how to address issues.
Under this methodology, corporate executives can expect that the IRS will attempt to focus its scope and resources on the most prevalent compliance risks initially identified for the review. From the taxpayer’s perspective, the most effective way to move the process along is to be aligned with the workings of the IRS audit team.
Circling the Wagons
The time for circling the wagons around one’s company is not after a firm receives the first Information Document Requests (IDRs) from the IRS. Those who wait for an IDR are one step behind and are now working under a deadline. Advanced coordination with tax professionals, as well as with any necessary non-tax related, in-house professionals, is crucial.
How does the inquiry process start? Original and amended tax returns are selected for review by the IRS based on several different methodologies. Generally, original filed-return selections are based on a formula If a company’s return is selected to be reviewed, the IRS will issue a Notice of Review or Notice of Beginning of an Audit, indicating a return has been assigned to a field office.
The notice also indicates that the field office has requested the tax returns for review, and an agent will contact a firm within 45 days (occasionally 60 days) of the field audit. Actual contact times vary based on the workload of the specific field office where the return is assigned. Even so, preparations for the audit must begin immediately after receiving a Notice of Review. Waiting for the first meeting or first IDR will potentially cause rippling negative effects throughout the entire audit.
An Active Approach
So how should CFOs and their staffs prepare for an IRS audit? Depending on the items claimed on a tax return, a corporation’s management team may need to speak with other professionals in the company. Knowledge of the items on the return, along with IRS practices provides significant insight for preparations.
For example, if a company claimed a credit for increasing research and experimental activity, responding to IDRs will likely require information from a firm’s researchers and their supervisors and support personnel. Speaking with a firm’s research-related employees in advance will reduce response times once an IDR is received.
Further, a company will want and need to assess their documentation and record-keeping capabilities relative to the potential areas of review. It is likely that any tax deduction that the IRS deems to be a high priority, or in the first tier of its old approach, such as R&D tax credits, will cause an examiner to reach out to the IRS’s subject matter experts in the Issue Practice Group (IPG) for advice and support.
Besides the IPG, IRS agents often rely upon the expertise of subject-matter experts like IRS Engineers and Chief Counsel Attorneys who have far more experience in the R&D credit, for example. Regardless of the particular return item(s) under scrutiny, the bottom line is to know the IRS auditor’s playbook and conduct proper preparations.
For large businesses or international firms it is vitally important that companies and their professional representatives are extensively familiar with, and actively engaged in, the Quality Examination Process. QEP is an outline of responsibilities and a systematic approach for taxpayers that must comply with the large business and international division (LB&I) of the IRS.
The QEP also helps the examination team in achieving a smoothly run audit. Aside from providing steps for tax payers, it also provides a framework for what the responsibilities are for IRS counsel, tax advisers, and specialists.
Contrary to popular belief, an IRS examiner’s primary objective is not to assess additional tax. Instead, her or his goal is to determine the appropriate and proper tax liability based on the facts and circumstances present in the case.
Under the law, an examiner is evaluated not by the amount of tax assessed but on the timeliness and the quality of the examination process. Such quality is measured by the efficiency at which the examiner reaches a finding, the evidence reviewed and gathered to support the findings, and communication throughout the process.It is important to be engaged and proactive during an audit, since providing the examiner with thorough, complete, and accurate information will expedite the audit process.
Despite seemingly limitless areas for review, IRS agents will tend to have a particular and specific area of focus when investigating an issue. That will include having minimum-requirement lists for companies in certain industries, as well as specific areas of compliance risks to inquire about.
Properly responding to these first inquiries can shape the scope and focus of the examination. Failure to adequately and properly grasp these areas of focus from the initial inquiry could lead to confusion and additional and perhaps unnecessary inquiries from the audit team.
After all, practitioners make the existing obstacles worse when they allow difficult inquiries to go unanswered. That can cause frustration–or extreme consternation–among IRS auditors and can move an audit in a non-productive direction from the point of view of the taxpayer.
But recognizing and managing the IRS auditor’s level of concern, and possible unproductive additional inquires, is not always an easy task. Establishing an expectation of discussion questions (such as from the IDRs) before their issuance can be help minimize such concerns and provide an opportunity for focusing agents’ inquiries. Simply providing complete and comprehensive responses will go a long way. Yet while some inquiries require a detailed explanation of the taxpayer’s accounting method for a particular item, others may simply require a response of “no.”
Walter Harris is director of IRS practice and procedure for alliantgroup, a tax advisory, and served with the IRS for 31 years.