When you file a tax return, you make a claim to the government about the status of financial transactions reported on those returns. For this reason, it is one of the few areas where the government can make inquiries of you without cause and does not have the burden of proof. Everyone knows that in criminal proceedings, the government has to make its case beyond a reasonable doubt. In civil audits, it’s actually you, the taxpayer, who has the burden of proof. You must produce “credible evidence” of your position. The government habitually treats you with skepticism and views your evidence in that light, and in this context, the government doesn’t have to prove its position. Only once you have provided support for your position does the burden shift to the government to prove that your evidence is incorrect. Therefore, in civil tax cases, the best defense is a good offense.
Receiving unexpected mail from a state or federal taxing authority can be a nerve-wracking experience, but it is important to recognize that the majority of unexpected correspondence is not actually related to an audit. For everyone with net income greater than $1 and less than $1 million, the number of audits is below 1.5 percent. The steps for dealing with correspondence are the same for both individuals and businesses and for all taxing agencies. The first thing a person or a business owner must do when this happens is open the envelope and read what is inside. The correspondence could be a notification of penalties assessed for late payments, a collection notice of a balance due because of a bounced check, or an inquiry relating to non-filing. These notices all come by mail and are much easier to resolve early on with a phone call. Delaying a response to these types of notices can lead to escalation within the taxing agency and irreversible consequences, even when the original correspondence was incorrect.
Once you have opened the letter, read what it is asking you to do. If you are being audited, the letter will request information about a return you filed. The notice will typically provide you with a phone number for responses but may not have a specific person assigned.
If the letter requests follow-up by mail, then you may have been selected for a correspondence audit. Correspondence audits are the most common form of audit and are generally simpler and lower risk than in-person audits. For example, correspondence audits are typically focused on a particular item or area of a return. For an individual, a correspondence audit might ask about itemized deductions; for a business, it might ask about cost of goods sold.
If the letter offers a date for an appointment, then you have an in-person audit. In-person audits will commonly take the form of an open inquiry for a particular year and ask that you provide all income and expense documents. If you are not able to get the documents by the deadline requested and do not have counsel hired, call the taxing agency and ask for more time. However, do not divulge information or have a discussion about the information you plan to provide. Instead, keep it minimal and state that you have received the notice, you are seeking legal advice, and you need more time. Allowing deadlines to lapse without response will create escalating notices.
When you receive an audit notice or questionnaire from a taxing agency, the first step is to call your accountant and your tax attorney. If you do not already have both, you can usually ask one to refer the other. Each performs a different role in the course of the audit, and, if you wish to be successful, it is important to consult both your accountant and attorney regularly.
In most cases, your accountant has an understanding of your business or personal finances, the types of records you have, and the tax positions you have taken. Depending on the complexity of your audit and your returns, your accountant may be required to assist you in filing current returns while the audit is still ongoing even though the returns will be impacted by the outcome of the audit. Maintaining a good relationship and open dialogue with your accountant is extremely helpful. Your accountant has an ethical obligation to the validity and accuracy of your return but is not your advocate and may even be ethically barred from taking an aggressive advocacy position on your behalf.
Your tax attorney, on the other hand, is meant to advocate for you and your positions and get the best result for you. A tax attorney has superior knowledge of the procedures and processes that govern the audit. The attorney will protect you from oversharing when you are not required to do so, demand that the government justify the tax positions it claims, and advocate for your position. The attorney’s goal is to resolve the audit in the best way for you, even if your case does not resolve in the most universally applicable or sustainable way. Where accountants value correct tax returns, lawyers push for correct clients. Also, lawyers have attorney-client privilege, which can protect your strategic communications and calculations from eventual exposure. An attorney can extend privilege to an accountant for the purpose of obtaining technical accounting advice (typically by using a “Kovel letter”), but not the other way around.
Once you have determined that you are being audited and you have your team in place, you need to set goals and expectations for yourself. You will be required to produce a variety of documents. The type of information you need to provide and the amount will depend on whether you are being personally audited or your business is being audited and will depend on what agency is auditing what form. Bank statements, general ledgers or budgets, payroll records or wage statements, point of sale (POS) system reports or credit card statements, and other records are likely to be requested. The financial life of the audited entity, whether that is you as a person or an entity, is subject to complete examination. From here, the outcome of the audit is largely based on the quality, quantity, and consistency of your records. The most important thing you can do at this time is provide as complete a disclosure as quickly as possible to your attorney. Let your lawyer know immediately whether you have previously had tax problems and the status of those problems, what you think might have “triggered” the audit, and if you know of any errors in your returns or records.
By providing this information up front, you can save a lot of time in back-and-forth communication. It’s important to recognize that your attorney is only funded by your budget; the person representing you will not fully investigate you and uncover every issue. On the other hand, the government has nearly unlimited resources: The government can summons bank records and subpoena every person involved with your returns. Expecting your accountants and attorneys to uncover any issues that you might suspect are lurking under the surface of your financial information is an expensive gamble. Instead, treat your attorney as a confidant and let him or her determine how best to navigate disclosing information. This means your attorney needs all the information about your case as you have it. From there, the documents and evidence can be analyzed for reliability, accessibility, and completeness, among other things, and, ideally, the audit can be strategically managed to avoid potential pitfalls and expanding scope.
The second most important issue is to set goals for the outcome of the audit and understand the scope of risk. The typical scope of an audit is three years for state-level business audits and one or two years for income tax audits. No matter what else is happening in your case, your goal with counsel should be to limit the scope of the audit to the years and issues about which the government initially inquired. Overzealous auditors can drag out audits indefinitely. It is frequently worthwhile to allow auditors extensions of time to make assessments, but you cannot allow an auditor to abuse the possibility indefinitely. Similarly, when audits impact other years through carryovers, depreciation, or similar issues, it is essential to ask to be able to resolve those issues through normal amendments. An unconfined auditor can become an unwanted fixture and, even, heirloom in your family life.
Next, whether your case is focused on an audit, tax collections, or both, it is essential to get into current compliance. Failing to file and pay your current taxes will be detrimental to your cause. The ultimate goal of every employee in the IRS, and most other taxing agencies, is to get you to file your taxes on time as you are supposed to and pay as you should. Errors of the past are vastly more likely to be forgiven when current compliance can be shown. When the audit outcome will impact current filings, you can also push for faster resolution more effectively by explaining this circumstance to the auditor and preparing the returns accordingly. You don’t want to admit wrongdoing by changing the tax treatment of an issue on your current and future returns before the determination has been made, but you also don’t want willfulness penalties assessed in the future. Ultimately, your attorney and CPA should strategize, and, depending on the outcome, the attorney can explain that you are taking the most conservative approach or that you are continuing your position and articulate the reasons to the auditor to limit or eliminate the possibility of penalties.
Finally, understand that absolute victory is typically not the goal. When you know there are errors in your records or aggressive positions on your return, you must be prepared to concede a loss on some of those issues in order to resolve the audit effectively. On the other hand, once something has been resolved in the audit, you cannot continue to make the same mistake. Therefore, when fundamental issues are at stake, such as worker classification or whether income on an individual return is from self-employment, depreciation and accounting methods, or other major adjustments, it’s important to assess the audit outcome in the context of the future as well as the past. In these cases, it may be worthwhile to continue to fight the issue as long as needed. In either case, remember that you have both the burden of proving your point and the burden of paying for prosecuting the case.
Once you have determined that you are being audited, the best way to handle the process is to treat it like any other government interaction: First, get your professionals on board, then get your evidence in line, and finally set some goals and get buckled up for what will be an undoubtedly bumpy ride through the audit process and post-audit compliance. Remember that your diligence and cooperation are likely to be rewarded.
