You can view the first half of this article by visiting http://www.cpataxmag.net/davidoff-stories/42-e-martin-davidoff-columns/869-steps-to-effective-irs-audit-resolution.
When taxpayers receive the dreaded notice that their business is going to be examined by the Internal Revenue Service (“IRS”), the first thing they do is seek your advice. This is the second part in a series of articles on Effective IRS Audit Resolution. See Steps to Effective IRS Audit Resolution to read the first part, which covers “Carefully Read the Communication” and “Speak Directly with the Revenue Agent/Tax Compliance Officer.”
3. Do a Thorough Pre-Audit
Prior to the IRS conducting the examination, I perform a pre-audit that is more thorough than the actual examination. I scrutinize every check, receipt, and all of the books and records, trying to learn where all the “bodies” lie, and to understand the client’s books, records, and business inside out. Knowing the weaknesses of the case allows me to prepare more effectively for the examination and, in some cases, I decide to offer up those weaknesses to the auditor up front as a gesture of good faith.
It is important, especially with corporations, to understand all balance sheet accounts. For example, the impact of tax basis on S corporations may provide adjustments for the examiner. How many of us have observed the dreaded “loan to shareholders” account on the asset side of the balance sheet? Ask questions of your client and their bookkeeper to ensure you have a comprehensive understanding of your client’s financial history.
With nearly all closely-held businesses, the IRS will be looking at deposits into bank accounts and reconciling such deposits to reported gross income. Be sure you do a thorough analysis of bank and brokerage account deposits. Also, the IRS may look into the personal living expenses of the owners of the business to determine whether their lifestyle is consistent with the income being reported from the business. If not, what is the source of funding the shortfall? In many instances the shortfall is unreported income!
To support deductions, you will need proof of payment and receipts reflecting the purpose of the expenditures. For certain expenditures, such as meals & entertainment, travel and local transportation, a diary may be critical.
Recognize when you are in over your head. Some cases require an attorney-client privilege. As soon as you recognize that, refer your client to counsel and stop asking questions of the client. Remember, CPAs and enrolled agents do not have privilege in representing clients before the IRS.
4. The Client Should be a No-Show
Have a frank conversation with your client regarding why he/she should be a “no-show” at the examination. Clients will often talk too much and inadvertently provide more information than necessary. They are often angry about their situation (of being audited) and show that anger during the examination. And, by poorly choosing their words or becoming defensive, they may lead the auditor into believing that something is improper, even if that is not the case. Most clients will be relieved that their presence is not required.
Your role will be to act as a buffer between the auditor and the client, enabling the client to give thorough, well-considered answers to all questions. Also, if the questions become too invasive, you can always state that you are not authorized to answer the question presented and consider responding after you seek further guidance and/or clarification from your client. Keep in mind that the IRS does not have the right to interview your client directly. You are their representative. [See Internal Revenue Code §7521(c) and Internal Revenue Manual §4.10.3.2.1.]
5. 7 Rules for Conducting the Examination
1. Prior to the examination, find out all you can about the auditor. Inquire of your colleagues and check out social media sites.
2. Have the examination in your office, not the client’s. This enables you to more carefully control the flow of the examination. Avoid letting the auditor sit alone all day looking over the records on his or her own. It is important that your staff and you spend time with the auditor, getting to know him or her and knowing what he/she is doing. Develop a rapport with the auditor.
3. Completely review and understand all documents provided to the auditor.
4. Never lie or make a misstatement to the auditor.
5. Never volunteer information, unless it is part of a strategy to do so.
6. Do not accept unreasonable timelines to get information back to the auditor.
7. Meet all commitments made to the auditor, or at least call in advance if you cannot do so.
6. Negotiate a Resolution
Attempt to arrive at a negotiated resolution of the examination with the auditor. By doing so, you save your client the cost of an appeal or, possibly, the expansion of the examination to additional multiple years. Weak issues can often be negotiated more easily if you are able to establish mutual trust and respect with the auditor. Fully document your strong areas and cover them early in the examination process. Thus, as you get to other areas, you may be able to reach a resolution more easily. Keep in mind that the auditor is doing his/her job and usually has not prejudged your client. The auditor is getting all their information on the examination from you, both in terms of the facts and your approach in communicating with the auditor. Treat them as the professionals they are and they will likely treat you the same in return.
7. Appeal Rights
Your client has both formal and informal appeal rights. The informal rights are to speak to the auditor’s manager or the Territory Manager (who is the manager’s manager). Often, difficulties in reaching a resolution can be resolved through such conversations. The auditor may lack the experience and/or the power to resolve the case on his/her own.
In the event you do not reach a resolution, you may file a formal appeal upon the receipt of the auditor’s report (often referred to as the “30-Day Letter” as it provides you 30 days to file the formal appeal). Such appeals are heard by the IRS Office of Appeals, the mission of which is to “resolve tax controversies, without litigation, on a basis which is fair and impartial to both the Government and the taxpayer in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the Service.”
You should discuss with your client the costs and benefits of pursuing an appeal. If you have little or no experience going to the Office of Appeals, you may wish to offer to represent your client in the appeals process at a nominal charge to gain experience. Often, when faced with the 30-Day Letter, practitioners are so focused on providing additional information to the auditor in order to achieve a more favorable result that they allow Appeal deadlines to pass. Be sure not to do so. You can request, in advance, additional time to make your appeal. If you do not secure the additional time in writing, you need to file the appeal if you wish to protect your client’s right to be heard by the IRS Office of Appeals.
E. Martin Davidoff, CPA, Esq. is the founder of the Dayton, New Jersey firm of E. Martin Davidoff & Associates, CPAs and has more than 30 years of experience practicing as a CPA and tax attorney. Davidoff is the founder of the IRS Tax Liaison Committee of the American Association of Attorney-CPAs and currently serves on the Executive Committee of the AAA-CPA. Mr. Davidoff may be reached at
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