Preparing and organizing the required documentation for Internal Revenue Service (IRS) examinations is a time-consuming process that has the potential to overwhelm your tax department resources. In order for tax departments to efficiently manage their IRS audits, it is important to understand some basic guidelines for the administration of examinations. The following discussion highlights key considerations about the IRS examination process, as well as best practices that may help taxpayers better manage IRS audits.
Establishing the IRS Examination Plan
The IRS is authorized by statute (Internal Revenue Code Section 7601) to conduct examinations. This authority gives revenue agents broad examination powers with few limitations. However, the IRS has established procedures that must be followed to ensure that a taxpayer's basic rights are protected.
In general, the IRS examination in the Large Business and International Division begins with a multi-step planning approach that incorporates the Quality Examination Process in the Internal Revenue Manual Section 4.46. The initial steps are meetings with the taxpayer to plan the examination process and to establish a cooperative working relationship. The product of these meetings is a written examination plan.
A critical aspect of this examination plan is the timeline. The audit timeline should have specific milestones to ensure mutual accountability. At a minimum, the timeline should establish mutually agreeable timelines for key audit points including start and completion dates, last date for Information Document Requests to be issued, last date for claims to be filed, issuance of Notice of Proposed Adjustments, and a target date for the revenue agent report. The audit timeline should also consider taxpayer and IRS resource needs and constraints. Specifically, both parties should be advising each other when planned vacations, training, periods of heavy workload, or other significant factors may result in exam delays or increased burdens.
Another critical part of the planning phase is setting the audit scope. The IRS has established goals aimed at condensing the cycle time of IRS exams. Reduced scope is one way an audit team can achieve this goal. The Quality Examination Process outlines possible tools for accelerated examination of returns including risk analysis, applying prior exam results, focusing on permanent items versus temporary ones, and using alternative issue resolution programs.
Materiality threshold agreements are another way to limit the audit scope. However, the definition of materiality can vary greatly (materiality can be defined based on taxable income, tax benefit, gross receipts, gross assets, etc.). It can also vary based on a combination of factors or the specific issue at hand. Taxpayers should take advantage of any opportunity to address audit scope as the first step to managing the examination process.
In addition, the planning process should institute ground rules for the structure of the audit. One of the most important areas is the establishment of parameters around the issuance of Information Document Requests, or IDRs. Response times for IDRs must be determined by the revenue agent working with the taxpayer. Both sides should be open to exceptions. In addition, the Quality Examination Process guide suggests that the exam team discuss all IDRs in draft form with the taxpayer in advance of issuance in order to ensure agreement and understanding on the scope.
At the end of the day, revenue agents have limited ability to settle issues. A revenue agent can resolve disputed issues of fact, but the agent is bound by the IRS positions taken on legal issues in Treasury Regulations, rulings and court cases. Revenue agents can, however, raise or not raise issues depending on legal interpretations and factual determinations. In practice, this effectively gives revenue agents some ability to "settle" issues. During audit negotiations, a taxpayer may be able to persuade the revenue agent that IRS positions on similar issues support the position taken by the taxpayer.
Sometimes issues will not progress. The taxpayer should consider elevating issues if warranted. The IRS has said its goal is to resolve cases at the lowest possible level. The normal progression under the IRS Rules of Engagement is team manager, then territory manager, then director of field operations (DFO). The DFO has a direct line of communication with an issue owner executive. The issue owner executive is usually not involved in specific cases. A high-level IRS official recently suggested that a taxpayer should contact the issue owner executive if he/she has tried to elevate a case under normal channels without success.
At times the local team may sense that they have limited ability to resolve issues that involve field specialists (e.g., computer audit specialists, engineers, etc.). Taxpayers always have the option to elevate an issue with technical advisors if they feel that field specialists are not being reasonable.
At the end of the examination, the revenue agent prepares an audit report, which either recommends accepting the return as filed or provides for a deficiency or an overassessment. If the case is not resolved at the local exam level, the taxpayer will be sent a "30-day letter" with proposed adjustments.
The IRS Appeals process offers taxpayers another opportunity to resolve issues. Appeals is supposed to seek a "fair and impartial resolution" of the case. Ex parte rules limit the communications between Appeals and the IRS examination team. Unlike the exam team, Appeals is able to settle issues based on an analysis of the "hazards of litigation."
If an issue previously was settled by IRS Appeals, revenue agents are authorized to settle the issue in the examination on the same basis (Delegation Order 236). If an issue is a coordinated issue, on which IRS Appeals has established written settlement guidelines, revenue agents are authorized to settle the issue in the examination according to the guidelines (Delegation Order 4-25).
Taxpayers should be aware of hot-button issues before an IRS examination begins. The IRS has stated that the primary reason for developing Schedule UTP (reporting uncertain tax positions) was to help the exam team identify issues so that more time can be spent auditing issues. Taxpayers should be aware that the auditors will carefully focus on the issues reported on the UTP schedule, and should be prepared to defend those issues. Taxpayer should also have a game plan for identified potential issues that may not have required disclosure.
Taxpayers (and their advisors) should be familiar with published IRS guidance (audit technique guides, settlement guidelines, notices, rulings, coordinated issue papers, and regulations) on known issues. In addition, a clear understanding of how a taxpayer's facts can be distinguished from existing guidance is as critical as understanding the technical guidance.
It is highly recommended that periodic meetings with the exam team be established (e.g., bi-weekly, monthly, or as needed) to review progress and emerging problems in the administration of the examination plan. These meetings can be for the overall exam administration as well as separate discussions when specialists such as engineers are involved. Often these meetings evolve into mundane timeline checks, but the taxpayer should use them as an opportunity to raise concerns early and often.
In order to manage the IDR process, the taxpayer should try at the start of the exam to negotiate a process that will ensure that IDRs are issued in draft form. It is much easier to negotiate IDRs before they are issued. The best approach may be to appeal to the common sense of the examining agent. Requests to produce "every" and "all" documents are simply not doable for either party. If extra time is needed to fulfill a particular request, communicate your concerns about timing as soon as possible.
The IDR scope is critical as well. It is important that taxpayers carefully read what is being requested by an IDR. Taxpayers should not volunteer to provide additional documentation unless specifically requested. If a request is ambiguous or incomplete, the taxpayer must consider whether it has options to comply narrowly or broadly, and must weigh the pluses and minuses of those options.
Alvarez & Marsal Taxand Says:
IRS audits can be a time-consuming process for many taxpayers. Perhaps the most effective tool you have to manage an IRS exam is a cooperative relationship with the IRS. Although the examination process is by nature an adversarial one, it is important to establish and maintain a good working relationship with the revenue agent. There are many ways to establish a cooperative approach. One would be presenting known issues to the IRS examination team at the start of the audit. Timely IDR responses and early warning of potential claims also should help establish a good and trusting relationship with Exam. While cooperation is certainly recommended, taxpayers should not cooperate to the point that it becomes a detriment.
You should also fully understand your issues, including the strength of your legal positions, the completeness of your documentation and the value of the disputed issues to your organization. You will then be prepared to elevate important issues or take advantage of the appeals process if the exam does not end favorably.
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