What’s the Point of a Tax Audit?

A former senior official at the IRS weighs whether its new tax audit policy will spawn cooperation or disaster for corporations.
Walter HarrisJanuary 27, 2014

Problem audits with the IRS are always a little bit of everybody’s fault. Taxpayers who feel bullied become unresponsive.  Auditors who feel ignored take a hard line.  Before you know it, no one is talking, every exchange is hostile and the point of the tax audit is entirely forgotten.

75px-US-InternalRevenueService-Seal.svg“What’s the point of a tax audit?” is a question I get asked a lot, and it seems that the answer surprises many people.  Believe it or not, the IRS audits your company to get to the right answer. Unfortunately, the complexity of the tax code, regulations and administrative rules means getting “the right answer” has to be a collaborative effort.

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For years, the service has considered a cooperative dialogue to be the gold standard of an IRS audit.  In my thirty years with the IRS — starting as a field examiner and ending as the Large Business & International (LB&I) Senior Executive for Financial Services — it was always my policy to talk to the taxpayers and their representatives as the jumping off point for every part of the audit. Over the last few years, the service has started putting in place policies to make cooperative dialogue not just the gold standard, but the standard.

On June 18, 2013, the LB&I division announced a new policy for audits that they hope will get auditors and taxpayers talking.  The policy, issued in Directive LB&I-04-0613-004, outlines a new approach to Information Document Requests – usually just called IDRs.  Agents issue IDRs to gather information about items under review.  Typical IDRs ask for documents, interviews and other information.  Unfortunately, many times IDRs wind up being overly broad, casting as wide a net as possible instead of narrowing the audit’s scope to get to the right answer.  The June 18 directive changes the emphasis of the IDR process in the hopes of encouraging greater cooperation and greater transparency in exams.

Opinion_Bug8Under the new guidelines, IDRs have three new universal requirements:  1) they must be “issue focused;” 2) they must be discussed with the taxpayer beforehand; and 3) appropriate deadlines must be discussed and set. On November 4, 2013, the service issued Directive LB&I-04-1113-009, clarifying how it would implement these new requirements.  The November 4 directive sets out 13 steps LB&I agents are supposed to take when issuing any IDRs:

  1. Discuss the issue related to the IDR with the taxpayer.
  2. Discuss how the information requested is related to the issue under consideration and why it is necessary.
  3. After this consultation with the taxpayer, determine what information will ultimately be requested in the IDR.
  4. Ensure the IDR clearly states the issue that is being considered and that the IDR only requests information relevant to the stated issue.
  5. Prepare one IDR for each issue.
  6. Use numbers or letters on the IDR for clarity.
  7. Ensure that the IDR is written using clear and concise language.
  8. Confirm that the IDR is customized to the taxpayer or industry.
  9. Provide a draft of the IDR and discuss its contents with the taxpayer.
  10. After this discussion is complete, determine with the taxpayer a reasonable timeframe for a response to the IDR.
  11. If agreement on a response date cannot be reached, the examiner or specialist will set a reasonable response date for the IDR.
  12. When determining the response date, ensure that the examiner or specialist commits to a date by which the IDR will be reviewed and a response provided to the taxpayer on whether the information received satisfies the IDR. This date should be noted on the IDR.
  13. If the information requested in the IDR is not received by the response date, the examiner or specialist will follow the IDR Enforcement Process set forth in Attachment 2.

If everything goes according to plan, this process will ensure that document requests are focused so that agents are only asking for what they need to get to the right answer. I am convinced that if the new guidance works as anticipated, taxpayers are going to see some positive changes in the form of more efficient, focused, faster, and – most importantly – transparent audits. That is, however, a potentially big “if.”

The November 4 Directive also sets out a new enforcement protocol in case everything does not go according to plan. Taxpayers who do not respond – or do not respond adequately – will quickly find themselves on a very unpleasant train they will be unable to stop.  Ten days after the IDR response is due, the agent must issue a Delinquency Notice – a formal notice indicating that the taxpayer has not responded or responded completely to the agent’s request.

The notice will also provide a new deadline of no more than fifteen additional days, after which a Pre-Summons Letter must be issued notifying the taxpayer that if they fail to provide a response within upwards of ten days, a legal summons for the information will be issued. As a last step, the agent is required to issue an enforceable summons.

At this point, the only options are to provide the information or go to court to challenge the summons.  To top it all off, IRS leadership has made it clear that enforcement will be automatic and exceptions will be rare, requiring the intervention of senior management.

Many of the people I have spoken to regarding the new protocol worry that this may be a recipe for additional auditing problems. While there may be some truth to their concerns, I honestly believe they will ultimately be proven wrong.

Enforcement is what happens when things go wrong. When things go right, the new guidelines require agents to reach out to taxpayers and their representatives to get the ball rolling on an IDR. Agents must talk about what really matters to the audit, namely, which issues will be the focus and what materials will be needed?

Taxpayers will have to tell agents their concerns ahead of time, such as a document being buried in a warehouse or if a request does not relate to the items at hand. From the very beginning, both sides must have an open discussion and they must speak to what matters – the right answer. Open, effective, and focused discussions are a recipe for transparency, efficiency and – in the long run – more cooperative exams.

Somewhere between the requirement to focus and negotiate IDRs ahead of time, and the threat of summons afterwards, I think taxpayers and auditors will adapt to the new rules.

There will be kinks to work out – I would not be surprised to see a temporary uptick in summonses – and in some exams there will be no avoiding distrust and hostility. But as time goes on, taxpayers and, more importantly, their representatives will adapt. A good representative has always known to reach out ahead of time and now that skill is going to make or break an audit. There is no doubt that the new landscape will be difficult to navigate, but the informed will be able to use these new guidelines to their advantage, allowing both sides to find a proper solution to problem audits.

Walter Harris, director of internal revenue service practice and procedure at alliantgroup, served as a senior level executive of the IRS from 2007 through 2012.