The Audit Wars Are About to Begin

CFOs need to be prepared for more audits and ones that will be more difficult to defend.
Bruce WilleyOctober 17, 2022
The Audit Wars Are About to Begin
Photo: Getty Images

Employee turnover is almost always costly for organizations, but it’s rare that hiring new staff can hurt clients and raise their costs. The exception? The Internal Revenue Service. 

The agency, which lost thousands of employees to retirement and budget cuts over the years, will soon be filling its many vacancies with the help of funding from the Inflation Protection Act. The new legislation has earmarked $45.6 billion for IRS tax enforcement activities, which, among other things, will pay for more enforcement agents. 

  Bruce Willey

Those agents, however, will lack the experience of their predecessors. 

New agents are more likely to make mistakes that result in costly audits or incorrectly levied tax penalties. Fighting these errors can cost small and midsize businesses tens of thousands of dollars in attorney fees and lost productivity. 

In the past, CFOs, along with their accounting advisors, could call agents and walk them through the filing. Problems were solved in hours, not days or years. 

But those days are over. Battles with the IRS will be more protracted and longer. CFOs, as well as their accounting colleagues, need to prepare for more audits and those audits will be more difficult to defend. 

Fighting these errors can cost small and midsize businesses tens of thousands of dollars in attorney fees and lost productivity. 

I currently have a case in tax court related to an incentive stock transaction that my client, a financial planner, had forgotten. After giving the IRS the documentation they needed regarding that transaction, I had to wait for four-and-a-half months before the next communication, in which they asked me to join a conference call with the IRS agent, their supervisor, and their calculation specialist to walk them through the documents. 

This request indicated to me that a fairly simple update was taking longer than needed to resolve and required extensive hand-holding. I expect timing issues like these to soar in the coming year.  

Prepare for a Potential Audit 

Here are some ways to ready your organization for this new, upcoming reality. 

1. Assume you’ll be audited. Be ready for a long, protracted fight if the IRS finds problems on your tax return that you believe is incorrect. 

Well before the upcoming tax season, you and your teams should review and upgrade all internal documentation processes. Save all documentation and – this is important – make sure you include citations of IRS code or other legal authority to clarify why and how transactions were completed. This process has two benefits: It will help you and future CFOs recall transactions years from now. It’ll also help instruct and aid your IRS agent who might be new to the job. 

2. Prepare your audit defense team. They might need to teach new IRS hires about the items on your return, as well as the legitimacy of those items. 

3. Preserve calculations used in returns. You’ll need to show them if your organization is audited. Also, make sure to reference the part of the IRS code that gives your company the authority for its calculations. This citation may help you win if you go to tax court.

If you’re concerned that a transaction could raise IRS red flags, get ahead of it. Obtain an opinion letter from a CPA or attorney that states how the transaction is valid. I also recommend disclosing the position on the return. 

Put time on your tax preparer’s calendar to review your returns. This will help you understand and rebut any possible IRS concerns. This is particularly true for companies with returns that include reconciliation schedules M1 and M2 for pass-through entities such as partnerships and S-corps. 

How to Retrieve Attorney Fees in Tax Court

Documenting every element of your company’s tax strategy will not only help it avoid tax penalties but also retrieve attorney’s fees. If the IRS takes a case to tax court and loses, and you can demonstrate that the court case was frivolous, the IRS will reimburse the company for tax attorney fees. Building a comprehensive file for the IRS can help you prove your position and win the case.

Another real-life example, I currently have a fee case before tax court involving a real estate developer who borrowed $6 million from a bank to fund a new development. Although we presented a 300-page loan binder from the bank and a letter from its president noting the loan was being repaid, the IRS agent characterized the loan as income. I expect to win that case and get my client’s attorney’s fees returned to him.

Small and midsize businesses suffer disproportionately from audits. They generally don’t have the time, staff, or budget to handle the reams of paperwork and related costs. As newbie IRS agents start scrutinizing returns, it’s more likely they’ll make mistakes that could increase audits on companies. CFOs of smaller firms need to be more cautious than ever. 

If there’s nothing else you remember to do, make it this: document, document, document. 

Bruce Willey, JD, CPA, is the founder and owner of American Tax and Business Planning, where he advises established businesses, start-ups, and individuals on tax planning, asset protection, exit planning, and estate planning.