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IRS Tax Administration and Audit Procedures

Learn about the responsibilities of the IRS in tax administration and enforcement, including audits and collection procedures. Understand how the IRS conducts letter rulings and determination letters for taxpayers. Explore the administrative powers of the IRS and its audit selection process.

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IRS Tax Administration and Audit Procedures

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Presentation Transcript

  1. Chapter 17 Tax Practice and Ethics

  2. Tax Administration (slide 1 of 3) • The IRS is responsible for administration and enforcement of the tax laws • Provides info to taxpayers through publications and forms with instructions so taxpayers can comply with the tax law • Identifies delinquent tax payments • Carries out assessment and collection procedures

  3. Tax Administration (slide 2 of 3) • In meeting its responsibilities, the IRS conducts audits of selected tax returns • About 1% of all individual tax returns are audited each year • Certain tax returns, such as those for high income individuals or cash-oriented businesses, have a much higher audit rate

  4. Tax Administration (slide 3 of 3) • To enhance its enforcement efforts, the IRS has focused much effort on: • Developing requirements for information reporting and document matching • Increasing pressure on tax advisers • The IRS has recently undertaken a major reorganization and adopted new operational strategies aimed at improving its efficiency while enhancing its interaction with taxpayers

  5. Organizational Structure of the IRS

  6. Letter Rulings (slide 1 of 3) • When a tax issue is controversial or involves significant tax dollars, a taxpayer may request a letter ruling from the IRS • The ruling provides a written statement of the position of the IRS concerning the tax consequences of a course of action contemplated by the taxpayer

  7. Letter Rulings (slide 2 of 3) • The ruling can only be relied upon by the party requesting the ruling • Other taxpayers may use the ruling as an indication of the IRS’ position on the matter • Letter rulings are generally followed by the IRS for the taxpayer who requested the ruling as long as all material facts of the transaction were accurately disclosed in the ruling request

  8. Letter Rulings (slide 3 of 3) • Letter rulings may be declared obsolete by the IRS for other taxpayers • A fee is charged by the IRS for processing a ruling request

  9. Determination Letters • Provide guidance regarding a completed transaction when the issue involved is covered by judicial or statutory authority, regulations, or rulings • Issued for various estate, gift, income, excise, and employment tax matters

  10. Technical Advice Memorandum • Issued by the National Office to IRS personnel in response to a request by an agent, Appellate Conferee, or IRS executive • May be requested by taxpayer when an issue in dispute is not treated by the law or precedent and/or published rulings or regulations • Also appropriate when there is reason to believe that the IRS is not administering the tax law consistently

  11. Technical Expedited Advice Memorandum (TEAM) • Can be used during an office or field audit • Designed to reflect the position of the IRS in a shorter time than a TAM otherwise would take • This quicker response time is possible because prior to submitting the TEAM request • The taxpayer and IRS agree to the facts and conduct a presubmission conference • Technology, including e-mails and faxes, is used to gather facts as part of the process • The IRS holds an internal strategic planning meeting, discussing potential responses to various holdings that could be issued as part of the TEAM

  12. IRS Administrative Powers(slide 1 of 3) • Examination of records • The IRS can examine a taxpayer’s records to determine the correct tax due • Burden of proof • If taxpayer meets the record keeping requirement and substantiates income and deductions properly, the IRS bears the burden of proof in establishing a tax deficiency during litigation

  13. IRS Administrative Powers (slide 2 of 3) • Assessment and demand • The IRS can assess a tax deficiency and demand payment of a tax • The assessment cannot be made until 90 days after a “statutory notice of deficiency” is issued to the taxpayer • During the “90 day letter” period, taxpayer may file a petition with the U.S. Tax court, which prevents the IRS from collecting the amount until after the Tax Court case is resolved • After assessment the IRS demands payment within 30 days

  14. IRS Administrative Powers(slide 3 of 3) • IRS collection procedures • If the taxpayer does not pay an assessed tax, the IRS can place a lien on all property belonging to the taxpayer • The IRS can garnish (attach) wages and salary and seize and sell all nonexempt property by any means • A taxpayer’s principal residence is exempt from the levy process, unless • The disputed tax, interest, and penalty exceed $5,000 and • A U.S. District Court judge approves of the seizure

  15. IRS Audit Selection(slide 1 of 3) • The IRS does not disclose its audit selection process • Utilizes mathematical formulas to select returns: • Likely to contain errors and • Yield a substantial amount of additional tax revenue

  16. IRS Audit Selection (slide 2 of 3) • Examples of audit selection • Certain taxpayers are more likely to be audited such as: • Individuals with gross income > $100,000 • Self-employed individuals with substantial business income and deductions • Cash businesses where potential for evasion is high

  17. IRS Audit Selection (slide 3 of 3) • Most audits of individual tax returns are started about two years following the date the return is filed

  18. Types of IRS Audits(slide 1 of 3) • Correspondence audits • The return is checked for mathematical accuracy or clearly erroneous deductions, etc. soon after the return is filed • In addition, several months after filing, all 1099s and W-2s and other matching information is verified • If a discrepancy is found in either of these cases, the IRS simply sends the taxpayer an explanatory letter and a bill or a refund

  19. Types of IRS Audits (slide 2 of 3) • Office audits • These audits are frequently limited in scope, and can be conducted in the IRS office • The taxpayer is generally asked to substantiate the items requested (i.e., present invoices, canceled checks, etc.)

  20. Types of IRS Audits (slide 3 of 3) • Field audits • Commonly used for corporate returns and for returns of individuals engaged in business or professional activities • These audits are generally conducted at a taxpayer’s home or business

  21. Audit Procedures (slide 1 of 4) • Prior to or at the initial interview, the IRS must • Provide the taxpayer with an explanation of the audit process and • Describe the taxpayer’s rights under that process • IRS representative must suspend the interview if the taxpayer clearly states a desire to consult an attorney, CPA, or enrolled agent

  22. Audit Procedures (slide 2 of 4) • The IRS must grant permission to make an audio recording of any interview, upon advance request • On completion of the examination, the IRS agent will file a Revenue Agent’s Report (RAR) outlining recommended changes to the return (if any)

  23. Audit Procedures (slide 3 of 4) • The RAR is reviewed internally before the IRS assesses an additional tax • The taxpayer may accept the RAR or appeal within the IRS • Appeal within the IRS must be accompanied by a written protest unless: • The amount of tax does not exceed $10,000 for any tax year • The adjustment resulted from a correspondence or office audit

  24. Audit Procedures (slide 4 of 4) • Settlement with an IRS agent is based solely on the merits of the case, given IRS policy • Settlement at the IRS appeals level can be based on the “hazards of litigation”—e.g., the likelihood that the courts would agree with the IRS position

  25. Offers in Compromise and Closing Agreements (slide 1 of 2) • Offers in compromise • IRS can negotiate a compromise if taxpayer is financially unable to pay the tax • May result in IRS accepting less than full amount of tax due • Final payment of taxes may be allowed through installment payments

  26. Offers in Compromise and Closing Agreements (slide 2 of 2) • Closing agreements • May be used: • When disputed issues carry over to future years • To dispose of a dispute involving a specific issue in a prior year or a proposed transaction involving future years • Binding on taxpayer and IRS

  27. Interest(slide 1 of 3) • Congress sets interest rates applicable to underpayments and overpayments of tax • Rate is determined quarterly • Based on federal short-term rates • For noncorporate taxpayers • The interest rate for both over- and underpayments is 4% for the first quarter of 2010 • For most corporate taxpayers • The rate is 3 % for overpayments and 4% for underpayments

  28. Interest (slide 2 of 3) • IRS deficiency assessments • Interest accrues from unextended due date of return until 30 days after taxpayer agrees to the deficiency by signing Form 870 • If amount due is not paid within 30 days interest again accrues on the deficiency

  29. Interest (slide 3 of 3) • Refund of taxpayer’s overpayments • If refunded within 45 days after return is filed or is due, no interest is allowed • If taxpayer files an amended return or a claim for a refund of a prior year’s tax, interest is accrued from the original due date of the return • Even then, no interest accrues until a return is filed or, if the return has been filed, if the IRS pays the refund within 45 days

  30. Taxpayer Penalties (slide 1 of 11) • A comprehensive array of penalties are used to promote compliance with the tax law • Failure to file a tax return • Penalty is 5% per month (up to 25%) on amount of tax due • Minimum penalty is $135 • If failure is due to fraud, rate is 15% per month (up to 75%)

  31. Taxpayer Penalties (slide 2 of 11) • Failure to pay tax due • Penalty is 1/2% per month (up to 25%) on amount of tax due • If failure is after notice of deficiency is received, rate is 1% per month • Both above penalties can be eliminated if reasonable cause exists for failure to file or pay • Failure to file penalty is reduced by any failure to pay penalty for the same month

  32. Taxpayer Penalties (slide 3 of 11) • Accuracy-related penalties • 20% of portion of tax underpayment due to: • Negligence or intentional disregard of law • Substantial understatement of tax liability • Substantial valuation overstatement • Substantial valuation understatement • Penalty applies only if taxpayer fails to show a reasonable basis for the position taken on the tax return

  33. Taxpayer Penalties (slide 4 of 11) • For purposes of this accuracy-related penalty • Negligence includes any failure to make a reasonable attempt to comply with the tax law • Penalty also applies to any disregard of rules and regulations whether careless, reckless, or intentional • Penalty applies to all taxes except when fraud is involved • Penalty can be avoided upon showing reasonable cause

  34. Taxpayer Penalties(slide 5 of 11) • Substantial understatement of tax liability • Occurs when tax understatement exceeds the larger of 10% of amount due or $5,000 • For a C corporation, a substantial understatement occurs when tax understatement is the lesser of • 10% of the tax due, but at least $10,000 • $10 million • This penalty applies unless: • The taxpayer has substantial authority for the tax treatment • Relevant facts are disclosed in the tax return

  35. Taxpayer Penalties (slide 6 of 11) • Penalty for overvaluation of an asset • Penalty is 20% of additional tax that would have been due if correct valuation had been used • Penalty applies if valuation is 150% or more of correct valuation • Penalty is doubled if the valuation is overstated by 200% or more • Penalty applies only to extent that resulting tax underpayment exceeds $5,000 ($10,000 for C corporations)

  36. Taxpayer Penalties (slide 7 of 11) • Penalty for undervaluation of an asset • Penalty is 20% of additional tax that would have been due if correct valuation had been used • Penalty applies if the valuation is 65% or less than the correct amount • Penalty is doubled if the reported valuation was 40% or less than the correct determination • The penalty applies only to an additional transfer tax liability in excess of $5,000

  37. Taxpayer Penalties (slide 8 of 11) • Appraiser’s Penalty • When a valuation penalty arises due to reliance on an appraisal and the appraiser knew the appraisal would be used as part of a tax or refund computation, then the appraiser pays a penalty equal to the lesser of: • 10% of the tax understatement, but at least $1,000, or • 125% of the gross income received by the appraiser from the engagement (e.g., the appraisal fee collected)

  38. Taxpayer Penalties (slide 9 of 11) • Penalty for Improper Refund Claim • If a refund claim is filed and later found to exceed the final amount allowed by the IRS or a court, a penalty of 20% of the disallowed refund results • The penalty is waived if the taxpayer can show a reasonable basis for the refund claim (i.e., probably a 20% chance that a court would allow the refund) • This penalty is meant to discourage the taxpayer from overstating the amount of the refund requested from the IRS

  39. Taxpayer Penalties (slide 10 of 11) • Civil fraud penalty • 75% penalty on any underpayment resulting from fraud by the taxpayer • For this penalty, burden of proving taxpayer civil fraud by a preponderance of evidence is on the IRS

  40. Taxpayer Penalties (slide 11 of 11) • Criminal penalties • Various monetary fines and/or imprisonment may be assessed • Burden of proof is on IRS to show guilt beyond the shadow of any reasonable doubt

  41. Estimated Taxes(slide 1 of 3) • A penalty is imposed for failure to pay estimated taxes • Applies to individuals, corporations, trusts, and certain estates • Penalty is not imposed if tax due < $500 for corporations, $1,000 for all others • Quarterly estimated tax payments should be paid on 15th day of the 4th, 6th, and 9th months of the current year and the 1st month of the following year • Corporations must make the last quarterly payment by the 12th month of the current year

  42. Estimated Taxes(slide 2 of 3) • An individual’s underpayment of estimated tax is the difference between the estimates that were paid and the lesser of : • 90% of the current-year tax, • 100% of the prior-year tax • If prior-year AGI > $150,000, the required payment for the prior-year alternative is 110 % • 90% of the tax on an annualized income basis

  43. Estimated Taxes(slide 3 of 3) • A corp.’s underpayment of estimated tax is the difference between the estimates paid and the lesser of: • The current-year tax, • The prior-year tax, and • The tax on an annualized income computation • For the prior-year alternative • The prior tax year must have been a full 12 months, and • A nonzero tax amount must have been generated for that year • For large corporations (taxable income of $1 million or more in any of the 3 immediately preceding tax years) • Can use this alternative only for the 1st installment

  44. Other Penalties(slide 1 of 3) • False Information with Respect to Withholding • A civil penalty of $500 applies when a taxpayer claims withholding allowances based on false information • A criminal penalty for willfully failing to supply information or supplying false or fraudulent information is an additional fine of up to $1,000 and/or up to one year of imprisonment

  45. Other Penalties (slide 2 of 3) • Failure to Make Deposits of Taxes and Overstatements of Deposits • A penalty of up to 15% applies for failure to pay the FICA and income tax amounts withheld from wages of employees • A 100% penalty applies if the employer’s actions are willful • In addition, the employer remains liable for the employees’ income and payroll taxes that should have been paid

  46. Other Penalties (slide 3 of 3) • Failure to Provide Information Regarding Tax Shelters • A tax shelter organizer must register the shelter with the IRS before any sales are made to investors • A penalty of up to $10,000 is assessed if the required information is not filed with the Service • The shelter organizer must also maintain a list of identifying information of all its investors • Failure to fully and truthfully maintain the list can result in a penalty of up to $100,000 per investment

  47. Statutes of Limitations (slide 1 of 2) • In general, any tax imposed must be assessed within 3 years of filing the return (or, if later, the due date of the return) • Exceptions to the 3 year rule include: • If no return is filed or a fraudulent return is filed, there is no statute of limitations • If taxpayer omits gross income > 25% of gross income stated on the return, statute of limitations is extended to six years

  48. Statutes of Limitations (slide 2 of 2) • Refund claims • Must be filed within 3 years of filing the tax return or within 2 years following payment of the tax, if later • A 7 year period applies to refund claims relating to bad debts and worthless securities

  49. Circular 230 (slide 1 of 4) • Generally, practice before the IRS is limited to CPAs, attorneys, and enrolled agents • In limited situations, other parties may be allowed to practice before the IRS • A taxpayer may always represent himself or herself • Employees may represent their employers • Corporations may be represented by their officers • Partnerships may be represented by any of the partners • Trusts, receiverships, guardianships, or estates may be represented by their trustees, receivers, guardians, or administrators or executors • A taxpayer may be represented by whoever prepared the return for the year in question (only through the agent level)

  50. Circular 230 (slide 2 of 4) • Circular 230 prescribes rules governing practice before the IRS • Includes prohibitions against: • Taking a position on a tax return unless there is a realistic possibility of it being sustained • Taking frivolous tax return positions • A frivolous return is one with a less than 5% chance of being sustained by the courts

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