Table Of Contents

Introduction and Legal Disclaimer

Federal tax liabilities arise from a variety of sources. The federal tax system depends, to a great extent, upon self-assessment and self-reporting of income, estate and gift, employment, excise and other taxes which are imposed on the taxpayer. This system of self-assessment, by its nature, requires voluntary compliance, accurate calculation, and reporting of the tax due by the taxpayer. The IRS utilizes its authority to conduct audits in order to verify that taxpayers have properly reported their tax due. Along with the power placed in the IRS to enforce the tax laws through audit and assessment, the system is balanced by the rights of the taxpayer to dispute the IRS’s findings within the administrative and court systems. Potential disputes with the IRS can either be Civil, in which only money is at issue, or Criminal, in which there is a possibility of criminal prosecution and imprisonment. To further complicate matters, an audit which is purely Civil at the outset can easily turn Criminal depending on what the auditor learns during the audit. Each type, Civil or Criminal, requires very different responses and procedures.

IRS examinations and appeals are part of an overall system of federal tax liability determinations that includes the taxpayer, the Internal Revenue Service (IRS), the Tax Division of the Department of Justice, the Joint Committee on Taxation, the U.S. Tax Court, Federal District Courts and the U.S. Court of Federal Claims, Federal Courts of Appeal, and the U.S. Supreme Court.

Federal income tax audits can be triggered in a variety of ways. The most common method for selecting a return for audit is through the use of Discriminant Index Function (DIF) formulas. The DIF system is a mathematical technique used to score income tax returns according to their audit examination potential. In general, the higher the DIF score, the greater the audit potential. A taxpayer’s return may be selected based solely on the return’s DIF score. The IRS may also select a taxpayer’s return for audit where the IRS receives conflicting tax information from two or more taxpayers. For example, when third party records such as Forms W-2 or Forms 1099 do not match the information reported on a taxpayer’s return, the taxpayer may be selected for audit. Finally, a return may be selected for audit based on a related examination by the IRS of another taxpayer. For example, returns may be selected for audit when they involve issues or transactions which are related to other taxpayers, such as business partners or investors, whose returns were previously selected for audit.

Once returns are selected for examination, the examination may be conducted as a computer-generated correspondence examination from one of the IRS Campuses, or, in more complex cases, by the Examination Division at the district office level. Area Office examinations may take the form of (1) a correspondence examination, (2) an office examination, or (3) a field examination, i.e., an examination outside of the IRS office, conducted at the taxpayer’s premises. An office examination audit reviews tax returns and third party information by correspondence, with requests for information by mail, phone or an in-person interview when necessary. Office audits usually are reserved for the more routine and lower value type of audit issues, often focusing on specific items or issues on the return. Field examination audits generally involve more significant amounts and issues. Field examinations are normally conducted at the taxpayer’s place of business or the location where the taxpayer’s books, records and source documents are maintained. A taxpayer, however, may make a written request to change the place set for examination. Should a taxpayer be selected for audit, the taxpayer will be notified by an audit notice letter or in rare circumstances, by telephone. In the case of a telephone contact, the IRS will still send a letter confirming the audit. E-mail notification is not used by the IRS.

Criminal tax investigations are conducted either by the IRS’s Criminal Investigations unit (“CI”), or by the Justice Department, typically through the use of a Grand Jury. Unlike New York State, IRS policy dictates that when criminal investigators contact the “target” of the investigation, they must warn that it is a criminal investigation and that statements given to them may be used against the target and that he has a right to remain silent and consult an attorney. However, investigators visiting a “non-target”, such as a CPA as a potential witness, need not give the warning, even though it is possible for that person to subsequently become a target of prosecution. As we will discuss more fully hereafter, one should always refrain from speaking to criminal investigators unless pursuant to advice of counsel, regardless of whether you receive a warning, or are initially considered only a witness rather than a target.

This article is general and informational in nature and you should read the terms of our legal disclaimer regarding its use.

Back to Table of Contents

Preparing For, and Protecting Yourself from, an IRS Audit

The absolute best way to protect against any significant consequences from an audit is retain accurate and sufficient records that support the returns you have filed. While legal issues are often present in any individual or business audit (e.g., the taxability of particular types of income and transactions, or the ability to use a particular deduction), most audits typically rise or fall on the availability and quality of accurate and sufficient records. In general, the taxpayer, and not the IRS, has the burden of proving, other than in the case of fraud, that the amounts claimed as receipts or expenses on a return are correct or that the return was actually filed.

Internal Revenue Code (IRC) §6001 requires every person liable for any federal tax or its collection to keep records, render statements, file returns and comply with such rules and regulations as the Secretary may prescribe. The regulations under IRC §6001 expand on the general record retention rule stating that every person subject to tax, or required to file an information return with respect to income, must keep permanent books of account or records, including inventories, that are sufficient to establish the amount of gross income and deductions, credits, and other matters required to be shown in any tax or information return. Retaining other information may be helpful as well. For example, to prove a capital gain or loss, a taxpayer should maintain records showing when and how the property was acquired, the motive for its acquisition, how it was used and maintained, and when and how it was disposed of. Taxpayers should also maintain records showing the taxpayer’s adjusted basis (historical tax cost) in the property, the gross selling price of the property and any sales expenses.

Moreover, taxpayers claiming specific deductions or credits may be required to retain specific records. An otherwise deductible expense will not qualify as a deduction unless the taxpayer is able to substantiate the expense. For example, a taxpayer is required to substantiate expenses incurred in the taxpayer’s business for which the taxpayer is claiming a deduction under IRC §162. Substantiation of a taxpayer’s business deduction consists of possessing proof of the amount paid or incurred for the expense and providing evidence establishing the character of the expense (e.g., business, personal, capital, charitable, etc.). Only ordinary and necessary expenses incurred for business or profit-seeking purposes are deductible under IRC §162. Examples of items to retain to provide evidence establishing the character and deductibility of the expense are receipts, sales slips, charge slips, payment acknowledgments, signed invoices, check registers, and carbon copies of checks. In the absence of records, the taxpayer may still be able to salvage certain claimed deductions through the use of the Cohan rule which allows a taxpayer to use estimates when they can show that there is some factual foundation on which to base a reasonable approximation of the expense (i.e., when they can prove that they had made a deductible expenditure but just cannot provide documentary evidence of the amount of the expense). However, a taxpayer falling back upon the Cohan rule to support a deduction can expect major push-back from the IRS as to the proper amount of the deduction. In addition, when courts do allow a deduction to be estimated under the Cohan rule, they generally err on the side of the lowest possible estimate under the circumstances.

If the taxpayer has deducted an expense which is listed in IRC §274(d), “strict substantiation” requirements apply and estimates under the Cohan rule are disallowed. The §274(d) strict substantiation requirements apply to deductions claimed for traveling expenses, entertainment items, business gifts, and expenses with respect to §280F(d)(4) listed property (e.g., automobile expenses). lf a deduction is one to which the §274(d) strict substantiation requirements apply, the deduction is not allowed unless, in addition to the regular trade or business expense requirements under §162, the taxpayer must also prove certain information by “adequate records or by sufficient evidence corroborating the taxpayer’s own statement”. To meet the “adequate records” requirements of §274 (d), a taxpayer must maintain records and documentary evidence sufficient to establish each of the following with regard to the expenditure:

  1. the amount of the item,
  2. the time and place the expense occurred,
  3. the business purpose of the item, and
  4. the business relationship to the taxpayer to the recipient of the entertainment item

The required books or records must be kept available at all times for inspection by Internal Revenue officers and must be retained for as long as they may be material in the administration of Internal Revenue laws. Generally, records that support an item of income or a deduction on a tax return should be kept at least for the period of limitation for that return. However, items that can have an effect on future years, such as capital improvements to property that might be sold decades later, should be kept beyond the latest statute of limitations date for the last year upon which they might have an effect. For example, if you add a kitchen to your home for $50,000, it would be a capital improvement raising the adjusted basis of your home. The adjusted basis, inclusive of the cost of the Kitchen, would reduce the gain reportable as income when you sell the home 30 years later. Therefore, you should generally keep documentary proof of the improvement and its cost until seven years after the sale or other disposition of the home.

During an audit, agents request documentary and other information using Form 4564, Information and Document Requests (IDRs). If the taxpayer fails to produce the requested information, the IRS has the authority to issue an administrative summons. Care must be taken to read IDR requests closely. If a request is ambiguous or incomplete, the taxpayer must consider whether it has options to comply narrowly or broadly, and must weigh the benefits and disadvantages of those options.

Extreme care must be taken when the IRS requests information and/or documents that is, or contains, privileged or protected information. Disclosing the documents to the IRS can cause the permanent loss of an otherwise applicable privilege. Partially disclosing portions of a document can cause an implied waiver with respect to the entire document. Likewise, providing a description of the substance of a document may cause an implied waiver with respect to the document. Disclosing a document could also cause a subject matter waiver of privilege on all documents that address the same subject.

If the IRS cannot reconcile the income reported on the tax return to the taxpayer’s books and records, the IRS can use indirect methods to reconstruct the taxpayer’s income. Indirect methods include the bank deposits method, the cash transaction method, the net worth method, the percentage of mark-up method, and the unit and volume method. The IRS is prohibited, however, from using financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the IRS has a reasonable indication that there is a likelihood of unreported income. However, this does not appear to prohibit the IRS from showing that specific items are the source of unreported income (i.e., using a direct or specific item methods of proof), or from requesting personal and business bank records in an initial contact letter from a taxpayer that derives substantial income from Schedules C and F when the return is randomly selected under the National Research Program (NRP).

Back to Table of Contents

Civil Audit vs. Criminal Investigation

The IRS will often assure the taxpayer that examination of the taxpayer’s return does not suggest a suspicion of dishonesty or criminal liability. However, the agent has no authority to assure a taxpayer that his books and records will be used solely for civil purposes. If a taxpayer insists upon such assurances, the agent is instructed to find out the reason why, and, if the taxpayer refuses to provide the requested information, may report the matter to his group manager and even refer the matter for criminal investigation.

Criminal investigations are performed by Special Agents within the IRS’ Criminal Investigations unit (commonly known as CI). If a criminal investigation is commenced, unless they are working undercover, IRS special agents (whose job title alone signifies that the matter is criminal) will identify themselves with their official credentials and are required to give a voluntary equivalent of a Miranda warning. Generally IRS special agents travel in pairs if they are going to interview someone. One special agent conducts the interview while the other takes notes and acts as a witness if necessary. Once a taxpayer becomes aware that the matter is criminal, the taxpayer should, and most likely would, retain criminal counsel for representation.

In the case of any criminal investigation, the taxpayer should not speak to the agents or provide any records or assistance without first contacting counsel who will then make the necessary determinations as to how to proceed. This cannot be overstated. It is stressful to be advised that you are the target of, or even a witness in, a criminal tax investigation. It is only natural to want to end the investigation by simply explaining “your side of the story”. Agents know this, and will often encourage a taxpayer to try to exculpate himself with an explanation, even after giving a warning that the taxpayer can remain silent and get an attorney. Unfortunately, taxpayers often believe what they want to believe, and jump to the bait of being asked to tell their story so the investigation can conclude quickly. Don’t do it. If you are already the target, the agents have already done all the investigation they can before contacting you. They likely have a summons to serve on you whether you talk or not, but will wait until you are finished if you insist on speaking to them.

The appropriate response to being notified that you are speaking to criminal agents is to politely say that you would be happy to speak to them, but you would like to speak to your lawyer first and do so at his direction. Don’t worry about the agents thinking you are guilty if you choose to be silent and get a lawyer. It is smart, not guilty, to take advantage of your rights, and they know it. Be firm. Ask for the agent’s card and tell them you will have your lawyer speak to them to arrange for any information they need.

Back to Table of Contents

Civil Audit Notice – Statute of limitations

Upon receiving a notice of audit, one must first determine whether the periods covered by the audit are within the statute of limitations for assessment. For a civil assessment to be valid, it must be made by a Notice of Deficiency that is mailed, within the statute of limitations, to the taxpayer’s last-known address. The ordinary statute of limitations applicable to personal income tax assessments is three years after the later of the tax return’s due date or date filed. If the return omitted gross income in an amount that exceeds 25% of the gross income reported on the return, the limitations period is extended to six years. An overstatement of the basis of an asset that causes income reported to fall short by more than 25% will extend the statute to six years as well. An item will not be considered as omitted from gross income if information sufficient to apprise the IRS of the nature and amount of such item is disclosed in the return or in any schedule or statement attached to the return. Corporate income taxes are subject to similar three- and six-year limitations statutes. If an income tax return is fraudulent, there is no statute of limitations for a civil assessment.

None of these civil limitation periods begin to run until a return is filed. The statute is always open if the taxpayer has not—or cannot prove that he has—filed the return. Proof of filing the return should be preserved forever to support a statute of limitations defense. If a taxpayer cannot prove a return has been filed, he can be audited and assessed at any time because the statute has cannot be proven to have begun to run. An IRS auditor must obtain approval before initiating an examination on any return with less than 12 months remaining on the statute of limitations for assessment.

When a civil statute of limitations is about to expire and the IRS had not completed its audit review, the taxpayer will often be asked to sign Form 872, Consent to Extend the Time to Assess Tax, prior to its expiration. A taxpayer can refuse to extend the assessment period and the IRS is required to inform the taxpayer of his or her right to refuse to extend the statute of limitations. Taxpayers, however, often execute the waiver under a threat that a refusal to extend will result in an immediate issuance of a notice of deficiency because no further audit examination will be possible in the time allotted. Such a notice, however, may not be issued without substantive basis solely to hold the statute open.

There are also certain circumstances when a taxpayer may decide to limit or refuse to extend the assessment statute of limitations. For example, the taxpayer may not want to provide the IRS additional time to consider additional audit issues or the taxpayer may not want to allow the IRS the opportunity to further develop audit issues already under consideration. With regard to limiting the IRS’ opportunity to further develop audit issues, the taxpayer may refuse to sign the limitations extension in order to force the hand of the IRS where there is the potential that the audit will become criminal. In addition, in cases where the civil fraud penalty could potentially be assessed, but information available at the time makes it unclear as to whether fraud exists or whether the IRS can carry its burden of proof, the taxpayer would be best advised to refuse the limitation extension and force an assessment. As previously mentioned above, if the Service asserts and can meet its burden in proving fraud, the statute of limitations on assessment never expires.

The IRS generally will not let the assessment period get within six months of its expiration date without a waiver or assessment. Generally, taxpayers and their counsel execute such waivers to avoid an assessment and allow time for negotiation. Alternatively, taxpayers can offer to extend the assessment period only with respect to particular issues, by means of a restricted consent. This can be effective at the end of the audit process, when the IRS has narrowed down the scope of the examination. However, sometimes the advantage inherent in terminating any further audit review or inquiry offsets the risk and costs of dealing with an immediate assessment, and a refusal to waive is appropriate. These involve very complex and technical tactical and legal issues, requiring judgment calls that are best resolved with the assistance of an experienced professional tax attorney. .

Back to Table of Contents

Criminal Tax Offenses – Statute of Limitations

If an audit is determined to be criminal in nature, one must first determine whether the periods covered by the audit are within the statute of limitations for assessment. Even if fraudulent concealment is established, a defendant cannot be convicted of tax evasion unless an additional tax is actually due. However, there are numerous tax crimes for which no evidence of tax evaded is required. Thus, you can be convicted of filing a false information return without any proof that taxes were evaded thereby.

The statute of limitations on criminal offenses is six years from the date the offense was committed. In the tax area, most disputes about the statute of limitations center on determining when the last act in furtherance of the “offense” was committed. When the willful act is alleged to be the filing of a false return under IRC §§7201 and 7206(1), the crime generally is deemed to have been committed when the return was actually filed (not on the due date), and the first day of the six-year limitation period is the day after filing. It is clear, however, that the willful act in a tax evasion case can occur after the filing of a false return.

For example, because false statements made to Treasury representatives during an investigation of the return constitute the completion of the crime, the statute may begin to run at the time the last false statement ismade, or false document submitted. When the due date for a return has been extended by an agreement between the taxpayer and the IRS, the statute of limitations for crimes based upon a false return begins to run when the return is actually filed, not when the return was originally due. On the other hand, if a fraudulent return is filed before its due date, the six-year limitations period does not begin running until the actual due date.

For the offense of willful failure to file a return, the crime is ordinarily completed and the limitation period starts to run on the day the return is due, taking any extension periods into account.

The six-year statute of limitations for prosecution of a taxpayer who commits a series of evasive acts over several years after incurring a tax liability begins to run on the date of the last evasive act, according to the Tenth Circuit in U.S. v. Anderson, 319 F3d 1218, (10th Cir. 2003003, 319 F3d 1218.

Back to Table of Contents

Effect of a Criminal Tax Plea on Civil Liability

A major issue in resolving any criminal tax charge is the collateral estoppel effect of a guilty plea on corresponding civil liabilities. The “criminal numbers” typically are used in settling the criminal case and consist solely of the liabilities that the IRS can prove “beyond a reasonable doubt.” “Collateral estoppel” is a doctrine “barring a party from relitigating an issue determined against that party in an earlier action, even if the second action differs significantly from the first one.” This doctrine typically deprives the taxpayer of any defense to significantly higher civil assessments for which the taxpayer has the burden of proof as well as onerous civil fraud penalties and interest. In the tax context, this means that once the taxpayer takes a criminal guilty plea and agrees to pay the tax criminal numbers, he is defenseless in a subsequent civil audit covering the same periods in which the tax authorities, both federal, state, and local can seek additional higher civil tax assessments for the same periods under the reduced standards of proof applicable in civil matters. Therefore in any criminal matter, the “800 pound gorilla in the room” is always the potential follow-up civil tax liabilities which should always be considered and dealt with in a comprehensive, global manner whenever possible.

Back to Table of Contents

Representation at the Audit

Taxpayers may deal directly with the taxing agency, or engage a representative to do so for them. Except in the very simplest audits with the very least amount at stake, it is always advisable to obtain expert advice and representation. Attorneys, Certified Public Accountants and Enrolled Agents are all authorized to represent taxpayers before the taxing authorities. Each brings a different set of skills and qualifications to the task of representing the taxpayer, with the particular skill, education and experience of the representative being the most important factor in determining the outcome. If there are any possible criminal tax repercussions from the audit, however, the only representative that one should choose is an attorney. That is because only attorneys possess the necessary Attorney-Client privilege to allow you to speak freely to them without the risk that they will be compelled to testify about your statements to them in a subsequent proceeding. Although recent legislation gives other types of representative’s confidentiality protection against forced disclosure in purely civil tax proceedings, no such privilege attaches in Criminal tax cases to anyone accept a licensed attorney who was consulted for his legal advice. Thus the mere fact that someone is an attorney does not afford privilege when he is only retained for the purpose of preparing tax returns, without associated legal advice. Attorneys who specialize or concentrate in the area of taxes often have a graduate law degree in taxation known as an LLM (taxation) from a respected Law School graduate tax program. Even if the matter is not criminal, in choosing a representative for a contested or potentially contested tax matter, it is important to understand that, at the end of the day, the tax dispute may ultimately be resolved by litigation in a judicial or administrative body. A representative who is to be effective in that environment requires litigation skills and experience before tax tribunals in addition to any substantive tax knowledge required to present the case. For tax controversies that generally requires an attorney with tax litigation experience and expertise. When matters involve criminal exposure as well, a team consisting of attorneys with both substantial tax and white collar criminal expertise is often optimal.

Back to Table of Contents

Conducting and Concluding the Federal Tax Audit

During the audit, be cooperative without giving away any substantive rights. It is not generally a good idea to volunteer anything. Let the auditors do their job and neither be obstructionist nor unnecessarily helpful. There is a certain rhythm to audits and they must run their course. Patience is a virtue in audit matters: attempts to speed things up are often counterproductive. However, dragging things out unreasonably is not only improper, but is likely to create more problems than it solves.

If there is a statute of limitations that will soon expire, the auditor will request a waiver of the statute of limitations as the price for continued discussions. This is something that should not be taken lightly. Although it is often executed by taxpayers and their representatives without much thought, the waiver surrenders significant protection which should not be done without weighing all the facts and circumstances as well as tactical considerations. The statute is discussed in more detail at Civil Audit Notice- Statute of limitations.

There are four possible outcomes to an examiner’s review of a return:

  • No change: the examiner proposes no change in the taxpayer’s tax liability;
  • Agreed: the examiner proposes adjustments to the taxpayer’s tax liability and the taxpayer agrees to sign a consent with respect to all of the adjustments;
  • Unagreed: the examiner proposes adjustments to the taxpayer’s tax liability and the taxpayer does not agree to sign a consent with respect to all adjustments; or
  • Partially Agreed: the examiner proposes adjustments to the taxpayer’s tax liability and the taxpayer agrees to sign a consent with respect to some of the adjustments, but not to others.

Auditors prefer an “agreed” case and this is often the basis for getting the best possible result. Often items are discussed, pro and con, as they come up during the audit although all negotiation should be based on the final “bottom line” at the conclusion of the audit. The audit supervisor or group chief is often the invisible guest at negotiation sessions. An auditor cannot merely give away an issue; it is your job to present them with a rational and plausible explanation or legal theory for doing what you would like him to do.

In particular, understand that the most effective negotiating style is that known as “win-win”. There doesn’t have to be a loser in a negotiation if both sides properly state and support their positions and act reasonably. Becoming offensive or hostile is not beneficial to either side, and a mutually acceptable conclusion is often the best, and most cost effective, possible outcome.

An Important Caveat

If you are not likely to reach an agreement, do nothing to improve the quality of a proposed adjustment. The second best thing to an agreed solution is one in which the agent takes a ridiculous or unsupported position that can easily be defeated on appeal. If you spend too much time instructing an uncooperative or unreasonable agent on the weaknesses in his proposed adjustment, it’s quite likely to lead to a stronger and more difficult adjustment, rather than a sudden revelation in the agent that you are right and should not be assessed. Often there are significant differences in approach required for Federal vs. State and Local audits and negotiations. It is OK to avoid unnecessary disclosure where possible, but not to perpetrate a fraud. Try not to be spontaneous. Get all questions in as formal a manner as possible and consider the possibilities.

At the conclusion of the audit, the auditor will generally invite an informal discussion either before or after issuing a Notice of proposed deficiency. The process of negotiation will often result in an informal agreement before any formal documents are issued at the conclusion of the audit. Therefore, the issuance of the documents becomes a mere formality, reflecting the deal the parties have already reached.

Back to Table of Contents

Audit Adjustments: Consenting and Pitfalls

An examination by the IRS of a taxpayer’s return may result in a determination that additional tax is owed. In such cases, the IRS will typically issue the taxpayer a Notice of Proposed Deficiency (commonly known as a 30-Day Letter), which details the nature and amount of the proposed adjustments. The Notice is prepared on, and often referred to as, a Form 5701. The Form 5701 is usually transmitted along with the revenue agent’s report (RAR). The RAR contains all the proposed adjustments, and a recomputation of tax liability showing the proposed deficiency.

The 30-Day Letter also outlines the taxpayer’s right to appeal the proposed adjustments by filing an administrative protest with IRS Appeals within 30 days of receiving the Notice of Proposed Deficiency. Upon issuing the 30 Day Letter, the auditor will solicit the taxpayer to execute a consent to their findings. The amount and character of these proposals will often incorporate the results of negotiations and agreements between the taxpayer and the auditors. If the taxpayer agrees with the proposed adjustments, the IRS will request that the taxpayer sign a Form 870, “Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment.” By executing a Form 870, the taxpayer waives the right to receive a statutory notice of deficiency and thus forfeits the right to go to Tax Court. The taxpayer, however, does not waive the right to file a refund claim and to proceed to refund litigation after the taxes have been paid. As a practical matter, signing the Form 870 often bring closure to the audit. It is the IRS’s policy not to reopen (for the purpose of making an unfavorable adjustment against the taxpayer) an examined case that has been closed as agreed unless (1) there is evidence of fraud, malfeasance, collusion, concealment, or misrepresentation of a material fact; (2) the closed case involved a clearly defined substantial error based on an established IRS position existing at the time of the previous examination; or (3) other circumstances exist indicating that the failure to reopen would be a serious administrative omission. Still, a taxpayer must be fully aware of the consequences of executing even an agreed-to consent if the taxpayer is to avoid simply substituting one problem for another.

A final federal determination triggers the commencement of time-sensitive state reporting requirements which are often accompanied by noncompliance penalties. In New York, a taxpayer has 90 days after the federal change to report such changes to New York. The taxpayer can avoid the imposition of penalties and penalty interest by filing the amended returns through New York’s voluntary disclosure program.

Back to Table of Contents

When Negotiation is Not Enough

With federal tax audits, negotiation is generally the preferable approach to conclude all but the most difficult of audits. If, however, the taxpayer disagrees with the proposed audit changes, and a negotiated agreement cannot be reached, there are several options available for protesting the deficiency.

As discussed above, the taxpayer may seek an administrative appeal of the agent’s findings by filing a protest with the IRS Appeals Division following the issuance of the 30-Day Letter. If the total amount of proposed additional tax, additions to tax and penalties, proposed overassessment, or claimed refund, credit, or abatement for any tax period, does not exceed $50,000, a request for an appeal is made using small case procedures, which simply requires a written request asking for Appeals consideration, indicating the changes the taxpayer does not agree with, and stating any reasons for the disagreement. A case with a deficiency exceeding $50,000 requires a formal written protest. A protest generally will be reviewed at the group level within seven calendar days of receipt to determine whether the protest is adequate, whether the case requires further development by the examiner, whether the examination report should be modified, and whether the written protest includes the requested information.

If the taxpayer and the IRS reach an agreement on the disposition of the proposed adjustments at the Appeals Division, the case is closed either with a Form 870-AD or a Form 906, ‘Closing Agreement.” Otherwise, the taxpayer may decide to litigate the issue in one of the three available forums: U.S. tax court, federal district courts or the U.S. Court of Federal Claims.

If the case remains unagreed after meeting with IRS Appeals, or alternatively, if the taxpayer does not seek Appeals consideration, the IRS will issue a statutory notice of deficiency (also known as a 90-day letter). Starting on the day after the 90 day letter is issued, the taxpayer has 90 days (150 days if the notice is addressed to a person outside the United States) to file a petition with the Tax Court to contest the proposed deficiency. The notice of deficiency is important since it provides the taxpayer with the ability to contest the proposed deficiency in Tax Court without having to prepay the tax, and provides the Tax Court jurisdiction to redetermine the proposed deficiency. If the taxpayer did not pursue an administrative appeal with IRS appeals prior to filing their petition with the Tax Court, IRS Appeals may consider settlement of the case for a limited period of time after the tax court petition is filed. Appeals will only consider the case at this juncture, however, if it had not previously considered the case. If a taxpayer reaches an agreement with Appeals, the settlement is made by a stipulation of agreed deficiency or overpayment filed with the Tax Court. If the taxpayer is unable to reach a settlement with Appeals during the time allowed, Appeals consideration will stop and the Tax Court case will proceed.

Until there is a final determination with regard to the proposed deficiency, the taxpayer is not required to pay the proposed deficiency. However, the interest on the proposed deficiency continues to run until paid. To stop the continued running of interest during the pendency of an appeal or tax court proceeding, the taxpayer can choose to make a deposit of the proposed deficiency, including interest and penalties. Care must be taken to ensure that the payment is properly designated as a deposit in accordance with IRS procedures.

It is strongly recommended that you be represented throughout this process by a person with the education, credentials and experience appropriate to the issues presented. The further you go in the process, the more difficult it is for someone without legal tax litigation training and experience to properly plead your cause. Further, as opportunities for resolving the problem are lost through lack of expertise, it becomes more and more difficult for even a professional to resolve the problem the further in the process you go unrepresented.