I had just left our Scarsdale, N.Y., headquarters on a business trip a couple of years ago when an Internal Revenue Service collections officer named Celeste Green stormed in, waving a “Notice of Intent to Levy” and demanding that we pay the IRS $25,000 by the end of that month.
Since I was not present, Green directed her brusque comments to our perplexed receptionist, who knew nothing about our business taxes, and to our equally perplexed administrative manager, Pascale Bocchino, who did. Pascale keeps our books and has worked out many snafus involving payroll, property and sales taxes over the years. We are diligent about complying with the tax laws — we are in the business, after all — and problems typically involve paperwork that was mishandled, most of the time on the government’s end.
But Green was not the sort of helpful customer service agent Pascale usually deals with. A collections officer gets involved only after the IRS has repeatedly tried to get a taxpayer to remit money that the government believes it is owed but which the taxpayer has neither paid nor properly challenged. We, on the other hand, had no idea that the IRS thought it had a problem with us. Green offered no documentation for why we supposedly owed all that money, and she was not particularly helpful when Pascale asked.
After some stonewalling, she told Pascale that a recent income tax deposit of $268 (representing withholding taxes for an employee’s maternity leave disability pay) was not timely because it was paid by check rather than electronically. That, said Green, resulted in penalties that brought the bill to $25,000. She told Pascale to pay up. Pascale told Green we would get back to her.
After talking to me, Pascale turned the problem over to Rebecca Pavese, who manages our firmwide tax practice from our Atlanta office and who had, coincidentally, just wrapped up an unrelated audit of one of my personal returns. Rebecca and I both knew that, though some of our tax laws are pretty strange, nobody ends up owing $25,000 because he or she makes a $268 payment by check.
Rebecca got to the root of the problem the next day. A few months earlier, the IRS processing center in Cincinnati had failed to enter data from our quarterly payroll tax return showing the various dates on which we had paid our employees. The data demonstrated that all of our withholding taxes were paid on time, but since it was missing, the IRS computers concluded that our payments were late. The processing center should have sent several letters alerting us to the problem. We never received any. Eventually, the computers referred the matter to collections.
An IRS customer service representative in Cincinnati canceled the liability as soon as Rebecca resubmitted the information. Rebecca notified Green, the collections officer.
Green was furious that Rebecca had contacted the processing center, which no longer had authority over the matter. The collections officer said she knew all along what the problem was. Then she reversed the IRS representative’s adjustment and put our nonexistent liability back on the books.
This forced Rebecca to interrupt her other work to immediately prepare IRS Form 12153, “Request for a Collection Due Process or Equivalent Hearing.” This submission prevented the collections officer from commanding our bank to hand over our money to satisfy a debt we did not owe. Though she took her sweet time about it, Green eventually got around to closing the case on her own.
This is not how the tax enforcement process is supposed to work. It is not how it usually works. Audits and collection procedures are not supposed to trick or bully taxpayers into paying fictitious taxes or incorrect penalties. Tax administrators are supposed to try to determine the proper tax, no more and no less, and see that it is paid. Taxpayers and tax practitioners such as those at my firm have the same obligation.
I got into the tax business 25 years ago, and for the most part, the revenue agents I have encountered were not out to victimize innocent citizens. They were just doing their jobs. Those who staff the IRS service centers, in particular, frequently try their best to sort out the foul-ups that byzantine laws and antiquated information systems regularly create.
Still, a quarter-century of representing other taxpayers and of running my own business has made me look at each tax audit as a minefield that contains a relatively safe path surrounded by hidden dangers. Here are my survival tips, and some of the war stories about how I learned them.
1. Don’t assume that the tax authorities are correct. Federal and state tax offices send out huge numbers of notices advising taxpayers that they owe money. If you carefully gathered your tax information and had someone competent prepare your return, there is a good chance such a notice is incorrect. But a lot of people just pay the bill. Check the facts, or ask your tax preparer to take a look.
In a more complex field audit, the revenue agent’s primary job is to gather facts. He or she has to know how to apply the law to those facts, but very often, in our experience, the agent does not understand the law, or sometimes even the facts.
The audit of my personal return that Rebecca handled for me was a good example. I had been expecting an audit, because my business income and expenses are mostly reported on the Form 1040 I file jointly with my wife, and my business has become much bigger than most similar sole proprietorships. So it was no surprise when an auditor asked for extensive detail about my business receipts, all of our business and personal banking transactions, and the three largest expense items reported for the business. He was probing to see if I might be skimming cash or otherwise hiding income, and whether I had records to support the expenses I claimed. This was all standard procedure.
The agent was polite and professional, but he had trouble digesting the information we presented. He calculated that the money the business distributed to me exceeded the taxable income I reported that year, and asserted that I must have had “unreported cash receipts” equaling tens of thousands of dollars. But he had looked at all of the bank statements and saw that all our receipts were properly recorded. Moreover, we never receive cash in our business, so I could not have had any unreported cash receipts. Our clients pay us hundreds or thousands of dollars at a time, always by check, credit card or bank transfer. The auditor had already signed off on this.
Rebecca explained that there are a lot of reasons the business could distribute more money than it reported as income in a given year. The business did not start the year with zero in the bank. It could draw on credit lines. The owner could contribute capital that would not be included in taxable income. It could receive cash distributions from partnerships whose income is reported separately. Some expenses, such as profit-sharing contributions, would be deducted in the current year but not actually paid until the next year. Other business expenses were paid by me from personal funds and were later reimbursed by the business. All of these reasons applied to us.
Still, the agent persisted in a ludicrous argument that I had “constructively received” income from myself. Rebecca told him to write up his assessment and send the case to the IRS Appeals office, where we would take it up with an independent reviewer. But first, the agent asked Rebecca to join a conference call with him and two supervisors. They tried to pressure her to agree to his assessment. When she held her ground, the trio muted the phone for a private conversation, then came back on the line and conceded the case.
The same auditor told Rebecca that the holiday gratuities we pay our building’s superintendent and garage staff could not be deducted beyond $25. We have never heard of such a limit, and the agent could not point to anything supporting it. His supervisors conceded that point, too.
We often find that field agents lack a detailed knowledge of the law, or seem to simply make up rules that are not in the tax code or regulations. In part, this is because field agents are some of the least experienced and least trained personnel in the enforcement staff. Those with greater knowledge tend to be promoted to appeals or other review-level positions. Educating the agent is part of our job when we represent a taxpayer, but what about individuals who represent themselves and who know even less about the tax laws than the auditor? They are vulnerable to pulled-out-of-thin-air declarations such as my agent’s $25 gratuity limit.
2. Do not represent yourself. I have dealt with many IRS agents over the years, but in these two cases that involved me personally, I never spoke with either one. My wife and I gave Rebecca our power of attorney and she handled everything. The audit process works best when it is professional and limited just to the issues that the auditor raises. The taxpayer’s presence invites incomplete or incorrect off-the-cuff answers to the auditor’s questions. An effective taxpayer representative (usually a CPA, attorney or IRS-authorized enrolled agent) will find out what the auditor wants to know, gather the information and present it clearly and concisely without triggering collateral issues.
The downside to hiring a representative, of course, is cost. Skilled professional representation is expensive, and your representative does not control how many hours the audit will consume — the auditor does. Auditors do not care how much they cost you in professional fees. In some instances, I have had the impression that tax authorities have a pretty good idea how much it will cost a taxpayer to appeal or litigate a dispute, and they offer to settle for about the same amount. It may be worth accepting such an offer if the auditor raises a valid point.
Once you hire a representative, get out of the way. Don’t go to meetings with the auditor. Don’t speak directly with the auditor (other than a polite hello if the auditor comes to your home or business). If your representative is good, you have nothing to gain by participating in the process.
3. Do not extend the statute of limitations. You have a few months after the end of the year to file your tax return. The authorities generally have three years thereafter to examine it and ask anything they want. Auditors have heavy caseloads, however, and they like to manage them by asking taxpayers and their representatives to waive the three-year limit. Taxpayers usually grant such requests. I think this is a mistake.
Waiving the statute is almost never in the taxpayer’s interest. It allows the agent to drag out the process, inflating the taxpayer’s cost for representation and increasing the exposure to any potential interest and penalty charges. It gives the agent more time to raise more issues. It lets the agent raise additional issues if new legislation, regulatory pronouncements or court decisions provide support. The taxpayer, who is entitled to compute and pay his taxes and get on with life, gets no benefit.
Taxpayers who represent themselves may not want to upset an agent who seems to want to be their friend. Professional representatives, I suspect, feel the same way, but they ought to know better. The auditor is not there to be anyone’s friend. Yet auditors sometimes react so negatively when we decline to extend the deadline that I am convinced that they almost never experience such rejection.
In one such case, a New York state tax agent sought to determine how much time one of our West Coast clients spent in New York in 2006. He asked for information in February 2009 — 20 months before the limitations expired — and Paul Jacobs, one of our client service managers, sent it to him a few weeks later.
Paul heard nothing from the auditor until December 2009, when the agent said he would soon get around to reviewing the file. Then there was no contact until August 2010. With two months to go before the deadline, the agent wanted more information — and an extension.
Paul promised to get the data to the auditor in a few days, but said we would not grant an extension. The auditor, who had been congenial to that point, then turned threatening and promised to make things difficult for our client by launching a broader examination of 2007’s return and by immediately assessing $70,000 in taxes that our client did not owe.
Paul put the auditor’s comments into a letter to the auditor, asked for a reasonable amount of time to provide the information he had belatedly requested, and told the auditor we wanted to complete the examination within the statutory period. This documentation of the auditor’s threats immediately changed his attitude. He accepted the data when Paul sent it to him, dropped his demand for an extension, and closed the case without assessing any tax.
4. Do not be bullied or intimidated. Most agents will not threaten, yell at or otherwise mistreat a taxpayer, but an occasional miscreant will. Paul’s approach of documenting the misconduct so that the agent’s supervisor or an appeals officer might learn about it is one way to handle this situation. Another is to simply ask to speak with the agent’s supervisor.
Some years back, an agent who was examining a client’s gift tax return wanted to come to my office to review voluminous documentation with me. It would have taken hours and cost my client a lot of money needlessly. I told the agent I would compile the information, send it to him, and we could then talk on the phone and discuss whether a meeting was necessary.
He began to scream at me, mostly along the lines that he, not I, was going to control the audit. When he paused to catch his breath, I calmly told him I would speak with his supervisor before having any further dealings with him. He gave me the supervisor’s name, and the supervisor quickly assigned another agent to the case. That agent let me send her the documents and then came to the office for a brief, to-the-point meeting.
5. Keep excellent records. This is the best tax advice I can give you. If you can demonstrate that your tax return is correct and complete, and that the positions you have taken comply with the law, you should have no problems if you are audited.
You might have to rely on professionals such as my colleagues for the compliance part, because the laws are just too convoluted for anyone else, except maybe someone whose financial affairs are very basic, to be expected to understand. But even the best-informed tax professionals must work with the information you give them. If you don’t have a system to efficiently maintain the records you need, your tax adviser can help you set one up, and maybe even maintain the records for you. It can be money very well spent.
Your goal in an audit should be to respond to questions quickly, accurately and completely, without getting bogged down with extraneous information. The auditor’s job is to build a good file showing that the taxpayer’s return is correct, or that it is not. You will get the best results by helping the auditor do his or her job well, by offering information that is credible, responsive and well organized.
6. Pay what you owe, promptly. Interest and penalties, including penalties for late payment, add up quickly. If you have the money to pay what you owe, pay it. Yes, it is possible to get installment plans and even compromises on tax debts, but the tax authorities are not cutting wholesale deals for solvent taxpayers. Do not kid yourself.
If an auditor raises an issue in which you clearly are wrong, concede the point. Owning up builds credibility and shows the agent (and any appeals officer who reviews the case) that you are making a good-faith effort to comply with the law. That credibility might earn you the benefit of the doubt on some other issues, such as minor gaps in your records.
Though tax enforcement is theoretically about collecting the correct tax rather than more tax, revenue agents do, of course, care about revenue. If they are not going to find a lot of money by auditing you, they want to move on to a more productive assignment as soon as possible.
Your goal in an audit should be to show the auditor that it is time to move on. That’s the quickest, safest route I have found through the audit minefield.