In 2013 the IRS audited slightly over one taxpayer in nine with an income of $1 million or more. This audit rate represents a sharp 69 percent increase from the 6.42 percent audit rate that similar high-income taxpayers enjoyed as late as 2009. The purposes of this article are to describe how high-income taxpayers can minimize their exposure to potentially catastrophic tax audits and to describe the five prongs of an effective tax audit defense.
We have published this article on our Blog as a service to all taxpayers and to the legal and accounting communities who serve them. For additional information, please consider attending a Brown Bag luncheon event on this topic sponsored by the Tax Section of the Boston Bar Association. This event will be held at the Boston Bar Association’s headquarters at 16 Beacon Street, Boston, MA at 12:00 noon on Thursday, June 12, 2014.
Policies That Minimize Exposure to Tax Audits and to Excessive Tax-Audit Defense Fees
Effective tax audit defense begins by minimizing exposure to potential future audits. Here are four important policies all high-income taxpayers can adopt to minimize (but not eliminate) their exposure to potentially catastrophic tax audits.
(1) Work Only With Tax Return Preparers Who Have Good Track Records. Some tax return preparers generate more tax audit adjustments than others. The IRS has the ability to track the audit adjustments associated with each tax return preparer – and it is disingenuous to believe that the IRS does not utilize this ability in selecting returns for audit. Taxpayers who wish to minimize their tax audit exposure will begin by choosing preparers with a solid track record with the IRS for having their returns “accepted as filed” following a tax audit or accepted with only minor adjustments. Taxpayers can learn the track record of their tax preparation professionals simply by asking them. Taxpayers have a right to the truth because all professionals have an ethical obligation to be candid and truthful with their clients on this issue.
(2) Avoid Inconsistencies on Filed Tax Returns. Schedule C (Business Income Tax Return) taxpayers are particularly vulnerable to tax audits. In addition, all business income tax returns become subject to audit verification when unexplained discrepancies exist between business, payroll and information (Form 1099) returns. For example:
Gross receipts reported on an business income tax return should bear a reasonable relationship (1) to credit card receipts reported to the IRS by third-party payers on Form 1099-K; and (2) to payments made to service providers and reported to the IRS by the providers’ customers on Form 1099-MISC.
Wages and salaries as reported on Forms W-2 and W-2 , should be reconcilable to the business’ payroll tax Forms 941 and 940; and the above forms should be reconcilable to the business’ Forms 1120, 1120-S or Schedule C (Form 1040).
(3) Insist on a Technically Correct Return. When an income tax return is technically inaccurate, tax auditors wonder what else is wrong with the return. So cautious taxpayers will insist upon (and pay for) a technically accurate return. For example, if the taxpayer is claiming a charitable contribution deduction for (1) the contribution of a work of art to a college’s art museum or (2) the granting of a conservation easement to a local conservation commission, the full documentation required by the Treasury Regulations should be included with the return. This contemporaneously supplied information can even forestall a tax audit.
(4) Document Substantial Authority for Tax Positions. Sometimes there is genuine doubt as to the proper tax treatment for a transaction or series of transactions. The 20 percent “substantial understatement” penalty can often be avoided by documenting the tax question and its good-faith resolution on IRS Form 8275: Disclosure Statement and the related Massachusetts Taxpayer Disclosure Statement (Form TDS). In our experience, the presence of a disclosure statement has never resulted in a tax audit. The disclosure statement, however, has prevented the assessment of the “substantial understatement” penalty.
The Importance of an Effective Filing System and an Appropriate Document Retention Policy
In our experience, the absence of adequate files is the single most important reason why tax audit defense costs spiral out of control. Thus, an effective tax audit defense should begin with establishing an effective filing system and an appropriate document retention policy. In our experience, essential missing documents can typically be located easily and relatively inexpensively on the microfiche records of banks and other financial institutions. The document retrieval costs, however, go far beyond the research fees paid to these financial institutions. Trained lawyers and certified public accountants must first determine what documents are missing and then: (1) identify the holders of the missing documents; (2) make the necessary requests from the document holders; and (3) follow-up to ensure that the documents requests are received and acted upon promptly by the document holders. The information from this documentation must then be incorporated into the financial analyses. The professional costs to create the financial analyses substantially exceed the research fees of the financial institutions. In addition, certain records are sometimes required as a condition for a deduction. For example, charitable deductions normally require a “tax letter” from the recipient charity for the expenditure to qualify as a charitable contribution deduction. Business travel requires a log that is best kept on a contemporaneous basis.
The Five Prongs of an Effective Tax-Audit Defense
The major objectives of any tax audit defense are to achieve reasonable tax audit adjustments; for a reasonable professional fee; within a reasonable time period. There are five strategic prongs that typically lead to the achievement of these three objectives.
(1) The First Prong: Controlling Potential Tax Audit Adjustments. Tax professionals begin to control potential tax audit adjustments by first quantifying the taxpayer’s potential tax audit exposure. Tax professionals then use the taxpayer’s estimated exposure as a guide to determine whether or not to accept or reject the auditor’s proposed tax adjustments. For details, see Estimating the “Correct” Tax Due, below.
(2) The Second Prong: Controlling the Audit Process. The triple objectives of the engagement – namely, achieving reasonable audit adjustments, for a reasonable professional fee, within a reasonable time period – require that tax-defense professionals proactively control the audit process. For details, see Controlling the Audit Process, below.
(3) The Third Prong: Minimizing Penalties. Tax penalties plus interest thereon can be significant – often approaching 50 percent of the underlying tax plus interest – and these penalties can often be avoided or abated if the taxpayer has a reasonable excuse for filing an inaccurate tax return and/or not paying in the correct amount of tax. Thus, an effective tax audit defense always considers whether penalties can be avoided or abated. For details, see pages 7 and 9, below.
(4) The Fourth Prong: Controlling the Tax Audit Defense Cost. The cost of the tax audit defense must bear a reasonable relationship to the potential tax exposure. See Prong (1), above. The cost of tax audit defense includes the professional fees of the tax audit defense team and the opportunity costs associated with the taxpayer taking time away from running the business to focus on the audit. For some individuals, tax audit defense can also involve considerable anxiety. We try to control the defense costs by establishing a budget.
(5) The Fifth Prong: Keeping the Taxpayer Off the Triennial Re-audit Cycle. Once the tax audit has been resolved, taxpayers will want to avoid being placed on a triennial audit cycle where their returns come up for re-audit every three years. Experienced tax audit defense counsel will attempt to persuade the tax auditor that an audit of the same taxpayer on the same issue in a subsequent tax year will lack significant “audit potential.” For details, see page 8, below.
Controlling the Tax Audit Process: The First Steps
An effective tax audit defense begins as soon as a taxpayer’s return is targeted for audit. Even before our client has a signed our engagement letter, we will:
(1) Determine the Scope of the Audit
We typically begin the audit defense process by obtaining a Power of Attorney and then calling the tax auditor to introduce ourselves and to confirm the scope of the audit: Is the auditor conducting a “general examination?” or is the auditor focusing the audit to certain limited issues, the so-called Limited Issue Focused Examination (LIFE) audit?
(2) Negotiate an Extension of Time
We typically negotiate an extension of time before the commencement of the audit. Reasonable extensions are typically granted as a matter of course and are available to accommodate a practitioner’s seasonal obligations (“tax season”). The most important reason to request and extension, however, is to give our firm the time needed to determine (or at least reasonably estimate) the “correct” tax due. See Estimating the “Correct” Tax Due, below, and “The First Prong,” on page 3, above.
(3) Draft a Preliminary Engagement Control
In the course of our work, we typically prepare one or more Engagement Controls. The Engagement Control outlines the scope of the work and the steps that must be taken to resolve the matter. These Controls typically list the procedural history of the case, areas of significant tax exposure, and possible audit defense techniques. These Engagement Controls are available to the members of the audit defense team (and to our clients, upon request) so that everyone on the team can see how their professional contribution fits into the overall defense effort. We typically amend our Engagement Controls as the work progresses and we learn more about the case. These Controls are part of our attorney work product and are therefore protected from turnover to the taxing authorities. They are also subject to the attorney/client privilege since our clients and their advisors expect that the information provided to us for tax audit defense and contained therein will be kept secret.
Estimating the “Correct” Tax Due
When we first begin to defend a tax return our first question is almost always: What is the “correct” amount of tax and is any additional tax due. An accurate estimate of the “correct” tax is critical to any rational resolution of a tax audit. The tax auditor will eventually arrive at his or her own estimate of the “correct” tax liability. If the auditor’s proposed liability is less than the liability we have estimated, we will typically accept the auditor’s proposal and conclude the audit – at least on that issue. If, however, the auditor’s proposed liability is significantly greater than the “correct” liability we have estimated, we will use our own analysis to demonstrate to the auditor why a downward revision of the proposed adjustment is appropriate. Thus, the first substantive work that we do is typically to make arrangements to estimate the “correct” tax. This work is especially important when an accounting breakdown has made it difficult to estimate easily the potential tax exposure. We typically use our in-house CPAs and attorneys work on the estimation process.
We never provide our estimate of the “correct” liability to the tax auditor without the approval of the client. Indeed, since we are preparing for a possible confrontation in court (if the audit does not settle) our tax projection represents protected “attorney work product” and is not “discoverable” by the taxing authorities. In addition, the information provided to us to defend the tax audit is subject to the attorney/client privilege since it is provided to us for legal defense of the tax audit – and not for purposes of preparing amended income tax returns.
Working with the Taxpayer’s Tax Return Preparer or Another CPA
The estimation of the “correct” tax due (see above) can be a double-edged sword. In our hands it helps us formulate a rational resolution to the tax audit. But in the hands of the taxing authorities, the estimation of the “correct tax” can sometimes be used offensively to demonstrate negligence, civil fraud, or more on the part of the taxpayer and/or the taxpayer’s advisors. We therefore always consider whether it is appropriate to work with the taxpayer’s present tax return preparer in estimating the “correct tax.” It may be helpful to use the present preparer because he or she is familiar with the taxpayer’s financial situation and may have referred the case to us. However, it may be more appropriate not to use the original preparer because it is likely that that the preparer will learn new information about the taxpayer’s situation. It will be difficult if not impossible for the original preparer to separate what he or she originally knew (which is not subject to the attorney/client privilege) and what he or she later learns when working under our direction (which is subject to the attorney/client privilege). Therefore, when it is important to preserve the attorney/client privilege it is best practice not to work with the prior tax return preparer – except to obtain guidance as to how the return under audit was originally prepared. When we work with outside Certified Public Accountants we ask them to sign a so-called “Kovel Letter.”
Controlling the Audit Process: Continued
Taxpayers cannot rely on governmental tax auditors to conduct an efficient audit – resulting in reasonable audit adjustments for reasonable professional fees within a reasonable time period – without professional intervention by the taxpayer’s representatives. The IRS is underfunded and is currently undergoing a massive turnover in the ranks of its tax auditors. As experienced auditors leave, their replacements are often inexperienced and undertrained and are therefore sometimes struggle to plan and execute a complex tax audit efficiently.
Thus, an effective tax audit defense consists of much more than responding timely to Information Document Requests and estimating the taxpayer’s tax exposure. Typically, as part of our representation, we will:
(1) Confirm the Scope and Timing of the Audit. We will confirm the scope and timing of the audit in writing. We will then insist that the tax auditor (and his or her supervisor) honor the agreed-upon audit scope. Unless this is done, the audit may expand into new areas, thereby increasing the taxpayer’s tax exposure as well as the time and professional fees of the tax audit defense team.
(2) Consider and Evaluate the Audit Resolution Tools Available. We try to determine what tools are available and appropriate to resolve the tax dispute. Over the past few years, IRS and the Massachusetts Department of Revenue have become more sophisticated in the use of various audit resolution tools. These tools include:
A possible request for a technical advice memorandum to clear up questions as to the proper tax reporting of a transaction or series of transactions which have now closed;
A possible request for “fast-track” settlement; and
A possible request for post-appeals mediation.
(3) Reach agreement on what evidence will be acceptable to the auditor and his or her supervisor. This agreement, which should be memorialized in writing, lets us understand the work product we must produce to comply with our professional responsibilities to the tax auditor.
(4) Reach agreement on a reasonable time table for the production of financial analyses and other evidence. The parties should come to an agreement on a reasonable amount of time to complete the financial analyses and additional documentation.
(5) Follow-up that the agreed-upon timetable is being followed – Both parties, the taxpayer’s representatives and the tax auditor, should communicate progress throughout the audit process.
(6) Attempt to Minimize Tax Penalties. Tax penalties, before interest thereon, can add an additional 45 or more percent to the tax liability. See footnote 9, above. Therefore, it is usually wise to attempt to negotiate penalty reduction and penalty elimination at the audit level. In our experience, we have been able to achieve significant penalty avoidance at the audit level where (1) a reasonable explanation for the misstatement on the tax return exists; (2) the taxpayer makes arrangements to pay promptly the tax deficiency plus related interest in full; and (3) we did not waste the auditor’s time since we cooperated fully with the auditor by conducting the audit quickly and professionally.
(7) Attempt to Keep the Taxpayer Off the Triennial Re-audit Cycle. Once the tax audit has been resolved, taxpayers will want to avoid being placed on a triennial audit cycle where their returns come up for re-audit every three years. Experienced tax audit defense counsel will attempt to persuade the tax auditor that an audit of the same taxpayer on the same issue in a subsequent tax year will lack significant “audit potential.” This can be achieved without too much difficulty where there is no ambiguity regarding the taxpayer’s liability. Sometimes, however, a taxpayer faces recurrent ambiguous transactions where the taxing authority will settle the ambiguous tax issue for the years under audit but is unwilling to settle the tax issue once and for all. In such cases, it is sometimes wise to litigate this issue (rather than settle) since in the long run the distractions (opportunity costs) and professionals fees associated with a triennial audit of the identical issue are greater than the cost of one-time litigation.
(8) Insist on professionalism. Unprofessional conduct on the part of a tax auditor, such as yelling or “steamrolling,” has no place in the audit resolution process. Where appropriate, issues connected with unprofessional conduct should be resolved with the auditor’s supervisor (or even the supervisor’s supervisor).
Helping the Tax Auditor Complete an Accurate Revenue Agent’s Report
We have learned that we can no longer rely on tax auditors to provide us with an accurate Revenue Agent’s Report at the conclusion of the audit. We therefore prepare proforma income tax returns, where appropriate, to reflect all agreed-upon changes to a taxpayer’s returns. Then, we compare the Revenue Agent’s Report to our proforma return. When there are discrepancies, we will share our proforma return with the tax auditor who uses it to correct her Revenue Agent’s Report.
Paying the Taxman and Negotiating Penalty Reduction at the Tax-Collections Level
Often the additional assessments for tax, penalties and interest are significant and the taxpayer cannot immediately make full payment. If the taxpayer needs additional time to make payment arrangements, we routinely negotiate an appropriate extension of time to pay the tax. In other cases, we have successfully negotiated installment payment agreements and/or offers in compromise with the IRS and the Massachusetts Department of Revenue. We have also negotiated significant penalty reductions at the collection level since tax collectors will sometimes trade penalty abatement for prompt collection of the unpaid tax.
Taking Penalty Appeals
As noted earlier (see footnote 9, above), penalties can often amount to 45 percent or more of the additional tax plus interest thereon. Therefore, if the taxpayer has a good “reasonable cause” defense but the tax examiner is unwilling to listen, consideration should be given to appealing the case to the (1) IRS Appeals Office and the United States Tax Court; or (2) the Massachusetts Department of Revenue Office of Appeals and the Massachusetts Appellate Tax Board.
Effective tax audit defense is not an accident. An effective tax audit defense is the product of a seasoned professional’s common sense, moral courage, and technical ability; supported by a dedicated team of trained CPAs and tax attorneys; and honed over a lifetime of representing taxpayers under audit, on appeal and before the courts.
 The reported audit rate was 10.85 percent.
 High-income taxpayers are often at or near the top of their professions. Like other taxpayers, they seek to minimize their overall tax burden. Unlike other taxpayers, however, a serious error on their tax returns can generate significant adverse publicity that, in turn, can jeopardize their careers. For example, more than one prominent taxpayer’s legal career was significantly and adversely affected by the seemingly trivial failure to report the so-called “nanny tax.”
 See footnote 4, above.
 Tax return preparers typically include their PTIN (Preparer Tax Identification Number) on every income return they prepare. Thus, it is trivially easy for IRS to track audit adjustments by PTIN.
 A high-income tax return may be flagged by the IRS computer for a particularly large deduction, such as a charitable contribution of a conservation easement. By supplying all required information contemporaneously with the filed return (as required by Treasury Regulations), the taxpayer is able to explain this deduction. Moreover, since all documentation is in place, the tax auditor conducting the preliminary review may well conclude that the deduction was competently taken – especially if the tax return preparer has a solid track record with IRS for having his/her returns “accepted as filed” or accepted with only modest proposed adjustments.
 An adequate document retention policy requires maintaining six or even seven years of financial records supporting income and deductions along with the tax cost (“basis”) for all assets that might be sold in the future.
 For example, the 20 percent federal “substantial-understatement” penalty becomes applicable if the tax audit adjustment exceeds the greater of $5,000 or 10 percent of the tax required to be shown. See Section 6662(b)(2) and Section 6662(d)(a)(1)(A). In addition, a failure-to-pay penalty can be as much as 25 percent of the additional tax. See Section 6651(a).These penalties can therefore total as much as 45 percent of the audit adjustment. Interest is than computed on these penalties.
 We cannot indicate “What We Will Do” in our engagement letter without first discussing the case with our client and with the tax auditor.
 Sometimes it is possible to determine a “correct” tax. But often there are irreducible ambiguities and we can reasonably estimate only a range of possible audit adjustments.
 It is called a “Kovel Letter” because it is based on the case of United States v. Kovel, 296 F.2d 918 (2nd Cir. 1961). Practitioners, however, should review the recent case of United States v. Adlman, 68 F.3d 1495 (2nd Cir. 1995) for limitations on the “Kovel” doctrine.
 IRS examiners will typically trade penalty abatement for the taxpayer’s full cooperation. Massachusetts has a formal pre-assessment abatement procedure that we have used successfully in the past.
 The decision about whether or not to cooperate fully with the tax auditor always requires the informed consent of the taxpayer. In some cases, full cooperation should not be attempted without first obtaining at least an informal opinion from a white-collar defense attorney.
 “Steamrolling” occurs when a tax auditor refuses to explain the basis of his or her position to the tax-defense professional on the basis that either (1) there is not enough time for the auditor to provide a detailed explanation; or (2) the tax auditor’s position is “obviously right” and the tax defense professional’s position is “obviously wrong” and so any discussion would be a waste of time.
 We recently encountered significant issues with the IRS handling of the alternative minimum net operating loss carryback and adjustments to the alternative minimum foreign tax credit on a high-net worth taxpayer’s Revenue Agent’s Reports.
 In one recently and as yet unreported case, the Appellate Tax Board abated just over $600,000 in penalties that had been erroneously assessed against our client.