A Guide to Office Audits with the IRS

Gray Reed
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When a tax return has been selected for office examination, generally the examination of the return will be conducted at the office of the IRS.  Normally a taxpayer will find an office examination has begun when he or she has received a letter or telephone call from the IRS informing him of such examination and that the IRS wants further records and information. Returns selected for office examination present issues which require some analysis and judgment in addition to verification of records.

Examples of issues that are prominent in office examinations are:

  1. Dependency exemptions;
  2. Income from tips, pensions and annuities, rent and royalties, partnerships, estates and trusts, and occupations where income not subject to withholding tax may have been received;
  3. Determinations of whether income reported constitutes capital gain or ordinary income;
  4. Deductions for travel and entertainment expenses;
  5. Deductions for bad debts;
  6. Determinations of basis of property; and
  7. Complex miscellaneous itemized deductions such as casualty and theft losses where determinations of fair market value are required.

The Audit

A return selected for office examination is subject to IRS procedures and substantial controls on the activities of the tax auditors.  The tax auditor has had no control over the content, preparation or issuance of the initial letter.  The taxpayer’s return is not assigned to an auditor until after the taxpayer replies, or until the day of or the day before the scheduled interview.  Therefore, the auditor is given little time to prepare for the interview, and the examination is more or less limited to the items on the checklist contained in the letter.

When representing a taxpayer at an office audit, the taxpayer’s representative should only bring those items that have been requested by the IRS.  The goal is to complete the audit at the first meeting with the auditor and limit the audit to the issues set forth in the initial letter from the IRS.

Generally, gross receipts are required to be examined in all cases.  In addition, the office auditor may have questions regarding the taxpayer’s sources of income; standard of living; purchase of assets; balance of his cash on hand and in the bank; payments on loans; and receipt of borrowed funds.  Based on the answers he or she receives to these questions, if the auditor has reason to believe the taxpayer may be underreporting income, then alternative methods will be employed to verify receipts.  If the examination reveals a material understatement of income in a given year, the examination may be expanded to subsequent or prior years and referred for criminal investigation.

Next Steps

When the interview has ended, resulting in a proposed adjustment, the taxpayer has an opportunity to agree with the findings of the tax auditor.  If the taxpayer agrees with the proposed changes, he or she is asked to execute an agreement form which permits the immediate assessment of the tax.  At this time, the auditor will ask for payment of the amount of the additional tax.  Should the taxpayer not agree with the auditor’s findings, either the auditor or the taxpayer may request an immediate informal conference with the auditor’s supervisor.  The IRS uses this procedure to avoid the expense and formality of appeal to higher levels within the IRS, and has stated that a high percentage of cases informally appealed to the supervisor are resolved.  However, if the taxpayer, or his or her representative, is not adequately prepared for this immediate appeal then resolution may not be in the taxpayer’s best interest.  If this immediate conference is not requested, or the issues are not resolved, the taxpayer will be advised by mail of the auditor’s findings and proposed adjustments and notified of his or her rights to appeal the findings to the Appeals Office.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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