Chapter 48
If the IRS Examines Your Return

Because the IRS is only able to examine a very low percentage of returns, it follows a policy of examining returns which, upon preliminary inspection, indicate the largest possible source of potential tax deficiency. Various weights are assigned to separate items on each tax return, thus permitting the ranking of returns for the greatest potential error.

This chapter discusses what may trigger an audit and how you can handle an audit if your return is selected for examination.

Also discussed in this chapter are various penalties the IRS can assess if you file an inaccurate return, and the penalties for not reporting your foreign financial accounts.

48.1 Odds of Being Audited

The odds are quite low that your return will be picked for an audit. In Fiscal Year 2016 (October 2015 through September 2016), the overall audit rate for individual returns was only 0.70%, compared to an overall audit rate of 0.84% in FY 2015. The audit rates are higher for taxpayers with large adjusted gross incomes and sole proprietors with substantial total gross receipts. Budget pressures on the IRS suggest that low audit rates will continue for most income groups for the forseeable future.

Audit odds vary depending on your income, profession, type of return, type of transactions reported, and where you live. Individual returns are classified by all income items on the return without regard to losses. Professional or business income reported on Schedule C and farm income reported on Schedule F is classified by total gross receipts, and corporate returns are classified by total assets.

Your return may command special IRS scrutiny because of your profession, the type of transactions reported, or the deductions claimed. The chances of being audited are greater under the following circumstances:

• Your information reported on the tax return does not match information received from third-party documentation, such as Forms 1099 and W-2.
• Your itemized deductions exceed IRS targets.
• You claim tax-shelter losses.
• You report complex investment or business transactions without clear explanations.
• You receive cash payments in your work that the IRS thinks are easy to conceal, such as cash fees received by doctors or tips received by cab drivers and waiters.
• Business expenses are large in relation to income.
• Cash contributions to charity are large in relation to income.
• You are a shareholder of a closely held corporation whose return has been examined.
• A prior audit resulted in a tax deficiency.
• An informer gives the IRS grounds to believe that you are omitting income from your return.

Itemized deductions. If your itemized deductions exceed target ranges set by the IRS, the chances of being audited increase. The IRS does not publicize its audit criteria for excessive deductions, but it does release statistics showing the average amount of deductions claimed according to reported income. Table 48-1 shows the IRS figures based on deductions claimed on 2015 returns filed through September 2016.

Taxpayer Bill of Rights. The “Taxpayer Bill of Rights” collectively refers to a series of laws that aim to protect taxpayers from mistreatment by IRS personnel and insure that they are treated fairly, professionally, promptly, and courteously by the IRS and its employees:

1. The right to be informed
2. The right to quality service
3. The right to pay no more than the correct amount of tax
4. The right to challenge the IRS’ position and be heard
5. The right to appeal an IRS decision in an independent forum
6. The right to finality
7. The right to privacy
8. The right to confidentiality
9. The right to retain representation
10. The right to a fair and just tax system

These rights are listed in the IRS instructions for Forms 1040, 1040A, and 1040EZ and in IRS Publication 1.

If you have a dispute with the IRS, you should ask for an explanation of the procedural rules affecting your case, if these are not already included in the documents sent to you. For example, before the IRS may enforce a tax lien by seizing property by levy, the IRS must provide you with a notice of your right to a hearing before an appeals officer, an explanation of the levy procedures, the availability of administrative appeals and the appeals procedures, the alternatives to the proposed levy such as an installment agreement, and the rules for obtaining the release of a lien. See IRS Publication 1, Your Rights as a Taxpayer, IRS Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund; IRS Publication 594, The IRS Collection Process; and IRS Publication 5, Your Appeal Rights and How to Prepare a Protest if You Don’t Agree.

Taxpayer Advocate. The Taxpayer Advocate Service (TAS) is an independent office within the IRS. The function of the TAS is to assist taxpayers in resolving problems with the IRS, propose changes in administrative practices of the IRS, and identify potential legislative changes that may mitigate problems and improve the tax system.

You may be able to receive TAS assistance if you have unsuccessfully tried to resolve your problem with the IRS and have not had your calls or letters returned. However, because of the demand on its resources, the TAS is most likely to provide assistance if you face a significant hardship because of an impending IRS action or lack of IRS response to your problem. If you qualify, you will be assigned a personal advocate to try to resolve your problem. Contact the TAS at its homepage at www.taxpayeradvocate.irs.gov. From the website, you can access a state-by-state list of addresses and phone numbers for TAS offices. The list is also in IRS Publication 1546. You can contact the TAS by calling 1-877-777-4778, or you may apply for assistance by filing Form 911 (“Request for Taxpayer Advocate Service Assistance (And Application for Taxpayer Assistance Order)”).

48.2 When the IRS Can Assess Additional Taxes

Three-year statute of limitations. The IRS has three years after the date on which your return is filed to assess additional taxes. When you file a return before the due date, however, the three-year period starts from the due date, generally April 15.

Where the due date of a return falls on a Saturday, Sunday, or legal holiday, the due date is postponed to the next business day.

Amended returns. If you file an amended return shortly before the three-year limitations period is about to expire and the return shows that you owe additional tax, the IRS has 60 days from the date it receives the return to assess the additional tax, even though the regular limitations period would expire before the 60-day period.

Six-year statute. When you fail to report an item of gross income which is more than 25% of the gross income reported on your return, the IRS has six years after the return is filed to assess additional taxes. An item that is adequately disclosed is not considered an omission. An overstatement of basis that minimizes gain is an “omission” of gross income in determining if the 25% test for triggering the six-year statute of limitations is met.

IRS request for audit extension. If the IRS cannot complete an audit within three years, it may request that you sign Form 872 to extend the time for assessing the tax. However, where an individual was “scared” into signing such an agreement, it was held invalid. See the following Example.

48.3 Audit Overview

When you file, the IRS checks your return for computational accuracy and clerical errors, such as a missing signature or missing or inaccurate Social Security numbers. To check whether you have omitted income from your return, the IRS will match your return against the Forms W-2 and Forms 1099 it receives from employers, brokers, payers of interest and dividends, and others who have filed information returns reporting payments to you.

If an error is found, or you have not submitted required attachments, you will probably be advised by mail of the corrections and of additional tax due, or you may be asked to provide additional information to substantiate tax deductions or credits. If you disagree with an IRS assessment of additional tax, you may request an interview or submit additional information. If you file early for 2017, are advised of an error, and the correction is made before April 17, 2018, interest is not charged.

If your refund is selected for a more thorough review, you will be notified by mail. This may not happen for a year or two; see 48.2.

Types of audits. An examination may be held by correspondence, at a local IRS office, at your tax preparer’s office or your place of business, office, or home. Correspondence audits are by far the most common type of audit. An examination at an IRS office is called a desk or office examination. An examination at your office or your preparer’s office, or your place of business or home, is called a field examination. When you are contacted by the IRS, you should receive an explanation of the examination process.

In a correspondence audit, the IRS sends you a letter asking for additional information about an item on your return. For example, the IRS may ask you to document a claimed deduction for charitable contributions or medical expenses. If the IRS is not satisfied with your response, you may be called in for an office audit. The IRS also notifies you by letter of mathematical or clerical errors you have made on your return, or if you have failed to report income, such as interest or dividends, that are shown by payers on information returns and matched to taxpayer returns by IRS computers.

If the IRS wants to conduct an in-person audit, the complexity of the transactions reported on a return generally determines whether a return will be reviewed at an office or field examination.

Most in-person audits of individual returns, except for returns reporting self-employment income, are conducted at IRS offices. An office audit usually covers only a few specific issues which the IRS specifies in its notice to you. For example, the examining agent may only be interested in seeing proof for travel expense deductions or educational expenses.

Field audits generally involve business returns; they are more extensive and time-consuming than office audits and are handled by more experienced IRS agents. For self-employed individuals, most examinations are field audits at their place of business. It is advisable to have a tax professional go over the potential weak spots in your return and represent you at the examination.

48.4 Preparing for the Audit

After an office audit is scheduled, the first thing to do is look over your return. Refresh your memory. Examine the items the IRS questioned in its notice of audit, and organize your records accordingly. Also check the rest of your return and gather proof for items you are unsure of. At this point, you should take a broad view of your return to anticipate problems you may encounter. Before the actual examination begins, consider possible settlement terms. Assume that the agent will assess additional tax, but establish the range you will consider reasonable. You can always change your mind, but giving some thought beforehand to possible settlement terms will help you later when settlements are actually discussed.

You may authorize an attorney, CPA, enrolled agent, or other individual recognized to practice before the IRS to represent you at the examination without your being there. To do so, give your representative authorization on Form 2848. An attorney or other representative authorized on Form 2848 can perform any acts that you could, including entering into a binding settlement agreement. Caution: For returns prepared and signed after 2015, only attorneys, CPAs and enrolled agents have full representation rights for their clients before any IRS officer. A preparer who is not an attorney, CPA or enrolled agent cannot represent you at an audit with respect to a return prepared and signed after 2015 unless he or she has completed continuing education courses and received a Record of Completion as part of the IRS’ Annual Filing Season Program (AFSP). Even with an AFSP Record of Completion, the preparer cannot represent you before IRS appeals or collection officers.

If you attend the audit, take only the records related to the items questioned in the IRS notice. Do not volunteer extra records; if the agent sees them, it might suggest new areas for investigation.

If you are concerned that there may be a problem of fraud, see a qualified attorney before you come into contact with an IRS official. The attorney can put your actions in perspective and help protect your legal rights. Besides, what you tell an attorney is privileged information; he or she cannot divulge or be forced to divulge data you have provided, other than data used to prepare your tax return.

A field audit of your business return is likely to involve a comprehensive examination and requires careful preparation. Together with your tax adviser, go over your return for potential areas of weakness. For example, the agent is likely to question deductions you have claimed for business travel. If you are an incorporated professional, the corporation’s deductions for expenses of company-owned cars or planes will probably be reviewed. The agent may suspect that a portion of these business deductions are actually nondeductible personal travel costs; be prepared to substantiate the business portion of your total mileage and operating expenses.

The IRS is generally required to hold an office audit at the office located nearest to your home. The IRS generally may not conduct a field audit at the site of a small business if the audit would essentially require the shutting down of the business, unless a direct visit is necessary to determine inventory or verify assets.

48.5 Handling the Audit

If you have authorized someone to represent you at the examination, your representative may appear at the examination without you. If the IRS wants to question you, it must issue you an administrative summons. If you are present and questioned, you may stop the examination to consult with counsel, unless the examination is pursuant to an administrative summons.

Audits conducted at an IRS office may conclude quickly because they usually involve only a few specific issues. In some cases, the audit may take less than an hour. The key to handling the audit is advance preparation. When you arrive at the IRS office, be prepared to produce your records quickly. Records should be organized by topic so that you do not waste time leafing through pages for a receipt or other document.

If the agent decides to question an item not mentioned in the notice of audit, refuse politely but firmly to answer the questions. Tell the agent that you must first review your records. If the agent insists on pursuing the matter, another meeting will have to be scheduled. The agent might decide it is not worth the time and drop the issue.

Common sense rules of courtesy should be your guide in your contacts with the agent. Avoid personality clashes; they can only interfere with a speedy and fair resolution of the examination. However, be firm in your approach and, if the agent appears to be unreasonable in his or her approach, make it clear that—if necessary—you will go all the way to court to win your point. A vacillating approach may weaken your position in reaching a settlement.

If the IRS has scheduled a field audit, ask that the examination be held at your representative’s office. If you have not retained professional help and the examination takes place on your business premises, do not allow the agent free run of the area: Provide the agent with a comfortable work area for examining your records. If possible, the workplace should be isolated so that the agent can concentrate on the examination without being distracted by office operations that might spark questions. Tell your employees not to answer questions about your business or engage in small talk with the agent. As with an office audit, help speed along the field examination by having prepared your records so that requested information can be quickly produced.

Recording the examination. You have the right to make an audio recording of any interview with an IRS official. Video recordings are not permitted. No later than 10 calendar days before the interview, give written notice to the agent conducting the interview that you will make a recording. Later requests are at the discretion of the IRS. You must pay for all recording expenses and supply the equipment. The IRS may also make a recording of the interview, upon giving notice of at least 10 calendar days. However, IRS notice is not necessary if you have already submitted a request to make a recording. You have the right to obtain a transcript, at your own expense, of any recording made by the IRS. Generally, a request for a copy must be received by the IRS agent within 30 calendar days after the recording, although later requests may be honored.

48.6 Tax Penalties for Inaccurate Returns

As discussed in this section, an “accuracy-related” penalty applies to the portion of any tax underpayment attributable to any of the following: (1) negligence or disregard of IRS rules and regulations; (2) substantial understatement of tax liability; (3) overvaluation of property; (4) undervaluation of property on a gift tax or estate tax return; (5) claim of benefits from a transaction lacking economic substance, (6) an undisclosed foreign financial asset, or (7) claiming a basis for property in excess of the amount reported on an estate tax return. There is no stacking of penalties. Only one penalty can be imposed on a portion of an underpayment, even if that portion is attributable to more than one of the above types of prohibited conduct.

The above accuracy-related penalties generally may be avoided by showing that you acted in good faith and with reasonable cause in underpaying the tax. Reliance on a tax preparer may constitute reasonable cause and good faith, but the reliance on the preparer must be reasonable. The Tax Court has held that reliance on a preparer is not reasonable if the taxpayer does not provide the preparer with the documents necessary to make a professional conclusion, or if the preparer lacks sufficient expertise to justify reliance. A stricter reasonable cause exception applies to the penalty for overvaluing charitable donations or the basis of depreciable property; see below. There is no reasonable cause exception for penalties attributable to transactions lacking economic substance.

Also discussed below are penalties for (1) failing to disclose participation in “reportable” transactions, (2) understating tax liability on “listed” transactions or on other reportable transactions with a significant tax avoidance purpose, (3) filing an erroneous refund claim, and (4) filing a frivolous return.

Negligence or disregard of IRS rules or regulations. The 20% penalty applies to the portion of the underpayment attributable to negligence. Negligence is defined as failing to make a reasonable attempt to comply with the law. Failure to report income shown on an information return, such as interest or dividends, is considered strong evidence of negligence.

The 20% penalty may also apply if you take a position on a return which is contrary to IRS revenue rulings, notices, or regulations. This penalty for disregarding IRS rules or regulations may be avoided if you have a reasonable basis for your position and you disclose that position on Form 8275 or on Form 8275-R in the case of a good faith position contrary to a regulation. Thus, disclosure will not avoid a penalty for a position that does not have a reasonable basis.

Substantial understatement of tax. If you understate tax liability on a return by the greater of $5,000 or 10% of the proper tax, you may be subject to a penalty equal to 20% of the underpayment attributable to the understatement.

The penalty may be avoided if you have a reasonable basis for your position and you disclose the position to the IRS on Form 8275, or on Form 8275-R in the case of a position that is contrary to an IRS regulation.

The penalty also may be avoided if you can show that your position was supported by “substantial authority” such as statutes, court decisions, final, temporary, or proposed IRS regulations, IRS revenue rulings and procedures, and notices, announcements, and other administrative pronouncements published by the IRS in the weekly Internal Revenue Bulletin. You may also rely on IRS private letter rulings and technical advice memoranda, as well as IRS actions on decisions and general counsel memoranda. However, according to the IRS, such rulings and internal IRS memoranda that are more than 10 years old should be accorded very little weight. Congressional committee reports and the tax law explanations prepared by Congress’s Joint Committee on Taxation, known as the “Blue Book,” may be relied on as authority for your position.

However, the exceptions for disclosed positions (with a reasonable basis) and substantial authority do not apply to items attributable to a tax shelter, which for this purpose means any arrangement that has tax avoidance or evasion as a significant purpose. An understatement of tax due to tax shelter positions may be subject to the understatement penalty for “reportable” transactions discussed below; if the understatement penalty for “reportable” transactions does apply, the 20% penalty discussed above for substantial understatements of tax does not apply to the same understatement.

Overvaluing donated property value or depreciable basis. If the claimed value of property donated to charity is 150% or more of the correct value, resulting in a tax underpayment exceeding $5,000, a penalty equal to 20% of the underpayment applies, and the penalty is doubled to 40% if the overvaluation is 200% or more. The same penalty thresholds and rates apply where the basis of depreciable property has been inflated. A reasonable cause exception to the 20% penalty is available (but not for the 40% penalty) if you relied on a qualified appraisal and you investigated the value of the property in good faith (14.16).

Undervaluation on gift or estate tax return. If the value of property reported on a gift tax or estate tax return is 65% or less of the correct value, and the resulting tax underpayment from the undervaluation exceeds $5,000, the penalty is 20% of the underpayment. The penalty doubles to 40% of the underpayment if the claimed value of the property is 40% or less of the correct value.

Claiming benefits from transaction lacking economic substance. If you claim tax benefits from a transaction lacking economic substance,the penalty is 20% of the resulting underpayment. There is no reasonable cause exception for transactions lacking economic substance. The penalty doubles to 40% of the underpayment if the transaction is not adequately disclosed.

Understatement due to undisclosed foreign financial asset. A 40% accuracy-related penalty applies to the portion of a tax underpayment that is attributable to an undisclosed specified foreign financial asset. These are assets required to be reported on Form 8938, as discussed in 48.7.

Claiming basis higher than estate tax value. As discussed in 5.17, you are subject to a 20% penalty if you inherit property that increased the estate tax liability owed by the estate and you claim a basis for the property (such as when you sell or claim depreciation) that is higher than the estate tax value reported to you on Schedule A of Form 8971.

Penalties relating to reportable transactions. A penalty may be imposed on individuals and business entities who fail to adequately disclose a “reportable” transaction on Form 8886. This penalty is in addition to any other penalty that may be imposed. Some reportable transactions may fall into the category of “listed” transactions. The Form 8886 instructions explain the difference between listed transactions and other types of reportable transactions. The amount of the penalty for failure to disclose is generally 75% of the tax reduction claimed on the return as a result of the transaction, but there is a minimum penalty of $5,000 per reportable transaction (whether or not listed) for individuals ($10,000 for non-individual returns). There is also a maximum penalty. If the failure to disclose involves a reportable transaction that is not a listed transaction, the maximum penalty is $10,000 ($50,000 for non-individual returns). If the transaction is a listed transaction, the maximum penalty is $100,000 for individuals ($200,000 for non-individual returns).

There is a separate “accuracy-related” penalty for understating tax liability attributable to a listed transaction or to any reportable transaction (other than a listed transaction) with a significant tax avoidance purpose. The penalty is generally 20% of the understatement if the transaction was adequately disclosed on Form 8886. There is an exception for reasonable cause, but to qualify, stringent requirements must be met; see Code Section 6664(d). If the transaction was not adequately disclosed, the penalty increases to 30% of the understatement and there is no reasonable cause exception.

Fraud penalty. A 75% penalty applies to the portion of any tax underpayment due to fraud. If the IRS establishes that any part of an underpayment is due to fraud, the entire underpayment will be attributed to fraud, unless you prove otherwise.

Interest on penalties. A higher interest cost is imposed on individuals subject to the following penalties: failure to file a timely return (46.9), negligence or fraud, overvaluation of property, undervaluation of gift or estate tax property, substantial understatement of tax liability, or understatements attributable to reportable transactions or undisclosed foreign financial assets. Interest starts to run on these penalties from the due date of the return (including extensions) until the date the penalty is paid. For other penalties, interest is imposed only if the penalty is not paid within 21 calendar days of an IRS demand for payment if the penalty is less than $100,000. The interest-free period is 10 business days after the IRS demand for payment if the penalty is $100,000 or more.

Penalty for filing erroneous refund claim or tax credit claim. A 20% penalty can apply to an erroneous tax credit or claim for refund on any original (46.4) or amended return (47.8), but it does not apply to claims relating to the Earned Income Credit (25.6). The penalty is 20% of the “excessive” amount, the excess of the refund or credit claimed over the amount allowed, unless there is a reasonable basis for the amount claimed. The penalty applies only where the IRS initially disallows part of the credit or refund at the time the return is processed. It does not apply to any portion of the excess that is subject to the accuracy-related penalties (including the penalty for understatements due to reportable or listed transactions), or the fraud penalty. If a refund is paid to a taxpayer and the IRS later determines that the refund was excessive, the accuracy-related or fraud penalty might apply, but the erroneous refund penalty would not apply since the IRS disallowance was after the issuance of the refund.

Penalty for frivolous tax return or submission. In addition to any other penalty, there is a $5,000 penalty for filing a frivolous tax return. A $5,000 penalty also applies to frivolous submissions, including requests for a collection due process hearing or an application for an installment agreement, offer-in-compromise, or Taxpayer Assistance Order based on a frivolous position. In Notice 2010-33, the IRS lists positions it considers frivolous. The IRS provides an in-depth rebuttal of frivolous positions at www.irs.gov/tax-professionals/the-truth-about-frivolous-tax-arguments-introduction.

Acting on wrong IRS advice. A penalty will not be imposed if you reasonably rely on erroneous advice provided in writing by IRS officials in response to your specific written request. It is necessary for you to show that you provided accurate information when asking for advice.

48.7 Penalties for Not Reporting Foreign Financial Accounts

If you have financial interests in foreign bank accounts or other foreign financial accounts or assets, you may be required to file a FBAR, Form 8938, or both. Depending on your holdings, you may be required to file both forms, so check the filing requirements for both. Failure to file a required form may result in substantial penalties.

FBAR. A Report of Foreign Bank and Financial Accounts, generally referred to as the “FBAR”, must be filed if you have a financial interest in or signature authority over foreign bank or other financial accounts and the aggregate value of the accounts at any time during the year exceeds $10,000. The annual report is FinCEN Form 114, which is filed electronically with the Treasury Department. FinCEN is the Treasury’s Financial Crimes Enforcement Network.

The FBAR, if required, is not filed with your income tax return. For 2017 foreign holdings, the FBAR report is due on April 17, 2018. The report is filed with the Treasury Department separately from the income tax return. There is an automatic 6-month filing extension for FinCEN Form 114; no form needs to be filed to obtain the extension.

In Part III of Schedule B (Form 1040 or 1040A) you must tell the IRS if you had a financial interest in or signature interest over a financial account located in a foreign country. If you answer yes, you are directed to the FBAR instructions to determine if you must file the form, and if you are required to file the FBAR, you are asked to enter the name of the foreign country where the financial account is located.

Penalties. If you are required to file a FBAR and fail to do so, a civil penalty of up to $12,459 per violation (this amount is subject to inflation adjustments) may be imposed if the violation was not willful. The penalty may be waived if there was reasonable cause for the failure and a FBAR is properly filed. For a willful failure to file, the civil penalty per violation can be up to the greater of $124,588 (this amount is subject to inflation adjustments) or 50% of the account balance at the time of the violation; criminal penalties may also apply.

Form 8938. Form 8938 must be filed with Form 1040 if you have specified foreign financial assets (SFFAs) at the end of the year in excess of the applicable threshold. SFFAs include, in addition to financial accounts maintained by foreign financial institutions, foreign stocks and securities, financial instruments or contracts issued by a foreign party, and interests in certain foreign estates, trusts, and partnerships. The Form 8938 instructions have detailed definitions of SFFAs and exceptions.

The reporting threshold depends on whether you live in the U.S. or abroad and whether you are married filing jointly. For example, unmarried taxpayers living in the U.S., and married taxpayers filing separately and living in the U.S., must file Form 8938 with their 2017 Form 1040 if the total value of their SFFAs on the last day of 2017 exceeded $50,000, or if the value exceeded $75,000 at any time in 2017. For married couples filing jointly and living in the U.S., reporting on Form 8938 is required if the year-end value of their SFFAs exceeded $100,000, or over $150,000 at any time during the year. For a U.S. citizen living abroad who has been a bona fide foreign resident for a full year or who meets a 330-day physical presence test, Form 8938 must be filed if the year-end value of SFFAs exceeded $200,000, or exceeded $300,000 at any time during the year; these thresholds are doubled to $400,000/$600,000 for married couples filing jointly. The Form 8938 instructions have examples of situations in which filing is and is not required.

Penalties. Failure to file Form 8938, or understating tax by omitting income attributable to an undisclosed SFFA, can result in substantial penalties.

There is a $10,000 penalty for not filing a complete and correct Form 8938 by the due date (including extensions) of your return, and a continuing failure to file within 90 days after receiving IRS notice to file may result in additional $10,000 penalties for each 30-day period, up to a maximum additional penalty of $50,000 (for a maximum penalty of $60,000). If you can show reasonable cause for not filing Form 8938 or not reporting one or more SFFAs, the penalty can be avoided.

As noted at 48.6, an accuracy-related penalty may be imposed if you do not disclose an SFFA and income related to the undisclosed SFFA is not reported on your return. The penalty is 40% of the tax underpayment resulting from the omission of income. The penalty can be avoided if you can show reasonable cause for the underpayment. An underpayment due to fraud is subject to a 75% penalty.

48.8 Agreeing to the Audit Changes

After the audit, the agent will discuss proposed changes either with you or your representative.

If you agree with the agent’s proposed changes, you will be asked to sign a Form 870, which, when signed, permits an immediate assessment of a deficiency plus penalties and interest, if due. The Form 870 is called “Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment.”

If you believe that you have done as well or better than expected regarding the proposed deficiency, you can bring the case to a close by signing the Form 870, but the agent’s supervisor must also approve the assessment.

By signing the form, you limit the amount of interest charges added to the deficiency. A signed Form 870 does not prevent the IRS from reopening the case to assess an additional deficiency. If on review the deficiency is increased, you will receive a revised Form 870. You can refuse to sign the form. The signed first form has the effect of stopping the interest on the original deficiency. As a matter of practice, however, waivers of acceptances ordinarily result in closing of the case.

It is possible, although unlikely, that upon examining your return, the agent will determine that you are due a refund. In this situation, a signed Form 870 is considered a valid refund claim. You should file a protective refund claim even if you sign the Form 870 acknowledging the overpayment. Generally, the agent will process the refund, but if he or she fails to do so or the review staff puts it aside for some reason and the limitations period expires, the refund will be lost. The refund claim will protect you from such a mishap.

The payment of tax before the deficiency notice (90-day letter) is mailed is, in effect, a waiver of the restrictions on assessment and collection. If the payment satisfies your entire tax liability for that year, you cannot appeal to the Tax Court. You must sue for a refund in either federal district court or the Court of Federal Claims.

48.9 Disputing the Audit Changes

If you disagree with the agent and the examination takes place in an IRS office, you may ask for an immediate meeting with a supervisor to argue your side of the dispute. If an agreement is not reached at this meeting or the audit is at your office or home, the agent prepares a report of the proposed adjustments. You will receive a 30-day letter in which you are given the opportunity to request a conference. You may decide not to ask for a conference and await a formal notice of deficiency (90-day letter).

Appeals conference. If your examination was conducted as an office audit or by correspondence, or the disputed amount does not exceed $25,000, you do not have to prepare a written protest for a conference with the IRS Appeals Office. The written protest is a detailed presentation of your reasons for disagreeing with the agent’s report. Even where a formal written protest is not required, you must provide a brief written statement indicating your reasons for disagreeing with the agent when you request an appeals conference; you can use Form 12203 (Request for Appeals Review).

At the conference you may appear for yourself or be represented by an attorney or other agent, and you may bring witnesses. The conference is held in an informal manner and you are given ample opportunity to present your case.

If you cannot reach a settlement, you will receive a Notice of Deficiency, commonly called a 90-day letter. In it, you are notified that at the end of 90 days from the date it was mailed, the government will assess the additional tax.

Interest abatement. An IRS delay in completing an audit increases the interest that you have to pay when a deficiency notice is eventually issued. You may ask the IRS on Form 843 for an abatement of interest charges that are attributable to unreasonable errors or delays by IRS employees in performing a ministerial or managerial act.

A ministerial act is defined as a procedural or mechanical act that does not involve the exercise of an IRS employee’s discretion or judgment, such as the transfer of a taxpayer’s case to a different IRS office after the transfer is approved by a group manager. A managerial act refers to the exercise of discretion or judgment by an IRS employee in managing personnel. Misplacing the taxpayer’s case file is also a managerial act. General IRS administrative decisions, such as prioritizing the order of processing returns, or decisions on applying the tax law, that result in delay, are not ministerial or management acts for which interest abatement is available.

If you make a request on Form 843 for an abatement of interest and the IRS rejects your claim, you can petition the Tax Court within 180 days to review whether the IRS abused its discretion, provided that your net worth does not exceed $2 million ($7 million for businesses). The same net worth limit applies to recoveries of administrative and litigation costs; see 48.10. The Tax Court has exclusive jurisdiction to review the denial of the interest abatement request; an appeal of the IRS decision cannot be brought in a federal district court or the U.S. Court of Claims.

Going to court. Within 90 days from the date a 90-day letter (notice of deficiency) is mailed to you (150 days if it is addressed to you outside the United States), you may file a petition with the Tax Court without having to pay the tax. The Tax Court has a small tax case procedure for deficiencies of $50,000 or less. Such cases are handled expeditiously and informally. Cases may be heard by appointed special trial judges. A small claim case may be discontinued at any time before a decision, but the decision when made is final. No appeal may be taken by you or the IRS.

Instead of petitioning the Tax Court, you may pay the additional tax, file a refund claim for it, and—after the refund claim is denied—sue for a refund in a federal district court or the U.S. Court of Federal Claims.

You should consult with an experienced tax practitioner before deciding to litigate.

48.10 Offer in Compromise

If you are unable to pay a tax debt in full, you may be able to make an offer in compromise (OIC), but it should be considered a last resort. An OIC is an agreement between a taxpayer and the IRS in which the IRS accepts less than full payment of the outstanding tax liabilities as settlement of the tax debt.

However, the number of accepted offers has declined steadily, and the National Taxpayer Advocate believes that taxpayers are deterred from applying by the burdensome disclosure and other application requirements. There is generally a $186 application fee (some exceptions apply) that the IRS will keep unless the offer cannot be processed. There also is a requirement to submit a nonrefundable payment with the offer on Form 656, and this has been strongly criticized as a major reason for reducing access to the OIC program.

There are two payment options. You can make an up-front payment on Form 656 equal to 20% of a lump-sum offer, with the balance payable in five or fewer installments within five months of IRS acceptance. Alternatively, you may choose the periodic payment option, which requires you to submit the first proposed payment with Form 656 and pay the rest of your offer within 24 months. You must make regular payments in accordance with your proposed offer while the IRS considers your application. These upfront payments are not refundable even if you withdraw the offer prior to IRS acceptance or the IRS rejects the offer; they will be applied to your tax debt.

The only exceptions to the application fee and upfront payment requirements are for (1) low-income individuals who certify that their income is below poverty guidelines, and (2) taxpayers who file an offer on Form 656-L based on doubt as to liability. The IRS as well as the Treasury Department and Taxpayer Advocate have called on Congress for legislation to eliminate mandatory upfront payments.

Grounds for an Offer in Compromise. The IRS has authority to settle or “compromise” for one of the following reasons: Doubt as to liability, doubt as to collectibility, and effective tax administration. Doubt as to liability means that doubt exists concerning the correctness of the IRS’ tax assessment. Doubt as to collectibility means that you may never be able to pay the full amount of tax owed. Even where there is no doubt that you owe the tax and you could manage full repayment, you can apply for an OIC on “effective tax administration” grounds if collection of the full tax would cause you economic hardship or there are exceptional circumstances that would make full collection unfair and inequitable.

Applying for an Offer in Compromise on Form 656 or 656-L. You must submit an OIC on Form 656 where the offer is based on doubt as to collectibility or effective tax administration (exceptional circumstances). The IRS will consider the OIC only after other payment options have been exhausted, including an installment agreement. An OIC based on doubt as to liability must be filed on Form 656-L; there is no application fee or upfront payment requirement for an offer made on Form 656-L.

When you submit an OIC on Form 656, you must make an upfront payment unless the exception for low-income taxpayers applies as discussed above. Form 656-B, the OIC booklet, includes an explanation of the OIC program and instructions for completing Form 656. The booklet also includes financial disclosure statements that must be attached to support an OIC based on doubt as to collectibility or effective tax administration. Wage earners and self-employed individuals must use Form 433-A, while partnerships and corporations use Form 433-B. In some cases, the IRS may request Form 433-A from corporate officers or individual partners. Form 656-B is available online at www.irs.gov or can be obtained by calling (800) 829-3676.

If your offer is rejected, you will be given an opportunity to appeal the decision and to amend the offer.

Application fee. An application fee must be paid with Form 656 unless you certify in Section 1 of Form 656 that your total monthly income is at or below federal poverty guidelines (Section 1 has a table showing the monthly income limits based on family size). The fee is $186. No fee is required for an offer made on Form 656-L based on doubt as to liability.

Compliance conditions. If the IRS accepts an OIC, you must pay the agreed-to amount in accordance with the acceptance agreement and must timely file and pay all required taxes for a period of five years from the acceptance date, or until the accepted amount is paid in full, whichever is longer. You may also be asked as part of the agreement to pay a percentage of your future earnings to the IRS. A failure to comply with the agreement causes default of the OIC and the reinstatement of the original liability.

48.11 Recovering Costs of a Tax Dispute

In a tax dispute, you may believe that the IRS has taken an unreasonable position, forcing you to incur legal fees and other expenses to win your case. You may be able to recover all or part of—

1. Reasonable administrative costs of proceedings within the IRS, and
2. Reasonable litigation costs in a court proceeding.

A judgment for reasonable litigation costs will not be awarded in any court proceeding if you did not exhaust all IRS administrative remedies. A refusal by the taxpayer to agree to an extension of time for a tax assessment is not a bar to an award, but unreasonably delaying the proceedings is.

You may not recover costs if your net worth at the time the action begins exceeds $2 million. The $2 million net worth limit applies separately to each spouse in determining whether a married couple filing jointly is entitled to recover legal fees. No recovery is allowed to sole proprietors, partnerships, and corporations if their net worth exceeds $7 million or they have more than 500 employees.

To receive an award, you must “substantially prevail” as to the key issues in the case or the amount of tax involved. If you do, you will be entitled to a recovery unless the IRS proves that it was “substantially justified” in maintaining the position that it did. You may be treated as the prevailing party if a court determines that your liability is equal to or less than an amount that you offered in settlement. The offer must be considered a qualified offer made during a period that begins on the date of the first letter of proposed deficiency allowing for an IRS administrative appeal and ends 30 days before the date first set for trial.

The Tax Court and other courts have interpreted “substantially justified” to be a reasonableness standard. The IRS is presumed not to be “substantially justified” if it does not follow its own published regulations, revenue rulings, procedures, notices, announcements, or a private ruling issued to the taxpayer. The IRS may try to rebut the presumption. A court may also consider whether an IRS position has been rejected by federal courts of appeal of other circuits in determining whether the IRS position was substantially justified.

Reasonable administrative costs include IRS fees, reasonable fees for witnesses and experts, and attorneys’ fees subject to the annual limit; see below. The IRS determines the amount of such an award, which may include costs incurred from the date the IRS sent its first letter of a proposed deficiency allowing you to ask for an administrative appeal. For an award of administrative costs, you must file an application with the IRS before the 91st day after the date on which the IRS mailed you its final decision. To appeal a denial of your application, you must petition the Tax Court within 90 days from the date the IRS mailed the denial.

Reasonable litigation costs include reasonable court costs, fees of witnesses and experts, and attorneys’ fees. Fees of witnesses may not exceed the rate paid by the U.S. government. For attorneys’ fees incurred in 2015 through 2017, the limit is $200 per hour. The limit was $190 per hour for attorneys’ fees incurred in 2013 and 2014 and $180 per hour for fees incurred in 2009-2012. The court may also increase the award for attorneys’ fees to account for special factors, such as the difficulty of the issues and the availability of local tax expertise. However, an attorney’s general expertise in tax law or experience in tax litigation is not in itself a special factor warranting a higher fee award.

You may not recover attorneys’ fees if you represent yourself (pro se). However, you are still entitled to recover fees for witnesses and experts. If you represent a prevailing taxpayer on a pro bono basis or for a nominal fee, a court may award you or your employer reasonable attorneys’ fees.

48.12 Suing the IRS for Unauthorized Collection

If an IRS employee or officer recklessly, intentionally, or negligently disregards the law or IRS regulations when taking a collection action, you may sue the IRS in federal district court for actual economic damages resulting from the IRS employee’s misconduct, plus certain costs of bringing the action. The lawsuit must be filed within two years of the date that the unauthorized collection action was taken.

For negligent IRS collection activities, you may sue for damages of up to $100,000, and for reckless or intentional misconduct, the maximum damage award is $1 million. Administrative remedies must be exhausted to obtain an award.

According to IRS regulations, actual economic damages that may be recovered are monetary losses you suffer as a direct result of the IRS’ action. For example, a business may lose loyal customers and suffer an actual cash loss if the IRS’ action damages the business’s reputation. Other actual expenses could include the cost of renting a house or a car if the IRS puts a lien on or seizes your property, or loss of income due to the garnishment of your paycheck. Damages from the IRS for loss of reputation, inconvenience, or emotional distress are allowed only to the extent that they result in such actual monetary loss.

The IRS defines “costs of action” that you may recover as (1) fees of the clerk and marshall; (2) fees of the court reporter; (3) fees and disbursements for printing and witnesses; (4) copying fees; (5) docket fees; and (6) compensation for court-appointed experts and interpreters.

Litigation costs and administrative proceeding costs are not treated as “costs of the action.” However, if the IRS denies your administrative claim for damages and you successfully sue in federal district court, you are considered a “prevailing party” and may recover attorneys’ fees, related litigation expenses, and administrative costs before the IRS as discussed in 48.11.