501 Service Center Correspondence Audit Program

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1 Checkpoint Contents Federal Library Federal Editorial Materials PPC's Tax and Financial Planning Library Dealing with the IRS Chapter 5 Audits of Individual Returns 501 Service Center Correspondence Audit Program 501 Service Center Correspondence Audit Program Generally speaking, correspondence examinations (corr exams) are appropriate when the questioned items are susceptible to direct verification from records that can be easily submitted by mail and the inspection of other returns is not necessary. Internal Revenue Manual (IRM) provides a list of issues that are conducive to a Wage and Investment (W&I) Division or Small Business/Self Employed (SB/SE) Division corr exam. By way of example, these include dependency exemptions and related credits [Earned Income Tax Credit (EITC), Child Care Credit, Adoption Credit, etc.], Hope and Lifetime Learning Credits, Schedule C or F income and expenses, employee business expenses, home office deduction (if tour of home is not required), and some itemized deductions. Itemized deductions that are not candidates for a corr exam include investment interest expense, noncash charitable contributions such as donations of art work that require an appraisal, contributions carried over from a prior year, casualty theft/loss deductions that require research and verification of records, and miscellaneous deductions such as investment expenses, attorney fees, gambling losses, and transportation expenses According to a June 2014 Government Accountability Office (GAO) report on correspondence audits (GAO ), the top four issues in corr exams closed in fiscal year (FY) 2013 in the Wage and Investment (W&I) Division were the EITC, Criminal Investigation (CI) cases (generally examinations of clients of return preparers who prepared false or fraudulent returns), miscellaneous credits, and Schedule A deductions. (In fact, of the 584,000 W&I corr exams closed that year, 336,000 involved the EITC.) The top four issues in corr exams closed in FY 2013 in the Small Business and Self-employed (SB/SE) Division were the EITC, nonfilers, Schedule A deductions, and employee business expenses. (Of the 466,000 SB/SE corr exams closed that year, 146,000 involved the EITC.) The main determinant for selecting EITC returns for audit is the score from the Dependent Database (DdB). Using filters created from various criteria, the DdB creates scores for returns before refunds are disbursed. Returns with the highest scores are selected for audit An August 2013 Treasury Inspector General for Tax Administration (TIGTA) report (number ) states that in fiscal years 2008 through 2012, the IRS conducted about 5.7 million correspondence audits and recommended approximately $40.4 billion in additional taxes from those audits. During the same period of time, the recommended additional taxes from correspondence audits

2 increased every year, in both absolute terms and as a percentage of total additional individual income taxes. One reason for this steady growth is that the correspondence audit process is more economical to conduct when compared to other types of audits. According to a December 2012 Government Accountability Office (GAO) report, correspondence audits of individual tax returns are significantly less costly on average than face-to-face audits conducted in the field. The GAO estimated that the average cost (including overhead) of correspondence audits opened in FYs 2007 and 2008 was $274, compared to an average of $2,278 for field audits Observation: Correspondence audits constitute an "examination" of the taxpayer (IRC Sec. 7602). Thus, the taxpayer has the right to appeal the Tax Examiner's determination to the Appeals Division (see section 801) unless there are extenuating circumstances (e.g., the taxpayer refuses to extend the assessment statute of limitations for the year under audit). Conversely, contact with a taxpayer solely to resolve a discrepancy is not an examination. (A discrepancy occurs when the amount from an information return cannot be accounted for on the tax return. Conversely, an examination occurs when the IRS goes beyond resolving a discrepancy, such as unreported income not covered by an information return.) Despite the limited scope of correspondence audits, every case must contain workpapers that document and support the examination process and results (IRM ). And while Campus examination personnel generally do not develop or assert penalties against tax return preparers, they are instructed to flag cases where there are indications of possible tax preparer violations and forward the case to the Examination Return Preparer Coordinator (IRM ) There are several aspects of the correspondence audit program that can be frustrating for practitioners. First, unlike the educational requirements for Revenue Agents (four year degree plus 30 semester hours of accounting), the Tax Examiner position is an entry-level position requiring a high school diploma or equivalent. To overcome this obstacle, Tax Examiners frequently follow "if when" scenarios to work their cases that do not account for gray areas of the law or differences in taxpayers' fact patterns. Second, there is no one Tax Examiner assigned to the case. Each time the taxpayer or authorized practitioner calls to discuss the exam, he or she may (will) reach a different Tax Examiner. Third, it can be difficult to reach any Tax Examiner because of the overloaded telephone lines-in her 2011 report to Congress, the National Taxpayer Advocate cited statistics that 62% of callers are repeat callers and 13% call more than eight times to resolve their issue(s). Finally, the IRS relies on a literal definition of the term "manual correspondence" to exempt computer generated correspondence from the 1998 IRS Restructuring and Review Act requirement that all manually generated correspondence include the name and telephone number of an employee that the taxpayer can contact Practice Tip: The Practitioner Priority Service (PPS) for tax professionals has a dedicated number for correspondence examinations. Practitioners can call (866) and select option seven for correspondence examinations Another problem is the length of time it takes the IRS to review and respond to taxpayers' responses. The overage threshold is 30 days for SB/SE and 65 days for W&I. According to the GAO, 50% of W&I's corr exam inventory was overage in FY 2013 while 77% of SB/SE's inventory was overage. The IRS responded that the increase in delayed responses was caused by several factors, including

3 budget reductions due to the sequester and staff furlough days that cut the resources for working taxpayer correspondence. Given reduced staff resources, the IRS has lowered the number of correspondence audits planned for FY 2014, which should help manage the backlog. The IRS plans to close 911,400 corr exams in FY 2014, a 13% reduction from the FY 2013 number According to IRM , "if a taxpayer requests a face-to-face interview, the request should be honored." Other instances where a face-to-face interview would be required include issues that have become too complex for correspondence and cases with fraud potential, since the "development of fraud requires face-to-face contact." Nevertheless, given the huge number of correspondence examinations and the limited number of IRS employees dedicated to handling and closing them, it can be difficult to get a case reassigned. In one portion of her 2011 Annual Report to Congress, the National Taxpayer Advocate stated that Campus employees are told to make taxpayers request a transfer in writing and to attempt to persuade the taxpayer to continue to resolve the matter through correspondence. Furthermore, the regulations governing changes in audit location do not even mention correspondence examinations, and prohibit transfers to an office lacking the resources (e.g., available examiners without a full caseload) to handle the examination. Responding to an Examination Notice Different notices are used to contact the taxpayer. They identify the issue(s) under audit and request information from the taxpayer to verify and support the identified credit or deduction. For example, Letter 566 (Initial Contact#Notification of Examination and Request for Documentation) informs the taxpayer of the area(s) the IRS has selected and requests documentation to substantiate the information shown on the return. Some initial contact letters also include issue-specific questionnaires, which are to be filled out and returned with the response. All initial contact letters should include a copy of Publication 3498-A, which explains the process for examinations conducted by mail and addresses taxpayer appeal and advocacy rights. Most Service Center letters provide for a 30-day response deadline. (There are exceptions, so each letter should be reviewed for the applicable deadline.) If additional time is needed, the IRS will usually provide a 30-day extension of time to respond to the notice The practitioner should determine whether there are any discrepancies between the taxpayer's documentation, the information reported on the tax return, and the IRS's information. This can be done by requesting a wage and income transcript from the IRS to compare the return with all information already provided to the IRS by third parties (such as employers and financial institutions on Forms W-2 or 1099). (However, the IRS website cautions that most recent year information may not be complete until the following July.) The e-services Transcript Delivery System allows practitioners with a power of attorney (Form 2848) recorded on the Centralized Authorization File (CAF) to electronically request and receive client transcripts 24 hours a day, seven days a week. Practitioners must register to create and access a secure mailbox. The registration process is a one-time automated process in which the practitioner selects a username, password, and personal identification number (PIN) that is used to log in to e-services.

4 The practitioner's objective is to make it easy for the Tax Examiner to review the taxpayer's documentation and/or tie the disputed item(s) to the client's tax return. Depending on the reason for the examination notice, the practitioner may want to include a spreadsheet with the response. For example, if the notice involves charitable contributions, the spreadsheet can have columns for the date and amount of each contribution, an identification of the payee, the tax return line (or schedule) where the contribution was reported, an explanation of the client's substantiation, and a reference to where a copy of the substantiation can be found (e.g., Attachment 1 of 3) Taxpayers and practitioners can communicate with Compliance personnel by telephone or in writing. The telephone enables the practitioner to instantly communicate information and obtain feedback concerning the current status of the examination but does not provide a written trail of what has happened. Facsimile (fax) transmissions are immediate but also provide a paper trail. However, to minimize problems, the authors recommend the following standards and procedures for faxing information to the IRS: a. Prior to faxing information, a telephone call should be made so the tax examiner will be expecting the fax and will receive the faxed information as soon as it is transmitted. b. All faxed items must have a cover sheet providing the following information to identify the person being faxed: (1) first and last name, (2) IRS Mail Stop, (3) office telephone number, (4) fax telephone number, (5) number of pages being transmitted, and (6) remarks. c. All faxed documents must be legible and have good contrast. It is not necessary to follow-up with an original copy unless it is a tax form that requires an original signature. The IRS cannot accept an income tax return, claim for refund, address change, or amended return unless the return has an original signature (but note that electronic signatures are often accepted). d. First-time inquiries should not be sent by fax since the IRS cannot acknowledge their receipt Practice Tip: The practitioner should carefully review the examination report to verify the accuracy of the content (factual and legal reason for any adjustments) and the resulting computations. The practitioner should also determine whether there is a reason for avoiding penalties. The taxpayer may have reasonable cause or a prerequisite may be lacking for the Tax Examiner to assert the penalty (e.g., to be a substantial understatement of income tax, the understatement must exceed the greater of 10% of the tax required to be shown on the return, or $5,000) Note: A recent Treasury Inspector General for Tax Administration (TIGTA) report (number ) concludes that the IRS is leaving tax revenue on the table by not examining prior or subsequent year returns when a tax understatement is identified during a correspondence audit. In a sample of 102 IRS correspondence audits with tax understatements of $4,000 or more, 43 cases had similar noncompliance issues in a previous or subsequent year. Of the 43 cases, the IRS failed to pursue follow-up audits with 32 taxpayers. This indicates an increased possibility in the future that a revenue-generating correspondence audit will be expanded to include additional tax years It bears repeating that the IRS does not initiate taxpayer contact via unsolicited , or ask for personal identification or financial information via or letter. A client who receives a suspicious

5 from the IRS should not open any attachments to the or click on any links. (The links often connect to a phony IRS website that prompts the victim for personal identifiers, bank or credit card account numbers, etc.) The client should forward the suspect or URL address to a special IRS mailbox ( phishing@irs.gov ) and then delete the from their inbox. Agreement with the Proposed Changes If the taxpayer agrees with the proposed changes, the letter should be signed and returned to the Service Center, within 30 days (along with payment, if possible, to stop the further accrual of interest). If the taxpayer sends payment but forgets to sign the letter, the case is considered closed as well. If the taxpayer agrees with the proposed changes but cannot pay, the Service Center will provide information on an offer in compromise or an installment agreement The IRS cannot reopen a closed case to make an adjustment unfavorable to the taxpayer unless fraud, a "clearly defined substantial error," or one of the other factors listed in Reg (j) exist. A subsequent office or field audit will not be subject to the reopening rules if the prior contact is intended to resolve a discrepancy and is limited to verification of the information amount. However, if the income on the information return cannot be considered without also considering other sources of income, an examination will result, and reopening procedures may apply. Taxpayer Explains Discrepancy or Disagrees with the Proposed Changes If the taxpayer's response contains a satisfactory explanation, the return will be accepted without change, and a "No Change" letter will be sent to the taxpayer. If the explanation is insufficient or the Service Center needs more information, a letter will be sent explaining what additional information is needed and the deadline for providing that information If the explanation is not satisfactory, a 30-day letter will be sent with a report advising the taxpayer of the proposed tax change and appeal rights. Although the IRS prefers resolving the matter by correspondence, if the taxpayer requests an interview or it is determined an interview is necessary (such as when issues have become too involved or the taxpayer cannot communicate effectively in writing), the case may be transferred to the Area Office. If the taxpayer does not exercise his or her appeal rights or fails to respond to the 30-day letter, a Notice of Deficiency (90-day letter) is issued. No Response to the Correspondence If no response is received, a 30-day letter will be sent with a report advising the taxpayer of the proposed tax change and appeal rights. If the taxpayer does not exercise his or her appeal rights or fails to respond to the 30-day letter, a Notice of Deficiency (90-day letter) is issued. Taxpayer Requests a Conference If the taxpayer requests a conference with an examiner, the case will be handled as unagreed. If an interview is necessary (e.g., issues have become too involved or the taxpayer cannot effectively

6 communicate in writing), the case should be transferred to the Area Office where the taxpayer resides, although the IRS will try to resolve the matter by correspondence or telephone before making the transfer. If a resolution of the audit cannot be obtained by corresponding with the IRS, it is best in most situations to request the case be transferred to the Appeals Office nearest to where the taxpayer resides. Strategies for Handling a Correspondence Audit A taxpayer contacted by the Service Center for a correspondence audit has two choices. First, the taxpayer can respond by answering the questions or resolving the issues raised by the Tax Examiner. If this option is chosen, prompt response to the Service Center's inquiry is crucial. Second, the taxpayer can request the case be forwarded to the Area Office for examination. It is usually advantageous to close a correspondence examination directly with the Tax Examiner. If nothing else, requesting an office audit exposes the taxpayer to the risk of the examiner raising additional issues In responding to a correspondence audit, the practitioner shoulda. Obtain a signed Form 2848 (Power of Attorney and Declaration of Representative) for each taxpayer involved in the audit (i.e., a separate power of attorney is required for each spouse). The Form 2848 will allow the practitioner to represent the taxpayer and obtain transcripts of the taxpayer's account from the IRS for the year of the notice. b. Review the notice received, specifically the response date. (Taxpayers are notorious for waiting to the last minute to forward IRS correspondence to their practitioner.) Analyze the issues in detail and reconcile the differences prior to contacting the IRS. c. Respond within the indicated response time. Generally, the IRS notices allow 30 days for a response. If additional time is needed, the practitioner may request an extension of time in writing prior to the deadline. However, a more efficient way to secure the extension request is via telephone contact with the IRS representative. The practitioner may request a "STAY" be put on the account that allows the practitioner more time to resolve the issues and prevents the taxpayer's account from being forwarded to the collection phase. d. Address each issue in the correspondence audit separately and provide detailed explanations, calculations, or supporting documents for the taxpayer's position. For example, if the dispute involves the substantiation of claimed charitable contributions, state: "The taxpayer correctly deducted $15,000 of charitable contributions allowable under the authority of IRC Sec See the attached documentation supporting taxpayer's claimed charitable contribution deduction." e. Document the progress of the audit in writing. If telephone contact is made, make sure to record the date of the conversation, the "badge number," and location of the IRS contact. Mail or fax a confirming letter outlining the verbal discussion and the terms of agreement, if any. Documenting each step of any dealings with the IRS is crucial. f. Do not mail original documents to the Service Center (Campus). If supporting documentation items are requested, send copies only because Service Centers sometimes lose or misplace documents. It is not uncommon to have to resend documentation. The practitioner should make sure to keep an

7 exact copy of what is sent to the IRS. Practice Tip: The authors recommend that the practitioner open a separate file entitled "IRS Audit-Correspondence" for each taxpayer and maintain all related documentation of the audit from inception to closure in a separate file. This facilitates easy access when an IRS examiner calls and maintains all documents in one spot. g. Include a copy of the immediately preceding correspondence sent by the Service Center. This allows prompt matching of the file with the correspondence, which reduces the likelihood of error. h. Consider sending all correspondence by certified mail, return receipt requested. It is critical to maintain the actual post office receipt of payment together with the "green card." The postal payment receipt and the green card both show the tracking number and will provide positive proof that the information was forwarded in a timely fashion. The IRS informally allows seven days from the due date to be considered timely. If the IRS Service Center (Campus) stamps the receipt date on the "green card" on the eighth day or later, the practitioner may receive notice of untimely filing. The only way to prove timely filing is with the postal receipt and green card. i. Contact the local Taxpayer Advocate if problems arise and/or request the issuance of a Taxpayer Assistance Order (see section 104) or complete Form 911 [Request for Taxpayer Advocate Service Assistance (And Application for Taxpayer Assistance Order)]. The Taxpayer Advocate's authority is not restricted to collection matters or problems originating from area-level office or field audits Practice Tip: As electronic funds transfers with the IRS become more common, responding to inquiries or errors about the account will require different information. When inquiring or responding to requests about an electronic transfer, provide the (a) date of the transfer, (b) bank account number and bank routing number, and (c) funds transfer number. Since many banks no longer return customers' checks with the bank statement, request a copy of the front and back when ordering a check to provide evidence of the payment so that the document locator number (DLN) can be used by the IRS to trace the payment. If the practitioner is eligible for e-services, an up-to-date transcript of the payments posted to the client's account is available online When requesting a change to a particular tax form or schedule, the practitioner should submit a corrected copy of the form or schedule with the words, "For information purposes only-do not process," written across the top. This will clarify the problem and expedite the request. On penalty adjustments, state the reason in a clear fashion. If the request is based on reasonable cause, explain the facts establishing the taxpayer's reasonable cause in as much detail as possible, including dates, supporting documents, etc. Closing a Correspondence Audit Closing a correspondence audit is relatively easy. Either the Tax Examiner will review the information supplied by the practitioner and accept the return as filed, or issue a 30-day letter. Once the 30-day letter is issued, the taxpayer has 30 days to appeal the determination. (See section 801.) If the statute of limitations for assessing additional tax will soon expire, the Tax Examiner may bypass the 30-day letter and issue a 90-day letter (Notice of Deficiency).

8 If the taxpayer does not appeal within 30 days, a Notice of Deficiency will be sent to the taxpayer. At that point, the taxpayer can either (a) file a Tax Court petition within the applicable 90-day period (or 150-day period for taxpayers residing outside of the U.S.); (b) pay the tax and file a claim for refund (see section 204); or (c) ignore the Notice of Deficiency, resulting in a transfer of the case to the Collection Division Thomson Reuters/PPC. All rights reserved Thomson Reuters/Tax & Accounting. All Rights Reserved.