How To Detect & Mitigate IRS Exams Before They Begin

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Loreen Houston
6 years ago
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Qualified as an N.T.P.I. Fellow in 2015.

1 How To Detect & Mitigate IRS Exams Before They Begin Learn how to detect IRS Exams early and mitigate the effects for your clients. Roger Nemeth, EA Started managing tax franchises in Developed Audit Detective in Roger working undercover narcotics in 1999 in Florida. Qualified as an N.T.P.I. Fellow in Worked as a programmer for the largest Tax Resolution Company integrating automated transcript systems into workflow programs. Assisted in the downloading and research of over 30 million transcripts. To date our software has been used to download just under one-fifth of a billion transcripts. 1

2 Presentation Overview This presentation will cover how to detect IRS Examinations before they begin. Once detected the exam effects can be mitigated. The required data is located on the tax payers IRS Tax Transcripts. This presentation will focus on how the Tax Help Software Executive Product will automate this process, but these processes can be done by a trained tax pro using IRS Transcripts. How To Generate Revenue From Early Audit Detection By detecting audits in advance it provides a revenue opportunity for a tax professional and/or firm. 1. CP2000 AUR s 1. Allows for an amended return to be filed plus any associated penalty abatement opportunities. 2. Field/Correspondence Audit 1. Possibly allows for an amended return. 2. Allows billable prep time in anticipation of audit. 2

3 Handout Overview Power Point Summary. IRS Transcript Cheat Sheet. IRS Examination Fact Sheet FS , January 2006 Tax Payer Advocate Information on Accuracy Related Penalties Exam Vs Audit There is always a great debate about what is an audit and what is an exam. For purposes of this presentation I use the words interchangeably while acknowledging that there is some debate on the subject. Presentation Note: A taxpayer can receive a CP2000 and also be audited with a field or correspondence audit. 3

4 Tax Help Software Description Tax Help Software Executive Product is software that is designed to download IRS transcripts and analyze the data within them. For purposes of this class all of the learning points can be accomplished manually with just a tax professional reviewing the transcripts. The Executive product has an optional feature that automatically downloads transcripts for all taxpayers under CAF authority and notifies the user of any changes since the last transcript pulled. The screen shots in this presentation are used to demonstrate the information a trained tax pro can extract from a transcript. Setting up THS Explanation Of How The Software Tracks Tax Payer s IRS Accounts 1. Install software and import all tax clients from tax software or CRM. 2. Check to see which taxpayers are under CAF. 3. Generate 8821/2848 for any taxpayer in bulk. 4. With optional auto order the software automatically checks daily to see if they pass CAF and then download transcripts back to 1990 on initial pull. Without optional auto order the user can still bulk request any transcripts and be notified of any changes. 5. Every week after the software will retrieve only the last four account transcripts and any prior year with an issue. 6. Any changes on the transcript (like a new audit flag or notice) will show up on the change report. 4

5 Types of Audits Correspondence Audit Exam conducted via mailed correspondences. Field Audit Exam conducted at taxpayer s business or residence. Office Audit Exam conducted at IRS office. National Research Program (NRP) Audits Randomly selected audits. Automated Under Reporter(AUR) - CP2000 This correspondence exam compares income & deductions reported with income filed on return. Chances Of Audit And AUR According to the IRS 2016 Data Book (Statistics of Income October 1, 2015 to September 30, 2016) An individual tax return has a 3.04% chance of receiving an audit or AUR in any given tax year Tax Year 2016 Calendar Year Totals Individual Returns Filed Total Audit/AUR % Audit % Total Audits Field/Office Audits Correspondence Audits AUR % Closed AUR Totals 147,967, % 0.7% 1,034, , , % 3,477,000 5

6 IRS Transaction Codes For Exam TC 420/424 Examination of return Correspondence Audit. Field Audit. Office Audit. NRP Audit. TC 922 Review of unreported income Automated Under Reporter(AUR) - CP2000 Misconception About IRS Audits on IRS Transcripts The misconception about the Audit Codes on the IRS transcripts is that the audit has begun and the letter has been mailed when the 420/424 is posted: 1. The Module (the tax year and period if quarterly) are flagged for audit. The transaction is recorded on the account transcript. 2. There is then a classification/survey period that takes place to determine if the actual audit should begin. The classification/survey period can vary. 3. If the IRS decides to move forward the letter is sent and the audit officially begins. 6

7 Exam Flag Transaction Codes All exam flags except AUR are: 420 Examination of tax return 424 Examination of tax return AUR Flag is: 922 Review of unreported income THS Detecting Audit Flag Audit Flag in 2015 AUR/CP2000 Flag in

8 AUR Information A common misconception with AUR s is that they are completely automated. The IRS computer determines what was filed on the return with what was reported to the IRS from third parties and if the two do not match resulting in more tax being owed then the audit letter is sent. AUR s are reviewed by IRS personnel just like regular audits except they are done within the AUR unit. AUR Information ( ) Background 1. Potential AUR cases are systemically identified through computer matching of tax returns with corresponding information returns in the Information Returns Master File (IRMF). Cases are selected for inventory in a manner determined to provide overall compliance coverage. Selected cases undergo an in-depth review by a tax examiner to identify underreported and/or overdeducted issues which require further explanation to resolve the discrepancy. Presentation Note: Information returns are the income documents in the Wage & Income Transcripts. 8

9 Wage & Income Complete Date The IRS considers the Wage & Income Transcripts to be complete 13 months after the year they were earned. For example for 2011 the W&I Transcripts would not be complete until February 1 st, 2013 When Do AUR Audits Take Place A misconception is AUR s are all sent during the same time frame. A review of 1,290 AUR s from the 2011 tax year show they are spread out through the year. (next slide) Although the date changes after the letter is sent it appears AUR s occur during the year and not all at once, but the best practice is to check for them early in the following year (January through March) to get the biggest head start. 9

10 2011 AUR Flag Breakdown IRS Considers W&I Complete 2015 W&I Populates through 2016 Matching Program FLAGS (Code 922) 2015 Unreported Income Feb-Mar Wage & Income Database Populates throughout Calendar 2016 AUR sends out 2015 CP2000 Notices March March

AUR Transaction Date Will Change As Audit Proceeds The date on the AUR 922 transaction code will update as follows. 1. The first posting is the AUR Flag. 2.

11 AUR Transaction Date Will Change As Audit Proceeds The date on the AUR 922 transaction code will update as follows. 1. The first posting is the AUR Flag. 2. The second posting will be the sending of the CP2000 or 2501 Notice. 3. The third date change will be when the audit results in an assessment. Presentation Note: There will only be one 922 transaction. The date is just changed. Detecting AUR Notice Sent When you see the date change for a AUR/CP2000 that usually means the notice is sent to the taxpayer. Presentation Note: The date change can also indicate the assessment is being made as well. 11

12 IRS Discriminate Index Function (DIF) Score IRS 6209 Section 12 - Examination 2. Discriminate Function (DIF) Discriminate Function (DIF) is a mathematical technique used to classify income tax returns as to Examination potential. Under this concept, formulas are developed based on available data and are programmed into the computer to classify returns by assigning weights to certain basic return characteristics. These weights are added together to obtain a composite score for each return processed. This score is used to rank the returns in numerical sequence (highest to lowest). The higher the score, the higher the probability of significant tax change. The highest scored returns are made available to Examination upon request. The DIF-system involves computer classification to mathematically determine the Examination potential of returns, and manual screening to set the scope of examinations and to select needed workload. DIF Score Meaning The IRS DIF Score does not determine Audit Chances for that return. It identifies the potential change in tax amount. The decision to audit is made during the classification/survey Period. Higher income returns are selected at a higher rate based on the calculation. The IRS is concerned about total amounts not percentages. Example 1: Two taxpayers take 75% itemized deductions (in relation to income). Taxpayer 1 wages = $100,000. Taxpayer 2 wages = $1,000,000. Taxpayer 2 will have a much higher DIF score because his itemized deductions are 10 times more than Taxpayer1. Example 2: Two taxpayers take $75,000 in itemized deductions. Taxpayer 1 wages = $100,000. Taxpayer 2 wages = $1,000,000. Taxpayer 1 will probably have a higher DIF score, but not by much if all things are static. 12

13 IRS Unreported Income Discriminate Function (UIDIF) Score From FS , January 2006 The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review. Presentation Note: Could not find much information on the UIDIF in the IRM and had to use other sources. The above Fact Sheet (FS ) is one of the presentation handouts. It is possible that the IRS views the UIDIF as a sub set of the DIF for the IRM. UIDIF Scores are high for those return types which have historically high unreported income. Example: Sole props, Strippers, contactors, etc. UDIF Audits Are Not The Same As CP2000 s The UIDIF Audits are looking for UNREPORTED income. Example: UIDIF focuses on cash businesses like exotic dancers, contractors, and sole proprietors. A CP2000 looks for UNDERREPORTED income. Example: A taxpayer did not report all of their W-2 s. 13

14 Audit Timeline 4/1/2015 Audit Flag 10/1/2015 Decision To Audit 4/1/ /1/2015 Survey/Classification Period Return Flagged For Audit ( ) Sources of Returns for Classification 1. Discriminate Index Function (DIF) and Non-DIF tax returns are selected for examination: By computer By manual identification Presentation Notes: Once a return is selected for audit the transaction code is placed on the account module and should be visible on the account transcript. The audit flag stops any refunds from being sent out for the module and also prevents an amended return from being accepted (it will still show as being received). This is the beginning of the survey period. 14

15 Survey/Classification Period ( ) What is Classification? 2. Classification is the process of determining: 1. whether a return should be selected for examination, 2. what issues should be examined, and 3. where the examination should be conducted. 3. According to Policy Statement P-4-21, the primary objective in identifying tax returns for examination is to promote the highest degree of voluntary compliance. See IRM , Policy Statement Due to limited resources, the IRS can examine only a small percentage of the returns filed. The classifier s role is to ensure that these resources are used effectively. 5. The classifier must decide which returns are most in need of examination. Thorough examination promotes the highest degree of voluntary compliance. Presentation Note: Not all returns flagged for audit are selected for audit. Survey/Classification Period ( ) Procedures for Screening Individual Returns 1. Once you determine that the return will be selected, decide if the examination should be conducted by a: Revenue Agent, Tax Auditor, or by correspondence. 2. This determination is based upon: the complexity of issues involved, the degree of accounting and auditing skills required to perform the examination, and whether it can be effectively completed by correspondence 15

Audit Begins Or It Doesn t 1. If the survey/classification period results in an audit the case is assigned and a letter goes out. 2. This is the official start of the audit. 3.

16 Audit Begins Or It Doesn t 1. If the survey/classification period results in an audit the case is assigned and a letter goes out. 2. This is the official start of the audit. 3. If the return is not selected for audit during the survey/classification period the audit does not begin and the audit flag officially expires on the ASED (If an original return was filed). 4. There is usually no indication on the transcript that the audit letter is sent or the decision was made not to audit the return. Audit Doesn t Begin 1. The actual transcript above shows a portion of a 2011 transcript filed a year late and 420 Examination of tax return on Code 421 Closed Examination of tax return 7 months later 3. NO EXAM letter was sent Budget problems and resources may have been the reason since a prior audit took over a year to get additional $40K in tax. 16

17 Typical Examination Letter CP2000 Notice ( Hard Notice ) 34 17

18 CP2501 Notice ( Soft Notice ) 35 Assessed Statutes Expiration Date (ASED) According to the IRM most audits begin within two years of the filing date. Definition: The ASED defines how long the IRS has to assess tax for a specific module/period. In most cases the ASED is calculated as 3 years after the original return received date or return filed date whichever is later. Common Tolling: Filing amended Return within 60 days of ASED. Voluntary extension of ASED. Joint return after filing MFS. Fraudulent Return. Under reporting of tax (Under by 25%). Presentation Note: The ASED only limits the amount of time the IRS has to assess not audit, but the assessment is one result of an audit. 18

Detecting ASED THS will also alert the user if the ASED has expired. The software cannot detect fraud (Fraud ASED is forever) or 25% under reporter (6 years).

19 Detecting ASED THS will also alert the user if the ASED has expired. The software cannot detect fraud (Fraud ASED is forever) or 25% under reporter (6 years). Determine What Audit Is On Evaluate the Tax Return and or the Tax Return Transcript for content and type and then compare it to the IRS IRM Classification of Work section. This is basically an educated guess Examination Classification of Work ( ) Non-Business Issue Conducive to Correspondence Examination 19

This is also a great tool to evaluate new customers returns.

20 THS Red Flag Report The THS Red Fag Report scores eleven different sections of the Individual Tax Return. This is also a great tool to evaluate new customers returns. THS Schedule A Summary Let s you compare the year under audit with the other years. 20

21 THS Schedule C Summary Let s you compare the year under audit with the other years. National Research Program (NRP) Audits Because the NRP Audits are random line by line exams there may not be an issue that needs resolving. It is difficult to tell the difference between an NRP Audit and a regular DIF generated Audit until after it has begun. If you are unable to determine what the audit is covering have the client confirm they have mileage logs and other proof of deductions ready to go. 21

22 NRP Audit Example When Jeff Long, EA was an auditor and conducted NRP exams in SB/SE, he was forced to adjust a couple who had been married for 60 years back to 'single' filing status because they couldn't find their marriage certificate. NRP exams are painful. Determine the AUR Discrepancy 1. Review the Wage & Income Transcripts. 2. Review the tax return and/or tax return transcript and look for any discrepancies. 22

Wage & Income Summary This is a great report to show the Wage & Income

23 THS Number Of Income Docs The THS report shows the number of income docs broken down by year. Wage & Income Summary This is a great report to show the Wage & Income Summaries from each tax year. Use it to confirm income when filing prior year returns or use it to look for past year issues with troubled clients. 23

24 Income Summary Compares the Income from the last 4 years of returns. Mitigating A Potential Audit 1. Once the potential audit issue is identified look at doing an amended return if the taxpayer will owe more tax. This will allow you to contest the accuracy related penalties. 2. Use the First Time Penalty Abatement to offset the assessment. Under Circular 230 you can charge a contingency fee for FTA. 3. Review the last four years of tax returns for a refund opportunity and do an amended return. 24

25 IRS Accuracy Related Penalties 26 U.S. Code 6662A - Imposition of accuracy-related penalty on understatements with respect to reportable transactions (a) Imposition of penalty If a taxpayer has a reportable transaction understatement for any taxable year, there shall be added to the tax an amount equal to 20 percent of the amount of such understatement. IRS Accuracy Related Penalties If you can file an amended return prior to the audit beginning (any of the audits including CP2000 s) the accuracy related penalty may not assessed. It is my understanding that an IRS employee must add the accuracy related penalty manually. I have had numerous reports from THS users if they file an amended return prior to an audit letter being sent the IRS does not always add the failure to pay penalty. This is possibly due to the age of the IRS system and lack of human follow up. 25

26 IRS Accuracy Related Penalties If the audit actually begins the tax pro can negotiate the accuracy related penalties (as well as the other penalties) during the audit negotiation. IRS Accuracy Related Penalties Actual Example Completed 1040 Office Audit for 3 years. Balance due is $55,089 which triggers the 20% Accuracy- IRC 6662 Penalty of $11, Audit is UN-Agreed at this point. Taxpayer has agreed that POA can accept audit and request penalty reduction or abatement. Using the script on the next page, representative abated the $11, Accuracy IRC 6662 Penalty. 26

IRS Accuracy Related Penalties Actual Script Taxpayer cannot provide compelling documentation to prove more of their ordinary and necessary expenses.

27 IRS Accuracy Related Penalties Actual Script Taxpayer cannot provide compelling documentation to prove more of their ordinary and necessary expenses. I will agree and sign the audit agreement today IF you remove the Accuracy-Related Penalties. If you do not, Taxpayer will petition Tax Court and get them removed in that venue. Let s save everyone time and money and remove the penalties today. Please check with your manager to see if we have a deal. Outcome: Examiner agreed and removed the $11, accuracy related penalty. IRS Accuracy Related Penalties If the accuracy related penalties have been assessed the tax professional can file an IRS Form 843 Claim for Refund and Request for Abatement. 27

28 IRS Accuracy Related Penalties From the Tax Payer Advocate s 2013 Annual Report (See Handout) The amount of an accuracy-related penalty equals 20 percent of the portion of the underpayment attributable to the taxpayer s negligence or disregard of rules or regulations or to a substantial understatement. The IRS may assess penalties under both IRC 6662(b)(1) and IRC 6662(b)(2), but the total penalty rate cannot exceed 20 percent (i.e., the penalties are not stackable ). Generally, taxpayers are not subject to the accuracy-related penalty if they establish that they had reasonable cause for the underpayment and acted in good faith. In addition, a taxpayer will be subject to the negligence component of the penalty only on the portion of the underpayment attributable to negligence. If a taxpayer wrongly reports multiple items of income, for example, some errors may be justifiable mistakes while others might be the result of negligence; the penalty applies only to the latter. First Time Penalty Abatement You may qualify for administrative relief from penalties for failing to file a tax return, pay on time, and/or to deposit taxes when due under the Service's First Time Penalty Abatement policy if the following are true: You didn t previously have to file a return or you have no penalties for the 3 tax years prior to the tax year in which you received a penalty. You filed all currently required returns or filed an extension of time to file. You have paid, or arranged to pay, any tax due. 28

IRS Accuracy Related Penalties Accuracy Related Penalties can also be challenged in CDP s, Equivalency Hearings, and Tax Court (Don t forget about Pro SE).

29 IRS Accuracy Related Penalties Accuracy Related Penalties can also be challenged in CDP s, Equivalency Hearings, and Tax Court (Don t forget about Pro SE). These options require more preparation and the practitioner should weigh the time cost versus the reward. Most penalty abatement work can be charged on a contingency basis per Circular 230. THS P&I Dashboard This page has the penalty, interest, and accrual amounts for each tax year and the totals. This is a great resource to determine if a client is eligible for penalty abatement. NEW!!! First Time Abatement evaluator. 29

30 Review Last Four Years Of Returns For Refund Opportunity H&R Block has educated consumers on this for years. With THS you can review the last four years of tax returns in just a few minutes. Look for the anomalies and out of place items. This can also be done manually just by pulling the last 4 Return Transcripts and comparing them side by side. Finding Return Anomalies 2013 Schedule E is the only year with a profit. 30

31 Contact Info Roger W. Nemeth, EA & NTPI Fellow THS Phone: Exclusive One-Time Only: Online Master Class Thurs. Nov. 9 th! Discover this ONE Proven and Elegant Strategy That Creates a Five-Figure PASSIVE Income stream WITHOUT Having to Add One New Client or Spend a Penny on Advertising!!! You ll Learn: Register Now: How to automatically enroll over 85% of your 1040/1120 clients into your very own Audit Protection Plan without having to sell it; That will net you an extra $80-$130 per return WITHOUT raising fees! To finally get compensated for ALL follow-up work you re doing for free; To gain an unfair advantage by income-proofing your practice and locking-in your client for life! Roz Strategies All rights reserved. Presented by: Michael Rozbruch, CPA, CTRS 31

32 Bonus Material ASFR Program Suspended On September 26, at a New York County Lawyers Association seminar entitled Nontraditional Tax Advocacy, Matthew Weir, the Assistant Inspector General of the office of the Treasury Inspector General for Tax Administration (TIGTA) spoke. Among other things, he announced that the IRS had, for lack of sufficient financial resources, suspended its Automated Substitute for Return (ASFR) program. This is shocking news! Mr. Weir said that TIGTA internally debated whether to disclose to the public the ASFR program s suspension because, normally, TIGTA does not like to disclose information that taxpayers could use to evade enforcement. But, TIGTA decided that the suspension of the ASFR program was too important to keep from the public. He said a TIGTA report on the suspension would be issued shortly. Credit to Procedurally Taxing Blog: procedurallytaxing.com QUESTIONS? Additional Free Information Can be found at: TaxHelpSoftware.com and AuditDetective.com FREE 2 Week Trial Of Any Of Our Products: THSTRIAL (Case Sensitive) 10% Discount Code is THS10 32

First Time Abatement (of Penalties) Made Easy Failure To File Failure To Pay Failure To Deposit

First Time Abatement (of Penalties) Made Easy Failure To File Failure To Pay Failure To Deposit Presenter Roger Nemeth, EA & NTPI Fellow President & Developer Audit Detective, LLC Working Undercover Narcotics