44th Annual Chesapeake Tax Conference September 16th, 2013 IRS Audit Update Stuart M. Schabes, Esquire Ober, Kaler, Grimes & Shriver smschabes@ober.com 410-347-7696 Overview IRS FY 2012 STATS Individuals Businesses Criminal Investigations Who is on the IRS Audit Radar? Agency Staffing and Budget Resources HOT IRS AREAS 1
Overview (cont.) Life of a Tax Audit Who is Controlling the IRS Activity? Type of Inquiry Field Audit Background of IRS Enforcement Action Automated Underreporter / CP2000 Notice Electronic Accounting Software High Net Worth Individuals Overview (cont.) Hiding Income Offshore Preparer Responsibility / Circular 230 Issues FBAR: Filing Requirements OVDP Form 8938 Reporting Certain Assets to the IRS Passive Loss Trust Fund Recovery Penalty Information Document Request vs. Summons S Election simplification 2013-2014 Priority Guidance Plan 2
IRS FY 2012 STATS - Individuals IRS FY 2012 STATS Individuals (cont.) 3
IRS FY 2012 STATS - Businesses IRS FY 2012 STATS Businesses (cont.) 4
IRS FY 2012 STATS - Criminal Investigations Who is on the IRS Audit Radar? Audits of individuals topped 1 million for the 6 th year in a row 1.03% coverage rate out of all tax returns filed Audits in the upper income ranges remained substantially higher than other categories Matching/AUR (CP2000 Notices) Especially on high net worth taxpayers 5
Who is on the IRS Audit Radar? Increased examinations across ALL categories of business returns by more than 12% in FY 2012 Largest increases coming in audits of flowthrough entities Include partnerships and Subchapter S corporations Audit rates exceeded 20% for the largest corporations Agency Staffing and Budget Resources How does this impact taxpayers? Fiscal Year 2012 budget was reduced by $305 million Corresponding decrease in staffing available to deliver service and enforcement programs Overall full-time staffing has declined by more than 8% over the last two years 6
HOT IRS AREAS Economic Downturn- may cause liquidity issues and Trust Fund Penalty Liabilities for owners and responsible person(s) Trust Funds Typically represents 2/3 of payroll obligations consisting of Federal Withholding And Employee s share of FICA (social security) HOT IRS AREAS - Examination Continued focus on flow through entities, (partnerships and LLC s); Schedule C entrepreneurs Expense substantiation Unreported Income Passive vs. Active loss Characterization NOL substantiation (verify amount, timing of expenses) accounting issues 7
Life of a Tax Audit Initiation of Examination Appeals Assessment Collection Who is Controlling the IRS Activity? Service Center Office Audit Field Audit 8
Type of Inquiry IRS Notices or other correspondence? Who is the contact person? Is the IRS party identified or just a general number? What department is the IRS Representative located with? Field Audit Definable/isolated issues IRS Office More involved audit issues Company identifies who the spokesperson will be and availability of records (additional information about this later) Thorough review of IRS Document Request and related inquiries 9
Field Audit cont. Coordination with the Tax Return Preparer/Accountant Type of IRS Agent Civil/Regular Agent Part of the Fraud Referral Unit Special Agent with the Criminal Investigation Division ( CID ) Background of IRS Enforcement Action Civil Matters Criminal Matters Life of a Tax Audit Does it Ever End Confusing IRS Notices 10
Automated Underreporter The IRS Automated Underreporter (AUR) program finds 20 million discrepancies annually when its automated systems match returns against the 3 rd party information statements 1 out of every 7 individual tax returns filed The AUR Unit then sends CP2000 Notices (Underreporter inquiries) to taxpayers to address any discrepancies CP2000 Notice The income and/or payment information the IRS has on file does not match the information reported on the tax return This may cause an increase or decrease in the tax liability, or may not change it at all The Notice is NOT a bill it is only a proposal that offers an opportunity to disagree, partially agree, or agree with the proposed changes 11
CP2000 Notice (cont.) What you need to do: Review the Notice carefully - it explains the information the IRS received and how it affects the tax return Complete the notice response form whether or not you agree or disagree with the notice Contact the 3 rd party that reported the information, if it is wrong. Ask them to correct it, and then provide the corrected information to the IRS. CP2000 Notice (cont.) It is important that you respond to the CP2000 Notice by the due date shown on the Notice If you do not, the IRS will assume the proposed changes are correct and continue processing the proposal. ultimately to an assessment If you need additional time to fully research your records and respond, call the number at the top of the Notice and you will generally be granted a 30 day extension 12
Electronic Accounting Software Examiners are increasingly requesting electronic files in the early stages of an audit Form 4564, Information Document Request, will be used to request: Copy of original electronic accounting software backup file Administrator s username & password Electronic file can be provided on CD, DVD, or a flash/jump drive Electronic Accounting Software (cont.) Uses by the IRS of the Electronic Data Ability to generate many different types of financial reports Reports can be modified to fit examiner s needs Software allows the examiner to test the integrity and veracity of the accounting records 13
Electronic Accounting Software (cont.) Typical IDR items: 1. Year-end work papers and reports: a) Worksheet reconciling the QuickBooks electronic books and records to the tax return for the tax year ending 12/31/. b) Adjusting journal entries and closing entries for the tax year ending 12/31/. 2. The electronic backup file of the QuickBooks books and records that includes the period from 12/31/ through 12/31/. The QuickBooks backup file should include any changes to the data entered after year end. 3. The QuickBooks administrator's user name and password. 4. The Version (i.e., year) and the Edition (e.g., Pro, Premier, Enterprise Solutions) of QuickBooks used to create the backup file. Electronic Accounting Software (cont.) Is the Auditor Really Allowed to Request This? YES Taxpayers are responsible for maintaining their own books and records in sufficient detail to support the income and deductions Taxpayers are required to present this to the IRS upon its request IRC Section 7602(a)(1) grants the Service the authority to summons, if necessary 14
Electronic Accounting Software (cont.) Although the IRS Agents are instructed to only review data that is relevant to tax year(s) under exam, it is advisable to condense or create a period copy of the electronic information However, Taxpayers may NOT reconstruct or edit the records The IRS needs a copy of the original data to test the integrity and veracity of the accounting records High Net Worth Individuals IRS Global High Wealth Industry Group Income Tax Gift Transfers Charitable Issues All Related Entities Unreported Income Domestic Foreign 15
Hiding Income Offshore Hiding Income Offshore (cont.) This is a Hot Topic and included in the IRS Dirty Dozen Tax Scams for 2013 Individuals and businesses have been identified as having evaded U.S. taxes by hiding income offshore The IRS uses information gained from its investigations to pursue taxpayers with undeclared accounts overseas While there are legitimate reasons for maintaining financial accounts abroad, there are reporting requirements that need to be fulfilled 16
Hiding Income Offshore (cont.) Failure to comply with reporting and disclosure requirements subjects a taxpayer to the risk of significant penalties and fines, as well as the possibility of criminal prosecution Since 2009, 38,000 individuals have come forward voluntarily to disclose their foreign financial accounts, taking advantage of special opportunities to comply with the U.S. tax system and resolve their tax obligations With new foreign account reporting requirements being phased in over the next few years, hiding income offshore will become increasingly more difficult Hiding Income Offshore (cont.) 2009 OVDP 2011 OVDI 2012 OVDP The IRS may end the 2012 program at any time The IRS has collected $5.5 billion so far from people who participated in offshore voluntary disclosure programs since 2009 17
Preparer Responsibility Karen Hawkins, Director of the IRS Office of Professional Responsibility stated that preparers have a duty to ask about ownership, control or interest in offshore accounts and to advise them about the obligation to file the FBAR document. Preparers must do more than simply ask the question on their intake form. They must affirmatively discuss the topic. Circular 230 Issues The IRS guidance makes it clear that a practitioner who represents a noncompliant taxpayer is in violation of Circular 230 FAQ # 47 of the Initiative s FAQ s states that if a taxpayer decides not to make the voluntary disclosure despite the taxpayer s noncompliance with U.S. tax laws, the practitioner must explain the consequences of the noncompliance to the client Moreover, under Circular 230, a practitioner whose client declines to make full disclosure of the existence of, or any taxable income from, a foreign financial account, may not prepare the client s income tax return for that year 18
FBAR: Filing Requirements Any United States person who has a financial interest in or signature authority or other authority over any financial account in a foreign country, if the aggregate value of these accounts exceeds $10,000 at any time during the calendar year. OVDP The OVDP process Three (3) distinct rounds of activity Round I - Pre-clearance Round II - OVD Letter and Attachments Round III - Full OVDP submission Each round has forms to file and deadlines 19
OVDP (cont.) The program allows taxpayers to become compliant and avoid possible criminal prosecution Taxpayers pay taxes, interest and penalties for the look back period of eight years Taxpayers also pay a fixed penalty for FBAR violations: 27.5% 12.5% 5% Form 8938 Reporting Certain Assets to the IRS Used to report a specified person s foreign financial assets total value of all specified foreign financial assets in which an individual has an interest and meets certain thresholds Filed with the annual Federal Tax Return and must be filed by the due date (including extensions) Failure to file a correct Form 8938 may subject an individual to a $10,000 penalty for each 30 day period (maximum penalty is $50,000) 20
Passive Loss IRS is focusing more on passive loss issues (passive v. non-passive) Must show material participation to treat an activity as non-passive (and take a loss) Code Section 469(h) provides that a taxpayer shall be treated as materially participating in an activity if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial Passive Loss (cont.) Treasury Regulation 1.469-5T provides seven (7) tests to determine if an individual materially participates in an activity 1. Taxpayer and/or spouse worked more than 500 hours a year in the business 2. Taxpayer did most of the work regarding business activity 3. Taxpayer worked more than 100 hours and is not less than the participation of any other individual 21
Passive Loss (cont.) 4. Taxpayer has several passive business activities, in which he worked between 100-500 hours each, and the total hours are more than 500 hours 5. Taxpayer has materially participated in the activity for any five of the last ten years 6. Taxpayer materially participated in a personal service activity for any three prior years Personal service activities are health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting Passive Loss (cont.) 7. Facts and circumstances indicate taxpayer materially participated Test cannot be used unless taxpayer worked more than 100 hours for the year Test does not apply if anybody was paid in connection with managing the activity or if any person spent more hours than taxpayer managing the activity 22
Passive Loss (cont.) Must only meet requirements of one test in order to materially participate Taxpayer has burden of proof to establish material participation Method of proof can be by any reasonable means Reasonable means may include the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries Passive Loss (cont.) Contemporaneous logs and records are best (and preferred by the IRS), BUT Narrative from a taxpayer or those whom work with the taxpayer (employee, contractor, colleague, etc.) may be used to substantiate material participation. Specificity is crucial 23
Trust Fund Recovery Penalty Trust Fund Recovery Penalty ( TFRP ) is a significant audit area for the IRS The IRS believes there is significant taxes that can be collected with a focus on TFRP As entities go out of business and owe trust fund taxes, the IRS may lose out on this revenue, unless TFRP assessments are made against responsible persons Trust Fund Recovery Penalty (cont.) A trust fund tax is money withheld from an employee's wages (income tax, social security, and Medicare taxes) by an employer and held in trust until paid to the Treasury It does not include the employer s share of the social security and Medicare taxes TFRP is a personal assessment 24
Trust Fund Recovery Penalty (cont.) IRC 6672 - Failure to collect and pay over tax Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax IRS sees this as a broad definition Owners Managers Controllers and bookkeepers Trust Fund Recovery Penalty (cont.) During the course of a TFRP audit, the IRS may request: Bank signature cards Copies of checks Internal control manuals Employment contract showing job duties IRS will conduct a 4180 Interview with individuals they seek to assess the TFRP 25
Trust Fund Recovery Penalty (cont.) Best Practice is to Designate Payments If business is still operating and able to make some payments towards outstanding trust fund taxes owed, be sure to designate the payment to Trust Fund Taxes Information Document Request vs. Summons The IRS requests documents by either: 1) Information Document Request ( IDR ) or 2) by Summons Generally, the IRS will first issue an IDR to a taxpayer or taxpayer s representative If the taxpayer does not provide the requested documents by the requested time, the IRS may issue a summons The Internal Revenue Manual 25.5 provides guidance on how the IRS will handle summonses 26
Information Document Request vs. Summons The IRS policy is to obtain information and documents by means other than a summons whenever possible. However. IRS personnel have larger caseloads and are under increasing pressure to close cases more quickly, therefore practitioners are seeing summonses being used sooner in cases and with more frequency In the past, an agent may have extended and IDR deadline to wait for documents, where as now summonses are being issued when the first IDR deadline passes and not all documents have been received. Service of Summons A summons must be served by hand to the person to whom it is directed or left at the person s last known address A summons issued to a third-party record keeper (typically a bank), may also be served by certified or registered mail 27
Service of Summons IRS must give timely notice to the taxpayer of a third party summons A summons may not require a taxpayer, or other party, to create a new record A summons may only be used to request documents/records in existence at the time of the summons S Election simplification The IRS has simplified late S Corp Elections Revenue Procedure 2013-30 facilitates the granting of relief to taxpayers who request relief for late filed S Elections Prior to Rev. Proc. 2013-30, taxpayers used parts of several Revenue Procedures to request relief; Rev. Proc. 2013-30 consolidates all provisions into a single Revenue Procedure 28
S Election simplification (cont.) The Revenue Procedure generally extends the time to request a late S Election until three years and 75 days after the Effective Date of the election In certain situations there is no deadline See Flow Chart included in Revenue Procedure 2013-30 for additional guidance 2013-2014 Priority Guidance Plan Issued August 9, 2013 Covers the 12 month period from July 2013 through June 2014 Contains 324 projects that are priorities for allocation of IRS resources This is only a plan and there are no deadlines placed on completion of projects Plan provides guidance on a variety of issues important to individuals and businesses, including international taxation, health care, and implementation of legislative changes 29
2013-2014 Priority Guidance Plan (cont.) TAX ADMINISTRATION Final regulations regarding the application of 172(h) to a consolidated group Regulations under 6662, 6662A, and 6664 regarding accuracy-related penalties relating to understatements Regulations relating to the active trade or business requirement under 355(b) Guidance under 1362 and 301.9100 regarding elections of S corporations 2013-2014 Priority Guidance Plan (cont.) EXCISE TAX Regulations under 4051 and 4071 on heavy trucks, tractors, trailers, and tires Guidance on the application of the air transportation excise tax under 4261 to aircraft management fees Guidance under 4261(e)(3)(C) regarding the application of the domestic air transportation excise tax under 4261 to the purchase of mileage awards 30
Proposed Rules Re: User Fee Changes IRS issued proposed rules to increase user fees Rationale is to recover more of the costs associated with these agreements Installment Agreement ( IA ) Increase to $120 (currently $105) Restructuring an IA in to $50 (currently $45) Direct debit IA s will remain at $52 Offers-in-Compromise Increase to $186 (currently $150) QUESTIONS?!? 31