Chapter Two: Audit
AUDIT SELECTION
Before proposing a deficiency, the IRS usually conducts an audit. Returns are
selected for audit by several methods. The most common is by use of a computer
program called the Discriminate Function System (DIF). Each return receives a
score (DIF score) for potential error. Returns that receive scores that are
higher than normal, based on past IRS audit experience, are flagged for
additional review by IRS personnel. As a result, not all returns that receive a
high DIF score are audited.
The DIF system is used for all individual, partnership, and fiduciary income
tax returns. Corporation returns are either DIF scored or manually classified.
This program also identifies returns that have “special” issues or
characteristics. Special items include returns with unallowable items, tax
shelters, non-cash charitable contributions, refunds in excess of one million
dollars and amended returns or returns that notify the Service of inconsistent
treatment of an item. Returns with “special’ items are also flagged for review
by IRS personnel. Again, not all special returns will actually be audited.
Returns are also selected for audit by the IRS’ use of informants. Informants
may receive awards based on the value of the information received by the IRS and
the motivation of the informant as well as whether or not the information was
furnished voluntarily. The informant makes the request for an award on a Form
211 Application for Reward for Original Information. Whether to issue a reward,
and the amount of the reward, is in the sole discretion of the IRS. See Carelli
v. IRS, 668 F.2d 902 (6th Cir. 1982), but also see Merrick v. U.S., 846 F.2d 725
(Fed. Cir. 1988).
Lastly, the IRS also shares information with state and local authorities, and
vice versa. Thus, a client who is audited by the Tax Department, who either
concedes to an increase in tax or loses at the Division of Tax Appeals, will
most likely be contacted by the IRS for exam, usually within a year or so of the
state change. The taxpayer’s loss of the issue at the state level, however, does
not bar the taxpayer from re-litigating the issue at the federal level. In
reverse, the same is true for federal issues that are later addressed by the
state. However, special rules apply regarding the statute of limitations at the
state level as they relate to federal changes. This issue will be addressed
later in greater detail when we discuss state tax matters.
TYPES OF AUDITS
EXAMINATION AUTHORITY OF THE IRS
POTENTIAL OUTCOMES
The four potential outcomes for any audit are no-change, agreed, unagreed, or
partially agreed. If the auditor determines that no change is required, a letter
is sent to the taxpayer or representative regarding the outcome. The auditor’s
report is usually not provided to the taxpayer unless the audit will result in
changes to other returns or years. However, if the representative is present,
and the taxpayer is not, a copy of the exam report is provided to the
representative.
If the auditor determines that an additional tax is due, and the taxpayer
agrees with the examiner’s report, the taxpayer will be asked to sign a
settlement agreement. The official form to be used depends on the type of tax
involved. A representative may sign an agreement on behalf of the taxpayer if
the representative has power of attorney.
If the auditor determines that an additional tax is due, and the taxpayer
disagrees with the proposed change(s), the examiner will usually issue a 30-day
letter. The 30-day letter informs the taxpayer of the amount and basis of the
proposed deficiency. The taxpayer has 30 days from the date of the letter to
request a conference with an appeals officer of the IRS Appeals Division. See
Reg. §601.106(b).
If the auditor determines that an additional tax is due, and the taxpayer
agrees with some issues but disagrees with the examiner on others, the taxpayer
will be asked to sign an agreement or waiver as to the agreed issues. The
unagreed issues will be treated as detailed above for unagreed cases.
When the taxpayer does not agree to the assessment, and fails to request an
appeals conference, a 90-day letter will be issued by either the service center
or the district director.
BACK
Bluestein & Muhlbauer, P.C.
333 International Drive
Williamsville, NY 14221
716.633.3200
