This article will discuss the organizations that manage taxes within the U.S., how it functions, and how the audit process works.
Internal Revenue Service
The IRS is set up by the treasury department. The head of the IRS is known as the Commissioner of Internal Revenue (presidential appointee and senate confirmation). The purpose of the IRS is to enforce the tax law.
Organization of the IRS is as follows:
- There are three current specialized divisions handling small business self employed (SB-SE) (less than 10 million in assets), large business and international (LBI) (more than 10 million in assets), and tax-exempt government entity (TE-GE) (such as charities).
- Taxpayer services (basic returns)
- Appeals, criminal investigations, and other litigation matters.
Written Guidance
The IRS will issue regulations (26 CFR), revenue rulings, private letter rulings (PLR), techical advice memorandums (TAM), and determination letters (such as a determination that an entity is a non-profit after being applied for).
Audit
Selection
Less than 1% of returns are audited overall. However, certain taxpayers are audited every year, depending on the complexity of the return (higher liklihood of making a mistake). Things the IRS looks for when determining who to audit include: (1) payout; (2) income, occupation, types of income and expenses, annoymous tipsters, high media coverage; and (3) those with a high discriminate function system (DIF) score (returns are significantly different from the average). Mismatched returns will also trigger a selection. So will being an informant or a whistleblower.
Types
There are three types of audits:
- Correspondence audits. These audits primarily are done through the mail and are the most common methods utilized by the IRS. Typically these are done if something is misreported and they are seeking additional documentation through the mail.
- Office audits. These are audits requiring the taxpayer to go to an IRS office for an interview with the necessary documents to discuss the return.
- Field audits. These are where the IRS comes to the taxpayer’s location to do an audit so they can do everything hands on.
Authority
The IRS has broad authority to conduct audits. They have the authority to examine all books and records. Taxpayers should then keep all documents for at least three years. The IRS can also subpoena third-party records (like bank statements). This authority is limited though by privilege in civil audits (tax advisor and client can discuss information only privileged to be discussed between those parties). The authority can also be limited by closing agreements between the IRS and the taxpayer where the IRS will not reopen the tax return.
Those who conduct audits are typically known as revenue agents or auditors.
Procedure
First the IRS will provide a notice that the taxpayer is being audited. Certain individuals can represent a taxpayer known as a federally authorized tax practitioner (FATP). These include an attorney, CPA, or Enrolled Agent. Those with the power of attorney can also represent a taxpayer.
After the audit, the taxpayer will receive a Revenue Agent Report (RAR), where the taxpayer has 30-days to remedy the issues the audit prepared (typically saying there is a deficiency). If there is a deficiency, then the taxpayer will send in form 870 to remedy the deficiency. On the other hand, the taxpayer could appeal the audit results.
Appeal Procedure
After an audit, if the taxpayer wants to appeal the results, then they will attend an appeals conference to settle the case (if no settlement, then litigation occurs). If the appeal is more than $10,000, then the taxpayer needs to issue a formal written protest.
Litigation
After receiving notice of a deficiency, the taxpayer has 90-days to begin litigation. The taxpayer can file in either U.S. Tax Court, U.S. District Court, or the Court of Federal Claims. However, if the claim is filed in the U.S. District Court or the Court of Federal Claims, the taxpayer is required to prepay the deficiency then hope for a refund if they win (no prepayment required in the U.S. Tax Court).
If the case is a small case (less than $50,000) in the U.S. Tax Court, then the result is final. Otherwise, the Court of Appeals would hear any appeals (followed the Supreme Court of the United States if Applicable).
The only option for a jury trial is the U.S. District Court.
Collections
The IRS can only send the claim to collections after assessment (all results final). Revenue Officers typically have broad collection authority to issue liens and levies on taxpayer property. However, the officers are required to follow collection due process (provide notice). Authority is also limited if there is a Taxpayer Assistance Order (TAO) (Form 911). Bankruptcy will not discharge tax liability, but it will stay proceedings.
Taxpayers will also be provided with IRS Publication 594, which informs the taxpayer of their collection rights.
After a tax has been assessed, they have 10 years to collect (unless the taxpayer filed for bankruptcy or is outside of the country).
Payment Methods
After receiving a deficiency bill where the taxpayer is unable to immediately pay, the taxpayer could enter into an installment agreement if their deficiency is less than $10,000 (Form 9465) (essentially a promissory note). An Offer-in-Compromise will occur if the taxpeyer would never be able to pay the full amount; the taxpayer then makes an offer of what they can pay to settle the deficiency (Form 656).
Penalties
Penalties may apply (including multiple at the same time) depending on what the taxpayer (or preparer) did. Interest can accrue on penalties.
Failure to pay a tax has a .5% penalty (plus interest) per month on the unpaid amount. After a notice of deficiency, that rate increases to 1%.
Failure to file a tax return is 5% per month on the unpaid amount. However, if the failure to file was due to fraud, the rate is 15%. Howeer, this penalty can be reduced by the failure to pay penalty (4.5% filing penalty + .5% nonpayment penalties).
There are also accuracy-related penalties (§ 6662). These penalties are 20% of the underpayment due. This penalty can occur if the taxpayer (1) was negligent, (2) substantially understated tax, (3) substantial valuation overstatement, and (4) substantial valuation understatement.
There is an estimated tax penalty (§ 6676). That is, the taxpayer is required to make estimated tax payments throughout the year. If you owe over $1,000, then a penalty may be assessed unless you paid 90% of your current year or 100% of your prior year’s tax liability.
There is a penalty is for civil fraud penalty which is a 75% penalty on the underpayment resulting from taxpayer fraud. However, the IRS has the burden of proof for this penalty by clear and convincing evidence.
Criminal Penalties
If a taxpayer has been convicted of criminal fraud (IRS proved there was fraud above a reasonable doubt), then the taxpayer could be subject to fines, impreisonment, or both. Failure to file, fradulent returns, and disclosure of client data by preparer is considered a misdemeanor. Making a false statement or tax evasion are felonies.
Preparer Penalties
The IRS can also assess penalties for paid preparers. These can include criminal & civil penalties.
If the preparer takes an unrealistic position on the tax return, then the penalty is $1,000 or 50% of the fee (whichever is larger).
Willfull attempt to understate the tax will result in a $5,000 or 75% of the fee (whichever is greater).
Aiding in preparing a return where the person knowns will result in a tax understatement is a $1,000 fee.
$250 for improper disclosure of client data.
$60 penalties for each failure to sign a return, failure to provide a copy of return to the taxpayer, failure to maintain list of taxpayers and keep copies.
Ethics
Professionals have a responsibility to the client, the public, and the government. The treasury department, AICPA, ABA, and State Board of Accountancy have rules that professionals are required to follow.
Circular 230
A preparer should only take a position on a return if there is a realistic possibility of it being sustained (2/3rds chance). There are other rules from taking frivolous tax return positions, delaying an audit, taking a contingent fee on a original return, failing to make a penalty disclosure or error disclosure.
