Archive for the ‘ Audits ’ Category

The IRS Appeals Officer & Process

When a taxpayer disagrees with the IRS auditor’s determination, the IRS assigns the matter to an appeals officer. This is a second, new IRS employee that the taxpayer can negotiate with. Importantly, as a taxpayer deals with successively-higher-level employees in the IRS, the discretion of each employee increases. Appeals officers almost always have more discretion in the kind of allowances they can make to settle a case than auditors do. The next step up in authority over an appeals officer is typically the IRS trial attorney, who defends the IRS’ position if the appeals officer and the taxpayer cannot come to an agreement about the tax return in question, and if the taxpayer decides to sue the IRS.

The IRS has set up the appeals process to be as fair as possible to taxpayers, and to save itself the cost of litigation whenever possible. After all, even the most conscientious and hard-working of auditors makes mistakes. Taxpayers can ask for a review of any auditor decision. Once the auditor issues a final, written report, detailing any changes to the deductions, income and taxes owed in the tax return being audited, the taxpayer can ask that the report (or elements therein) be reconsidered. The appeals officer performing this reconsideration is an IRS civil service employee who has auditing experience, but who has not been previously involved in the particular case. Appeals officers have quasi-judicial power to settle disputed audits. They are not allowed to contact the auditor on the case but rather receive the document file of the taxpayer to review, meet with the taxpayer as necessary to understand the nature of the objections to the auditor’s determination, and adjust those determinations as they think is appropriate.

IRS personnel love their appeals officers and, frankly, so do I. For the IRS, the appeals officers often make the determinations of the IRS more transparent and fair to the taxpayer, thus enhancing the legitimacy of the IRS. Appeals officers settle a vast majority of cases set for trial, thus saving the IRS substantial resources. Finally, the IRS does not like to have public losses, and appeals officers help to filter out the weaker/losing tax cases before they reach the courtroom. I like appeals officers, particularly compared to Auditors, because the appeals officers have more discretion to settle cases and are generally more amenable to finding a mutually-acceptable solution than are auditors.

If you really don’t like the outcome of an audit, don’t be afraid to appeal: with the IRS, at the appeals stage, you can fight “city hall” and often come out ahead.

Debtors can discharge their taxes in bankruptcy so long as they meet certain tests: the three-year test, the two-year test, the 240-day test and no fraud. I lay it out in the first paragraphs here  and in the last paragraphs here .

One of the tests is that the return has to have been actually filed: “A discharge … does not discharge an individual debtor for any debt … for a tax or a customs duty … with respect to which a return … was not filed or given.” 11 USC § 523(a)(1)(B)(i).  A “return” must satisfy non-bankruptcy law, and can be a return prepared by the IRS under IRC § 6020(a), but not under 6020(b). 11 USC § 523(a).  Got that?

This jargon and its cross-references mean that a taxpayer has to have submitted their own good-faith tax return in order to have the resulting tax be dischargeable.  Under IRC § 6020(b), the IRS can prepare a return without the taxpayer’s cooperation and make an assessment on it.  This is known as a “substitute for return” (or SFR), and its assessment is never dischargeable.  The taxpayer can never replace the SFR with a late-filed return after taxes owed from an SFR have been assessed.

How do you know that the IRS has filed a substitute for return?  You look at the taxpayer’s account transcript.  The first entry is almost always under TC (transaction code) 150.  When the taxpayer files his own return, the entry states “tax return filed,” and it shows the taxes due on the return, such as here.  When the IRS files the taxpayer’s return, the entry states “Substitute tax return prepared by IRS,” and it shows a dollar entry of “0.00,” such as here.

Just because the IRS has filed a substitute for return, however, does not mean that the IRS has assessed a tax based on that return.  The SFR is only one step in the audit process: it comes after the IRS has failed to reach the taxpayer, but before it has figured out how much the taxpayer owes.  Having filed the substitute for return (usually a blank form 1040), the auditor sets it aside for a few months, then pulls wage and income transcripts to find out how much money third parties report that the taxpayer received.  The auditor figures out the tax owing based on no deductions and single filing status; in other words, the least advantageous situation for the taxpayer.

But sometimes a taxpayer shows up after the SFR has been filed, and before the IRS has assessed the taxes. If the taxpayer brings the IRS information regarding his or her liability, signs a tax return, and hands it to the auditor, that is “filing” a return.  If the IRS assesses the tax based on this return rather than its audit, then the tax is dischargeable.  If the IRS rejects the return because it does not appear honest, then the tax can’t be discharged.

IRS personnel will routinely deny discharge to any tax year that shows a substitute for return. They don’t take the extra step of looking to see if the taxpayers filed a return after the SFR and before assessment.  I have recently been successful in overturning this decision by showing that the taxpayer filed a return after the SFR was filed but before it was assessed.  On the account transcript, this shows as a “duplicate return filed.”

The key here is what led to the assessment of the tax: was it the IRS audit, or was it the taxpayer’s proffer of information?  If the latter, then the tax will be dischargeable, even if IRS initially balks at discharging it.

There are hundreds of strategies for handling IRS issues. But not all strategies are as effective as others.

A car-repair owner got audited and brought his tax-return preparer (Jim) to handle the audit. The preparer said to give the IRS as little information as possible . “The IRS won’t want to go to trial, and they’ll cave in at the last minute,” he said. But something didn’t seem right to the car-repair owner. Perhaps it was the approaching trial date, the lack of apparent concern on the IRS side or (most likely) the way the IRS threw Jim, the return preparer, out of the meeting when Jim became too confrontational. Whatever the reason, the tax-payer called me.

I explained why Jim’s advice was off-base: the law requires that taxpayers prove their expenses; the IRS does not disprove expenses. Unless there is a receipt and a valid reason for an expense, the IRS – and the Tax Court – will not allow it. Trial for an IRS attorney litigating expenses is a walk in the park; the IRS does not ‘cave’ in these situations, no matter how aggressive or obnoxious your accountant or tax attorney is.

I also told the taxpayer a bit more about ‘Jim’. I had handled a case against him when I was an IRS attorney and he obstructed that case to the point where I needed to tell the taxpayer to fire him. Jim was a disbarred attorney from another state. His advice routinely lost his clients’ cases, while costing them thousands of dollars.

I worked to get the best outcome for the car repairman, despite a poorly-prepared return. Jim had included many unsubstantiated expenses. My client ended up owing, but the audit ended more quickly and the final bill was lower than if Jim had continued stonewalling the IRS.

When it comes to expense substantiation, it’s always best to provide information, documentation, and answer questions quickly. Any advisor who tells you otherwise is simply wrong. Check credentials: a valid law license or an up-to-date CPA license won’t guarantee a good result, but they do indicate some level of responsibility.

Investment Activity and Your Tax Return

Have your Investment Expenses Been Disallowed on Your Tax Return?

Most people know that they can’t claim losses incurred by a hobby – say, for instance, their side hobby of breeding and raising Great Pyrenees dogs.  No profit motive, no deduction of losses.

Despite the profit motive in investing, the same rule goes for investment activities that are not a “trade or a business.”  If an investor claims a loss on a Schedule C business whose sole purpose is lending and collecting money, IRS auditors will almost automatically disallow the expenses.  Even though most of us know better, the auditors see investment activities as something less than a business.

What, then, makes an investment activity a business in the eyes of the taxman?

Courts look for continuous and regular involvement in the activity, as well as a profit motive, to turn any activity into a trade or business.  When it comes to money-lending, the activity is a trade or business in those “exceptional” situations where the involvement is so continuous and extensive as to “elevate” the activity to that of a separate business.  Imel v. Commissioner, 61 T.C. 318, 323 (1973).

How do you prove this?

This question generally comes up in an audit, so the first person to convince about the “trade or business” is the IRS auditor.  An investor being challenged on these expenses should produce any documentation and explanations of the business that show continuous and extensive involvement in managing the investments, such as timesheets, advertising, loan agreements, and so forth.

IRS audits start with low-level employees who have little discretion, and who are likely to just deny the expenses.  When a taxpayer doesn’t just agree with the audit results, the audit gets handed to people who have successively more discretion than the prior person. Expect to rehearse the same story not only to the auditor, but also to the auditor’s manager, the appeals officer, the IRS docket attorney, and eventually the Tax Court judge.  The longer and further you escalate the audit, the better the odds of having your investment losses deducted.

This gauntlet of decision-makers will look for certain factors: the number of loans made by the taxpayer (more is better); the time period over which the loans were made (again, more is better); the quality of the taxpayer’s books and records relating to this activity (a trade or business will have good books and records); the time the taxpayer spends on the lending activity (it doesn’t need to be full-time, but the lender should seem committed to spending time at the activity); how the taxpayer sought out lending business, including word-of-mouth referrals and advertising (more aggressive marketing suggests a trade or business); whether the taxpayer had a separate office for the business (again, a devoted office looks more businesslike); the taxpayer’s general reputation as a lender (someone in the trade of lending will be known as a lender); and the relationship of the debtors to the taxpayer-lender (borrowers who are not relatives help this factor).  U.S. v. Henderson, 375 F.2d 36, 41 (5th Cir. 1967).

Interestingly, the failure to claim the activity as a trade or business for some time, even decades, does not prevent the lender from starting to do so.

If any one of the series of decision-makers agrees with the taxpayer, the audit closes with no change to the taxpayer’s return.  Because it gets more expensive to fight the IRS the longer the fight lasts, a taxpayer has a good incentive to show up with as much documentation and argument as possible from the beginning.  In some situations, taxpayers may recover part of their attorney fees from the IRS if they can show that the IRS took an unreasonable position, such as when an auditor completely ignores documentation of the Henderson factors.

Taxpayers seem to do very well according to the case law: most reported cases show the IRS losing on this issue.  However, every case turns on its own unique facts, and we don’t know how many lenders decided to agree with the IRS and not fight the “trade or business” battle.  What the case law does tell lenders is that it is often worth fighting the IRS on this issue.

The audit that isn’t an audit

IRS has sent out tens of thousands of letters to small businesses asking them to explain the difference between the businesses’ receipts reported on the tax returns and reported by third parties, as well as the difference between the cash receipts reported on the tax returns and the average cash receipts for similar businesses (see links hereherehere, and here). These informal letters are not actually audits, but does the mom & pop shop down the street know that? Also, if the recipient doesn’t answer the letter, does that make them more likely to get audited?

I would love to see an actual copy of this kind of letter. If you have gotten one, please email it to me at jdf @

Conservative commentators point to this as evidence of the IRS’s “war on self-employment.” I don’t think that the IRS is fighting a war on self-employment: it’s just trying to do the job of collecting taxes and impart the same amount of pain on everyone. The IRS’s bite is numbed somewhat by the cocoon of a full-time job with a paycheck and tax withholding; the small business person, who watches the money come in and go out, is much more conscious of the payments that need to go to the sovereign, and has much more control over whether those payments actually get made. W-2 employees have a lot less incentive and opportunity to cheat on their taxes than small business owners; like Willie Sutton, the IRS targets small businesses because that’s where the money is.

The taxman sitting in the waiting room

IRS audits for doctors and other medical professionals are on the rise. The stereotype of doctors is that they have a lot of income and keep poor records. The IRS is making hay with this stereotype when it is accurate.
I recently assisted one doctor with an audit. The revenue agent asked for verification of auto expense: the doctor had no mileage log, but he could verify driving between his office and various hospitals on a seven-day-a-week basis. His preparer had done something of a slapdash job. I got the IRS to agree to allow more auto expense than he had claimed on his return.
The IRS will also examine income closely for unreported income. The standard procedure: they add up all deposits into all accounts, and ask the taxpayer to verify that any of the deposits are not taxable. If there is a discrepancy between the income claimed on the return and the deposits into the accounts (minus nontaxable deposits), that difference is determined to be taxable. It’s hard to argue against the documentation.
Tax problems can sink a medical practice.
If this happens to your medical practice, call us. We are experts at resolving tax issues, and particularly enjoy helping doctors.

Statutes of Limitation, the IRS, and the FTB

A potential client called me last week for help in dealing with the IRS.

It seems he owed a lot of taxes for tax years from 1992 to 1996. Had he filed the returns on time? Yes. Had he filed bankruptcy in the meantime? No. Had he filed an offer in compromise? No. Has he heard anything from the IRS in the last three years? No, but he thought that was because he had moved and not written to the IRS collection department to tell them about the move. Has he filed a tax return from his new address? Yes.

I told him not to worry, that he probably didn’t owe the taxes anymore because it took more than 10 years for the IRS to collect those taxes. And it occurred to me that I should explain how statutes of limitation can work to the taxpayer’s advantage.

Audit and Assessment – Three Years IRS, Four Years FTB

The IRS has a three-year limitation period on assessment from the time of the return’s filing. That means that if three years pass from the time you, the taxpayer, filed your return, the IRS can no longer audit you for that tax year.

Sounds simple, right? But when did you actually “file the return?” Let’s take a return for the 2011 tax year. If you filed it before April 15, 2012, the law says that the return was filed on April 15. If you had an extension until October 15 and filed the return on September 1, the limitation period starts on October 15.

If you filed the return late, the law says that it was filed on the day the IRS received it.

In California, the Franchise Tax Board generally enjoys more liberal state laws than the federal IRS. The FTB has four years to assess more taxes on a filed return.

There is a big difference between how the IRS and the FTB go about “assessing” a tax, and how their audit procedures work. For the IRS, assessment occurs at the end of the audit process. Thus, the IRS generally tries to reach potential audit targets within a one-to-two-year window after the return is filed. If the three-year clock has been ticking for two years and ten months, and you haven’t heard from the IRS, you are unlikely to get audited for that year – although there are relatively uncommon exceptions. The IRS has to start its audit soon enough that it can complete the process and issue a Statutory Notice of Deficiency more than four months before the end of the limitation period, for reasons that are too complicated to mention here.

The relatively uncommon exceptions? The IRS gets six years to audit you if it can show a large understatement of income, and if it can show that your return is fraudulent, it can open the audit and assess at any time; there is no statute of limitations on a fraudulent return.

The FTB, on the other hand, assesses the increased tax as soon as it smells a problem. Like a deputized posse member who shoots first and asks questions later, the FTB starts its process with a Notice of Proposed Assessment; this counts as the “assessment” for purposes of the statute of limitations. This notice can be mailed on the last day of the four-year clock, and it’s still effective.

If the taxpayer gets audited by the IRS and agrees to a higher assessment, the taxpayer has a duty to inform the FTB within six months. The FTB then has two years to make its assessment. If the taxpayer doesn’t make the six-month deadline, there is no limitation period – the FTB has an infinite amount of time to make the assessment.

These assessment clocks can be tolled (and often are) by agreement between the taxpayer and the taxing authority. Sometimes this is a good idea, especially if the taxpayer just needs a bit more time to gather records to show to the auditor. Sometimes it’s a bad idea, if the tax authority’s case is not very strong.

Obviously, the laws strongly favor the taxing authorities: our legislatures want to make sure that people do not get out of taxes owed by skillful procedural. And while the FTB’s laws sound even more tilted against the taxpayer, there is a counterbalance: the FTB is generally less effective at opening and closing audits, and investigating a taxpayer’s affairs, than the IRS. “Generally,” of course, doesn’t mean that it can’t be extraordinarily effective if it wants to be.

Collection – Ten Years IRS, Twenty Years FTB

Once the assessment is made, the taxing authority then has to try to collect it. The IRS has 10 years. The date that the collection authority ends is called the “CSED” (Collection Statute Expiration Date). The ten-year clock can be tolled by any of several events: bankruptcy, offer in compromise, or collection due process hearing. Installment agreements do not toll the collection period.

For the FTB, the statutory period is 20 years. Installment agreements, bankruptcy, military service, presence in a disaster area, and child support collection actions all toll the statutory period.

While I have counseled taxpayers at the end of the IRS’s 10-year period, I have never counseled anyone at the end of the 20-year period. The main reason is that the statute of limitations is less than 20 years old: prior to July 1, 2006, there was no statute of limitations on collection actions for income tax in California. No one has yet had their California tax liability extinguished by operation of time.

Period before Dischargeability in Bankruptcy – Three-year, Two-year, 240-day Rules

Taxpayers may discharge their liabilities in bankruptcy. However, the law requires the taxing authorities to have a chance to collect those liabilities before the taxpayer can discharge them. Thus, 11 USC Sec. 507(a)(8) and 523(a) work together to create several rules, familiar to most bankruptcy attorneys: in order for a tax liability to be discharged, it must come from a return last due more than three years before the bankruptcy filing (this is October 15 if the taxpayer got an extension), actually filed more than two years before the bankruptcy filing, and the tax on that return must have been assessed more than 240 days prior to the bankruptcy filing (this becomes relevant in an audit situation). These periods may be tolled by bankruptcy, collection due process hearings, and offers in compromise.

Because these rules are set by federal bankruptcy law, not federal and state taxation law, they are identical for the IRS and the FTB. But there is yet a wrinkle between the two: the 240-day rule operates slightly differently for the FTB than for the IRS.

The “assessment date” for the IRS is straightforward: it is the date appearing on the transcript, the date that the tax return was received, the taxpayer agreed to an increased assessment, or the date that a Tax Court decision became final. For the FTB, it is the date that the assessment proposed in the Notice of Proposed Assessment becomes “final.” While the NOPA serves as the assessment date for all kinds of clocks (including the inter-agency agreement determining priority of liens), it does not serve as the starting period for the 240-day rule. Rather, the 240-day clock starts 60 days after the NOPA, thus effectively giving the FTB a 300-day period before dischargeability is allowed.

Whittling a Tax Debt Down from $513,000 to $30,000!

“Impossible,” you’re probably thinking. But it’s not. Here’s why.

My client knew he had $200,000 in tax debt, only $30,000 of which was income tax debt; the remaining $170,000 was for back payroll taxes from a pizza shop he’d owned a decade earlier.

The first issue to address was whether he should file a Chapter 7 or 13 bankruptcy. I advised against a Chapter 7 (liquidation) because my client had almost no tangible assets and thus the IRS would not file a Proof of Claim (for taxes owed) since there would be no way for the agency to get money out of my client. We would miss any chance to find out exactly how much the IRS thought he owed, and contest that amount.

In a Chapter 13 bankruptcy, all creditors step forward to assert what they are owed, and the debtor proposes a plan in which the creditors are paid off over five years. Some debts (secured and priority claims) must be paid in full; other debts (general unsecured, like credit card or stale tax debt) must be paid according to the debtor’s means. If we filed a Chapter 13 for my client, then the IRS would most certainly file a Proof of Claim for the $200,000 it believed the agency was owed since the back taxes could be paid (partially) from my client’s wages over the next 5 years. And, once the IRS filed a Proof of Claim in the Chapter 13, we could contest the amount.

The second issue was the unexpected curve ball the IRS threw at us: in its Proof of Claim in my client’s Chapter 13, the IRS asserted not the $200,000 tax debt we were expecting, but rather $513,000! Huh? The agency was trying to stick my client for $313,000 in payroll trust fund taxes (the taxes withheld by employers for their employees to fulfill Social Security, Medicare and other tax obligations – this is different from payroll taxes which are the employer’s obligations on Social Security and Medicare for their employees) owed to IRS by a non-profit entity in which my client had worked at the VP of Finance years earlier. His reaction to this unwelcomed news? “That’s crazy! I had nothing to do with the payment of withholding taxes in my job there!”

Indeed, the third issue that arose in this case was whether my client was a “responsible person” who had “willfully” failed to withhold and pay withheld payroll taxes on behalf of the non-profit organization’s employees. My knowledge strongly suggested he did not meet the IRS’s “responsible person” criteria: my client did not have check signatory privileges, nor did he have the discretion to choose to pay another creditor over the IRS. (The IRS views non-payment of trust payroll – the taxes withheld from employee’s paychecks – as almost criminal: it will treat as a thief any agent of an organization who had the power to withhold employee wages and the discretion to choose which creditors of the organization to pay – the so-called “responsible person” who failed to pay the withheld wages to the government.) Obviously, we objected to the IRS’s claim that my client was responsible person. Unsurprisingly, after interviewing my client and doing a search of the documents at the non-profit organization, the IRS agreed that my client was not a “responsible person” for the $313,000 of owed trust fund payroll taxes at the non-profit he’d worked at. Whew – unexpected curveball successfully addressed.

Now on to the original $200,000 tax debt, $170,000 of which was outstanding FICA and FUTA tax owed by the debtor’s pizza shop. The pizza shop was never incorporated, so the client owed the payroll tax as an employer. The IRS never took the extra step of assessing the debtor as a responsible person for any portion of this tax, and the statute of limitations has passed, so it can no longer find him personally liable for the trust fund portion of the payroll tax. This is an important distinction: the payroll tax is dischargeable in bankruptcy, the trust fund tax is not; here, the debtor was able to put the payroll tax into the bucket of dischargeable taxes, saving himself $170,000.

The final tab: only the $30,000 in income taxes. That’s right: we went from $200,000 owed to the IRS, to $513,000 owed, to a final outcome of $30,000 owed! That $30,000 by the way, will be paid out over five years in my client’s Chapter 13 bankruptcy – or $6,000 annually which breaks down to $500 a month. I know. I didn’t hope for, or believe in, such a positive outcome at the beginning of this case either. But, the outcome of this case reaffirmed three claims I often make to my clients or potential clients on tax matters.

First, the IRS is not infallible: it makes mistakes and will admit to them when challenged. Second, it is not difficult to challenge the IRS. If the agency does not have good evidence to back up its claims against you, it will fold because it is an agency with limited resources and it will concentrate its money and manpower on more promising cases. It’s also a conservative litigator: with the law so heavily on its side, it tends to give taxpayers the benefit of the doubt in close factual situations. If your facts are good, the agency will often back down even when it sees a reasonable chance it could prevail. But note: if you’re just trying to shirk taxes you legitimately owe, then no amount of legal mumbo-jumbo will get you off the hook. Third, the cost-benefit analysis of hiring good legal counsel on tax issues is often a no-brainer. In this case, my fee to the client was around $10,000. For that amount, my client saved $483,000. While this was an unusually positive result, the amount you can save by hiring an experienced tax attorney often is very disproportionate to what you can save in debt to the IRS. Lesson? At least speak to a tax attorney before you concede to the IRS. Good, ethical attorneys will be honest with you about whether you have a good reason to contest an IRS judgment.