Procedural and substantive framework of audits of mid-size businesses and selfemployed

Transcription

1 DEFENDING BUSINESS AUDITS, PART 1 & PART 2 First Run Broadcast: August 12 & 13, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) IRS audits of mid-sized businesses and self-employed business professionals individuals can be a very costly and time-consuming distraction. The audit, if not properly managed, can grow in the scope of issues involved, require the production of boxes of documents, and involve substantial time by the owners and/or mangers of the company. Representing clients in the progressive stages of an audits requires a practical understanding of the types of audits to which a business client may be subject, how they differ from each other, how to respond to the IRS and how to define reasonable expectations by a client and work toward closure of the audit or a settlement. This program will provide you with a real-world guide to representing a mid-size business or a self-employed individual in an IRS audit, including responding to the IRS, managing the stages of the process, and working toward closure, settlement, or on appeals. Day 1 August 12, 2014: Procedural and substantive framework of audits of mid-size businesses and selfemployed individuals Types of audits letter, field, office and the implications of each type Common issues arising in audit employment taxes, reporting in cash-based businesses, improper deductions Containing the scope of an audit over time and the role of an examiner s discretion Essential preparation for an initial IRS interview, including document assembly and review Overall timeline of audits and deadlines Day 2 August 13, 2014: Statute of limitations of limitation and extensions Issues common to S Corp audits, including unreasonably low compensation How audits involving employment taxes differ from other audits Penalties and interests, and opportunities for waver or abatement Settlements defining what s reasonable, negotiations, and closing agreements Appeals within the IRS from an examiner s determination Speaker: Stephen J. Turanchik is an attorney in the Los Angeles office of Paul Hastings, LLP, where his practice focuses on tax litigation at the state and federal levels as well as tax controversy work at the administrative levels. Before entering private practice, he is previously litigated for six years for the U.S. Department of Justice, Tax Division, where he litigated over 300 tax cases in federal, bankruptcy, state and probate court. He has also lectured at Loyola Law School and California State University, Fullerton on topics relating to tax litigation and is chair-elect of the executive committee of the Los Angeles Bar Association s Tax Section. Mr. Turanchik received

2 his B.A. from the College of the Holy Cross, his J.D. from Fordham University School of Law, and his LL.M. in Taxation from New York University School of Law.

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Defending Business Audits, Part 1 Teleseminar August 12, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 PAYMENT METHOD: NO REFUNDS AFTER August 5, 2014 Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

4 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Defending Business Audits, Part 2 Teleseminar August 13, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 PAYMENT METHOD: NO REFUNDS AFTER August 6, 2014 Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

5 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Date: Seminar Title: Location: Credits: Vermont Bar Association August 12, 2014 Defending Business Audits, Part 1 Teleseminar -LIVE 1.0 MCLE General Credit (60 minute total program time) Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

6 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Date: Seminar Title: Location: Credits: Vermont Bar Association August 13, 2014 Defending Business Audits, Part 2 Teleseminar -LIVE 1.0 MCLE General Credit (60 Minute total Program Time) Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

7 Stephen Kadish, Esq, Stephen Turanchik, Esq. Kadish, Hinkel & Weibel Paul Hastings LLP 1360 East Ninth St., # S. Flower Street, 25th Floor Cleveland, Ohio Los Angeles, CA (216) (213) IRS Audits of Medium and Small Sized Businesses Part 1 I. Procedural and Substantive Framework of Audits of Mid-Size Businesses and Self- Employed Individuals A. Voluntary Systems of Reporting Taxes 1. Contrast with involuntary system like sales taxes 2. Threat of an IRS Audit encourages voluntary compliance

8 Day 1 - August 12, 2014 B. Percentages of Corporations Audited in Fiscal Year Assets > $250 million were examined at a rate of 22.5% 2. Assets between $10 million and $50 million was 7.0% 3. Assets < $10 million was 2.0% C. Percentages of Individuals Audited in Fiscal Year Business Returns with income between $200k and $1 million was 3.2% 2. Individuals with positive income > $1 million was 10.8% D. Willie Sutton, the notorious bank robber, was asked, Why do you rob banks? His answer: That s where the money is. 1. IRS takes the same approach 2. But can vary with political climate / administration E. How Are Returns Selected for Examination? 1. Potential participants in abusive tax avoidance transactions a. Information obtained by the IRS through third parties. 2. Computer Scoring a. IRS Computer programs give each return numeric scores. b. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. c. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highestscoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review. 4. Related Examinations a. Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination. 2

9 Day 1 - August 12, 2014 II. Types of Audits and the Implications of Each Type A. Initial Inquiry May be Made by Information Document Request (IDR) B. Correspondence Audit 1. Description a. Conducted by correspondence b. Usually only addresses one tax year and one tax item. 2. Conducted by Tax Examiners a. Qualifications of Examiners b. During fiscal year (FY) 2013, more than 70 percent of the examinations of were performed by correspondence (mostly for individuals) 3. According to the Taxpayer Advocate, in Correspondence Examination, the IRS is less likely to ask questions that would yield an accurate determination. (But they re automated, so it s cheaper for the Government). 3

10 Day 1 - August 12, 2014 C. Office Audit 1. Description 2. Conducted by Revenue Agents a. Qualifications of Revenue Agents D. Field Audits 1. Description 2. Conducted by Revenue Agent E. Criminal Tax Investigations (CID) 1. The doorbell rings while you re at dinner mind if I come in? 2. One Agent shows a badge. a. Be aware if two agents are present. 3. Talk to my lawyer. F. Obtaining Representation (aside from Tax Return Preparer) 1. Form 2848, Power of Attorney and Declaration of Representative a. July 2014 Revision III. Common Issues Arising in Audit A. Employment Taxes 1. Determination of employment classification a. Employee v. Independent Contractor 2. Trust fund taxes failure to withhold and/or remit. 3. Determination of Responsible Persons ( 6672) B. Cash-based businesses 4

11 Day 1 - August 12, 2014 C. Improper deductions D. Shareholder Loans IV. Containing the Scope of an Audit and Examiner s Discretion A. Understanding the IRS Goals 1. IRS objective is a quality audit 2. Not necessarily disallowed deductions or additional tax 3. Audit may be limited in scope to particular items, or could be broad based 4. The agent is looking to understand the business of the taxpayer and ensure that the appropriate tax has been paid. B. Understanding the Client s Goals 1. Learn what soft spots if any are on the tax return a. Interviewing your client b. Speaking with the tax return preparer c. Will influence what strategy you take with the IRS 2. IRS audit defense can be costly (accountant / attorney fees) a. Internal business costs b. Swift resolution may be cheaper than a long fight 1) Especially if there are items of exposure that have not been examined 2) Be prepared early and set the stage 5

12 Day 1 - August 12, 2014 V. Essential Preparation for an IRS Audit A. How to Respond to the IRS 1. Assemble files and records of the client in good order. a. It helps reduce the time of the examination both for the taxpayer and for the agent. b. An expeditious examination is convenient for the agent and beneficial for the taxpayer. c. It conveys to the agent an impression of efficiency and cooperation that can prove to be an intangible benefit to the taxpayer during the course of the examination. d. Review of the records also gives some indication of what questions the agent is likely to raise. 2. No obligation to volunteer information; but no stonewalling a. Do not count on the agent forgetting about a request b. Beware client interviews, especially without representative (attorney, CPA) present 3. Keep records of everything provided and/or said to the agent B. Representative s Goals 1. Limit the scope of the examination. 2. Keep a record of what the agent has seen (i.e., what the agent knows and does not know) 3. Move the agent through the examination as quickly as possible 4. If possible, get the IRS Agent on your team all working together to get to the right result. C. Determine the Client s Goals 1. Expectations May Need to be Adjusted 2. Limit Scope of Audit 6

13 Day 1 - August 12, Limit Monetary Exposure 4. Any Concerns About Fraud? (Identify as early as possible). VI. Developing an Audit Strategy A. Treat the IRS Agent professionally 1. Probably the most important point of these two hours 2. Avoid an adversarial climate a. It can cause extensive delay, unnecessary challenges, and excessive costs to the client. 3. Representative should attempt to establish an atmosphere of credibility and trust with the agent. a. Failure to provide adequate records to support items on the return, for example, may unavoidably create a credibility gap and either prolong the examination or force the agent to resolve questionable items in the Service's favor, leaning heavily against the taxpayer. 4. An agent should be treated with courtesy and consideration. 5. No representation should be made without support, and promises made (e.g., production of records; deadlines) should not be broken. a. As desirable as a proper atmosphere is, in some cases it will not be possible, no matter what the representative's wishes. 6. Control over all circumstances affecting the result of an examination may not be possible, but representatives will have performed their obligations 7

14 Day 1 - August 12, 2014 to clients if they are prepared and deal with the agent in a professional manner. VI. Overall timeline of Audits and Deadlines A. Statutes of Limitations on Assessment 1. Generally, 3 years from the date the income tax return was filed 2. Can be extended to 6 years in the event the taxpayer has a substantial omission of gross income 3. No statute of limitations in cases of fraud or when no tax return has been filed. B. Consents to Extend Statutes of Limitations for Assessment 1. IRS will routinely ask for extension when statute has only six months left before expiration 2. Pros/Cons in agreeing to extend statute of limitations C. Criminal Tax Evasion Statute of Limitations 1. There is a six 6 year limitation period for the offense of willfully attempting to evade or defeat any tax. 2. Statute begins to run: a. Statutory due date where no return is filed or where the return is filed early. b. Actual filing date where the tax return is filed late. c. Date of the last affirmative act of evasion where acts of evasion occur after the filing due date. D. Statute of Limitations on Collection 1. Generally, 10 year period from date of assessment 2. May be extended by making Offers in Compromise or filing for bankruptcy. 8

15 Day 1 - August 12, 2014 E. If Unsuccessful in Persuading IRS/Courts that Taxes are Not Owed a. Collection Alternatives b. Potential Innocent Spouse Defenses 9

16 Stephen Kadish, Esq, Stephen Turanchik, Esq. Kadish, Hinkel & Weibel Paul Hastings LLP 1360 East Ninth St., # S. Flower Street, 25th Floor Cleveland, Ohio Los Angeles, CA (216) (213) IRS Audits of Medium and Small Sized Businesses Part 2 I. Issues Common to S-Corp Examinations A. Unreasonably Low Compensation 1. Tendency to underpay owners in order to minimize Social Security and Medicare (FICA) taxes. a. Income tax effect is the same. 3. Underpaying shareholders wages for work actually performed is viewed as an impermissible way to avoid employment taxes. 4. Courts have supported the IRS position that shareholders who work for their corporations must take reasonable compensation for the work performed. 5. Caveat: transitioning from S Corp to LLC is a taxable event. B. Shareholder Loans v. Dividends 1. Courts have looked at the following factors to determine whether a corporate advance is a loan or a dividend: a. The extent to which the shareholder controls the corporation b. The earnings and dividend history of the corporation. c. The size of the advances. d. Whether a ceiling existed to limit the amounts advanced. e. Whether or not security was given for the loan. f. Whether there was a set maturity date and repayment schedule.

17 Day 2 - August 13, 2014 g. Written evidence of a loan, such as an interest-bearing note. h. Whether the corporation ever took steps to enforce repayment. i. Whether the shareholder was in a position to repay the loan. j. Whether there was any indication of attempts to repay by the shareholder C. Excessive or Inappropriate write-offs. 1. Taking deductions for items that should be capitalized (e.g., costs that should be added to inventory rather than separately deducted); and 2. Travel and entertainment expenses that lack the necessary records and receipts to support them. 3. Health Care Deductions more than 2% Shareholders D. S Corporation Can Only Have One Class of Stock 1. S corporation stock must confer identical rights to distribution and liquidation proceeds for all shareholders 2. No preferred stock 3. Failure to maintain only one class of stock is a conversation to a C corporation E. Correcting Faulty S Corporation Elections 1. Private Letter Ruling a possibility 2

18 Day 2 - August 13, 2014 II. Employment Taxes Differ From Other Audits A. Personal Liability for Trust Fund Taxes Code section B. Form 4180 Interview Report Questions - Responsibility 1. Determine financial policy for the business? 2. Direct or authorize payments of bills/creditors? 3. Prepare, review, sign, or authorize transmit payroll tax returns? 4. Have knowledge withheld taxes were not paid? 5. Authorize payroll? 6. Authorize or make Federal Tax Deposits? 7. Authorize the assignment of any EFTPS or electronic banking PINS/passwords? 8. Who was authorized to sign checks? 3

19 Day 2 - August 13, 2014 C. Form 4180 Interview Report Questions - Willfulness 1. When and how did you first become aware of the unpaid taxes? 2. What actions did you attempt to see that the taxes were paid? 3. Who handled IRS contacts such as phone calls, correspondence, or visits by IRS personnel? 4. Be sure to obtain copy of completed form. IV. Penalties and Interests, and Opportunities for Waiver or Abatement A. Penalties 1. Failure to File 2. Failure to Pay Tax Shown on Return 3. Estimated Tax Penalties 4. Non/Late Filing of Entity Returns a. Penalties can be per partner per day for flow-through entities. 5. Section 6694 Penalties for Return Preparers 4

20 Day 2 - August 13, 2014 a. Circular 230. b. Office of Professional Responsibility (OPR). B. Abatement of Penalties 1. Reasonable Cause a. If the taxpayer exercised ordinary business care and prudence and was nevertheless unable to meet its obligation then the delay may be due to a reasonable cause and the penalty can be abated. b. Many claims the reasonable-cause escape hatch are concerned with claims of reliance on attorneys, accountants, and other advisors. 1) If a taxpayer relies in good faith on the advice of an attorney or accountant on a matter of tax law, such as whether a liability exists, the reliance is reasonable, the 2) On the other hand, if a taxpayer relies on an attorney or accountant to file a timely return and the attorney or accountant fails to do so, the reliance is not reasonable cause for the failure to file. 3) Such a duty, the court held, cannot be discharged merely by delegating it, even if the delegation is to a competent and responsible person. 4) Taxpayers who are not misinformed by a tax expert but who decide for themselves that a return is not required or is not yet due are likely to be told that self-reliance, though ordinarily a virtue, is not reasonable cause for failing to file on time. 2. First Time Abatement Program for Failure-to-File or Failure-to-Pay Penalties. a. Business taxpayers can also make such a request for failure to deposit payroll taxes. b. To qualify, the taxpayer must demonstrate: 1) The taxpayer must have filed, or filed a valid extension for, all currently required returns and not have an outstanding request from the IRS for an unfiled return; and 5

21 Day 2 - August 13, ) The taxpayer must have paid, or arranged to pay, any tax due. i) The client can have an open installment agreement, as long as payments are current. b. Does not require a showing of reasonable cause c. An administrative waiver and not statutorily mandated. d. Implemented in the early 2000s, and has been underutilized by taxpayers, largely because the IRS has not publicized the program and fails to provide taxpayers with guidance when clearly applicable. e. Procedure for Requesting C. Interest Accrues as a Matter of Law 1. Narrow Exceptions -- Abatement / Suspension a. The IRS can abate assessment of interest on: 1) any deficiency attributable to any unreasonable error or delay by an IRS officer or employee in performing a ministerial or managerial act; or 2) any payment of tax subject to the deficiency procedures, to the extent that any unreasonable error or delay in the payment is attributable to an IRS officer or employee's erroneous or dilatory performance of a ministerial or managerial act. 3) No significant aspect of the error or delay can be attributed to the taxpayer involved, and an error or delay is considered only if it occurs after the IRS has contacted the taxpayer (in writing) with respect to the deficiency or payment 2. The IRS can suspend interest when the IRS delays issuing a notice regarding an underpayment. a. This relief (referred to as a suspension) is available to a taxpayer who files a timely income tax return. 6

22 Day 2 - August 13, 2014 b. It is triggered by the failure of the IRS to provide a notice to the taxpayer stating the correct liability and the basis for it by a certain deadline: i) The deadline is 36 months after the later of the date the return was filed or the due date of the return without regard to extensions. ii) The suspension period ends 21 days after the issuance of the notice V. Settlements What s Reasonable, Negotiations, and Closing Agreements A. Revenue Agent s Authority 1. Revenue agents have no formal authority to settle cases, but as a practical matter, settlements on issues do occur during the examination. 2. It is to a taxpayer's advantage to dispose of issues or adjustments with the revenue agent after the examination. 3. At the agent level, there is no Service position to justify. There is no administrative record as such, and consequently no need to support any change from the position the agent has taken. a. Once the agent takes a position, there is a certain amount of administrative inertia that makes abandonment of the agent's position more difficult. b. The taxpayer is perceived by the IRS as having the burden of proving that the agent is wrong and the taxpayer is right in the position taken on the return. B. Settlement on Some Issues May Not Be Possible 1. The agent is bound by the National Office's position on an issue and cannot settle a prime issue on which the National Office wishes a court decision. 2. The agent must follow: a. IRS regulations and/or rulings on point 7

23 Day 2 - August 13, 2014 b. Non-acquiescence to a Tax Court decision adverse to the Service c. IRS internal audit directives. 3. The agent also cannot take into account the hazards of litigation. 4. Factual issues are easier to settle than legal issues VI. Appeals from an Examiner s Determination A. Four Possible Outcomes 1. No change- the examiner proposes no change in the taxpayer s tax liability 2. Agreed - the examiner proposes adjustments to the taxpayer s tax liability and the taxpayer agrees to sign a consent with respect to all of the adjustments. (Note the auditor is not concerned with collecting the liability, just ascertaining the correct number). 8

24 Day 2 - August 13, Unagreed -- the examiner proposes adjustments to the taxpayer s tax liability and the taxpayer does not agree to sign a consent with respect to all adjustments. 4. Partially Agreed the examiner proposes adjustments to the taxpayer s tax liability and the taxpayer agrees to sign a consent with respect to some of the adjustments, but not to others. B. Types of Settlements 1. Mutual Concession Settlements a. Both parties concede that there is substantial uncertainty as to how the courts would interpret and apply the law, or as to what facts the courts would find, in deciding the issue in dispute. b. There is substantial strength to both parties position so that neither party is willing to concede in full. c. Each party makes concessions based on the relative strength of the opposing position in an attempt to reach a settlement that is fair to both sides. 1) For example, a property valuation issue and an issue involving reasonable compensation typically involve mutual concessions. 2. Split Issue Settlements a. A form of mutual concession settlement of an issue that, if litigated, would result in a decision totally for or against the taxpayer. b. A split issue settlement is based on a percentage or stipulated amount of the tax in controversy. 1) Appeals Officers use this when no other method of settlement is appropriate. c. Distinguishing feature: the result could not be reached if the issue were tried in court. 1) for example, whether a debt is a business or nonbusiness bad debt, whether a bond issue qualifies for exemption, or whether a reorganization is tax-free. 9

25 Day 2 - August 13, 2014 d. In a case involving multiple issues, frequently settlement is reached not by splitting issues but largely by trading one issue for another. 3. Appeals officers may send cases back to exam if not developed (or sometimes just concede the underdeveloped issue). C. Three Options for Appealing an Adverse Determination at Audit 1. IRS issues a 30-day letter. Taxpayer must timely file Protest after an Examining Agent s adverse determination. Matter is sent to IRS Office of Appeals. a. IRS Office of Appeals 1) Purpose is to resolve tax controversies without litigation to the extent possible. 2) Unlike Revenue Agents, Appeals Officers can take into account hazards of litigation i) Both factual and legal 3) Appeals officers do not want to conduct an audit i) Appeals cases should be factually developed; ii) Appeals officers are not supposed to raise new issues; 4) No ex parte communications. 2. IRS issues a Notice of Deficiency (90-day letter, or statutory notice ). Taxpayer has 90 days to file a petition in U.S. Tax Court, to be able to contest the liability without first having to pay. 3. Full Pay Tax, Make a Claim for Refund and then File a Suit for Refund (U.S. District Court or Court of Claims). 10