Navigating the IRS Tax Audit Process - my-CPE.com · tax •Can point to this if IRS starts fishing...

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Transcript of Navigating the IRS Tax Audit Process - my-CPE.com · tax •Can point to this if IRS starts fishing...

Page 1: Navigating the IRS Tax Audit Process - my-CPE.com · tax •Can point to this if IRS starts fishing expedition •80/20 Concept –IRM 4.10.3.2.1 •IRS wants substantially correct
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Navigating the IRS Tax Audit Process

Nick Preusch, CPA, JD, LLM

[email protected]

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Types of Audits

• Matching Notices

• TCO

• RA – LB&I, SBSE, Employment, etc

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Why Adopt an IRS Approach?

• Limits audit surprises

• Helps with due diligence

• Can help raise additional fees

• Can protect your clients interests

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Limit Audit Surprises

• Client failed to report $190,000 in sale of stock that had close to $0 of basis

• Wage and income transcripts prior to audit helped us identify this

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Due Diligence

• Due diligence is a requirement under Circular 230

• When you take on a client, knowing the issues and identifying possible issues helps you utilize due diligence

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Protecting Client Interests

• Qualified Amended Returns• Helps save negligence penalties

• Needs to be filed prior to audit notice for that tax year

• Client under-reported gross receipts

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Pre-Contact - IRS

• Determine SOLs

• Determine Collectability

• Check classification sheet

• Reconcile IRP to return

• Research Industry

• Look for LUQs – IRM 4.10.2.3.1

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How Are Returns Selected

• National Research Project• Totally random

• Looks at every line item

• Used to create DIF score

• DIF Score• Each return scored

• Higher the score, the more likely the return will be audited

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How Returns Are Selected

• After audit selection will go to IRS group

• IRS group will look over return and select key areas to examine

• Could say return does not warrant audit

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How Returns Are Selected

• Returns then sent to local area where taxpayer is and provided to Group Manager

• Group Manager assigns the case to an RA

• RA reviews the case for:• If the case warrants audit

• Taxpayer in combat zone

• Repetitive audits (non-Sch C audits only)

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RA’s First Steps

• Pull IDRS Reports

• Check to see if potentially dangerous taxpayer

• Do Internet Search

• Reconcile all forms provided to the IRS to the tax return (similar to matching notice)

• Determine if scope should be expanded from the selected issues

• Prepare mail correspondence

• Check all other filing requirements

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Initial Taxpayer Contact

• Almost always done through mail

• NPR audits allow for phone calls

• If POA on file, they may call POA instead of mailing

• Need to provide Pub 1

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First Interactions With IRS

• These are the most important

• After client receives audit notice, may call IRS

• If a taxpayer calls, the first call the RA will try to get as much information out of the taxpayer as possible. They know the taxpayer may get a POA, so this may be the only time the IRS can talk to taxpayer

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First Interactions with IRS

• Try to limit the scope

• Try to stay away from discussing specific facts over the phone.

• Schedule the appointment

• RA’s are flexible if you need to cancel an appointment and change the date. However, doing this too often will make them mad

• Group managers track how long a case has been open. They get pressured by the territorial managers to get overly long cases closed as soon as possible.

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First IDR

• If not with initial correspondence,, RA will send IDR

• Try to limit as much as possible.

• Fax G/L and ask for them to sample

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Initial Interview

• As POA, you need to demonstrate that you know the client well and can answer any questions.

• If you demonstrate you do not know the answers to questions, the RA can ask to meet with the Taxpayer

• Generally, if you know the answers to their questions, they cannot talk to the client without a summons

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Initial Interview

• Minimum Income Probes

• BLS stats on income reconciliation

• Internal Controls

• Issue specific questions

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Second IDR

• Once the RA goes through the interview and the initial IDR documents, if he has anymore questions, he will issue a second IDR

• Malpractice point – do not provide any documents without an IDR

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Privilege/5th Amendment

• You do not need to provide documents that are privileged

• If client feels there is criminal issues, they can plead their 5th

amendment rights

• While these are useful, they are generally not great because it may tip the RA off that something is wrong

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Managing the Client

• Client expectations need to be managed

• Do not give false hope

• Progress bill is the best way to make sure you will get the most money from your client and not have uncollectible A/R

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Closing Report

• After IRS has done everything and is comfortable with their adjustments they will provide a RAR with all of their adjustments

• There are frequently mistakes in the IRS calculations.

• Always double check the agents work

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Closing Report

• Can either agree and close the audit or disagree and go to appeals.

• Unagreed reports take a long time to create, so the threat of an unagreed report may help to avoid penalties or other issues

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Closing Report

• Closing report will be the write up of exactly why the IRS thinks the adjustments are appropriate

• Have to respond that you want to appeal within time frame.

• Failure to respond will create a stat notice

• Only way out after that is Tax Court

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Why Is Issue Identification Important?

• Early identification allows for mitigation of problems

• Can expand representation

• Risk management for your firm• Is this client someone that you feel comfortable representing?

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Mitigation of Issues

• Found client had 941 issues and IRS was preparing to audit

• Filed a qualified amended return

• Escaped negligence/substantial understatement penalties

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Expand Representation

• Client has $2,000,000 in assets seized by IRS

• Hired to consult on IRS procedure

• Picked up book reconstruction, amended pass-through and 1040s, and amended all payroll taxes

• All due to early issue identification

• Turned about $2,000 representation into $200,000

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Collectability

• Going into an audit/tax debt issue, can you make a good collectability argument?• Example: Taxpayer lived in foreclosed house. Lived in upstairs with blanket

over staircase so people could not see he lived there

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Collectability

• Look at client returns

• Where is income coming from?

• How much income?

• Has income changed?

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Collectability

• Is considered throughout the exam

• If facts change for client, bring them up

• Practitioners often ignore this in audit situations

• Why should IRS use time and resources on a taxpayer who will be CNC next 10 years?

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Collectability

• Great way to get your clients out of an audit

• Not done enough

• Usually requires manager sign off

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Expenses

• IRS uses a classification guide

• Classification guide based on LUQs

• Auditor has ability to select additional LUQs not previously classified

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Classification Guide

• Couple ways that returns get selected• NRP vs DIF

• Goes to Philly (or other service center)• Usually a GS-12/13 RA with experience

• Duty for 1 to 2 weeks

• All day just classifying returns

• Marks on sheet of paper what are the issues of the return• These issues must be audited, no way around them

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NRP – National Research Program

• Issue checking not too important

• IRS will look at every single line item (even AMT items)

• All items must be accounted for, even small amounts

• Totally random – seen college students selected and seen people with 400+ pages to their return selected

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Classification Guide

• You can usually tell classified issues because they are what is specifically requested pre-contact

• How do they make determination of what to classify?

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LUQ

• Large• $100,000 deduction for meals and entertainment on company with $150,000

of gross receipts

• Unusual• 90,000 miles driven for day trader

• Questionable• All expenses end in $0, i.e. $400, $50, $20

• No M-1 adjustment for meals and entertainment

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LUQ - Defined

• Comparative size of the item — an expense item of $6,000.00 with total expenses of $30,000.00 would be a large item; however, if total expenses are $300,000.00, the item would not be generally considered a large item.

• Absolute size of the item — despite the comparability factor, size by itself may be significant. For example, a $50,000 item may be significant even though it represents a small percentage of taxable income.

• Inherent character of the item — although the amount of an item may be insignificant, the nature of the item may be significant; e.g., airplane expenses claimed on a plumber’s Schedule C.

• Evidence of intent to mislead — this may include missing schedules, incomplete schedules, misclassified entries, or obviously incorrect items on the return.

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LUQ - Defined

• Beneficial effect of the manner in which an item is reported — expenses claimed on a business schedule rather than claimed as an itemized deduction.

• Relationship to other items — incomplete transactions identified on the tax return. For example, the taxpayer reported sales of stock but no dividend income.

• Whipsaw issues — when there is a transaction between two parties and characteristics of the transaction will benefit one party and harm the other. Examples include alimony vs. child support, sale vs. rental/royalty, employee vs. independent contractor, gift vs. income.

• Missing items — consideration should be given to items which are not shown on the return but would normally appear on the returns of similar taxpayers. This applies not only to the examination of income, but also to expenses, deductions, etc., that would result in tax changes favorable to the taxpayer.

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LUQ

• However, it is not intended that examiners should consider every possible issue. For instance, it is not proper for examiners to make a detailed analysis of a specific account unless the potential adjustment will materially affect the tax liability or will be important from a compliance viewpoint. In addition, examiners are expected to adequately explain the items which are examined and the large, unusual, and questionable items which are accepted without examination.

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LUQs As Practitioners

• Should be part of due diligence if filing a tax return for client

• Should be able to document LUQs• Could be is simple as an e-mail verifying records are correct

• For audits, might be areas you want to keep an auditor away from• Example – Built-in Gains on S Corp converted from C Corp

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LUQs - Note

• Remember, reason for LUQs are for efficient assessment of additional tax

• Can point to this if IRS starts fishing expedition

• 80/20 Concept – IRM 4.10.3.2.1• IRS wants substantially correct tax liability

• Value-added decision making that weighs the impact of our decisions with investment of additional case time and is applicable throughout the audit to evaluate and determine the scope of the examination

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Income

• All business exams require income verification

• IRS Uses Cash-Ts as part of pre-audit plan

• IRP Reconciliation

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Cash-T

• Cash-T uses BLS data to see if taxpayer can live on his reported income

• IRS needs this to be reconciled by close of audit.

• Do you own Cash-T in your head.. Does the income align with what is being reported

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Cash T

• You can use Cash-T as pre-screener for clients

• If client reports $2,000 of AGI, will he ever be able to pay your fees?

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Cash-T Example

• AGI is $20,000

• Standard living costs for family of 2 in the area is $28,000

• Cash-T has $8,000 discrepancy

• Pretty Common Sense Analysis

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Cash-T Example

• Person owns $1,000,000 home with $800,000 mortgage

• AGI is $40,000

• Where is money coming from to pay the mortgage?

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Cash-T Story

• Buffalo, NY

• Person audited without representation

• Had the IRS come to his home for the interview

• IRS agent saw several Audis, BMWs, etc in drive way

• Taxpayer was only reporting about $30,000 a year

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Cash-T – Handling Clients

• When first working with client, bring this issue up

• Get the process going early for getting documentation on non-taxable funds received

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Cash-T – Common Errors

• Often IRS fails to:• Look at pass-through distributions

• Takes net gain on sales instead of cash sales

• Backs out non-cash depreciation – but fails to account for CY asset purchases

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IRP - IDRS

• IDRS is the IRS information document retrieval system

• Has all W-2s, 1099s, etc on it

• Can get the same thing with wage and income transcript

• Most audited returns do not go through the matching program, so auditors do a manual matching

• All discrepancies need to be reconciled

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IRP

• Can get this information through the Wage and Income Transcripts

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Businesses

• Business returns are a different type of audit

• Balance sheet driven

• Whenever looking at a business, start with the balance sheet

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Balance Sheet Basics

• Accounting Equation• Assets = Liabilities + Equity

• Add up the assets to see if they match liabilities + equity

• This is frequently incorrect• Really a lack of due diligence if balance sheet does not balance

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Balance Sheet Basics

• Assets = $50,000

• Liabilities = $25,000

• Equity must equal?

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Balance Sheet Basics

• Check the prior year

• The ending amount on the PY Tax Return should be the beginning amount on the CY Tax Return

• These are great clients to find because they tend to need all their books re-worked

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Balance Sheet Basics

• Accounts Receivable = $10,000 on 12/31/14

• What is Accounts Receivable on 1/1/15?

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Balance Sheet Basics

• Cash vs. Accrual• One will has accounts payable and accounts receivable

• Other will not

• If you see AR or AP on a cash basis taxpayer, you know there is an issue

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Balance Sheet Basics - Example

• For divorce

• Husband owned several businesses

• 2014 return had ending cash of $114,000

• 2015 return had beginning cash of $10,000

• Where did the cash go? Wife really wanted to know!

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Balance Sheet Basics - Depreciation

• On the balance sheet, you should be able to reconcile the change in accumulated depreciation to the current year depreciation and any depreciable asset sales

• Example:• CY Depreciation is $50,000

• Sold assets with $20,000 of accumulated depreciation

• PY Acc. Dep = $400,000

• CY Acc. Dep = ???

• ??? = $430,000

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Balance Sheet Basics

• Inter-Company amounts should match between entities

• Tax preparer had several entities

• On one entity had $1,000,000 loan from another entity

• The other entity did not show the $1,000,000 asset

• Can’t really trust books anymore

• Ended up was using these fake loans to conceal income

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Balance Sheet Basics

• On the topic of intercompany• Any related documents should be cross referenced

• For example• W-2 of S Corp officer should be on 1040 and on 1120S. These amounts should match.

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Balance Sheet Basics

• Scan account names – see what they are

• Look for shareholder loans – imputed interest

• Look for LUQs

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Balance Sheet Basics

• Apply analytics and common sense

• Example:• 12/31/14 – Cash was $50,000

• 12/31/15 – Cash was $800,000

• No new loans on balance sheet

• No new equity in the company

• Company had a profit of $20,000

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Balance Sheet Basics

• Balance Sheet Driven• On previous example:

• Tied liabilities and equity

• Cash was off and most of the difference should have been reported as income

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Balance Sheet Basics

• Bank reconciliations• IRS always requests

• Easiest way to tie cash and gross receipts

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Great Way to Limit Scope

• Provide entire GL

• But also provide print outs of just accounts relating to classified issues• Helps limit scope/what auditor sees

• Can ask for sample prior to first meeting so you do not need to get all invoices too

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The Company

• When going into an audit, you need to know the company

• IRC 7521(c) allows the representative to not have the taxpayer interviewed – but representative needs to have knowledge of business

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IRC 7521(c)

• Any attorney, certified public accountant, enrolled agent, enrolled actuary, or any other person permitted to represent the taxpayer before the Internal Revenue Service who is not disbarred or suspended from practice before the Internal Revenue Service and who has a written power of attorney executed by the taxpayer may be authorized by such taxpayer to represent the taxpayer in any interview described in subsection (a). An officer or employee of the Internal Revenue Service may not require a taxpayer to accompany the representative in the absence of an administrative summons issued to the taxpayer under subchapter A of chapter 78. Such an officer or employee, with the consent of the immediate supervisor of such officer or employee, may notify the taxpayer directly that such officer or employee believes such representative is responsible for unreasonable delay or hindrance of an Internal Revenue Service examination or investigation of the taxpayer.

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Internal Controls

• Internal controls are very important to an IRS audit

• If you can demonstrate internal controls are strong, then IRS will look at less support

• These are questions all practitioners need to know about their client prior to an audit

• This will help show knowledge for 7521(c) purposes

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Questions to Ask Client Before Audit

• Chart of Accounts Used?

• Accounting Method?

• How was Income Determined?

• Is a double-entry accounting system used?

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Questions to Ask Client Before Audit

• Individual Responsible for:• General Bookkeeping

• Cash Receipts

• Accounts Receivable

• Accounts Payable

• Sales

• Purchases

• Reconciling Bank Statement

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Questions to Ask Client Before Audit

• Who adjusts and closes book?

• Who handles deposits? How often are deposits made?

• Who opens the mail?

• How are credits memos and returns handled?

• Are personal funds of shareholders and officer kept completely separate from business funds

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Questions to Ask Client Before Audit

• Are sales orders, work orders, and invoices pre-numbered? Are all numbers accounted for and used in sequence? What happens to voided orders and invoice?

• How do you handle month-end and year-end cut-offs?

• Are there policies covering the aging of accounts receivable? Are they followed?

• Who authorizes write-offs of receivables?

• Who authorized write-off of obsolete inventory? What guidelines are used? Who authorizes the write-off of other assets?

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Questions to Ask Client Before Audit

• How are cash sales handled? Are duplicate deposit slips kept? Is cash deposited intact?

• Who authorizes purchases of major items?

• How are payrolls handled? Example: Separate payroll account?

• How much petty cash is kept on hand? Who has access? Is a voucher system in use?

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Questions to Ask Client Before Audit

• How often are bank reconciliation’s prepared?

• Are physical counts of inventories made? How often? Are the records available?

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Required Filing Checks

• Check return• Subcontractors? – 1099s?

• Salaries – W-2s, 941s, 940s

• Pension Plan – 5500?

• 990s

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990 Review Story

• From divorce case• Husband started 990

• Reported $10,000 of compensation – 1099 on 990

• Not reported on tax return

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Know Your Client’s Audit History

• Can request a survey if non-business client and client audited recently

• Can request a limited scope if client just audited• Example – client audited for 11, 12, 13. Audit ended in 15

• Client received a refund in 11, 12, 13 for pass-through issues

• Only tax due from built in capital gains tax

• In 16, client gets audited for 14

• Request limited scope to just built in capital gains tax

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TEFRA

• Different audit rules apply to TEFRA

• TEFRA is going away

• Mistaken TEFRA• Once TP elects TEFRA, they stay TEFRA

• Only TEFRA has Tax Matters Partners (TMPs)

• If we report a TMP on non-TEFRA entity, could accidently put them in TEFRA

IRS is not good at keeping past elections – could get audit/request abatement and ask why we report a TMP if we never elected TEFRA

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New TEFRA

• Effective for tax years starting after 12/31/17

• Partnership tax due is calculated at partnership level (instead of partner level)

• This is calculated at HIGHEST corporate or individual income tax rate during the year (depending in types of partners)

• Very rough and costly, so most practitioners do not want this to apply

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Electing Out – Changing Partnership Agreements• Three Types of Elect Outs

• Annual election if non-TEFRA (100 partners or less, partnership and trust owners cannot make election)

• Must be timely filed

• Partnership must tell each partner of the election

• Partnership gives IRS names of all partners and TINs (if S corp is owner, needs names and TINs of all those shareholders)

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Electing Out – Changing Partnership Agreements• Non-Electing (1)

• Can elect out during audit

• 270 days from receiving partnership adjustments

• Partners can amend returns

• Non-Electing (2)• 45 days after final notice

• Partnership can elect to send partners and IRS share of adjustments

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Partnership Agreements

• With these new elections• Firms are urging partnerships to amend partnership agreements to include:

• Requirement partnership makes opt-out each year, if applicable

• If not applicable, partner will agree to amend returns within 270 day window OR partners consent to electing under the 45 day window

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Partnership Agreements - TMP

• The TMP will be gone

• In its place is a partnership representative

• Has very broad powers

• All partnerships required to appoint

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New Partnership SOL Assessment

• After the later of: • (i) the date the partnership filed its return;

• (ii) the partnership return’s due date; or

• (iii) the date on which the partnership filed an administrative adjustment request

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Statutes of Limitation (SOL)

• SOLs are a limit on government action against the taxpayer

• Main SOLs to know:• Refunds

• Assessment

• Collection

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SOL Refunds

• Later of:• Three years after return is filed OR

• Two years after tax is paid

• Extension possible when also extending SOL on assessment

• Protective Claims

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SOL Refunds Example

• Client files on 4/15/15. Owes $100,000 of taxes. Pays $50,000 on 4/15/15 and $50,000 on 9/25/18.

• Three years from date filed – 4/15/18• Can get refund on all $100,000 if by 4/15/18

• Two Years from Paid• 4/15/17 – doesn’t matter since 3 year rule applies

• 9/25/20 – can get a refund up to $50,000

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IRC 6511(h) Exception

• If TP is:• “unable to manage his financial affairs by reason of a medically determinable

physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months.”

• Then, the statute actually freezes

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6020(b) Return - SFR

• IRC 6020(b) allows the IRS to file a tax return for a taxpayer (also known as substitute for return or SFR)

• IRS uses wage and income determination to create return – no deductions

• SFR is not a taxpayer filing, so SOL for refunds never starts

• Can file actual return at any time

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SOL on Assessment

• General Rule – IRS can assess additional tax due - 3 Years from the date filed

• Exceptions:• False, Fraudulent and No Return• 25% unreported income – 6 years• Extension by Agreement• Tax from Changes in Certain Income Tax or Estate Tax Credits• Termination of Private Foundation Status• Amended Returns• Failure to Notify Service of Some Foreign Transfers• Gift Tax on certain Gifts Not Shown on Gift Tax Return

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Exceptions

• False/Fraudulent Returns• No SOL forever

• Filing non-fraudulent return does not give return an SOL

• Amended Returns• Do not change the SOL

• Unless filed within the last 60 days of SOL period, then extends an additional 60 days

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Exceptions

• NOL Carrybacks• SOL is with return of NOL

• Substantial Omission• More than 25% of income not reported – 6 year statute

• Can be avoided with adequate disclosure

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SOL - Passthroughs

Note – This issue can be difficult with TEFRA (explained later)

2nd Circuit:• the “return” that starts the running of the limitations period at issue is that of the

taxpayer whose liability is being assessed, and not that of a third person or entity whose return might also report the transaction that gives rise to the liability. On this reading, the return referred to in § 6501(a) would thus be the individual's income tax return for an assessment of individual income tax. – Siben v Commish 930 F2s 1034

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Shorted SOL to 18 months

• Can shorten SOL to 18 months in two situations:• Any tax (but estate) where return is required and for which a decedent or an

estate of a decent may be liable

• Any tax where a return is required for a corporation contemplating dissolution, is dissolving or has dissolved

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Mitigation

• Under limited circumstances, the mitigation provisions in sections 1311-1314 of the Internal Revenue Code permits a taxpayer (or the government) to correct an error made in a year closed by the statute of limitations. The circumstances under which an adjustment is authorized are spelled out in section 1312. For instance, that provision authorizes a refund for income reported in a closed year only if there has been a determination that the income should have been reported in an open year. In this circumstance, without the application of the mitigation provisions, an item of income could be taxed twice. – CCA 1996-2

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SOL - Collection

• IRS has 10 years after tax assessment to collect money due from taxpayer

• OICs can extend SOL

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Penalty Abatement

• First Time Penalty Abatement• FTF (IRC 6651(a)(1), IRC 6698(a)(1), and IRC 6699(a)(1));

• FTP (IRC 6651(a)(2) and

• IRC 6651(a)(3));

• and/or FTD (IRC 6656)

• Needs to have no penalties previous 3 years

• All returns need to be filed or on extension

• Template on Intranet

• Try to use Reasonable Cause argument before FTA

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Partnership Penalty Abatement

• Rev Proc 84-35• If partnership has 10 or less partners, can generally get partnership penalties

abated

• Needs to be non-TEFRA (see later)

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Quicker Ways to Get IRS Info

• Taxpayer Advocate• For cases not moving or issues not getting resolved

• Hard to get / use special language to qualify

• Practitioner Priority Line 866-860-4259• Can call and fax POA to person you are talking to

• IRS Eservices – Transcript Delivery• Need 5 days for CAF to Process

• Quiet Disclosure – If client has tax due, this is the best way to go. If calling IRS, IRS will set deadlines for taxpayer and could get ACS involved again

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Transcripts

• Tax Return Transcript• Copy of tax return.. Doesn’t look like a tax return

• Wage and Income Transcript• Copies of W-2, 1099, K-1, etc, information

• No state withholding on W-2s

• Account Transcript• *Most important

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