If you are selected for an IRS exam, you likely do not feel like a winner. In fact, you have at least some bad luck or karma to be selected in the first place. But, if you are selected, what can be considered a win against the IRS? The answer is: it all depends on where you start!
The IRS expends substantial resources when selecting tax returns for audit. Unfortunately, the IRS is adept at the return selection process as the returns selected generally are problematic for the taxpayer. Out of the million plus returns selected each year, the IRS has their normal targets: the super-wealthy, tax protesters, individuals and businesses with offshore bank accounts, claiming a loss on a hobby, using a sleazy preparer and using round numbers on a return…. But the IRS also audits ordinary everyday people and business owners without the aforementioned characteristics.
The best possible outcome for an IRS audit is a “no change” letter. This means the return has been accepted as originally filed with the IRS. Considering the aforementioned resources the IRS puts into exam return selection, a “no change” result is unusual. If you have a “No Change” exam consider this a “Win” against the IRS. Generally, the taxpayers with “No Change” exam results have at least some of the following factors going for them: they are exceptional record keepers, have a competent and conservative CPA preparing their returns, do not have any IRS targeted positions on their return and/or their return was selected randomly.
Often, an acceptable outcome in an IRS exam include changes to the original return that include additional tax due. There are, however, acceptable outcomes in IRS exams that include changes to the original return which result in tax due. This can occur if all income is not reported or deductions are not valid or deductions cannot be adequately substantiated. The IRS will compute a balance due with interest and late pay related penalties. But as long as Accuracy-Related Penalties under IRC § 6662(b)(1) and IRC § 6662(b)(2) are not assessed a taxpayer is essentially in the same position as he or she would be if their return was originally filed correctly. I would consider this result a win for the taxpayer under most circumstances.
Now the most common result in an IRS audit are changes to the return that increase income and tax due along with the aforementioned Accuracy-Related Penalties under IRC § 6662(b)(1) and IRC § 6662(b)(2). The amount of an Accuracy-Related Penalty can total 20% of the portion of any underpayment attributable to the taxpayer’s negligence or substantial understatement of income tax. Therefore a taxpayer will pay additional tax for the changes on the return, interest, late pay penalties and a 20% Accuracy-Related Penalty. Now this does not appear to be a win but again it all depends on where you start. If you are a college educated small business owner and you claimed substantial deductions for personal expenses on your Schedule C that are clearly not ordinary and necessary business expenses, then it could have been worse. Instead of the 20% Accuracy-Related Penalties, the IRS could have assessed a Civil Fraud Penalty under IRC §6663 which imposes a 75% penalty on the amount of any underpayment of tax required to be shown on a return that is due to fraud.
We are all flawed creatures and have lapses of judgment. Suppose you own a barber shop that has sales of 500K. These sales consist of 400K of cash and 100K of credit cards. You receive a 1099-K from your third-party credit card payment processor. While completing your return you intentionally fail to report all of your cash sales and only report the 100K from the 1099-K. You just had a considerable lapse of judgment while completing your return thinking you could evade paying tax on your cash sales. If this is your starting point for your IRS audit, then the increased tax, interest, late pay penalties, and the 75% Civil Fraud Penalty under IRC §6663 might be a win. It could be a colossal win as the alternative would be a referral to the IRS Criminal Investigation Division and eventually a criminal conviction with incarceration.
No matter where you start with an IRS audit a tolerable result is possible, it may not feel like a win but the alternative would feel a whole lot worse. An experienced tax attorney will be able to protect you by knowing your taxpayer rights, minimizing financial and criminal exposure and limiting the scope/time of an exam.
If you have questions about your IRS audit, please contact Brian Crepeau at firstname.lastname@example.org or 410.649.4981.