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Responding to the IRS Focus on Midsized Businesses

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I can't think of a business in America that welcomes an IRS audit with open arms; for most, it is a highly stressful and worrisome time. But I can share some common sense steps, gleaned from my time as commissioner of internal revenue, which small and midsized businesses should take if served with an audit notice to make the process as easy as possible. 

The IRS Focus

Knowing how to respond is all the more important, especially considering the increased focus of the IRS on wealthier individuals -- who often are owners of small- and medium-sized businesses. These businesses tend to be organized as pass-through entities.  

On individual returns, the IRS is increasing audits of wealthier individuals. Its coverage rate of households with over $1 million in income has increased from 5.57 percent in 2008 to 12.48 percent in 2011. While the overall number of audits has gone up significantly, it is important to keep in mind the increased coverage rate also reflects a notable decrease in the number of returns received claiming more than $1 million in income -- from 392,000 in 2008 to 291,000 in 2011.  

The primary areas of interest for business audits include transfer pricing, offshore accounts, passive activities/hobbies, executive compensation and employee status (such as independent contractor).  Responding to studies on the tax gap, the IRS also remains particularly concerned with unreported and under-reported income. Businesses with a high volume of cash transactions and no third-party reporting also are garnering a good deal of attention.  

Over the last couple of years, I have met on a number of occasions with senior IRS officials - especially those with the Large Business and International Division. The meetings were most constructive, and some readers may be surprised to learn that the IRS senior management has considerable interest in running the exam process efficiently.  Based on discussions with the IRS, as well as from ongoing representation of hundreds of businesses before the IRS that my colleagues at alliantgroup have handled, the following best practices will help you navigate the audit process.  

1. Assemble your team.  Immediately upon receiving a notice of an exam or review, bring together your key internal employees, gather relevant documents, and involve your CPA or other tax professionals.  An untimely or unprepared response -- especially at the first meeting -- can leave a negative impression and affect the tone and tenor of the entire audit.  

2. Mutual respect. IRS agents have a difficult job. It is only natural that treating IRS employees with professional courtesy will make the IRS more likely to respond in kind.  Also, they will be more likely to listen with open ears to better understand your take on the matter.

3. From the get-go, establish the scope of the examination. This is key. The IRS, to its credit, has embraced the concept of using an opening dialogue to discuss the framework for the audit. This is good news and can go far in preventing surprises or unwanted detours during the exam.  Business owners and their counsel should embrace this opportunity.

4. Meet deadlines. The IRS will want to establish deadlines for production of information and material. It is a balance for the business owner. The desire for the exam to be in the rear view mirror should not cause the setting of unrealistic deadlines. Missing a deadline potentially could have significant ramifications on a timely completion of an audit. The IRS examiner may have to reschedule your review for a day further down the road. Given the current environment of budget cuts and bigger workloads, the IRS is facing very real resource limitations. That's why the IRS will be working very hard to get the job done on a tight schedule. 

5. Document production and interviews. Organize and label documents. Personnel should be knowledgeable and well-prepared. Dumping irrelevant documents on the agent or stonewalling the agent with people who can't provide the necessary information is not in your interest.  

6. Conduct your own review. I have seen businesses have great success in an audit when they go beyond what is required by the IRS. For example, working with your tax professionals, engage in a thorough scrubbing to see if tax credits or incentives not previously taken (or fully taken) by the business can be raised. This scrubbing during the exam process can result in actually receiving a check from the Treasury.  

7. When necessary -- see the manager. Ask to meet the agents' manager to resolve a question of law or fact.  To its credit, IRS senior management actively encourages business owners to go up the chain of command to seek a resolution.  

8. Mediation/arbitration.  The IRS has significantly expanded the opportunity for taxpayers to seek a resolution through mediation and arbitration.  While it is more art than science as to when it is appropriate, mediation and arbitration are great avenues to consider for solving a problem.  

9. Appeals and litigation. From the moment you receive an audit notice, be aware you may have to seek a resolution either through mediation/arbitration, IRS appeals, or even litigation. This means having a clear record of what facts were provided to the IRS and also ensuring the legal issues have been properly developed and put forward.  

Small and midsized business owners need to know the IRS is stepping up its activities in this sector.  While it's never a walk in the park, taking an engaged approach throughout an audit will greatly improve your chances of a better outcome.  

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