In an effort to enforce the tax laws, the IRS examines taxpayer’s returns in order to verify whether the return filed reflects the taxpayers’ correct tax liability. The Small Business / Self-Employed Division is responsible for auditing individual and most small business returns, while the Large Business and International Division examines large corporations and partnerships, as well as international returns. The IRS’s investigatory authority derives primarily from IRC Sec. 7602, which grants the IRS power to “examine any books, papers, records, or other data which may be relevant” to determining the correctness of any tax return. IRC Sec. 7602(a)(1). The authority in section 7602 is backed by section 6001, which give the IRS the authority to “require any person, …to make such returns, render such statements, or keep such records, as the Secretary deems sufficient to show whether or not such person is liable for tax”.

All taxpayers have an obligation to maintain records that substantiate the accuracy of their returns. Treas. Reg Sec. 1.6001-1(b). The Code and regulations also impose specific recordkeeping requirements for certain deductible expenditures. For example, the regulations under section 274 specify the type of documentation necessary to substantiate travel and entertainment expenses otherwise deductible under Code section 162. A taxpayer’s failure to maintain supporting documentation can lead to negligence penalty (Treas. Reg. Sec. 1.6662-3(b)), and can prevent the taxpayer from shifting the burden of proof to IRS under Code section 7491 if the tax controversy ends up in court. IRS Sec. 7941(1)(2).

According to IRS, its primary objective in auditing returns is to promote voluntary compliance. IRM 4.1.1.1. This objective is consistent with the basic deterrence model of tax compliance, which says that the risk of audit, combined with the prospect of penalties for noncompliance, provide an incentive for taxpayers to report their income and expense items correctly. Another reason the IRS audits returns is to generate additional revenue. Therefore, those returns selected for audit are generally ones that the IRS expects will reflect a tax understatement.

The IRS uses various methods of selecting returns for audit. In the case of individual tax returns, the most common method relies upon is the Discriminate Function (DIF). The DIF is a mathematical technique used by the IRS to classify income tax returns as to their error potential. The DIF formula divides returns into various audit classes. For example, individual income tax returns are classes based on their total positive income figure shown on the return. The computer formula then assigns weights to certain return characteristics. Those weights are then added together to obtain a DIF score. The computerized scoring takes place at IRS Campuses where tax returns are sent for initial processing. Generally, the higher the DIF score, the greater the potential that IRS will select the return for audit. IRM 4.1.3.2. Those return with very high DIF scores are first flagged by the IRS’s computerized system, then reviewed by IRS employees to determine whether the return should be audited and the type of audit that is appropriate.

The IRS has other methods of targeting returns for audit. If a taxpayer files a claim for refund, the IRS normally will screen the original return to determine whether an examination should be made to substantiate the claim. The IRS’s information return matching program may also trigger an audit if the receipt reported on the taxpayer’s return differs in amount from that reported on the information return. Audits may also arise from the process of “infection”. If a corporation’s tax return is being audited and there are discrepancies or other suspicious circumstances, this might lead the IRS to audit the shareholders of the corporation as well. Newspaper reports can also lead to audits.

Once IRS selects a return for audit, there are various ways in which the audit may be carried out. There are main types of audits such as correspondence audits, office audits, and filed audits. Correspondence audits are normally conducted by mail: as a result, they are limited to issues that lend themselves to verification from records that can be forwarded to the IRS. With respect to the other types of audits, whether the IRS conducts a filed audit or an office audit of a particular taxpayer will depend primarily on the complexity of the issues involved. Office audits are usually conducted at the IRS’s local premises by a tax auditor. The initial contact letter usually contains a request that the taxpayer or the taxpayer’s representative meet with the auditor at the IRS office. Normally the contact letter will also ask the taxpayer to bring specified pieces of information or documentation to support the treatment of a particular item. Returns selected for office audits generally involve issues that are too complex to be resolved by mail, but not complex enough to warrant a filed audit. Office audits are used to handle such issues as unusual or large itemized deductions, dependency exemptions, travel and entertainment expenses etc.

Field audits are reserved for more complex business and individual returns. They are conducted by revenue agents, usually at the taxpayer’s place of business. A revenue agent is generally more experienced than a tax auditor and has more education. A taxpayer must be more sensitive when it comes to a field audit. Generally, the potential issues involved in a field audit are not as clear as in correspondence audit or an office audit. Thus, the taxpayer should cooperate with the agent and provide the requested information, but the taxpayer should not be overly generous, given that the scope of the audit may expand later on.

One of the best sources of information on how the IRS conducts an examination is the Internal Revenue Manual (IRM). The IRM is a resource intended primarily for internal use at the IRS, but it has been made available to the public under the Freedom Information Act. The IRM is divided into several different parts. Of special interest to taxpayers and their representatives is Part 4.10, which contains income tax audit guide lines for IRS Examiners. These guidelines set forth audit procedures, along with exhibits and instructions to examining agents about commonly encountered taxpayer errors. The IRM can very helpful to a tax practitioner in planning a taxpayer’s response to an audit. If for example, an office audit involves travel and entertainment expenses, the attorney can consult the section in the IRM that tells the auditor what questions to ask, what information to request, and the like. By knowing the likely approach of the auditor before the meeting, the attorney can prepare the client to answer the questions correctly and honestly, but without providing any additional information.

Audit strategy varies depending on the type of audit. For correspondence audits, the best course generally is to respond to the requests for information and documentation quickly and concisely in order to prevent the audit from being expanded to cover other issues. Resolving the matter with employee at the IRS Campus means it is unlikely that a tax auditor or revenue agent will be assigned to the case. As a general rule, an office audit is limited to the issues that are listed in the initial contact letter. A tax auditor generally must get permission from a superior to expand the scope of the audit. In contrast, a revenue agent conducting a filed audit may use his or her own discretion to expand the audit. In either case, it normally does not pay to antagonize the examiner.

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