Your Startup Received an Audit Notice – What’s Next?

While no one (even those of us who do this for a living) likes receiving an audit notice in the mail, the process can be less daunting if you understand some of the basics.  While we focus below on IRS audits, most of the concepts are transferable to state tax audits as well.

How Likely Are You to Be Audited?

Audit rates have steadily declined over the years.  In the most recently available statistics the IRS audited 1.1 percent of corporate income tax returns (excluding S corporations).  This is for several reasons.

First, budget cuts.  IRS funding has been reduced by almost $1 billion over the last eight years and enforcement staffing levels are down 30 percent since 2010.

Second, technology.  Electronic tax return filing lets the IRS automatically correct common errors.  Investments in technology now allow the IRS to match tax returns to information filings like W-2s, K-1s, and 1099s by computer, a job that previously had to be done by auditors.

Third, the IRS has focused resources on areas most likely to yield either information about compliance or additional tax dollars.  This leads to concentrated audit efforts honing in on particular issues (think transfer pricing or the research and development credit) or industries.  It used to be that the IRS would rarely audit taxpayers in a net operating loss (NOL) position—not so anymore.  The IRS views NOLs as a target for tax base increases, additional revenue, and an early indicator of potential tax avoidance strategies.

When Will an Audit Happen?

The IRS has three years (with some exceptions) from the date a return is filed to propose additional tax.  Many factors can influence the precise timing of an audit notice, but in our experience, an audit is most likely to happen between 18 and 30 months after a return is filed.

What Happens During an Audit?

Most audit notices include a proposed date for an opening conference and are accompanied by a request for information (called an Information Document Request or “IDR”).  You can see what an IDR looks like here.

A typical opening IDR will ask for information like copies of the tax returns under audit, accounting records, an organizational chart, and transfer pricing studies.  If the agent already has studied the return and identified issues for examination that should be apparent from the information sought.  At an opening conference, the auditor usually will ask you to describe the company’s business, its history, and its organizational structure.  If you have not  been through an examination before, it may be helpful to have an experienced advisor participate in the opening conference to help negotiate an audit plan with the examiner, including expected timing of IDR responses, issue identification, and closure. Most audits progress through a series of IDRs and responses.

One important thing to know is that the IRS can only require you to provide information that you already have—in other words, the IRS cannot require you to create information that does not already exist.  Two things to note: (1) the IRS will almost always ask you to create information, such as a narrative description of a transaction or a reconciliation of various accounts and (2) it may or may not be in your best interests to create such information.  In addition to requesting documents from you, the IRS also has the power to interview witnesses and to request information from third parties, like banks and counterparties.

The IRS Wants to Extend the Statute of Limitations — Can They Do That?

It is very common for the IRS to request an extension of the statute of limitations during an examination.  An extension is voluntary and whether it is beneficial to the taxpayer to agree to extend the statute of limitations depends on many factors.  At a minimum, you should ask the agent why the extension is needed, what the agent expects to do during the extended period and when you can expect the case to be closed.  You may also consider whether to grant a shorter extension than the one requested and whether to limit the extension to certain issues.  More information about your rights with respect to statute of limitations can be found here.

The Agent Is Proposing Adjustments You Don’t Agree With — What Next?

If you think the agent has made a mistake, you can request a meeting with the agent and his or her manager to discuss the issue.  You also can elevate a problem within the IRS’s chain of command.  If you are unable to resolve the issue at the audit level, you usually will have two options: (1) file a protest (like a legal brief) requesting a conference with the IRS Office of Appeals or (2) seek court review of the IRS’s decision.

Most taxpayers try to resolve their issue with the IRS Office of Appeals.  IRS Appeals is an independent organization within the IRS that is responsible for trying to resolve tax disputes without litigation.  Although statistics vary depending on the type of case, more than 90 percent of cases are resolved at Appeals.  You can find helpful information about the IRS Appeals process here.