Introduction
This is the third article in a series of articles we are writing on IRS audits. The purpose of this series is to demystify the audit process, inform readers about how IRS audits are conducted, and provide readers with an understanding of the audit process. In Part I of this series, we discussed how taxpayers are selected by IRS for audit. We also discussed the various types of examinations that are conducted. In part II, we discussed the audit process. In this part, we will take a look at special types of audits, including employment tax audits, estate tax audits, and coordinated examination program and limited issued focused examinations, which are variations on the audit types discussed in the previous articles. This part concludes with a discussion of early resolution programs.
Employment Tax Audits
Employment taxes, such as Federal Insurance Contribution Act (“FICA”) and Federal Unemployment Tax Act (“FUTA”) taxes, are imposed by the federal government. A common issue in employment tax audits is whether the worker is properly considered an employee or an independent contractor. This question is analyzed under a multi-factor test derived from case law. The application of this test can be a source of contention during the examination. An important feature of employment tax audits is the multiple potential targets involved. Employers and employees share liability for employment taxes. The employer is required by law to collect and pay over to the IRS both the employer’s and employee’s shares of both FICA and FUTA taxes. If the employer fails to pay, one or more of its so-called “responsible persons” (generally, those with discretionary authority to pay the employer’s bills) may be held secondarily liable for payment of the employer’s portion of the FICA tax and the federal income taxes that were withheld or required to be withheld from the employees.
Estate Tax Audits
Audits of estate tax returns are conducted by estate tax examiners, who typically are attorneys. The largest class of issues in such audits involves valuation of assets. The IRS employs a staff of appraisers, called valuation engineers, in both the National Office and the field offices. They sometimes are assisted by specialized functions, such as the IRS’ Art Advisory Panel, which consists of well-regarded private sector art experts. In large cases, the IRS may hire outside personnel as valuation consultants or experts. A distinctive feature of estate tax examinations is that Section 6501(c)(4)(A) precludes extension of the statute of limitations on assessment of estate taxes by consent of the parties. This imposes an urgency that is not present in other types of audits.
Coordinated Examination Program (“CEP”) and Limited Issue Focused Examinations (“LIFE”)
A substantial percentage of returns filed by large corporations are examined each year. Very large corporations experience what are essentially perpetual audits. A team of IRS revenue agents from the Large and Mid-Sized Business Division (“LMSB”) is assigned to each corporation, and they examine each return. The agents are re-assigned periodically.
Large corporate examinations are through the CEP. The exams are performed by the most experienced revenue agents. They have the benefit of industry-specific position papers and audit programs developed through and coordinated by the Industry Specialization Program (“ISP”) and the Market Segment Specialization Program. ISP covers about twenty-four nationwide industries. CEP features early involvement by IRS Chief Counsel attorneys to provide legal analysis. The idea is to weed out bad issues early in the process and to see that potentially good issues receive the development they need during audit. CEP also can entail accelerated Appeals Office consideration.
LIFE was created in the early 2000s as a targeted audit program for very large businesses. The aims are to improve communications with taxpayers and to streamline examinations when appropriate in order to improve the IRS’ allocation of resources. Using benchmarks, the audit focuses on only the most significant issues. The revenue agents and the taxpayer enter into agreements as to the process to be followed and time frames within which each will respond to the other’s requests.
Early Resolution Programs
Taxpayers with the jurisdiction of the LMSB can ask IRS to examine specific issues before the taxpayer’s return for the year is filed or due to be filed. The goal is to resolve the issues promptly and in a cooperative fashion. If such resolution is reached, the taxpayer and the IRS executed a Prefiling Agreement (“PFA”), which operates as a closing agreement. Because of the constricted time frame, the prefiling process is confined to factual issues governed by well-settled law. It does not address issues of law, which are handled through traditional private letter rulings. PFA’s are not free. In fact, they are pretty expensive. The price tag for a PFA starts at $50,000.1
Another early resolution mechanism is the Advanced Pricing Agreement (“APA”). APAs also entail pre-return discussion and agreement, but they are narrower in scope. They are mainly used in transfer pricing cases. Section 482 allows the IRS to recast pricing and other terms of transactions between related parties if the terms set by the taxpayers do not clearly reflect the parties’ incomes. APA’s were developed to resolve Section 482 matters early and non-confrontationally. The taxpayer informs the IRS of the related-party transaction before filing the return for the year, and suggests a given tax treatment of the transaction. The IRS considers the suggested treatment. The parties confer and, hopefully, agree on a satisfactory treatment of the transaction. The taxpayer then reports consistently with the agreement.2
LMSB has also developed the Compliance Assurance Program, under which revenue agents and specialists work with taxpayers to identify and resolve recurring issues. The goal of the program is to increase coverage and decrease audit time by allowing the taxpayer to seek agreement with IRS on the treatment of one or more issues on a return before the return is filed with IRS.3
Finally, in some situations, the taxpayer can compel the IRS to accelerate the examination. For example, taxpayers who are debtors in bankruptcy can request prompt determination of their tax liabilities.4 Also, executors can request prompt determination of decedents’ gift tax and income tax liabilities.5 The executor is excused from personal liability for any such taxes beyond amounts the IRS determines within nine months of the request. As a practical matter, the restricted time frame often compels the RIS to streamline such audits.
The foregoing is a discussion of specialized audits and early resolutions programs. Next month, we’ll conclude the series with a discussion of partnership audits.
Footnotes
- Rev. Proc. 2007-17, 2007-4 I.R.B. 1.
- See Rev. Proc. 2004-40, 2004-29 I.R.B. 50. The IRS report annually on APAs. See e.g. Ann. 2006-22, 2006-1 C.B. 779.
- See Harvey Coustan, The IRS’s Compliance Assurance Program, J. Tax Prac. & Proc. 5 (Feb-Mar. 2006).
- 11. U.S.C. § 505(a).
- IRC § 6905(a). See also § 6501(d) (permitting requests for prompt assessment of certain taxes by fiduciaries and corporations).