It is becoming increasingly common for businesses to be audited not just by the IRS but also by state and local taxing agencies as well. Whether or not the taxing agency is right, how the business handles the audit and, if necessary, the appeal, will have a tremendous bearing on the outcome.
“In addition to federal tax audits, state and local taxing jurisdictions are becoming more aggressive and sophisticated in finding both potential taxpayers (especially those out-of-state) and potential taxes due,” says David C. Blum, tax partner at Chicago’s Levenfeld Pearlstein, LLC. “You must be proactive and take every step of the audit seriously.”
Smart Business talked with Blum for his insight on handling tax audits and appeals — referred to as “tax controversies.”
What are the steps in a tax controversy?
It starts when the taxing authority notifies the taxpayer of its intent to conduct an audit, usually via a ‘notice of audit’ sent through the mail. The scope of the audit will be set out in the notification. This will generally include who is conducting the audit, the type of tax involved, tax years at issue and the proposed start date of the audit.
In most instances, the auditor will go out to the taxpayer’s business to review its books and records. If the auditor determines that additional taxes are due, the auditor will generally provide the taxpayer with a notice of proposed assessment. At that point, the taxpayer can choose to pay the assessment or protest some or all of it by filing an appeal. The form and procedure for a proper appeal, as well as possible settlement opportunities, will depend on the particular taxing agency.
What should be the initial response to an audit?
Upon receipt of a notice of audit, the taxpayer should contact its tax advisers. This is because there are many things that a business should and shouldn’t do before and during an audit. In certain circumstances, an audit may be inappropriate or a taxing authority may not have constitutional authority to impose a tax in the first instance thereby obviating the need for an audit. A good adviser will be able to identify this. Additionally, there are things that can be done during the audit to either eliminate a proposed assessment or to set the tone and position it for a successful appeal.
What is the best advice during the audit?
Be prepared, responsive and cooperative. The taxpayer should demonstrate a willingness to work with the auditor and provide him or her with the requested information. If an auditor feels that the taxpayer is hiding something or he or she is not getting all of the requested information, the auditor may be more willing to dig and could become uncooperative or unreasonable for legitimate issues or concerns raised by the business. Ultimately, auditors generally have the power to subpoena information relevant to the audit. So you will likely have to provide the information anyway.
How should you make sure that you are prepared?
The business should go over its books and records first and essentially do its own audit. Next, the business should strategize with its advisers with respect to any issues or questions that an auditor may raise, and if necessary, do the appropriate tax research in advance. This way, if and when the auditor raises the issue, you’ll have a ready response. Also, by preparing in advance, the business can focus on its strongest arguments and explain its rationale and legal authority to the auditor if a position is challenged.
What about the appeal process?
If the taxpayer has represented itself up to this point, he or she is well advised to involve a tax professional to navigate the appeals process. Separate and apart from the audit strategy, the taxpayer must have an appeal strategy. This includes how and where to appeal the audit, what issues to focus on, what issues to concede (if any), whether settlement is an option, how much to offer and what are the hazards of litigation.
Generally, you must first exhaust your administrative remedies and then go to court, but in other circumstances, you may be able to go right to court and skip the administrative appeal. The particular circumstances of each audit will dictate what makes most sense. The answer will also depend in part on whether the appeal involves a federal or state tax issue.
Any final thoughts?
Nobody wants to be audited. Defending tax audits can be stressful and challenging for a business. A good adviser can help a business navigate its way through the audit and appeal process while providing some sanity along the way. Being prepared and proactively addressing each step of a tax controversy could help avoid unintended, adverse and costly consequences.
DAVID C. BLUM is a tax partner at Levenfeld Pearlstein, LLC in Chicago. Reach him at (312) 476-7557 or by e-mail at email@example.com.