Managing an IRS audit: practical insights and techniques.

• Author: Herskovitz, Donald L.
• Position: Interview

This is an edited transcript of an interview on Managing an IRS Audit. The interview was completed as part of an audiotape series produced by the Deloitte & Touche LLP Washington National Tax Group on various tax topics. Donald Herskovitz (DH) is a Senior Technical Advisor with the firm's Washington National Tax Group and an adjunct law professor at Georgetown University Law Center. David G. Blattner (DB) and James A. Dougherty (JD) are directors in the firm's Tax Controversy Services Team. Prior to joining Deloitte & Touche, Mr. Blattner was the IRS Chief Operations Officer and Regional Commissioner (Midwest Region), and Mr. Dougherty was the IRS National Director of Appeals. Mr. Blattner has been a frequent speaker at TEI's popular audits and appeals seminar (addressing the topics of preparing for managing the audit), and Mr. Dougherty will participate at the Institute's 1997 Annual Conference on preparing an effective appeal. Anyone wishing to receive an audiotape of the complete interview should call Deloitte & Touche at (202) 879-5623.

DH: To get us started, can one of you describe what you mean by "Managing an IRS Audit?"

DB: What I mean is you have to be an active participant in the process, through the entire life cycle of the audit, to produce the desired results with the least cost and burden to the client. Actually, the time to start preparing for an audit is when a transaction starts coming together. If there's a significant transaction during the year, that transaction has to be reviewed for the associated tax risk. The best records that you'll have to support your position are probably the records that are available as the transaction is coming together. That's the time you should build your file to support the position you're going to be taking on the tax return. Files should be maintained with an audit in mind. As you're maintaining the records you should be considering the fact that there's a high probability that, if this is a significant transaction, those records will be reviewed by a revenue agent. Those files need to be created and maintained with that ultimate outcome anticipated. Then, as you move closer to the examination, you have to develop a strategy for the exam. Assess your risks.

Definitely, you need to be an active participant in the examination plan. The IRS case manager's handbook was changed in February 1995, and it now provides for the client to play an active role in developing the examination plan. In the past, what happened was the Service would develop the plan, give one part to the taxpayer, keep two parts in a drawer hidden from everybody, and then proceed with the examination. Under the current handbook, the client should participate in developing the examination plan and should have access to all three parts of the plan. One thing the examination plan includes is the arrangements for the Examination team. Where are you going to put the Examination team? Generally, it's not right in the middle of your tax department or next to the CEO's office. You need to have a location for the Examination team that provides team members adequate space and supplies without putting them in the middle of your tax department.

DH: Do you think at this point it would be good for the company to prepare a memo to circulate among its employees so that they know exactly who these new people are at the company, and how they should act in dealing with them?

DB: That is a very good idea, informing the employees that the individuals are IRS agents and that they will be on site for probably a prolonged period of time. I don't suggest having an announcement over the loudspeaker system once a day, "Be careful folks, the IRS is here." But I do think that the employees should be aware of the fact that the IRS is on the premises. And it is probably a good idea to have them wear a different colored badge, so that everybody is aware that the distinguishing badge means it's a non-employee.

DH: Jim, what about you? Do you have any particular views on this topic of managing an IRS audit?

JD: It's important, as Dave said, that all employees, not just those in the tax department, know that the IRS is doing an audit. I also believe that agents should have a different color badge, and sign in, or at least notify someone when they come into your building. The question is, "Why do you want to manage an IRS audit?" It's a very, costly process. It's also a disruptive process. Not only will the tax department be involved, but other departments will have to gather information to support the positions that you have taken on the return. It is important from the outset to have a plan to manage the process. Because if you're not managing the process, you're going to end up with results you don't like and, quite possibly, an unagreed case.

DH: Dave, do you actually believe that it's possible to successfully manage the audit, even when the IRS already has its own goals?

DB: I mentioned that the case manager's handbook was changed in February 1995. In September 1996, there was a meeting in Texas of all large case branch chiefs. The purpose of that meeting was to talk about how the taxpayer should participate in the planning process. The branch chiefs have taken that information back to the case managers. The Ohio District, interestingly enough, recently entered into an agreement with TEI's Cincinnati and Cleveland Chapters that specifically sets forth the expectation that the case managers will work with taxpayers in planning an examination. What types of things can you influence? You can influence the cycle size, how many years are going to be examined, and when the audit team is going to be on site. If you have a busy period when you cannot be dealing with them, you can arrange a schedule so that they won't be on site during your busy time. You can establish a mutually agreeable lapse time from the start of the examination to the completion. When you know what issues the Exam team is going to pursue, you can participate in prioritizing those issues so that you are taking on issues you want to take on first, or when it's in your best interest to have those issues developed. You can definitely focus on information flow, and this is critical, so that all requests are coming to you through one source and all responses are coming from you, through one source. You have to actively manage the information flow. I really think that you have to play an active role in monitoring the progress on an ongoing basis. We'll be talking about some, techniques you can pursue in doing that throughout the examination.

DH: We've been talking about managing an audit. What's the normal course life-cycle of an audit?

JD: An audit has six phases: preparing for an audit, the opening conference, the Information Document Requests (or IDR) review, the interim cycle review, the closing conference, and the post-examination critique.

Preparing for an audit doesn't begin when you receive the letter that you've been selected for an audit. Preparing for an audit takes place prior to filing the return, as transactions occur throughout the year. You've got to be thinking how a particular transaction's going to play out when you're audited. How do you prepare? Look at what records you have. Review the return itself, and prior returns, and what positions the Service took in prior years. Are there issues we settled in Appeals for which we can use Delegation Order 236 (Revision 2), which allows Examination to carry forward issue settlements? Evaluate your documentation, make sure you have all the records, assess your risks.

The opening conference. You want to set the tone for the audit. Go to an opening conference with a plan. The Service is going to come with its initial plan. Prior to the opening conference, the IRS may deliver some IDRs to you. They're usually looking for general information. For example, copies of the returns, information about mergers or acquisitions, and minutes. Have the right people there. Insist that the Service bring, not only the auditors and specialists who are going to work the case, but also the IRS case manager and branch chief. Agree to how problems will be resolved. It's a lot easier contacting managers when you've met these people. IDRs are the real lifeblood of an audit. You've got to manage this process, because agents like information. Remember gathering information is costly. Try to minimize the amount of information gathering.

The interim cycle review creates ongoing communication with the Service. You set this up to make sure that you have reviews quarter-way and midway through the audit. This does not replace the daily communication. Also, you should have at least monthly meetings between management and the IRS representative. I can't tell you how many times I've been involved in audits that have wonderful plans, but nobody discusses or monitores the plan. A year and a half later, the audit is going nowhere, or maybe it's going in the opposite direction of what the plan provided.

The next step in our cycle is the closing conference. There should be no surprises. This is your last shot to resolve the case with Examination. You have made your arguments with the agents; they disagree. Don't be afraid to discuss the issue again. You have additional players, you have the higher players in there from the Examination division. The best place to resolve issues is at the Examination level. Once something gets written up and moves forward, it's like set concrete. You have to tear it up when you get to Appeals or further up the line. If you can resolve things before they are in the Revenue Agent Report (RAR), you're a lot better off.

The post-examination critique. A lot of people put it off. The Examination team sometimes will suggest waiting till the next cycle; and combining it with the opening conference. Bad idea. You should have two closing critiques. The first one should be with your own department and...