Improving the audit process: a cooperative venture.

Introduction

The Chicago Chapter of Tax Executives Institute and the Chicago District of the Internal Revenue have jointly produced a video entitled Improving the Audit Process: A Cooperative Venture. The video is intended to give taxpayers and IRS agents alike a glimpse of the audit process from the other's perspective. It conveys a range of impressions of many different players on the proper role of the examination function in the coordinated examination program--from the company's chief financial officer and tax director, to the IRS district and national office, to the U.S. Tax Court. It also demonstrates that, where an examination falters in developing factual matters, the result may be costly, time-consuming, and needless litigation.

Most important, the video provides insights into the examination process that, taken together with the concepts discussed in this brochure, will permit tax and non-tax personnel to appreciate the need for both sides to keep open and improve the channels of communication. This article is intended to complement the video by providing tax executives, examing agents, and other interested parties with information on how the goals of currency and burden reduction can be attained by improving the examination process.

Improving the Audit Process: A Cooperative Venture brings home the message that, though taxpayers and the IRS sit on opposite sides of the table, both have an interest in ensuring that resources expended in examining corporate tax returns are used efficiently, wisely, and minimally. Thus, the IRS and taxpayers have recognized that the effective management of increasingly scarce resources demands that audits be initiated and concluded as promptly as possible. The IRS, for its part, has undertaken several initiatives to improve the currency of examinations. Likewise, taxpayers have found that applying total quality management techniques (such as statistical process controls, seeking frequent customer (IRS) feedback, etc.) and increasing communication with the IRS on the audit plan and document requests will improve the audit process and, ultimately, expedite issue resolution and the closing of tax years.

Maintaining a Cooperative Process

Improving the examination process involves a commitment by both the IRS and taxpayers to the idea that their counterpart is committed to the same process goals, even though there may be, and often are, disagreements on specific audit issues. At the inception of an examination the IRS and taxpayer will have their best opportunity to agree to joint objectives including involving the taxpayer in planning the examination, identifying the proper resources (in terms of personnel, tools, and facilities), establishing joint examination objectives, exchanging fundamental information, and committing mutually to resolving substantive issues at the lowest possible level. Most important of all, taxpayers and IRS should establish the ground rules for the administration of the examination--especially the resolution of all process-related issues.

Constant, Continuing Communication Is the Key

The examination process is an exercise in continuous communication regarding the information sought by the IRS and the production of that information by the taxpayer. A commitment from each to fulfill its respective obligations in a professional manner, as well as a recognition of the commitment of the other side to do the same, will help establish mutual trust. Moreover, perception and expectation have a way of becoming reality. Thus, just as suspicion breeds suspicion, trust will breed trust.

The hallmarks of a successful cooperative examination include the following--

The IRS providing taxpayers with:

* The complete audit plan.

* The commitment of examination personnel (specialists such as international examiners, engineers, economists, payroll or pension specialists and computer audit specialists) to adhere to the agreed examination schedule.

* The commitment of examination management (particularly case managers and branch chiefs) to control the case.

* Identification of new or continuing industry issues for examination.

* Proposed treatment of rollover issues--whether consistent with prior examination or, if not, an explanation for the inconsistency.

* The expected time frame from initiation to completion of the examination.

* Identification of off-site support needs (including cross-district support examinations, involvement of Chief Counsel personnel, whether technical advice is necessary, etc.).

* List of initial documents to facilitate the audit planning process.

Taxpayers should provide IRS with:

* The commitment of personnel (in and out of the tax department) to provide timely responses.

* SEC Form 10K and Annual Reports for public companies/ annual reports and audited financial statements, where available, for private companies.

* Locations of principal facilities and subsidiaries for each year under examination.

* Company policy and procedure manual for the accounting system.

* Summary of accounting system changes from prior years.

* Summary of taxpayer view of status of prior examinations.

* Copies of the primary tax return to be determined and information in connection with related returns.

* Primer on the company, including commercial, economic, and regulatory environment, industry practices, company accounting systems, overview of tax return preparation process, and glossary of special company terminology.

* Corporate stock ownership structure charts and tax department organizational chart.

* Disclosures under Rev. Proc. 94-69 (the successor to Rev. Proc. 85-26), relating to matters to be disclosed within 10 days of the initiation of a coordinated examination in order to avoid substantial understatement penalties.

Early Issue Resolution

Another key to timely completion of an examination is resolving issues early and at the lowest possible level, i.e., with the case manager, team coordinator, or specialist. In this regard, taxpayers should review with the case manager the following issues:

* Disposition of rollover/recurring issues.

* Authority of the case manager to settle or resolve issues.

* Advance Issue Resolution Procedures.

* Early Referral to Appeals.

Administrative Matters

Every taxpayer in the coordinated examination program eventually will develop an administrative approach to managing its tax examinations that reflects the views of its tax department personnel and the culture of the company. Nonetheless, it is useful to review some of the basic administrative processes that many companies employ singularly or in combination in managing the examination process. In particular--

* Discuss with the IRS the scope, nature, and desirability of record retention agreements.

* Establish regularly scheduled meetings for presentation of information document requests (IDRs), to discuss progress toward completion of unfilled requests, to clarify the nature and scope of IDRs, and to discuss follow-up requests for information that builds on previously completed requests.

* Establish clear guidelines at the outset of the examination on the number of topics to be addressed on each IDR (preferably no more than one topic per request) and the number of specific items to be gathered, collated, or analyzed per topic. In addition, to permit the taxpayer to respond in a timely fashion, the number of IDRs issued within a given period (say, one week) should be agreed upon to prevent "burying" the taxpayer with requests that cannot all be fulfilled within an established time frame.

* Establish procedures to question the breadth of IDRs to clarify ambiguous requests, to discuss the scope and relevance of the information sought, and to promote generally the responsiveness of the information to the request.

* Consider establishing procedures for issuance of a preliminary or hypothetical notice of proposed adjustment to encourage discussion and refinement of identified issues. (This approach will either demonstrate the need for further factural development and information gathering or engender a discussion of the merits of the issue.)

* Establish procedures for issuance of Forms 5701 (Notices of Proposed Adjustments), keeping the focus on the factual matters presented in each notice, and understand that the issuance of the Form 5701 represents an informal means of communicating a potential adjustment based on the information presented to date.

* Schedule meetings to discuss the content and status of Forms 5701 and the taxpayer's formal response, if any is to be made, to the proposed adjustment. The meetings may be held in conjunction with or separately from the meetings to discuss the status of IDRs.

Operating Framework

The objective of the taxpayer and IRS is to conduct a quality examination in the most effective and efficient manner possible. As with any human endeavor, the objective will more likely be met if there is a tacit agreement to complete various stages of the examination by preset dates. Consequently, at the outset of an examination both sides should agree, for example, on the likely date for conclusion of the examination and issuance of the revenue agent's report. All status meetings on information requests should begin or end with a discussion of progress toward this goal, or consider the reasons for the delay in achieving the stated objectives.

Taxpayers should urge the IRS to refrain from examining areas or issues unless there is a risk of a material adjustment. That is, areas should be selected for examination based upon "risk analysis" criteria set forth in the examination plan. Taxpayers should respond in a timely manner to produce the information sought or request immediate clarification of ambiguous, vague, or overbroad document requests.

Both the taxpayer and the IRS should strive to meet the stated examination deadline with the commitment of proper resources. To meet the overall time goal, an IDR response time should generally be agreed upon and adhered to by the taxpayer. Separate response times for production of foreign- or domestic-based (or on- or off-site) records should be considered. If a taxpayer encounters difficulty in meeting the generally agreed upon response times, the taxpayer should be forthright in explaining, and the government should accept, reasonable delays. In addition, the IRS should establish priorities among the various unfilled IDRs to permit the most efficient use of taxpayer and IRS resources.

Finally, the taxpayer and IRS should set forth clear and reasonable objectives for various milestone dates during the examination, for example:

* The date of the opening conference.

* The date for issuance of all IDRs.

* The times and dates for visits and discussion with non-tax department employees.

* The final date for completion of outstanding IDRs.

* The date for issuance of all Forms 5701.

* The date for final responses to Forms 5701.

* The date of the closing conference.

* The date of issuance of the revenue agent's report and the post-examination critique.

Both the taxpayer and the IRS should recognize that the dates for any of the actions is not binding in anyway. Both parties should also recognize, however, that unreasonable delays will undermine the trust that is necessary to a cooperative examination process. Acceptable reasons include, for example, sickness of personnel, diversion of tax or financial department personnel during busy time periods--such as closing of the taxpayer's books, final preparation of the return, etc.--unusual business demands such as major acquisitions, divestitures, of reorganizations.

Conclusion

Improving the Audit Process: A Cooperative Venture is intended to spawn a wide-ranging exchange of views not only between taxpayers and the IRS, but between members of the tax department staff and between members of the examination team. It is recognized that the examination process cannot be transformed or perfected overnight, but a candid dialogue cannot help but begin the transformation process.