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Does representation matter in IRS office audits?

It is generally assumed that clients enjoy significant benefits when represented by a tax practitioner during an IRS audit, such as limitations on the final assessment of tax and penalties. This study examines the potential benefit of taxpayer representation during an IRS office audit on the final tax assessment. We provide empirical evidence that representation results in a significant reduction in the final tax assessment from an office audit both in actual dollars and as a percentage of the potential deficiency.

This research uses data on 45 taxpayers subject to office audits from the Federal Student Tax Clinic operated by the University of North Texas between 1993 and 1997. This unique dataset provides the opportunity to obtain empirical evidence regarding the impact of taxpayer representation on IRS audit outcomes and to analyze specific audit adjustments for a sample of office audits. Of the 45 taxpayers included in the study, 31 taxpayers requested student representation and 14 taxpayers declined student representation during the office audit.

The average taxable income for the sample was $18,792, an indication that the sample generally consists of lower- and middle-income taxpayers. A Schedule C was included in 37 of the 45 returns (82 percent) with the reported Schedule C income (loss) ranging from -$17,915 to $47,461. t-tests for differences between the returns with and without representation indicate no significant differences between the groups for adjusted gross income, taxable income, and total tax.

In this study, individuals chose whether to use a representative, based on their perception of the relative costs and benefits of representation, resulting in a potential self-selection bias. The study uses Heckman's (1976, 1979) two-stage process employing a correction term to address self-selection bias. The first stage models the representation decision. The estimates from the representation model are used to generate the Mills ratio ([lambda]) for each sample observation. In the second stage, the Mills ratio (lambda]) is added to the equation examining the potential benefit of representation during IRS audits.

We estimate the benefit of representation both in terms of dollars and as a percentage of the potential deficiency, controlling for the use of a paid preparer and the inclusion of a Schedule C in the return. Taxpayers with representation during the office audit paid final tax deficiencies that were lower by an average of $1,329 and the difference between the potential audit deficiency and the final tax deficiency is approximately 40 percent greater for taxpayers with representation. Sensitivity testing removing the impact of self-employment tax adjustments and analyzing the impact of marginal tax rates both provide additional support that representation results in a significant reduction in the final deficiency.

We believe our results provide a useful foundation for addressing when an individual should hire a professional representative for an IRS office audit. Since hiring a professional representative is costly, a rational individual would perform a cost benefit analysis and make the decision to hire a professional representative only if the expected tax savings from representation is greater than the cost of representation. This paper provides empirical evidence that representation results in a significant reduction in the final tax assessment from an office audit, both in dollars and as a percentage of the potential deficiency. This information should assist individuals in estimating their expected tax savings from representation to use in a cost benefit analysis.
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Title Annotation:Summaries Of Papers In This Issue
Author:Nichols, Nancy B.; Price, John Ellis
Publication:Journal of the American Taxation Association
Article Type:Editorial
Date:Mar 22, 2004
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