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It's a jungle out there: survival techniques.

Preparing for an IRS audit of a closely held business should begin when the CPA complies the corporate income tax return and owner's personal returns. Remember that each year's returns provide the Service with potential audit candidates despite past attention or inattention by the IRS.

The Service plans to double its audit coverage of corporations with assets below $10 million book value in 1992 (relative to 1987's level), and it has an automated system for information report match-ups (payer/recipient reporting) due to begin operations in 1993. These changes should work to create greater breadth and depth of examination coverage for the typical local or regional CPA firm's client base. How can clients be better prepared?

First, make sure that all information on the business and personal returns reconciles. The various information reports issued for corporate wages, commissions, rents, dividends (and other profit distributions) and interest should be properly classified and easily traceable by an IRS agent to the returns.

Break expenses into small components

On the corporate return, break down income and expenses into their smallest components. Descriptive labeling of items is something of an art, and can be handled if you get the necessary detail. Many believe this exercise can significantly lower a return's chance of selection for exam.

Also, practitioners should advise their clients to update the corporate minute book annually. Current minutes are important support for many tax-related issues (such as salary and bonus policy), and should be reviewed by the client's attorney with full understanding of the tax objectives.

If a business return is selected for an IRS exam, the practitioner should advice the client not to hide the fact from employees, particularly those who may be called on to assist in gathering the requested records and documents. The client should choose an employee liaison to deal with the IRS agent when he is present at the client's office. (Most agents will not accept working solely at the CPA's office.) In this way, the owner can be present, but "insulated" from the agent. Owner visibility is important to substantiate participation and compensation.

The experience and knowledge level of IRS agents can vary greatly. It is not the practitioner's role to educate an unsophisticated agent. Instead, agents should be asked to submit questions and requests for information in writing directly to the CPA.

Just the facts

It is sufficient to provide only that which is specifically requested. An associate or partner (and attorney, when appropriate) can review what is to be given to the agent. It is important not to delay responses to agent requests and keep the audit pace moving. Informal chats between the agent and any employees should be avoided (except for those necessary with the liaison person). Above all, the client should not handle the exam alone. Competent outside representation is well worth the cost to the client when his financial welfare is one the line.

Don't take the bait

If an agent goes on a "fishing expedition," or simply "camps out" at the CPA's office, or his client's business, it is within the CPA's right to complain to the agent's supervisor. This does not mean that the agent must limit any inquiries to the activities within the specific entity under exam, but there must be a reasonable basis for agent requests.

Business activities of the owner conducted through other corporations, as well as the owner's personal activities, are all fair game for an agent. An agent may try to ferret out unreported income or develop issues regarding business versus personal activities, or transactions between related companies. Any tax returns inspected by the agent, but nor formally examined, may be subject to exam by a different agent at a later date.

The CPA should set certain ground rules with the agent at the start of an exam, including a time schedule for completion and agreement on areas of exam concentration. If the agent develops significant issues, those issues should be resolved, if possible, at the agent's level.

Unfortunately, there are many complex issues in the tax law, and even a well-documented fact pattern may be subject to conflicting (but reasonable) interpretation. If an appeal of the agent's proposed tax increases for a business is deemed necessary by the practitioner (and the client's attorney, when appropriate), the time lag can be substantial before the case is heard by an appeals office.

This time lag may require the client to give the Service an additional period of time in which tax can be assessed, which should be limited to one year or less, and perhaps even to specific issues. Use Form 872, Consent to Extend the Time to Assess Tax, and not the special consent (Form 872-A). If consent for an extension is not given, the Service will assess the tax immediately, which would require the client to pay the contested tax and hire an attorney to attempt recovery in Federal court. This alternative is advisable only when there are undiscovered "skeletons in the closet" for the year of examination.

Note: There is much incentive for clients to be prepared for an IRS exam as though it would be an annual event: it is not just the ease of doing work "up front." Penalties have risen substantially in recent years, which could result in an assessment that exceeds the amount of underreported income. Practitioners should recognize the need for penalty-avoiding disclosure under Sec. 6662, and advice their clients accordingly.

Also, the administrative cost of reconstructing information years after the fact is much greater than the cost clients would incur to keep all their records current and filed to facilitate easy retrieval. Fee problems may also be eased or eliminated if CPAs can avoid this "looking-for" time.

What agent look for

Listed below are a few of the Service's primary targets when examining the books of closely held businesses. It is important to keep them in mind when preparing for an exam.

* Internal controls and accounting systems.

* Owner's and relatives' annual compensation.

* Travel, meals and entertainment.

* Prepaid income issues.

* Cash control and transactions, including reporting of transactions over $10,000.

* Filing and payment requirements for excise taxes.

* Documentation of write-offs on bad debts.

* Nondeductible accruals to owners and relatives.


If clients prepare for an IRS examination that never occurs, at least they (and their CPAs) will be able to sleep well. And if an exam does come about, anxiety and disruptions in daily operations will be minimized by their advance planning.

Finally, billings will be for "quality time," both annually and at audit time."

Editor's note: Ms. Lazzaro is a member of the AICPA Tax Division Tax Practice Management Committee.
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Title Annotation:preparation for IRS audit
Author:Lane, David F.
Publication:The Tax Adviser
Date:Sep 1, 1992
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