Tax Audit
Audit Selection
In the IRS, a computer program called the Discriminant Inventory Function System (DIF) assigns a numeric score to each individual return after they are processed. The higher the DIF score, the higher the potential that an exam will result in a change to income tax liability. While the DIF program identifies most of the returns examined, other fillings may also generate exams. For example, claims for refund, return preparer programs, information matching programs, or inspection of related-party returns during another exam may trigger an audit.
Financial Status Audit
Financial status auditing focuses on a taxpayer’s standard of living. Auditors use public records and statistical data to trace spending and changes in wealth to determine whether the taxpayer has unreported income. Records examined include credit reports, property tax records, business license applications, motor vehicle records, 1099 information, currency transaction reports and SEC filings. Under Section 7602(e), the IRS cannot use financial status or economic reality techniques unless the IRS already has a reasonable indication that there is a likelihood of unreported income. The statute does not define “reasonable indication.”
Tax Lien
A tax lien is a claim on property to satisfy a debt. Federal law gives the IRS an automatic lien on a taxpayer’s property when a taxpayer is notified of a tax liability and does not pay within 10 days. A Notice of Federal Tax Lien informs the public and the taxpayer’s creditors that the IRS has a claim against all property owned by the taxpayer. A lien notice is generally filed in counties where the taxpayer resides or owns property.
Offer in Compromise
An Offer in Compromise (OIC) is a written agreement between the IRS and a taxpayer that enables the taxpayer to pay a lesser amount in full satisfaction of an unpaid tax liability, including interest, penalties and additions to the tax.
Grounds for Compromise
The IRS compromises tax liabilities in three circumstances:
1. Doubt as to liability. There is a genuine dispute about the existence or amount of the tax. Include a detailed argument of the taxpayer’s position on Form 656-L.
2. Doubt as to collectibility. The taxpayer cannot pay the full amount due and meet basic living expenses. An acceptable offer must be the maximum amount the taxpayer can pay after allowance for basic living expenses, calculated as follows:
Realizable value of the taxpayer’s assets (80% of FMV),
Plus future income,
Less allowance for basic living expenses
The number of months of future income and basic living expenses included in the calculation depends on the payment terms of the offer. Future income and basic living expenses are calculated for 48 months (if taxpayer will make cash payment), 60 months (for short-term deferred payment) or over the remaining statutory collections period (for deferred payments).
3. Effective tax administration. Collection would create a significant economic hardship or exceptional circumstances make collection unfair or inequitable.
Economic Hardship: The taxpayer is incapable of earning a living due to a medical condition which will deplete his or her financial resources, will be unable to meet basic living expenses if his or her assets are liquidated to pay outstanding tax, cannot borrow against assets, and the impact of seizure or sale makes enforced collection unlikely or needs all available funds for the care of a dependent.
Payment Options
Starting July 16, 2006, a lump-sum OIC requires a 20% down payment. A lump-sum offer is any proposal to pay the tax in five or fewer installments. Taxpayers who submit an OIC involving periodic payments (more than five payments) must make the payments (based on the schedule submitted) while the IRS considers the OIC. These payments will be applied to the tax liability (are nonrefundable) regardless of whether the IRS accepts or rejects the OIC.
Levy Release
A levy is the seizure of property to satisfy a tax debt. The IRS may seize and sell any type of property, including real property, personal property, wages and bank accounts. The IRS must give 30 days’ notice before placing a levy on a taxpayer’s property. Banks must hold accounts for 21 days before surrendering levied funds to the IRS.
Property exempt from levy:
- Necessary clothing and school books.
- Personal household effects.
- 85% of wage replacement payments (unemployment, workers’ compensation, welfare, disability, pension).
- Income needed to pay court-ordered child support.
- Weekly income equal to the standard deduction and personal exemption divided by 52.
- Business or trade property. Property used in the taxpayer’s trade or business can only be seized if an IRS district director or assistant determines that the taxpayer’s other assets are insufficient to pay the liability.
- Main home if tax, interest and penalties are $5,000 or less. Written court approval is required for seizure of a residence.
- Undelivered mail.
Levy Release – Temporary Delay
The IRS may delay collection activities if the taxpayer’s income is insufficient to pay the tax and also meet basic living expenses. The IRS will require a Collection Information Statement (Form 433-A or 433-B) to determine the taxpayer’s monthly income and expenses and verify that the taxpayer has no assets which can be used to pay the tax.
Levy Release – Emergency Delay
Significant Hardship. A taxpayer facing significant hardship can apply for a freeze of IRS collection activity by filling Form 911, Application for Taxpayer Assistance Order.
Statute of Limitations
Claim for refund:
Three years from the date the return was considered filed or two years from the date the tax was paid, whichever is later. If no return was filed by the taxpayer, two years from the time the tax was paid.
IRS examination of return and assessment of additional tax:
Generally, the later of three years from the date the tax return is due of filed.
False or fraudulent return or failure to file:
No limit.
Collection of tax after assessment:
10 years.
IRS suit to recover erroneous refund:
Generally two years, but five years if the refund was induced by fraud.
Claim for refund due to bad debts/worthless securities:
Seven years from the return due date for the year the debt became worthless.
Omission of more than 25% of gross income without adequate disclosure:
Six years from the date the return was due or filed, whichever is later.
Appeals
Taxpayers subject to a lien, levy or seizure will receive IRS Publication 1660, Collection Appeal Rights, which explains the taxpayer’s rights and procedures for requesting an appeal. Two main procedures for appealing a collections action are Collection Due Process (CDP) and the Collection Appeals Program (CAP). CDP is only available when the IRS places a lien or levy on the taxpayer’s property. The IRS decision in a CDP hearing can be appealed in court. The CAP process is available for additional collection actions and is generally quicker than the CDP process. However, the CAP decision is binding. The taxpayer cannot go to court to appeal it.
Innocent Spouse Relief
Each spouse who signs a joint return is fully responsible for the accuracy of the return as well as the payment of tax. A spouse can sometimes be relieved of part of a joint tax liability by requesting one of three forms of innocent spouse relief, as follows:
1. Traditional innocent spouse relief.
2. Separate liability election.
3. Equitable relief.
Request relief request must be made within two years of the first IRS collection activity. Collection activities include garnishment of wages, notice of intent to levy, and other actions that give the spouse notice of the IRS intention to collection tax related to a joint return from the electing spouse. A notice of deficiency and demand for payment addressed to both spouses does not ordinarily begin the two-year period.