Baring the company's books to IRS auditors is, at least, a nuisance, at most, a Controller's worst nightmare. A proactive stance and following some basic ground rules can help you guide the process toward the best possible outcome.

When the focus shifts from mistakes to fraud

If Bruce Nelson ever excuses himself awkwardly while he's auditing your company, you might want to think about firing up the file shredder and booking a flight to Bolivia.

Nelson is an auditor for the state of Colorado. Like other auditors, his job is to determine the accuracy of filings. If he, or any other auditor, suspects that he has stumbled onto a case of fraud, he will try to leave the premises without arousing suspicion (so you don't destroy key files and flee the country) and bring back someone whose job is to investigate crime.

Fraud investigations are out of your average auditor's league, and usually out of the Controller's as well. “Anytime you get a call from someone who has a badge, you don't talk to them. You call your attorney,” Nelson advises.

A normal audit merely identifies mistakes in filings. In a fraud investigation, the government will try to gather information to prove that your company deliberately mishandled funds.

When an Internal Revenue Service auditor sits down to inspect your company's books, the official purpose of the work is to determine whether the “correct” tax has been paid. Given all the judgments, gray areas and interpretations of tax laws, it's a quixotic mission at best — and one that you can influence greatly by your attitude and approach.

Auditing has grown more sophisticated over the past several years as the IRS has trained specialists in certain industries and injected experienced managers into the nuts and bolts of field audits. The agency also has initiated the Coordinated Examination Program (CEP), which examines the tax filings of America's largest companies over many years, and the Large Case audit program, which scrutinizes about 45,000 companies with more than $10 million in assets. These programs send whole teams of the agency's most experienced agents to review the books. They can stay indefinitely, auditing every year's returns and continuing far into the future.

The results: According to an October 1995 report by the General Accounting Office (GAO), every dollar spent on auditing large corporations yields $15 in assessments and penalties. But Controllers, tax managers, accountants and lawyers are doing their jobs, too. For every dollar the IRS recommends in added payments, the figure ultimately reached by negotiation or litigation is 27 cents. “That may seem like good news,” says Ken Jones, partner in the Washington National Tax Practice of KPMG Peat Marwick LLP. “But the real issue is how many dollars they're proposing.”

The answer to that question depends to a large degree on the trust and cooperation that develops between the auditor and the company. Bruce Nelson, an auditor for the state of Colorado for 12 years, says the situation is naturally adversarial: Many auditors think their job is to extract more money, and companies naturally want to hang onto their cash. “It creates a tough environment,” he says. “But you can still be professional. You can still be friendly.”

Rule 1: Don't be Enemies

“I've seen cases where you get particular auditors who make your life miserable if you try to get tough with them,” says John Harrison, president of LedgerPlus, a Tallahassee, Fla., company that specializes in tax preparation work for small businesses.

Hostility doesn't pay. Give the auditor a parking spot, a pleasant working space, a phone line and a fax machine if you can spare one. Go ahead and chat about kids, the weather or the big game last night — anything but business. Ultimately, you and the auditor will have to resolve issues and sell the compromises to your respective bosses; this lays the groundwork for cooperation later.

It's also important to get to know the IRS agent's supervisor. Jones of KPMG Peat Marwick says the initial meeting and periodic updates should include the supervisor, opening up a second channel of communications in case things get difficult later. “I can't be running around behind the agent's back,” Jones says. “I can say, if I have a problem, 'let's sit down with your manager and talk about this.'”

Rule 2: Set Strict Limits on the Audit

In a sense, a taxpayer is guilty until proven innocent. Your company has made assertions on a legal document, and the auditor is asking you to prove the truth of those assertions. In practice, that means the auditor should stick to fairly specific questions about particular matters. Fishing trips through the company's books are not allowed.

Who gets targeted for audits?

The IRS Coordinated Examination Program (CEP) puts the tax returns of America's 1,700 largest corporations under the microscope. The Large Case audit program targets about 45,000 more businesses with $10 million or more in assets. Both programs can be much more rigorous, and much longer-lasting, than a typical audit involving an IRS agent examining returns from one or two years.

CEP audits send teams of the IRS's most experienced agents through a company's books. The good thing about that, says Ken Jones, partner in the Washington National Tax Practice of KPMG Peat Marwick LLP, is that the agents are sophisticated, knowledgeable and professional. The bad news is that they might turn up more issues to investigate during their audits.

Although CEP and the Large Case program are ambitious, they also are expensive for the IRS, according to a recent study by the U.S. General Accounting Office (GAO), Audit Trends and Taxes Assessed on Large Corporations. The study found that the IRS spent 25 percent more hours on audits in 1994 than in 1988, but audited only 3 percent more returns. The audits actually yielded less additional taxes than in the past, in constant dollars, according to the study.

The GAO study identified these trends in IRS corporate auditing:
  • In 1994, the IRS audited roughly 24 percent of all large corporations' returns.
  • Since 1988, the IRS has increased the resources devoted to large case audits by 25 percent.
  • About 34 percent of CEP audits are in banking, insurance and other financial services. About 28 percent of audits focus on manufacturing companies.
  • Amounts collected in audits vary greatly throughout the country. In the Cleveland district, every dollar of recommended assessment and penalty ultimately yields $1.03 in collections, because new issues surface during the appeals process. In Baltimore, the figure is less than 1 cent. The national average is about 27 cents. The IRS is investigating the wide disparities.

Source: GAO, KPMG Peat Marwick

Additionally, the IRS has set guidelines for looking into the books of companies in a number of industries. “It's a very easy matter to look at the list of issues that an auditor will typically examine,” Jones says.

On the other hand, the auditor is responsible for following trails wherever they lead. “You may be looking at one thing and see something else to look at,” says Wilson Fadely, a spokesman for the IRS. It's also common for an auditor to look simultaneously at a company's books and at the tax and bank records of its owners and top officers to be sure that statements correspond.

At the beginning of the process, the auditor and tax manager will meet to discuss what will be examined, what techniques will be used and how long the process should take. Robert E. Meldman, an attorney at the Reinhart, Boerner, Van Deuren, Norris & Rieselbach law firm in Milwaukee, says this is a key time for you to set some limits.

The auditor may ask you to sign Form 872, a waiver extending the three-year statute of limitations on tax filings for a specified period. Meldman says he generally tells his clients to sign. There are two situations, however, in which refusal to extend the statute may be justified: If the agent is asking for a second or third extension and has not been diligent in trying to complete the audit, or if the agent has been joined by a “special agent” of the Criminal Investigation Division looking for criminal fraud rather than tax errors.

In some cases, the IRS might hand you Form 872-A instead — a waiver keeping the statute of limitations open almost indefinitely. “Never sign,” Meldman says. “I just don't allow my clients to execute 872-A's.”

Nelson, the Colorado auditor, says the taxpayer can avoid trouble by analyzing plans and requests rather than just signing off on them. For example, state sales tax audits often involve surveying specific periods or types of transactions rather than reviewing every item on the ledger, he says. The auditor will propose a survey strategy and ask the Controller to approve it. It might be wise, he says, for the Controller to invite the auditor to go ahead with that plan and bring back the results to see whether it really was a valid sample. If you just sign, you may have to accept the results regardless of their outcome.

Rule 3: Control Access to Information

After an auditor has been showing up for work at your company and eating in the lunchroom everyday for a month or two, people might begin chatting with him or her. That's fine, as long as they know not to talk about business.

The auditor is not supposed to be a spy, trying to dupe unsuspecting office workers into spilling financial secrets. However, auditors are free to investigate anything that comes to their attention — even something overheard in the lunchroom is fair game for the auditor.

“You've got to set out your own ground rules with the IRS,” says Jones of KPMG Peat Marwick. Tell the auditor that all requests for information are to go through you. Keep a log of documents requested, delivered and returned. Require that all questions be submitted in writing. Set up a daily meeting schedule to take the questions and requests so the audit doesn't become too disruptive.

Meldman suggests some other techniques that can subtly control the flow of information. For example, you should put the auditor in an office that isn't adjacent to yours — thus making it harder for the auditor to continually pop in and ask you to clarify something. Also insist that all requests and questions be communicated in writing. “If it's easy to get an answer, the auditor will ask,” he says. “Sometimes, if it's not, maybe the auditor won't ask.”

Auditors may ask for internal audits and other memos commonly known as “accrual work papers.” Such documents can give the IRS a detailed map of where to look for potential tax issues. Some private-sector Controllers contend that this constitutes a fishing expedition rather than a part of an audit strategy. On the other hand, the IRS manual provides that no special circumstances need be shown to request these work papers. If a Controller refuses to provide this information, the IRS can issue a summons; however, it can only be enforced through a formal court proceeding. Tax professionals taking a firm stand on this issue feel that the auditor might back down rather than go through a long and protracted judicial proceeding.

Keep in mind, however, that the IRS has other ways to get information it really wants. Howard Borenstein, an attorney and CPA with the Covington & Crowe law firm in Ontario, Calif., says the IRS can get your bank or other records from the sources under summons if you refuse to turn them over. “They can go around the taxpayer,” he says.

Rule 4: Be Honest and Candid

The advice from Meldman on this matter is quintessentially lawyerly: Respond to requests as honestly and fully as the question requires. Generally, it's a bad idea to volunteer information or to discuss things more fully than you need to.

It's also a bad idea to invite the agent to survey your current-year financial information. That may turn up problems with how you have done things in the past, widening the scope of the audit already underway.

“Some clients feel that when an agent comes in, it is like going to confession,” Meldman says. It's a bad idea to blurt out the tax matters that concerned you or the positions that you consider to have been aggressive. Let the agent identify the issues.

However, if you discover a genuine error in your documents before you turn them over to the auditor, a proactive posture is best, Meldman says. Identify the extent of the error, determine what you think is the proper resolution to it, and present the whole package to the auditor. “You're doing the agent's work for him,” he says. “Whenever I can, I try to prepare whatever the agent may need to sell our case — his and mine — to his superiors.”

Rule 5: Don't Stall — Don't Rush, Either

Tax preparers play a key role in audits

A tax professional should be directly involved in an audit from the beginning — but that doesn't mean the person who prepared your taxes ought to be in the room, says Dan L. Mendelson, associate national director of the Professional Tax Practice at Deloitte & Touche in Washington, D.C.

A large CPA firm should send someone experienced in negotiating with the Internal Revenue Service rather than the original tax preparer, Mendelson says. At Deloitte & Touche, they're called tax controversy specialists.

“Most taxpayers have very limited exposure to the Service,” Mendelson says. “Even if they are audited every year, their experience is only in the context of their own company. They might not know about other rulings or decisions or policies that are acceptable.”

At the start of the audit, the specialist will negotiate ground rules with the auditor and IRS supervisors. This is an essential step for limiting the scope of an audit and controlling the agent's access to information, Mendelson says. Throughout the audit, the specialist will take part in progress reports and any other meetings where he or she may be needed.

One significant ground rule is that the IRS generally cannot look at the work papers generated between a company and its accounting firm during the tax preparation process. While the U.S. Supreme Court has held that these documents are not legally privileged like communications between a lawyer and a client, the IRS has agreed not to pursue them unless it is unable to get the information in any other way. “They should be getting them directly from the client or collateral sources,” Mendelson says.

You want the auditor to be done as quickly as possible. The auditor wants that, too — career advancement in the IRS depends in part on the ability to complete cases quickly.

You and the agent will meet routinely throughout the audit, and it is likely that he or she will identify issues that have surfaced to date. You can negotiate settlements as they come up or wait until the audit is over and handle them all at once.

“By taking them on an individual basis, you don't know what's coming up,” Meldman says. “Some people like putting out fires as they come up. I like to see the whole picture first.”

Rule 6: Negotiate Wisely

GAO statistics show that auditors recommend far more in assessments and penalties than they actually collect. They're willing to negotiate to resolve cases quickly and to stay out of court.

Jones of KPMG Peat Marwick says you can negotiate many of the auditor's points down to “timing” issues — extending depreciation or moving deductions from one year to another. This increases your tax for the period audited, a win for the auditor, but lets you get the money back in future tax periods, a win for you.

The agent who conducts the audit is empowered to negotiate the settlement, but the deal requires approval from above. Similarly, you should make any agreement contingent on approval from your board, Meldman advises. “The agent can't commit the IRS,” he says. “You should not commit your company.”

Rule 7: A Breakdown in Talks Doesn't Necessarily Mean War

If negotiations don't bring a settlement, the appeals process and threat of going to court might. Borenstein of Covington & Crowe says that while an accountant can handle the bulk of audits and appeals, legal issues also are involved. If negotiations are fruitless, a lawyer will review the documents generated during the audit and, if necessary, file a Freedom of Information Act request on the audit. The documents obtained through the Freedom of Information request often will reveal the strengths and weaknesses of the IRS's position.

Lawyers generally will focus on the law as it relates to the numbers, Borenstein says. They also can assess the “hazards of litigation” to the taxpayer and the IRS. If a case could set a precedent that would be bad for the government in the future, there may be more leverage for a compromise that keeps it out of court.

All of the gamesmanship and posturing, however, can't escape the immutable fact that government assesses taxes and ultimately decides what the “correct” tax is. Says Nelson, the Colorado auditor: “In some ways, the auditor always gets the last laugh.”

Who gets audited — and what happens next

Figures for the 1993 tax year (returns received and reviewed in 1994) show that businesses are far more likely to be audited than individuals. Not all reviews listed below are formal audits; the figure includes inquiries from service centers that may involve only errors or omissions in filings, reviews by IRS agents and reviews of large corporations under the Coordinated Examination Program (CEP) and Large Case audit program.

Co. Size
($assets)
Percent
Reviewed
No Change
By Auditor (%)
Avg. CEP
tax+penalty
Avg. Agent
tax+penalty
No bal. sheet1.8717%$2,294,460$44,745
<$250,0000.8421%$520,244$10,569
$250K-$1M2.4723%$27,973$15,814
$1M-$5M7.1123%$168,316$26,872
$5M-$10M15.8323%$32,892$58,342
$10M-$50M22.4919%$199,038$82,455
$50M-$100M24.6914%$240,734$123,554
$100M-$250M30.7710%$657,342$265,832
$250M+55.145%$5,286,414$567,248
Source: Internal Revenue Service