A Look At A Typical IRS Audit

One of the interesting aspects of practicing as a tax lawyer who handles IRS tax cases is that you can regularly read what your "opponent " is up to. This post discusses the recently published case of Miller v. Commissioner. This case doesn't discuss interesting tax laws or structures and it really doesn't add anything new. I decided to write about this case because it reminds me so much of scores of other tax cases and taxpayers that I have represented (on first read, I wondered if this was one of my prior cases - which, of course, it wasn't). This case lays out what taxpayers can expect if they are subject to an IRS audit. I get a lot of questions about this, so perhaps this post will help answer some of those questions.

The taxpayer, Miller, was a small business owner. The business, which was a Subchapter S Corporation, took out loans in the business' name. Miller was a grantor on the loans. The business subsequently incurred losses for six straight years. The tax losses exceeded the Miller's taxable basis in the business so Miller was not able to deduct the losses. At the Miller's accountant's suggestion, Miller took out a personal loan and contributed the loaned funds to his company and his company repaid the debts that were presently outstanding to the bank. This made Miller more than just a grantor on the loans, which entitled him to increase his tax basis in the business by the value of the loans. This increased basis in the business allowed Miller to deduct the losses to the extent of that tax basis.

The key to these transactions is that at the end of the day the taxpayer is indebted to an independent third party (i.e., the bank). At the end of these transactions Miller was indebted to an independent bank. This is a pretty common transaction that many small business owners engage in, yet the IRS took the position that Miller was not entitled to deduct the losses. The IRS based its denial on the argument that the transaction should be ignored for tax purposes. As the Tax Court opinion alludes to, even a cursory review of the applicable law reveals that the IRS' position was without legal support or basis. The IRS also cited the fact that Miller was inconsistent in reporting the interest from the transactions, a fact that the Tax Court "attached little consequence to. " Of course the Tax Court held for the taxpayer.

Based on the court opinion, it is apparent that the IRS agent undertook the tax audit with the sole aim of disallowing the losses. Ultimately the IRS logic is that Miller paid too little in tax in relation to other somewhat similar situated taxpayers - even though he was well within the law - therefore it is the IRS agent's job to collect tax revenues from Miller. I have seen this numerous times (so much so that I can almost see the look on the agents face as he or she is interviewing the taxpayer).

I bet the agent ended up spending a couple of weeks looking through Miller's records and probably taking up a lot of Miller or Miller's attorney's time. When the agent wasn't able to find anything significant (such as underreported income or inappropriate tax deductions or credits), the IRS agent closed the audit by proposing to deny the losses.

The IRS agent no doubt reminded Miller that he failed to consistently account for the interest on these loans and therefore he somehow wasn't entitled to claim the losses. I often hear this argument by IRS agents in a number of contexts. Instead of addressing the main issues, the agents seem to always fall back on "the taxpayer elected an accounting method and he failed to comply with that election, therefore, he is not entitled to _______________. "

Each time I hear this argument I cannot help but think how absurd it is. It reminds me of when I was a child and I would win an argument with a friend, only to have the friend say something unrelated and nonsensical such as "I know you are, but what am I? " It us just such a silly statement that it is hard to find the right words to respond with. Based on the frequency with which I hear this statement, I think that it must be helpful for the IRS agents in convincing un-represented taxpayers that they will loose their case if they opted to fight their case. Luckily it didn't work on Miller (Miller had already retained legal counsel) and the court didn't even consider the argument worthy of further inquiry.

The agent probably even encouraged Miller by telling him that he could appeal the denial and that the process would only take a few more months to reach a resolution. Miller no doubt took the IRS agent up on that and lodged a timely appeal with the IRS Appeals Office. The Appeals Office undoubtedly offered Miller a compromise, as did the IRS attorney who was assigned the case; offers that were slightly less favorable that a full denial. The whole process probably took more than a year, perhaps more than two years.

This case presents such a common scenario, that it is worth pointing out to taxpayers. The Miller case highlights the IRS audit process and it shows that the IRS can and do take unsupportable positions and file frivolous lawsuits. It also shows some of the tactics IRS agents employ to encourage taxpayers to accept IRS determinations. Not an exciting case, but it has some instructional value.

IRS Looks At Improving Informants Rewards Program

One would think that the IRS using paid informants to identify compliance-challenged taxpayers would generate some controversy. But it really hasn't. As a new TIGTA audit report reveals, the IRS' Informants Rewards Program hasn't generated much controversy because the program has been so poorly administered.

The informant process begins when a person approaches the IRS or when someone submits a Form 211 to the IRS. The Form 211 goes through an initial screening process, which consists of a review of the alleged taxpayers tax compliance and to see if the IRS is already pursuing the matter. At this point the claim will either be rejected or accepted for further review.

If an award is to be allowed:

the reward percentage is determined by whether the information directly led to the recovery (15 percent); indirectly led to the recovery (10 percent); or caused the investigation but had no direct relationship to the determination of tax liability (1 percent). The dollar amount of the reward is computed by multiplying the reward percentage by the amount of taxes, fines, and penalties (but not interest) collected. Different reward percentages can be used if the case involves multiple taxpayers and/or tax years. The reward amount must total at least $100 to be paid and cannot exceed $2 million in total.

The audit states that $340,329,427 was recovered due to informant information for FYs 2001 through 2005. Given the size of this figure, you might be wondering if "The Dog" bounty hunter might be in the wrong business. Based on the TIGTA report, the answer is clearly "no."

There can be little doubt that most informant claims are rejected. Even if a claim is paid by the IRS, it is likely that the information provided will be deemed to "have no direct relationship to the determination of the tax liability" - which results in a mere 1% payment. Even then, the audit report indicates that it may take up to seven and one half years to receive payment. Given these constraints, potential informants should engage a tax lawyer to help them present their claim in a way that increases the chances that they will be compensated and be compensated sooner rather than later.

If the IRS implements the TIGTA audit recommendations, it is very likely that program could become one of the most efficient means for collecting unreported and underreported tax and interest and penalties. I wonder if we will then see a cottage industry of "tax bounty hunters" spring up….