Audit Defense: An Open Invitation to Play the Audit Lottery?

A major player in the tax preparation business has opted to provide “audit defense” to clients who use its services to complete their state and federal tax returns. A careful review of this company’s contractual terms raises some serious issues for taxpayers and for the IRS.

The IRS employs a number of techniques to identify false or frivolous tax returns. However, due to the millions (if not billions) of tax forms filed with the IRS each year, millions (if not billions) of tax false or frivolous tax returns are accepted “as filed” by the IRS (and state tax revenue collection agencies). This is where the phrase “audit lottery” comes into play (recall the prior post about prisoners who submit false tax records to get tax refunds).

The term “audit lottery” refers to the attempt by taxpayers to under report their taxable income, claim tax attributes (such as tax deductions or credits) to which they are not entitled, or otherwise eliminate their tax liability, by guessing (or gambling) that the IRS and state taxing authorities will not recognize the deceit due to the number of tax forms that the IRS and state tax authorities process.

The primary tools that the IRS has to combat and deter this type of activity are IRS tax penalties and interest and, in some cases, criminal penalties. Unfortunately (this is me speaking as a taxpayer), tax penalties and interest, whether civil or criminal, are typically only applied in cases where the IRS detects the taxpayer’s false or frivolous tax return. Taxpayers who play the audit lottery make an affirmative decision to couch these costs in light of the relatively low chances of actually being audited. Of course, taxpayers also have to factor in the costs associated with hiring tax counsel if their false or frivolous tax forms are caught and the headaches involved in this process.

This brings me to the so-called “audit defense” service provided by this major tax return preparation company (technically it appears that this company has created a separate legal entity to provide this service to shield or segregate the legal liability associated with the endeavor), as this service purports to relieve some of the costs associated with hiring tax counsel and with the headaches involved.

Because the “audit defense membership agreement” does not exclude taxpayers who make false or fraudulent representations in their tax returns, it appears that taxpayers will still be entitled to “audit defense” using this company’s services if they (1) misrepresent their tax and factual information or (2) they take positions that are contrary to our tax laws (even if the misrepresentation or position is blatantly false or frivolous). If either case, this “audit defense” service seems to imply that the company – free of charge – will help the taxpayer address IRS and state tax law issues if a state or IRS tax audit arises from the tax returns prepared using this company’s services.

This free service will most likely encourage taxpayers to take false or frivolous tax positions, with the expectation that they will be “represented” should an IRS or state audit occur. Taxpayers may think “what is the risk, if I get free tax representation?”

Before taxpayers make this leap of faith, they should be aware of how the term “defense” is defined. In the contractual agreement for this particular company the term “audit defense” specifically excludes representing clients in court or providing legal advice. As such, many taxpayers may falsely believe that this “defense” includes services that, by law, only tax lawyers can advise taxpayers on (and most tax attorneys will not be able to participate in these cases pursuant to this company’s agreement because the company’s agreement uses the term “specialist,” which is a violation of the ethical rules for many state attorney regulation rules). The agreement does not specify how the services by these “Specialists” are limited and the agreement does not specify what education and experience these “Specialists” have (or if the “Specalists” are even located in the United States). Many taxpayers may find themselves in the position of having their “audit defense” not being able to provide any real “defense” at all.

There are several other factors that taxpayers must consider before relying on this company’s “audit defense” service. For example, the terms of the contractual agreement for this particular company also denies help to taxpayers who do not report IRS or state notices to the “audit defense” company within 15 days of the “date of the first notice.”

It is probably safe to say that most taxpayers do not understand that the IRS backdates notices and other IRS notices are not dated at all, which results in many taxpayers not receiving IRS notices within 15 days. Moreover, many IRS notices are sent to the wrong address or delivered to the wrong address and even when notices are delivered, many taxpayers do not receive them until weeks if not months later (think of the taxpayer who is sick or on vacation). In these cases the taxpayer’s “audit defense” appears to be 100% zero.

The agreement also seems to exclude IRS claims that are brought beyond the period that the IRS and states have to collect the taxes, which ignores the fact that the IRS and some states have a practice of sending out random notices after the collection expiration date with, apparently, the hope that taxpayers will pay the tax without knowing that the collection statute has expired. It appears that the “audit defense” by this company will not cover taxpayers who find themselves in this position.

The agreement for this company also specifies that taxpayers are required to “[p]rovide the [audit defense company with] information and documentation necessary to substantiate the various items of income and expense in question so that your Specialist(s) can prepare your defense”. This ignores the realtiy that not all taxable transactions must be documented, many taxable transactions are never docuemnted, and many documents are lost, stolen or destroyed. If taxpayers could document every transaction, then there would be no need for “audit defsense” in the first place – because taxpayers could just provide their documents to the IRS and/or state – remember that legal tax services are specifically excluded from this agreement (and that does not address the taxspayers who will have to turn over boxes and boxes of documents to this third party — some of which may include documents incriminating evidence, which would most likely waive any right of the taxpayer to keep those records private). In these cases the taxpayer will have breached the agreement, therefore not entitiling the taxpayer to any “audit defense.”

If that is not bad enough, the terms for this particular tax preparation service specify that it “does not prepare or amend our members’ Federal, State or Local income tax returns.” Hello? Many tax remedies require taxpayers to file amended tax return, especially since the IRS has recently issued new regulations defining what constitutes an amended tax return.

And that is just the start. The contractual terms for this company also exclude “audit defese” for entities that taxpayers have an ownership interest in,” which will exclude almost all Schedule C small business oweners; it excludes late filed tax returns, regardless of whether the taxpayer was at fault for the late filing; it excludes other tax issues that may arise (such as employment taxes that are assessed due to an income tax audit); and the company “reserves the right to cease providing service where reasonably warranted,” which means that they can leave their clients high and dry should push come to shove.

After reviewing the terms, I am left wondering what kind of “audit defense” this really is? The answer in my mind is that it is only another marketing ploy. Unfortunately many taxpayers may be mislead into beleiveing that this company will acutally provide them with “audit defense.”