Howard's IRS and the Law Blog

Getting ready for your IRS audit: Organizing your records

by Howard S. Levy, Esq. on February 16, 2015

in IRS audits

Most IRS audits start because the IRS believes there is something wrong with your tax return.

I mean, let’s face it, the IRS is not spending time auditing tax returns that they think are clean.

In other words, an audit starts with you behind the eight ball, presumed to have filed a return that has mistakes on it.

How do you fight that negative presumption of guilt before you even get started?  One word:  credibility.

Credibility in IRS audits does not come from words, but from organization.

But how do you organize you records for the auditor to gain credibility?  And what if your records are incomplete?

Here are some tip to solve frequently encountered problems in preparing for your records for an IRS audit:

1.     Make the auditor’s job easier.  That means understanding what the auditor wants ahead of time, and giving it to him.  You do not want to go through and organize that box of receipts, and neither does the IRS auditor.  But somebody has to.  And it is better you then the auditor.  Remember, the auditor is coming in expecting the worst; try to gain credibility by slowly adjusting his preconceived expectations of you.  So, put the time in so the IRS auditor does not have to. Ultimately, your preparation can give you the benefit of the doubt on judgment calls – you want those calls to go your way.

If possible, put your receipts in their own file folders.  Each expense should have its own file folder – i.e., one for subcontractor labor, one for your charitable contributions, one for your home office expenses.  Name each file folder for the expense it holds.

If necessary, receipts should be marked to further explain the expense it verifies.  For example, if you entertained for business, mark on the receipt who you entertained, and why.

If you have a bill for services and a check showing the bill was paid, staple the check to the bill.

Add the totals of the receipts up for each expense category and provide your tabulation to the auditor.

Do away with plastic grocery bags with receipts in them.  This makes for a poor presentation and takes away credibility.

Prepare this way:  How would you like the records to look if you were the auditor?  What would impress you?

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An offer in compromise can put IRS troubles behind you and bring a fresh start on your taxes.

But the road to a fresh start with the IRS is not necessarily as simple as it may sound.

The IRS has very strict criteria that they use to determine if a tax debt should be compromised.

Before jumping in with a compromise, there is much you need to know about the IRS settlement process, including:

–     Whether you should even file an offer in compromise.  For example, if the IRS has a limited time left to collect your debt (out of the 10 year period they are given by law), should you jump in or remain on the sidelines?  Sometimes, it is better to hold ’em, but you need to know when.

–     What are your chances of success. The IRS rejects more comprises than it accepts, due in part to its rigorous financial guidelines that are used to determine if they should settle or if they believe they can get paid in full.  Know if your your situation merits the time invested to settle ahead of time.

–     How to use the internal IRS criteria to negotiate the best settlement.  It is important to know the IRS offer in compromise valuation formula before jumping in.  Do you make too much to settle?  What if you spend too much and the IRS wants you to cut your budget so you can pay them more?  The IRS has specific formulas that are used in valuing a compromise that should be reviewed and applied to your situation before jumping in.

–     The best ways to handle the full financial disclosure that the IRS requires.  The IRS wants to know where you work, bank, the amount in your retirement accounts, what cars you drive, what your house is worth, what you make, and what you spend.  What if your income varies year to year, and right now it is at a high?  What income do you pick (hint:  the IRS permits income-averaging over several years to even out the highs and he lows)?

–     How to complete the IRS financial statements and compromise forms.  For example, the IRS guidelines permit you to reduce the value of your cars and house by 20% on the financial statements, effectively lowering the value of your compromise by 20%.  Proper completion of the forms can result in significant savings in settlement.

–     Your rights to dispute an IRS rejection of an offer in compromise.  Maybe they think your home is worth more than it is.  Or aren’t allowing you necessary living expenses.  Or think you earn more than you do or will in the fixture.  Either way, any IRS compromise decision is subject to an independent review by the IRS Office of Appeals.  Many offers that are initially turned down are ultimately accepted by appeals.

Success with an offer in compromise is based on knowing the IRS’s settlement guidelines, understanding how to apply those rules to your situation, and responding if the IRS does not properly follow and implement them.

In that regard, on Wednesday, January 28, 2015, I will be giving a live webinar with on how to negotiate an offer in compromise settlement with the IRS.  If you are unable to attend the webinar, feel free to email me at and we can set a time to review helping you get a fresh start with the IRS.  And if an offer in compromise is not your best option, we can determine if you qualify for other alternatives, including how much longer the IRS has to collect, bankruptcy, currently uncollectible, or a monthly payment agreement with th IRS.

You just received a letter from the IRS notifying you that they are rejecting your offer in compromise.  Enclosed with your letter are the IRS calculations, detailing why your offer was rejected.

The IRS might as well be speaking a foreign language – what do all their calculations mean? And do you have a good reason to appeal the rejection?

One reason the IRS rejects an offer in compromise is because they think that you can pay them in full from your future income.  The IRS defines your future income as the amount you earn, less your necessary living expenses.

The IRS has schedules of what your necessary living expenses should be.  And if your actual expenses are greater than the IRS allowances, the IRS will cut you short on expenses.  This creates more future income to IRS, increases the value of your compromise, and can result in a letter proposing rejection.

Here’s an example of how the IRS living expense allowances work:

Let’s say you live in Cincinnati, Ohio and have a family of four.  The IRS will allow you a monthly housing and utility expense of $1,942.

But what if your housing and utilities – mortgage payment, gas/electric, water, sewer, trash, cable, and phone bill – total $2,300/month?

The IRS won’t allow you to deduct your full monthly living expense in their offer in compromise calculation, and will cap the expense and allow you only their number, $1,942. The result is that the IRS calculations have you at $358 more left over every month to pay them than you actually do ($2,300 actual – $1,942 allowed).

This is what I call phantom cash flow – you don’t have it, can’t afford to pay it to the IRS, but they will use that $358 a part of what is collectible from your future income in their offer in compromise calculation.

These expense limitations are known as IRS Collection Financial Standards.

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You have not filed your tax returns with the IRS in years, and want to put that behind you and make amends with the IRS.

But how many years of nonfiled returns do you need to prepare to become compliant with the IRS?

It seems so overwhelming – where do you start?

5 years?

10 years?

20 years?

The good news is that the IRS does not require you to go back 20 years, or even 10 years, on your unfiled tax returns.

In most cases, the IRS requires you to go back and file your last six years of tax returns to get in their good graces.  And then, to make arrangements on payment of what is owed.

That’s right, a fairly reasonable and more manageable six years and working with IRS collections on payment options.

The six year enforcement period for delinquent returns is found in IRS Policy Statement 5-133 and Internal Revenue Manual

Part of the reason the IRS requires six years is manpower – the IRS cannot administer and staff the enforcement of unfiled tax returns going back as far as 10 or 20 years.  And believe it or not, the IRS’s records rarely, if ever, go back that far.  The IRS is looking to draw a line in the sand that is consistent with their internal resources, and at the same time secure a good faith effort at compliance from taxpayers to get current.  And that line in the sand is six years.

As for payment of what you will owe after the returns are filed, the IRS offers several programs, including installment agreements, offer in compromise settlements, and even currently not collectible status (where the IRS agrees not to enforce collection of your tax debt as it would create a financial hardship).  In some situations, bankruptcy can eliminate what you owe on the returns, too.

Bear in mind that this is a general rule, and will likely apply to most taxpayers who seek in good faith to come forward to the IRS on their unfiled tax returns.  The IRS can seek enforcement of longer periods if there are unique circumstances, such as income from illegal sources or hiding or concealing assets.  That is the exception, not the rule.

Indeed, not filing your tax returns is most always a civil issue (not criminal) that simply requires (1) filing the last six years’ tax returns and (2) making arrangements with the IRS to repay what you owe.

If you do not have all the records to prepare the returns, the IRS will often have copies of your W2s, 1099s, etc.  There are also methods to recreate your income and business expenses if your records are incomplete – one way, for example, is to determine your living expenses for any year you did not file.  You likely earned at least what you spent, and that forms a basis to recreate your income for a good faith tax return filing.

And criminal nonfiling cases are the exception, not the rule.  In most every case, the IRS simply wants you to voluntarily file the last six years returns, and then work with them on an agreement to pay or settle what you owe.  Criminal cases usually involve a level of sophistication and planning on your part that would show an intent beyond the good faith reason why you probably did not file – poor recordkeeping, medical trauma, divorce, fear or procrastination.

You do not have to be held back by unfiled tax returns.  The path to a fresh start is the last six years’ returns, and providing the IRS a plan of repayment. You do not have to be in a state of fear and inaction from the prospects of getting this behind you, and moving on.  It can actually be more manageable than you may think.

You just received a batch of IRS collection letters stating that your tax problem is “Urgent,” that the IRS might levy your wages, and, finally, that you should call the IRS immediately.

You consider doing what the IRS asked – picking up the phone and calling the IRS Automated Collection System (commonly known as “ACS”).  The day of reckoning cannot be put off any longer.

But the call to the IRS is not always that simple.

First, know that when you call, the IRS ACS agent on the other end is trained to immediately ask you a script of questions.

Here are the first questions you should expect to be asked when you call the IRS Automated Collection System:

1.     Your current address.

2.     Your telephone number.

3.     Where you bank.

4.     The name of your employer.

That’s right, before you can even get started in conversation, the IRS account representative is trained to extract financial information from you, including where you bank and work.

The purpose is to update the IRS’s database with bank levy and wage garnishment sources.

You are five minutes into the call, have disclosed valuable information, and received nothing back.  And the IRS is not done with its requests for information.

Expect the IRS account representative to next request that you provide a financial statement, which will include the amount of your income, a list of your monthly living expenses, the car you drive and what it’s worth, and the value of your house.  The IRS has specific forms for you to use for completing the financial statement disclosures, known as Form 433F (short form) or 433A (longer form).

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Will my IRS debt ever just go away?  Will there ever be a time that the IRS will just leave me alone?

Yes, and yes.

The collection of most every IRS debt eventually ends, and that would include yours.  This is called the statute of limitations on IRS collections.  The Internal Revenue Code gives the IRS a window of time to collect from you; after that window closes, you are free from your tax debt and the IRS.

Here are five truths about how many years the IRS to collect back taxes from you:

1.     There is an IRS statute of limitations on collecting taxes.  The IRS is limited to 10 years to collect back taxes, after that, they are barred by law from continuing collection activities against you.

2.     The IRS 10 year window to collect starts when the IRS originally determines that you owe taxes – that is usually when you filed your tax return, or when the result of an IRS audit becomes final.

3.     You can unknowingly give the IRS more time to collect.  The filing of an offer in compromise, innocent spouse request, collection due process appeal or bankruptcy all gives the IRS more than 10 years to collect.  Each of these acts extends the 10 years during the time they are pending.  If you submit an offer in compromise, and it takes the IRS 9 months to investigate it, and the compromise is rejected, the IRS will tack 9 more months on to your collection time frame.

4.     IRS tax liens become legally unenforceable when the collection window closes.  After the collection statute of limitations expires, the IRS will no longer have an valid lien on your property, including your house.

5.     After the IRS can no longer collect from you, they will make an internal adjustment to their books and credit your account for the amount of unpaid taxes, interest and penalties. IRS account transcripts can be obtained verifying that you no longer owe them – they will contain a line entry along the lines of “Time Frame To Collect Expired” and a resulting zero balance.

We can determine how much time the IRS has left to collect from you.  First, the IRS has a date in their internal database – they will tell us what it is if we ask.  Also, IRS account transcripts can be obtained and analyzed to determine and confirm your end date.  If you are uncomfortable calling the IRS, a Federal tax lien will have information on it that can be used to calculate the statute of limitation on collection.  It is important to know where you stand with the IRS, and to know whether you may soon be on ground that the IRS will be unable to reach.

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