HOW TO CHALLENGE TAX AUDIT DECISIONS
What Every Citizen Needs to Know About a Notice of Deficiency
The evidence outlined in this report clearly shows that over the next five years, the IRS will be extremely aggressive in its audit attacks. That’s why I insist that every citizen needs to know how to challenge tax audit results, and that means every citizen needs to know how to challenge a Notice of Deficiency.
Evidence of a Pending Audit Assault Tax audits are quickly on the rise. There are a number of reasons for this, not the least of which is that upon taking office, Commissioner Mark Everson promised Congress that he would dramatically increase the number and scope of tax audits conducted by the IRS. The statistics indicate that Everson is achieving his goals.
The number of audits went up 11 percent from 2002 to 2003 and 25 percent since 2000. As a key element in his plan, Everson pointed the IRS’s guns right at tax returns claiming income of more than $100,000. Audits of these returns are up 40 percent from 2000 to 2003. Audits of business tax returns are up about 24 percent in 2003 alone. And correspondence audits are up by about 37 percent from 2000 to 2003.
Correspondence audits are the IRS’s “secret weapon” in the audit war. The reason is they are fast and cheap. The typical correspondence audit takes only a fraction of the time to complete compared to a face-to-face audit and nets the IRS, on average, about $3,400. This is why the agency is focusing heavily on these audits.
The Bad News for Taxpayers – This Collection Growth is Not Enough
In 2003, the IRS Oversight Board released its annual survey of taxpayers’ attitudes about the IRS and taxes. The results sent shock waves through the IRS. The report showed that 17 percent of those surveyed felt it was “acceptable to cheat” on their tax returns, compared with 11 percent in 1999. “2003 IRS Oversight Board Annual Survey on Taxpayer Attitudes,” September 2003.
The IRS Advisory Committee responded to the report by saying people have “become less afraid of being caught.” The committee recommended that the IRS “increase enforcement and change taxpayers’ attitudes.” Even more to the point, Roger Harris, the chairman of the IRS Oversight Board stated specifically that, “IRS enforcement needs to touch more people.” In other words, the attitude of those in and around the agency is that the hammer must fall on citizens to straighten out their thinking. This is the attitude that’s been driving the IRS for the past two years. And the above statistics clearly indicate that,
- The IRS has returned to an attitude of enforcement,
- The agency is not satisfied with the growth in audit activity thus far, and
- That’s why it’s so vitally important for you to understand how to challenge tax audits.
In late 2004, the IRS released its latest Five-Year Strategic Plan. The plan lays out the initiatives the agency will pursue for the years 2005 through 2009. In the March 2005 issue of my newsletter, Pilla Talks Taxes, I outlined the areas identified by the IRS as its targets. They are:
- “Verification of return accuracy,”
Ascertaining that “the correct income is reported,” and
Determining that “deductions meet Internal Revenue Code requirements.”
The IRS’s audit priorities fall into four areas:
- Tax return “non-filers and underreporting of income.” The IRS now estimates that there may be as many as of 8.6 million non-filers. This number is up from about 6 million estimated non-filers just a few years ago. With its increased ability to match information returns with tax returns, expect the IRS to focus substantial resources on those who either don’t file or who underreport their income.
Small businesses using “flow-through entities.” Such entities include partnerships and S corporations. Flow-through entities do not themselves pay taxes. Rather, they merely report gross income and expenses. The profit (or loss) “flows through” to the owners of the company, who then pay the taxes.
Promoters and users of “abusive tax schemes and avoidance transactions.” This means the IRS’s almost religious zeal in attacking tax shelters over the past three years is far from over. It’s really just beginning. Expect all tax shelter and tax avoidance strategies to be closely scrutinized and subjected to enforcement action.
Use of “offshore transactions.” This means continued investigation of all forms of offshore transactions and entities involving United States citizens and U.S. source income.
In the face of all this, it’s time to learn how to deal with a Notice of Deficiency.
What is a Notice of Deficiency?
A Notice of Deficiency (NOD) is the final administrative step in a contested audit. It is the written determination issued by the IRS explaining why the agency believes that you owe more taxes. The NOD is the key to the so-called deficiency procedures set out in the tax code. It is your ticket to the Tax Court. The NOD gives you the power to call any IRS bluff issued in the context of an audit. The NOD is a proposed assessment. It is not a final assessment.
Properly handled, the NOD assures you that you will never pay taxes you don’t owe.
Identifying the Notice of Deficiency
Of the thousands of potential letters you might receive from the IRS, the NOD is clearly one of the most important. It can be intimidating and is easily misunderstood. Unlike most other IRS communications, people often mistake an NOD for something it is not. It is not, for example, a communication from the IRS declaring that you in fact owe more taxes, though clearly, that’s exactly what it seems to be.
You can be certain whether your correspondence is indeed an NOD by simply reading the first two sentences of the letter. Please see the sample NOD at the end of this report. The first two sentences read:
We have determined that you owe additional tax or other amounts, or both, for the tax year(s) identified above. This letter is your NOTICE OF DEFICIENCY, as required by law.
If you ever receive a letter with this opening salvo, you must act as outlined below. Failure to act as outlined below will result in an assessment of tax against you, regardless of the merits of the claim.
Understanding the Deficiency Procedures
Under code sections 6211 through 6214, the IRS can’t unilaterally assess additional taxes against you in the case of income, estate and gift taxes. Rather, the assessment must be “proposed” and you must be given an opportunity to challenge the proposal before it becomes absolute. The NOD is the proposal and the “deficiency procedures” are the means by which the proposal is made. Two key exceptions to the deficiency procedures apply in income tax cases. The first is in the case of “math errors,” as defined by code section 6213(b). The second is in the case of jeopardy and termination assessments under sections 6851, 6852, and 6861. I do not spend significant time on the exceptions here but some background is necessary to fully understand the process. A math error speaks to simple mistakes in a return relative to addition, subtraction, etc., or, for example, the misuse of table or formula. The idea is that errors of this nature are not generally subject to debate. Therefore, the IRS is allowed to correct these mistakes and impose an assessment without regard to the deficiency procedures. But even then, the citizen may file an abatement request within sixty days of math error assessment. Code section 6213(b). If such a request is filed on time, the IRS must abate the assessment and is required to follow the deficiency procedures before re-assessing the tax. Code section 6213(b)(2)(A). For the details on math error assessments and the abatement process, see chapter two of my book, The IRS Problem Solver . Jeopardy and termination assessments are permitted when the IRS can prove that the citizen is taking affirmative steps to divest himself of his assets or is preparing to move them beyond the reach of the IRS. This is a rare circumstance but even in this case, the IRS must issue an NOD to give the citizen an opportunity to challenge the IRS’s determination.
When to Expect a Notice of Deficiency
The term “deficiency” is defined in code section 6211(a). It’s important to know what a deficiency is because not every tax debt is a deficiency. For example, if you file a tax return that shows an amount due that is not paid at the time of filing, this is not a deficiency. This is an underpayment. The IRS need not send a Notice of Deficiency in order to collect an underpayment of tax. In that case, the tax may be assessed upon filing the return and the IRS may begin the collection process immediately.
A “deficiency” is defined as the difference between the tax that’s owed under the tax code and the tax that’s shown on the tax return. The difference is generally ascertained through the audit process. Thus, the NOD is issued following an audit or the appeal of an audit. The NOD proposes additional tax liability based upon adjustments to your taxable income. This can include the disallowance of deductions, inclusion of additional income alleged to be unreported, or the denial of other tax benefits that you claimed on your return.
For example, suppose you file a tax return for the tax year 2002. The return shows a tax liability of $2,500. You pay the tax on time. Later, the IRS audits the return and disallows several deductions. Based upon the disallowances, your correct tax liability is determined to be $6,000. The difference between the $6,000 the IRS determines is owed and the $2,500 liability you reported on the return is a deficiency. The IRS will then mail an NOD alleging a deficiency of $3,500 of tax for the year 2002, plus penalties and interest.
Before the proposed deficiency of $3,500 can be assessed, the IRS must issue a Notice of Deficiency. The NOD imparts several important rights that we discuss later.
The IRS must also use the deficiency procedures in cases where a citizen failed to file a tax return. The simple fact that a person failed to file a return does not excuse the IRS from the deficiency procedures. Because of the current intensive focus by the IRS on finding non-filers, the agency is issuing a growing number of NODs to non-filers. Non-filers have the same rights to challenge an NOD as one who files a return.
How to Challenge a Notice of Deficiency
A Notice of Deficiency constitutes an administrative determination by IRS that you owe additional taxes. The decision is final insofar as the IRS is concerned, but you’re not stuck with it. You have the right to challenge it through the judicial process in one of two ways. Note this, however, if you do not challenge it within the time allowed, the proposed assessment will become final and you’ll have to pay in full, even if you clearly don’t owe the tax.
The first method of review is to pay the tax then file a claim for refund with the IRS. Since the IRS already determined that you owe additional tax, it will deny the claim. The denial of the claim gives you the right to file a suit for refund in the United States district court. This method of judicial review is generally impractical because before you can invoke a suit for refund, the tax, including all penalties and interest, must be paid in full.
The second alternative is generally more practical for the vast majority of taxpayers. It is to file a Petition for Redetermination of the Deficiency in the United States Tax Court. There are a number of advantages to using the Tax Court option as the means of challenging the NOD. Here are some of the key advantages:
- The tax need not be paid prior to obtaining court review. The Tax Court presents the only pre-payment deficiency review process that’s available.
- Once a timely petition is filed with the Tax Court, the law expressly prevents any assessment or collection of the tax. Code section 6213(a). If the IRS violates this provision (which is does from time to time), the Tax Court has the authority to enjoin the IRS from collecting the tax and to order an abatement of the assessment.
- Not until the Tax Court’s decision becomes final may the IRS legally collect any deficiency, and then only in the amount ordered by the court.
- Tax Court procedures offer an extensive negotiation process involving both the IRS’s Office of Appeals and its Area Counsel attorneys. These negotiations lead to amicable settlements in the vast majority of cases without the need of a trial.
- The Tax Court’s Rules of Procedure offer a much simpler litigation process and in fact, a “small tax case” can be adopted for cases involving disputes of $50,000 or less. Code section 7463.
- Tax Court judges are accustomed to citizens representing themselves before the court and are less inclined to strictly enforce procedural rules, especially while testifying.
The Importance of a Timely Petition
The jurisdiction of the Tax Court is invoked by filing a timely petition with the court. It is vital to understand the importance of this.
Code section 6213(c) reads:
If the taxpayer does not file a petition with the Tax Court within the time prescribed in subsection (a), the deficiency, notice of which has been mailed to the taxpayer, shall be assessed, and shall be paid upon notice and demand from the Secretary.
The Notice of Deficiency itself contains this warning: The time you have to file a petition with the court is set by law and cannot be extended or suspended. Thus, contacting the IRS for more information, or receiving other correspondence from the IRS won’t change the allowable period for filing a petition with the Tax Court. [NOD Example, page 1, last paragraph.]
If a timely petition is not filed, the Tax Court loses its authority to redetermine the deficiency. The IRS may assess the tax and at that point, your rights to challenge the deficiency are restricted. You may end up having to pay the entire tax in order to gain the right of review in the district court. It could not be simpler.
When Must a Petition be Filed?
Code section 6213(a) sets a ninety-day deadline for filing a petition with the Tax Court. If you are outside the United States, you have 150 days in which to file the petition. The countdown begins with the date stamped on the NOD as the “letter date.”
The deadline is hard and must be calculated correctly. There is no provision for extending it. The deadline (ninety days or 150 days) is counted as calendar days. That is, you must count each day, including Saturdays, Sundays and legal holidays. Because some months have thirty-one days, you cannot just skip forward three months.
If the last day for filing the petition lands on a Saturday, Sunday or legal holiday in Washington, D.C., the filing deadline moves to the next business day in Washington, D.C. Please note that some states have holidays that are not recognized as legal holidays in other states. If the holiday is not considered a legal holiday in Washington, D.C., it does not count to extend the deadline. See Revenue Regulation section 301.6213-1(a); Tax Court Rule 25(a). Legal holidays in Washington D.C. are defined by Tax Court Rule 25(b).
The upper right corner of the NOD contains the statement: “Last Day to File a Petition With the United States Tax Court.” A date follows that statement. Sometimes the IRS makes mistakes in computing that date. Please note that any mistake the IRS makes in computing the last day for filing the petition is not binding on the Tax Court and does not extend the filing deadline. You should determine the filing deadline yourself and double-check it to be sure.
Beware of Confusing and Misleading IRS Correspondence
It bears restating that there is no legal provision available for extending or suspending the filing deadline. It is set by statute and nothing on earth can change it. This is sometimes forgotten or confused when the IRS sends apparently contradictory correspondence.
There are two common situations where this arises. The first involves tax return non-filers and the second involves common audits. I address each one here.
Tax return non-filers. As stated above, the IRS must use the deficiency procedures to assess taxes against non-filers. When the IRS issues an NOD to a non-filer, it often sends an accompanying letter that is outright deceptive. The letter invites the non-filer to mail a tax return to the IRS in response to the NOD. The letter states, “Filing a petition in the Tax Court is not necessary if you file the return with the IRS within the time stated in this letter package.”
This letter very clearly says that filing a tax return is an alternative to filing a Tax Court petition. The apparent alternative is very attractive since it eliminates the need to file a petition and go through the Tax Court process. However, you must avoid the temptation to follow the letter’s recommendation.
Please note that once an NOD is issued, the IRS has made a final administrative determination as to your liability. Filing a tax return will not alter that determination. The IRS is under no duty to process a tax return filed after an NOD is issued. Moreover, in my experience, the IRS will not process a tax return after issuing an NOD. The agency is likely to simply throw the tax return in the trash. If you then fail to petition the Tax Court by the deadline set out in the Notice of Deficiency, the amount proposed in the NOD, which is often three to four times higher than what you really owe, will be assessed. See code section 6213(c), quoted above.
Likewise you must be cautious about advice you receive from accountants regarding unfiled returns and NODs. Many tax professionals are unaware of the nuances of the tax code that I’ve outlined above. As such, they advise clients that the mere filing of a tax return is a valid means of handling an NOD. They might suggest you phone the IRS to explain the situation and express to them that you’ll file by the deadline. You might even get an IRS employee to tell you that all you have to do is file the return by the deadline and you’re covered. None of this is true.
Make no mistake about it. Your one and only pre-payment option for challenging an NOD is to file a petition with the United States Tax Court before the deadline expires. If you fail to file the petition on time, whether or not you file a return with the IRS and regardless of what the IRS might have told you, the amount of tax and penalties shown in the NOD will be assessed and you will likely lose any rights to a pre-payment challenge to the assessment. This could be disastrous, depending upon the amount of tax demanded by the IRS.
Common audit situations. It is quite common for the IRS to revise its audit decisions as the case progresses, based upon new facts and evidence the citizen presents. Revised audit decisions can be confusing and misleading once a Notice of Deficiency is issued. For example, the IRS uses Letter 3581 to communicate that “no change” was made to a tax return under audit. This is good news since the IRS concedes that no additional tax is owed.
However, the letter goes on to say,
If you received a Notice of Deficiency from us for this tax return and tax period and have not filed a petition with the United States Tax Court, please disregard that notice. You will not need to file a petition with the Tax Court for reconsideration of your tax liability.
This too sounds very encouraging, but for all the reasons stated above, it is not reliable. Remember the language of code section 6213(c), which says that if a petition is not filed, the amount of tax shown in the NOD “shall be assessed, and shall be paid.”
The only safe and acceptable alternative to filing a petition is to seek the formal “rescission” of the NOD. The procedure for doing so is outlined below.
How to Cancel a Notice of Deficiency
The law provides a means of canceling Notices of Deficiency. This is a little-known procedure that is very strict yet quite simple. It is known as the rescission process. It is the only procedure available for canceling an NOD. Unless you use this method for canceling the NOD, you must petition the Tax Court to avoid an excessive and erroneous assessment.
The procedure is set out in code section 6212(d), which states in part:
The Secretary may, with the consent of the taxpayer, rescind any notice of deficiency mailed to the taxpayer.
When an NOD is expressly rescinded, you need not file a petition in the Tax Court and the IRS cannot assess the tax. Once the NOD is rescinded, it is treated as if it never existed. The IRS rescinds an NOD under any of the following grounds:
- The NOD was issued as a result of administrative error. For example, the NOD was issued: 1) to the wrong taxpayer, 2) for the wrong tax period, or 3) without considering a properly executed Form 872, Consent to Extend the Time to Assess Tax, or Form 872-A. This is a waiver giving the IRS more time to assess without violating the statute of limitations. IRS generally has three years from the date a return is filed in which to make an assessment. Code section 6501.
- The citizen provides information establishing that the actual tax due is less than the amount stated in the NOD. Or,
- The citizen specifically requests a conference with the Appeals Office for the express purpose of entering into settlement negotiations. The IRS will rescind an NOD if the Appeals Office decides that the case is susceptible to agreement. Revenue Procedure 98-54, 1998-43 I.R.B. 7.
A rescission must be in writing and on IRS Form 8626, Agreement to Rescind Notice of Deficiency. To request rescission of an NOD, notify the “Person to Contact” identified on the upper right portion of the NOD. See NOD Example, top right corner. Write a letter explaining that you wish to have the NOD rescinded under code section 6212(d), for one or more of the reasons set out above. Be sure to explain that you’re willing and able to meet with the IRS Appeals Office to reach a settlement of the issue. Be careful to write this letter well before the deadline expires for petitioning the Tax Court. Explain in your letter that unless a Form 8626 is signed by both you and the IRS before the deadline expires, you will petition the Tax Court. Give the IRS a deadline for action that gives you enough time to file a timely petition if the agency fails to act or denies your request.
IRS procedures identify the conditions under which the IRS will not rescind an NOD. They are very important. The IRS will not rescind the NOD if,
- The assessment statute of limitations will expire within ninety days or less unless you agree to execute Form 872, Consent to Extend Time to Assess Tax.
- The deadline for filing a petition has expired but no petition was filed. At that point, the tax will be assessed and the issue becomes a collection problem.
- The citizen filed a petition with the Tax Court. At that point, the Office of Area Counsel gets involved as the legal representative of the IRS. Resolution of the matter is handled through that office.
Please note that merely requesting a rescission does not extend the time for filing your petition. Moreover, any statement, written or otherwise not constituting a signed rescission on Form 8626 has no bearing on the time limit for filing a petition. That time is fixed by law and cannot be extended. Only a signed Form 8626 eliminates the need to file a Tax Court Petition. You should carefully monitor the filing deadline. If you get no response from the IRS or your request to rescind is turned down, be sure to file your petition before the deadline expires.
A Common Problem in Non-Filer Cases
I stated earlier that the IRS is not excused from using the deficiency procedures in non-filer cases. While this is true, it’s also true that the IRS ignores the law in many situations. The IRS is authorized to use summary assessment procedures in cases of math errors. A math error, as discussed above, is narrowly defined by code section 6213(g)(2). It encompasses simple errors over which there should be no real dispute, such as addition and subtraction.
Failure to file a tax return, the resulting tax liability and the penalties related thereto are not among the things that are classified as math errors. Consequently, the IRS cannot use summary assessment procedures to assess taxes in non-filer cases. This rule is clearly expressed in numerous court decisions. See Bothke v. Fluor Engineers, 713 F.2d 1405 (9th Cir. 1983); Millsap v. Commissioner, 91 T.C. 926 (1988), Spurlock v. Commissioner, 118 T.C. No. 9 (2002).
The reality, however, is that the IRS regularly bypasses the deficiency procedures in non-filer cases. If you receive a collection notice from the IRS demanding payment of taxes for a tax year in which you didn’t file a return yet never received a Notice of Deficiency, the assessment is illegal and must be abated.
You should immediately make a written request for an abatement of the assessment. Follow the examples in chapter two of my book, The IRS Problem Solver, for writing a letter seeking the abatement. A proper abatement request letter requires mandatory abatement. Code section 6213(b)(2); Service Center Advice Memo 1998-040, April 2, 1998.
Make Sure You’re on the IRS’s Mailing List
I know this doesn’t sound appealing, but it’s very important. The reason is that the validity of a Notice of Deficiency is not dependent upon whether you actually received it. Rather, the question is whether the IRS mailed it. Under code section 6212(b)(1), the IRS is commanded to mail an NOD to the citizen’s “last known address” using certified or registered mail. If the IRS mails it in that fashion and you don’t receive it, the IRS may nevertheless assess and collect the taxes shown on the NOD, even when the assessment is dead wrong. In this case, however, you would have other appeal rights.
The phrase, “last known address,” is defined in the regulations as:
The address that appears on the taxpayer’s most recently filed and properly processed Federal tax return, unless the IRS is given clear and concise notification of a different address. Revenue Regulation section 301.6212-2(a).
A person who files a tax return in April then moves in May will have an old address on file with the IRS. If the IRS sends an NOD to the address on the return and for whatever reason the NOD is not forwarded to the new address or is forwarded slowly, that person could miss his Tax Court filing deadline and will be faced with a collection problem.
The answer, therefore, is to provide “clear and concise notification” to the IRS of your new address when you move. Notice of a new address is adequate if it contains:
- A signed statement informing the IRS that you wish to change your address,
- Your full name, signature, old address, and social security number or employer identification number,
- In the case of joint return, the names, social security numbers and signatures of both spouses,
- In the case of changed last names, the last name used on the most recently filed return and the new last name,
- A specific statement as to the new address, and · In the case of a joint return, if either citizen establishes a separate residence, such as in a divorce, each should send separate notices to IRS, Abeles v. Commissioner, 91 T.C. 1019 (1988); Revenue Procedure 2001-18, 2001-8 I.R.B. 708.
IRS Form 8822, Change of Address, is comprehensive as to the above items and should be used to communicate your change of address to the IRS. Send it to the service center where you file your tax returns and be sure to use certified mail with return receipt requested. Keep copies of the form and the Postal Service certified mail receipts in your permanent tax file.
How to File a Tax Court Petition
A Tax Court petition is filed by submitting the proper form to the Clerk of the Untied States Tax Court within the time permitted. Remember, if you miss the deadline, the court has no authority to hear your case and the IRS will assess the taxes and move to collect them.
The Clerk’s address is:
Clerk of United States Tax Court
400 Second Street, NW
Washington, D.C. 20217
You cannot file petitions by fax or e-mail.
You can call the Clerk at 202-606-8754 to obtain a copy of the Rules of Practice and Procedure for the Tax Court. The rules and filing information are also on the court’s website, which is http://www.ustaxcourt.gov/. The details of a Tax Court petition and court procedures are beyond the scope of this report. However, my book,Taxpayers Ultimate Defense Manual has a detailed discussion of the process of writing a petition and working your way through a Tax Court case. If you have a Notice of Deficiency in hand or expect one because of a pending audit, you must have this book.
Get Professional Help
If you’re not sure whether you have or at some point received a Notice of Deficiency regarding a tax year or you’re just not sure what to do if you have one, get professional help. Don’t wait until the last minute and certainly don’t wait until after your filing deadline has passed in order to get help. Get help now. In most cases, dealing with an NOD is imminently manageable—if you still have time to act.
© Copyright 2005, Daniel J. Pilla and Winning Publications, Inc. All rights reserved.
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