Stop me if you’ve heard this one. A taxpayer and a tax attorney walk into a room. The taxpayer pulls out an IRS examination letter and says, “I’ve always filed my returns this way, and the IRS has never cared in the other years. Why is the IRS suddenly out to get me?” The tax attorney looks at the return and the letter. “Ah. The answer is simple: You’ve always filed your returns wrong. This is just the first time the IRS has noticed.”
And everyone in the room shares a good laugh.
Or, more likely, the tax attorney begins shifting uncomfortably in their seat the moment they see the problem -specifically, that there are a lot of erroneous returns filed by your client that have not been caught and may realistically never be. The obligation (or lack thereof) to file an amended return to fix errors has previously been covered by Keith (co-author: Calvin Johnson) in an article here. In a different context, I have written about when you do or do not have an obligation to correct IRS mistakes here and here.
In this post I’d like to take the conversation in a slightly different direction. Specifically, I want to wrestle with the issue of advising clients on exposure to future audits -a thorny topic in the tax community.
In my most recent post I covered a TIGTA report suggesting improvements to correspondence examinations, prompting my own suggestions to focus more on high-income earners and non-filers. That same TIGTA report included a raft of recommendations for examining taxpayers that appear to have the same tax issue over multiple years (“subsequent year exams”). Those recommendations are what caught my eye and inspired this post.
TIGTA’s concerns were that the IRS didn’t appear to be initiating as many subsequent year exams as it should, and the IRS could increase efficiency by considering subsequent year returns as part of the already open exam. In a nutshell, TIGTA’s recommendations hinged on the idea that if a taxpayer erroneously claimed a deduction/took a credit in one year, there is a good chance that the same deduction/credit is erroneous in the next year as well. And I’d say that is a fair assumption. But it carries some interesting considerations that I believe tax practitioners should be aware of.
The recommendations put forth by TIGTA were more narrowly focused than just increasing audits on those that have been audited already. For one, it pertained only to subsequent returns with the same issue identified as in the year audited (the same “project code”). Second, it focused on taxpayers that actually resulted in an increased assessment of tax, thereby filtering out those who were selected for exam but ultimately demonstrated that their return was correct. Third, and importantly, TIGTA particularly keyed-in on subsequent returns where the taxpayer defaulted – that is, where they never responded to the exam in the open year and had similar identified issues in subsequent years.
“Silence is Violence”
A key takeaway from this may be that when the IRS selects you for examination, generally the worst thing you can do is to do nothing at all. The TIGTA recommendation (which IRS management agreed with) is to “change the subsequent return process to address only subsequent year returns in which the taxpayer did not respond to the [Initial Contact Letter] for the current examination.” Page 12 of the TIGTA Report (emphasis added).
In other words, if you don’t do anything (or don’t respond to the very first letter) it may carry worse consequences than if you respond with a full concession owning up to your error. Apart from just doing the “right thing,” it may be in your self-interest to proactively agree with the IRS rather than just letting things run their course.
Note also that the IRS also has internal policies against “repetitive” audits. They are a bit narrow (I covered an unsuccessful attempt to raise the policy in court here) and don’t apply to Schedule C returns (even though the prohibition is explicitly mentioned on the IRS Publication for Schedule C Filers: Pub. 334, page 45). However, whatever protections the policy does offer are more likely to apply when the taxpayer actually responds to the audit. See IRM 22.214.171.124.2.
All of this taken together, I think, should factor into any advice that is given to a client. I think it is important to impart the wisdom you’ve gleaned as a practitioner on the black-box of audit: “if you don’t respond to the IRS letter, there may be a heightened possibility that you will be audited on subsequent years.” If I was the average taxpayer that is definitely something I’d want to know and take into consideration.
The Audit Lottery
And now, the backlash.
“You can’t advise your client on the likelihood of audit!” Chants of “audit lottery!” and “Circular 230!” drum in the background as the torches are lit. My demise (the stripping of my ability to practice before the Service) is nigh.
Or so it would seem. But only based on a misunderstanding of what prohibited advice about audit likelihood actually entails. When I talk to (or test) my students about the “audit lottery” some take that it to mean you cannot talk to a client about audit risks. Period. In this understanding, when a tax lawyer reads the (publicly available) IRS Stat Book and sees the (abysmal) exam rate, that knowledge is forbidden fruit. One must never utter a word of it to the innocent, untainted client.
This misunderstanding of the audit lottery is not limited to students. There is, in fact, enough confusion about the topic that Professors Michael Lang and Jay Soled wrote a helpful article in the Virginia Tax Review on it here.
To be clear, there is no blanket prohibition on telling clients about audit rates and general likelihoods of audit. Consider the absurdity and inability to effectively counsel or communicate, while meeting the requirements of the MPRC (specifically MRPC 1.4) if such a blanket prohibition did apply. As an example:
I frequently have clients where the problem is that their ex claimed a child of theirs. The client is the custodial parent and has the right to claim their child under IRC § 152. However, the ex was first in the race to the e-file button. Because of this, any subsequent attempt to claim the child (generally through a paper return) will very likely trigger an exam. I know this both from experience as a tax practitioner and because of my familiarity with “whipsaw” and “correlative US Taxpayer” procedures. See IRM 126.96.36.199.
Am I not allowed to tell my client that if they do file a paper return claiming the child they are at a high risk of audit?
Believe it or not, audit exposure is something that matters to clients even when they are 100% substantively right on the return position. Some of my clients simply would rather not deal with the IRS or, importantly, the ire of their ex. Similarly, I know of a few people that claim a smaller charitable deduction than they actually are entitled to solely because of their (inflated, inaccurate) fear of audit. It is wholly within these taxpayers’ right to make that determination, since they are not legally required to claim the child or the charitable contribution, but only have the right to do so. For a discussion on that point, see the law review article, “No Thanks, Uncle Sam, You Can Keep Your Tax Break.”
So in advising the client with a previously claimed child, what must I do? As a lawyer and as a counselor, I would go so far as to say under the Model Rules I must disclose the risk of audit to the client in that situation, rather than keep it stored away as secret knowledge. To me, a lawyer in that situation should advise the client that on the information they have: the client is entitled to claim their child if they wish, but they are at a heightened risk if they do so. The lawyer should then calm the client down and explain what an audit would actually look like in these circumstances (a few letters back and forth), so that they can make an informed decision about what they’d like to do. To me, getting the client to a more-fully informed decision considering the myriad legal and non-legal issues at hand is the bedrock of being a counselor. See MPRC 2.1.
All of this is to say that one does not “play” the audit lottery simply by speaking of or considering audit likelihood. The prohibition is on advising individuals to take a return position based on the likelihood that it might be “caught” in audit. You play a lottery hoping you win, not simply for the fun of playing. Winning, in the prohibited sense, is having a questionable (or crazy) return position pass by the IRS because of their low audit rates rather than the merits. And you cannot let your knowledge of the odds of success (in this case, the perversely high chance of winning the lottery) color your responsibilities towards the IRS. See, e.g. Circ. 230 § 10.22, 10.34 and 10.37.
Now, rant completed, let’s bring this back to advising someone as to whether they should respond to an IRS letter after an audit has been initiated. In this case you are not counseling them on prospectively taking a return position at all. If they’ve made that same mistake year-over-year, the position has already been taken before they even came to you. What you are doing is simply letting them know that failing to respond to an IRS audit might make future audits more likely. If that is true (and there is reason to believe it is), it is unclear to me how keeping that important information to yourself doesn’t run afoul of your many responsibilities to the client under the MPRC (loyalty and communication, foremost among them).
I want to close with a note to those feeling squeamish about the preceding paragraphs: I feel your pain. If someone has previously taken an incorrect tax position I counsel them to change it. I want them, genuinely, to change it, because I believe we all have an obligation to pay the correct amount of tax. However, I cannot tell them that they must change it, because that would be my imposing my own personal morality on a legal question that has different considerations. (Note that this all changes if and when there is an actual controversy for that tax year before the IRS.)
But there is more to this than just hand wringing and pleading that someone do the right thing while acknowledging they don’t technically have to. Once the taxpayer knows (through the counseling of their tax attorney) their position is untenable they cannot freely take that position in as-yet unfiled tax years. Now, your advice changes: “Look, you should fix the back years, but you don’t technically have to. However, now that you know those positions are wrong, you cannot take them moving forwards and if you do there could be criminal exposure.”
Thus, the tax attorney sleeps at night.