A centerpiece of bankruptcy law is the concept of an “automatic stay.”    The automatic stay stops creditors from calling and writing to enforce or collect a debt from you.  The “stay” on your creditors – including the IRS – starts the minute you file bankruptcy. 

The automatic stay is why the IRS will immediately release a levy if you file for bankruptcy protection. 

But can bankruptcy stop the IRS from conducting an audit?

Bad news first:  Although bankruptcy can be pretty absolute on the IRS, it falls short of being able to slow down an IRS audit.  The bankruptcy stay does not apply to IRS audits and will not stop them (Bankruptcy Code section 362(b)(9)). 

Here’s the good news:  Bankruptcy can, however, eliminate any taxes, interest and penalties you might end up owing after an audit is completed.  The timing of the filing of the bankruptcy is important – among other conditions, you have to wait 240 days after the audit is final to be able to bankrupt an audit result.  

IRS audits are often painstaking, but there can be light at the end of the tunnel.  You may not be able to stop the machine, but bankruptcy can clean up the damage.

Thanks to the tax case of Cohan v. Commissioner,39 F. 2d 540 (2d Cir. 1930), the IRS will allow expenses even if receipts and checks are missing.

All you need is a reasonable basis to recreate the expense and credible testimony that you actually spent the money.

The Cohan case is law, and is followed by the IRS and the U.S. Tax Court.

Examples of using the Cohan rule:

A mileage log can be recreated if the basis for it is reasaonable – a calendar, for example, showing appointments.  Ever hear of a realtor who sells houses without travel?  A reasonable basis exists for the expense.  A realtor would make a log book from a review of her calendar showing open houses, supplemented by an affidavit providing an overview of how business is conducted. 

For a flooring contractor to his subs, for example – labor expenses can be proven by recreating the jobs performed and the manpower used.  Carpet and flooring does not get laid by itself – a statement as to how the business was conducted supports the expenses.  No reciepts, but there is a basis to recreate and prove the expense.

In many cases, your testimony is valuable support for the reconstructed evidence.  In IRS audits, your testimony can be given in the form of an affidavit (a sworn written statement) of facts reciting how you paid the money.

Audit Reconsideration for missing records.

If your audit has already been completed and you are looking at a bill that is too high, the audit can be reopened to allow you to recreate expenses.  This is called audit reconsideration.

The Cohan rule, as it is known, is almost 70 years old, but it has withstood the test of time.  The decision still stands - direct records are not needed to verify an IRS expense deduction.  If you can reconstruct the evidence, you can use that to make an reasonable estimate for the deduction.

You are not a professional record-keeper.  Fortunately, thanks to the Cohan rule, you can overcome holes in your recordkeeping.

There is good news – IRS auditors are not the end of the road.

Before the IRS can finalize an audit, they are required by law to give you rights to dispute it in federal Tax Court and with an IRS appeals officer.

Before the audit becomes final, the IRS must notify you of your rights to dispute it.  This letter called a “Notice of Deficiency.” The Notice of Deficiency gives you a very important legal right – to take the IRS audit to Tax Court and have an independent judge review it.  You will have 90 days to file a “petition” to Tax Court after the IRS sends you the notice of deficiency. If the 90 days has already expired, you may qualify for audit reconsideration instead.

Before the IRS goes to trial, they will send your case to an IRS Appeals Officer for settlement.  The IRS Appeals Officer’s job is to settle the case based on how a judge would rule, not an auditor.  IRS Appeals Officers have flexibility not always shown by IRS auditors.  Most IRS examination cases settle this way with results not available from an auditor’s point of view.

Tax Court judges and IRS appeals officers perceive cases differently from IRS auditors.  If you are right, you can testify to it – summarize to the appeals officer what you will tell the judge. If the IRS – in preparation for trial – sees that their auditor was being unreasonable, they will most likely make attempts to settle the case on the basis of how an independent judge would rule.

The auditor often has a small view of your case and does not consider how outsiders would decide it; that changes when the final decision is not that of the IRS, but is put in the hands of the Tax Court.

An IRS Revenue Officer is in collection enforcement. Often, the first contact you will receive from a Revenue Officer is an unannounced visit to your home or office.  Revenue Officer’s collect taxes and pursue nonfilers.   Revenue Officers work in your town.  They want financial information to determine the best way to collect the taxes (or not collect them, if it would create a hardship).  Revenue Officers carry badges and can take your wages, bank accounts and other personal and real property if there is a lack of cooperation.  The goal is case closure representing your ability to repay.

An IRS Revenue Agent audits tax returns for the IRS. Like Revenue Officers, Revenue Agents may want to meet you at your business, or ask that you come to an IRS office.  You will get notified of the audit by mail – no unannounced surprise visits.  Common audit triggers include Schedule C businesses and expense deductions not in reality with your stated income (like claiming $10,000 in charitable contributions on $40,000 in income). Audits are usually about finding money that you should owe on the return, but it can turn criminal if the Revenue Agent finds significant unreported income or fraudulent deductions.

IRS Special Agents are criminal investigators. In addition to criminal referrals from Revenue Agents (auditors), Special Agents can receive cases from Revenue Officers (collectors).  Examples of Revenue Officer collection referrals include lying about your finances and assets, or intentionally failing to pay employment taxes.  Special Agent priorities also include non-filers, concealing income off-shore, and tax returns prepared to obtain fraudulent refunds. If you are under criminal investigation you most likely will be the last to know, with Special Agents making an unannounced visit to question you.  They often know the answers to their questions.  Stop, state you wish to contact an attorney, and respectfully decline to answer.

Of course, you can come in contact with an IRS employee in the strangest of places and not know it.  When I worked for the IRS as a trial attorney, I was at dinner at Benihana, and at my table were two businessmen talking very loudly about how they cheated on their taxes.  You never know.

Although they disagreed with the audit, they did not understand the need to take the dispute to IRS appeals or Tax Court.  As a result, the audit became final, and IRS collections followed.  In many cases, there was a lack of understanding on how to deal with an IRS auditor and present documentation.

There is a solution to these frustrations:

It is called IRS audit reconsideration.  If you went through an audit that has become final, but you think the IRS did not adequately consider your arguments or you have additional information to submit, a request can be made for the IRS to reopen the audit so you pay the correct amount of taxes.

Authority for IRS audit reconsideration can be found in Internal Revenue Code 6404(a), which allows the IRS to abate a liability if it is erroneous, and in Internal Revenue Manual 4.13, “Audit Reconsideration.”  The IRS does not take any collection action while they are reconsidering the audit.

It is best to have all documentation compilied ahead of time and submitted with the audit reconsideration request.  For those situations where you are entitled to a deduction but your records may be lacking, the use of affidavits and documentation reconstruction is a strategy accepted by the IRS as a means to telling your story.

At the conclusion of the audit reconsideration, the IRS will either abate the liability or issue Letter 2726 (full disallowance) or Letter 2737 (partial disallowance).  If you still disagree, you will then have 30 days to file a request for a hearing with an IRS Appeals Officer for additional audit reconsideration.  See Internal Revenue Manual 4.13.4.7 and 4.13.6.1.

Although reopening the audit is discretionary with the IRS, they do have a public interest in collecting the correct amount of tax.  Audit reconsideration can be the avenue to not only stop IRS collections, but pay what is really owed.

Expect enhanced IRS enforcement in the coming years from the increased staffing.  Enforcement hires will be in training first, then be dispatched to the field and mentored by senior personnel.  Check out what is available at the IRS website. 

Having worked for the IRS as a trial attorney in the Office of Chief Counsel, it is a good place to be – I received great experience there and made many friendships that I still maintain.  You may just find that the IRS agents you fear are really not all that bad behind the scenes.  Sometimes, they have a job to do.

Here are some ways to get problem IRS audits resolved:

1.   Try to work it out with the manager.  Every auditor has a manager. Sometimes, a call to the manager can resolve thorny issues.   

2.   Take the case to IRS appeals.  IRS Appeals Officers settle cases on what is known as the “hazards of litigation” – meaning if you went to Tax Court, what would an impartial judge say about your case?  Auditors rarely consider that, which is often the cause of the bottleneck.  

3.   Go directly to Tax Court.  If you are at a standstill, request that the auditor close the case out and issue a Notice of Deficiency so you can take your case directly to Tax Court.  

An advantage to going to Tax Court first and then conducting settlement negotiations is that the trial is real.  The “reality” of a pending trial can help negotiations, especially if the IRS evidence is weak. See my prior post “Tax Court – providing a level playing field in IRS audits.”

4.  If you already are getting billing notices from the IRS, request audit reconsideration.  If you did not take advantage of going to IRS Appeals or Tax Court and you are getting billing notices for an amount you do not owe, you can still request that the IRS reconsider the audit after the fact.  You do not need to overpay your liability if you have documentation that supports your position and it was not adequately considered during the audit.     

The Internal Revenue Manual states that if you are contacted by the IRS, and had a similar issue examined by them in either of the two prior years, and there was no change or a small change in the tax from the audit, the new examination will be discontinued.  If a substantive tax change resulted from the prior audit, the IRM provides that the repetitive audit procedures do not apply and the examination will go on. 

The issue in a potential repetitive audit is whether the prior case had a small change (discontinue) or a substantive change (continue).

What if the IRS accepts 97% of taxpayer verifications in a one year audit, resulting in a $5,000 tax deficiency, but seeks to audit the next year’s return after completing the audit?  This is a real life case currently pending with one of my clients before the IRS, involving a successful real estate agent who was able to verify 97% of auto mileage, subcontractor labor and match income on the return to that on his bank statements.  But the IRS wanted to audit a second year.   

Isn’t a 97% verification rate saying the taxpayer is abiding by the laws?  Or is a $5,000 deficiency substantial enough to continue on?  IRS Policy Statement 4-21 provides that auditors are to make efficient use of examination staffing and resources and promote the highest degree of voluntary compliance.  How does this situation fit within that directive?  Is further pursuit of a 97% verification rate promoting more voluntary compliance?   

There are no limitations by law as to repeat audits.  The limitations are administrative and discretionary within the IRS from the Internal Revenue Manual.  That being said, if you are being audited and the IRS has found minimal changes, but wants to go into other years, be sure to assert your rights against repetitive audits.

I recieved a letter to meet an auditor from the IRS to audit my 2005 – 2007 taxes. My house was broken into several times, and I don’t have any of my paperwork to show deductions. My computer was also taken the first time, and I did fill out a police report. What will happen if I don’t go to the audit, or if I go without anything?

There are many issues raised here, all important.  

1.     Poor records/lost records for the audit.  Of course, the best case for an IRS audit is to have perfect records.  Few people do.  And that, believe it or not, is okay.

There is a well-recognized U.S. Tax Court case that permits recreating expenses when direct records do not exist.  The case is Cohan v. Commissioner, 39 F. 2d 540 (2d Cir. 1930).  Cohan established a rule that permits estimates to be made of paid expenses when direct proof does not exist. To make the estimate, a foundation has to be laid that the expenses were actually incurred.  Here is a real life example:

Over-the-road truck driver hauls furniture for individuals moving cross country.   He subcontracts in each city with laborers to load and unload the personal belongings of his clients.  He cannot load and unload the furniture by himself.  But he pays in cash, no receipts.  Over $80,000 in expenses for this were being questioned by the IRS, a significant amount.

As a beginning premise, we knew he incurred the expense – couches and refrigerators do not move by themselves.  So, we recreated from his travel log and calendar each job he did.  He knew that if he moved 10,000 pounds of furniture, it would take two men a total of 8 hours to complete the job, and the going rate was $150/day.  He recreated a spreadsheet for each day, listing the city he was in, his recollection of the weight of the load, how many men he used and the time it took to complete the job.  

This took some work, but an $80,000 deduction was on the line.

The IRS allowed everything he recreated.  We were able to establish that the amounts were actually paid, and a reliable method was used to prove it. 

I have had similar cases, for example, for an owner of a landscaping company, who paid his subcontractors in cash and kept no receipts.  Those lawns were not mowed by themselves.  Jobs and customers were recreated, detailing how many workers were used per job.  This Cohan method of recreating expenses has been applied to have the IRS allow other expenses like charitable contributions, or business miles driven by a real estate agent (recreating a mileage logbook).  Cohan is an important rule that should be used to alleviate a harsh result in cases where perfect records do not exist to prove expenses that were clearly paid.      

2.     Understand who you are dealing with.  IRS auditors sometimes take very narrow views of substantiation cases.  But if you cannot reach an agreement in audit, you have the right to have an appeals hearing or to take your case to U.S. Tax Court.  In appeals, there is a broader view of your case.  The question appeals officers ask themselves is “If this case went to court, what would happen?”  If you can testify to a reasonable basis to the expenses being incurred, appeals officers will likely allow a portion of the expenses. Appeals officers try to replicate what a Tax Court judge would do.  Auditors are often too distant from that reality, and usually do not allow enough leeway.   See my prior post “Tax Court – proving a level playing field in audits.”

3.     Do not ignore the audit.  If you do, the IRS will send you what is called a “Notice of Deficiency.”  This is your notice that the IRS has found a “deficiency” in your taxes, and calculates the tax, interest and penalties they are charging.  If you ignore this notice, the amount becomes final and the IRS will start collection activities.  Participate in the audit to the extent that you can determine if the auditor is open to application of the Cohan rule (they should be).  If the audit is not going your way, exercise your rights to have an appeals hearing, and if necessary to have your expenses reviewed by the Tax Court.  If you are entitled to it, you will be allowed expenses equal to the level of your credibility.   

If you incurred the expenses, do not walk away from the audit.  There are methods to recreate the expenses and reach the correct result.  

I had a recent case in which a Revenue Officer sent my client a notice stating that that there would be an interview at my client’s house.  These meetings usually take place at an IRS office.  It was a somewhat bold move to request access to a personal residence for an interview in a collection case, especially because my client lived with her mother.  This made my client very uncomfortable, for good reason (then again, wasn’t that the point of the IRS request?).

Here is my response:

     1.     The IRS has no right to access a taxpayer’s private living quarters or business without the permission of the taxpayer or a court ordered writ of entry.   Sometimes it makes sense to grant permission or access, but not this time.

     2.     Under Internal Revenue Code 7521(c), the IRS cannot compel the presence of a taxpayer at a meeting if the taxpayer has representation. 

     The relevant parts of Section 7521 state as follows:

Any attorney, certified public accountant, enrolled agent, enrolled actuary or any other person permitted to represent the taxpayer before the Internal Revenue Service… who has a written power of attorney executed by the taxpayer may be authorized by such taxpayer to represent the taxpayer in any interview…(a)n employee of the IRS may not require a taxpayer to accompany the representative in the absence of an administrative summons issued to the taxpayer.

The taxpayer is not required to meet with the IRS if there is representation.  If the representative is not going to be at the client’s house or place of business, then there is no meeting.  The Revenue Officer is required to meet with the representative, and that would either be at the representative’s office or at the IRS. Compelling the taxpayer’s attendance can only be done with a summons, which was not present in this case. The IRS was testing the waters on this one.  

There can be circumstances where access to a personal residence or business can be beneficial.  A Revenue Officer once drove by my client’s mobile home and stated afterwards that she believed (correctly, I might add) the case would be uncollectible.  

As a general rule, cooperation and good communication is essential in dealings with the IRS, but that must be tempered with knowing when to say no.