The federal tax gap has received much attention in the past two years. In her 2006 Annual Report to Congress, National Taxpayer Advocate Nina Olson identified it as “one of the most serious problems facing taxpayers today”; see www.irs.gov/advocate/article/0,,id=165806,00.html. In an effort to address this growing concern, the IRS has been increasing the use of correspondence examinations. In a 2006 report to Congress, Treasury Inspector General for Tax Administration J. Russell George reported that during fiscal years 2002–2005, face-to-face examinations increased by 25%, while correspondence examinations increased 170%. Correspondence examinations account for more than 70% of the Service’s total audit coverage, involving more than one million audits annually.
The IRS has a number of limited-contact programs in addition to correspondence audits, including programs on mathematical/clerical error abatement, unallowable items, information returns and the earned income credit; see Saltzman, IRS Practice and Procedure (Warren, Gorham & Lamont, 2d ed., 1991). Under these programs, Service Centers look for readily identifiable problems that can be resolved via correspondence. For example, under the unallowable items program, the Service questions items on individual returns that appear to be unallowable by law. Taxpayers whose returns are identified as containing unallowable items under this program are contacted by correspondence, and corrections are made to the return. Tax advisers should note that the IRS does not consider correspondence to a taxpayer under one of these programs to be an examination of a return, regardless of whether the return was changed or accepted as filed; see Internal Revenue Manual Section 126.96.36.199.1. As such, the Service is not precluded from future examinations of the taxpayer’s return and is not subject to the second-inspection prohibition of Sec. 7605(b).
With the increase in IRS correspondence compliance initiatives, practitioners should clearly understand the types of correspondence a client has received and respond promptly. For example, the most common IRS correspondence to taxpayers is CP-2000, Notice of Underreported Income (in effect, a 30-day letter). Failure to respond timely or in accordance with the notice’s instructions will result in the Service Center issuing a Notice of Deficiency (90-day letter) and could also subject the client to backup withholding under Sec. 3406(a)(1)(C). An amended return is rarely required; filing one at this point could result in more notices (requiring more responses) and a significant delay in resolving the issue.
Practitioners should give a correspondence examination the same due diligence and attention as an office examination. The tax adviser should first file Form 2848, Power of Attorney and Declaration of Representative. Next, he or she should review the issues raised by the Service Center to determine if they can be reasonably responded to by correspondence. If the matters are too complex to be addressed properly without a face-to-face discussion with an examiner, the practitioner should request that the case be forwarded to the area office for examination.
Converting the case to an office examination increases the possibility that the examiner will review the entire return or at least raise additional issues. The tax adviser should consider this when deciding how to proceed. Should he or she elect a correspondence examination, the response should include detailed explanations of each issue, including copies of supporting documentation, reconciliations or any other corroborating evidence that the taxpayer’s position on the return is correct.
As with a face-to-face examination, the practitioner should document the examination process. Responses and supporting documentation should be sent via certified mail, return receipt requested. Telephone conferences with the Service should be documented (1) in the practitioner’s files, identifying the agent’s name and badge number and the date and results of the conversation; and (2) by a written response to the IRS contact, outlining the practitioner’s understanding of the issues discussed and the resolutions agreed to.
Concluding a correspondence examination is similar to the office examination process. The Service will either accept the return as filed or issue a 30-day letter. The taxpayer then either accepts the IRS’s changes and pays the additional tax or files an appeal. Failure to respond or to file an appeal in 30 days will result in the issuance of a deficiency notice.
More Changes Needed
To address more completely the tax gap, additional informational reporting will be required. An Aug. 3, 2006 staff report by the Joint Committee on Taxation, “Additional Options to Improve Tax Compliance,” contains a number of proposals, including basis reporting by brokerage firms for sales of publicly traded securities and state and local government reports of real estate taxes paid; see http://finance.senate.gov/press/Gpress/2005/prg101906.pdf.
This increase in informational reporting will allow the Service to enhance its correspondence compliance programs.
Tax advisers should know the appropriate procedures for addressing Service Center correspondence. Just as important, however, they should minimize IRS correspondence to their clients by providing return information in a manner that allows the Service to reconcile the return with third-party information reporting.
Mr. Miller is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. Mr. Brennan is the chair, and Messrs. Snow and Tierney and Ms. Hodes are members, of that committee. For further information about this column, contact Mr. Miller at email@example.com.