The IRS’s Examination Workhorse: The Correspondence Audit

The AICPA has had active conversations with the IRS over the past several years about the difficulties taxpayers face with correspondence examinations. This is an area that national taxpayer advocate (NTA) Nina Olson, in her 2009 annual report to Congress, calls one of the most serious problems facing tax administration.

While the IRS generally relies on correspondence, field, and office audits of taxpayers’ returns, the correspondence audit is the IRS’s examination workhorse. According to Olson’s report, 72% of all examinations in fiscal year 2008 were correspondence audits, a significant increase from 54% in fiscal year 2000. The NTA report suggests that this increasing reliance on correspondence audits has a lot to do with the fact that “IRS employees spent an average of only 1.6 hours in ‘direct time’ on each correspondence examination in FY 2008, as compared to 8.5 hours on each office examination, and 46.4 hours on each field examination” (National Taxpayer Advocate, 2009 Annual Report to Congress 158 (December 31, 2009)).

Correspondence audits are much less labor intensive, and more computerized and cost efficient, compared with other types of examinations. In general, in a correspondence exam the IRS mails a letter to the taxpayer, asking him or her to address a few limited issues on the tax return, often focusing on credit or deduction issues. Unfortunately, when receiving the letter many taxpayers either assume they made a mistake on their return and quickly send in a check to cover the IRS’s computation of the tax underpayment, or they ignore the response deadline set out in the IRS’s letter, which is often 30 days. If the taxpayer ignores the letter, the IRS’s computers automatically send out a notice of deficiency to the taxpayer.

To the IRS’s credit, it does acknowledge that it can make improvements to the correspondence audit program. Over the past several years, the IRS has actively engaged the AICPA and other stakeholders to identify areas for improvement in the program. The NTA report indicates that the IRS views correspondence examinations as “part of the overall strategy to close the tax gap by identifying issues which can be addressed through correspondence that may otherwise remain untouched by other compliance streams” (p. 163).

Olson believes that correspondence audits are more likely to obtain the wrong results because of communication problems and the limited scope of the audits. She contends that the IRS would be more likely to reach the correct conclusions if taxpayers were better able to communicate with an IRS representative in person or by telephone.

Olson’s report points out that an IRS multifunctional improvement initiative proposed a pilot program to develop tools and training addressing:

• The types of expenses allowed for a significant number of occupations;
• Acceptable documentation; and
• The use of sampling techniques in lieu of taxpayer documentation.

The IRS also has an internal joint project team that is considering a pilot program involving training and improved call routing for its telephone assistance lines.

The IRS’s goal for fiscal year 2010 is to expand the use of correspondence examinations to complex business and individual examinations. The AICPA will keep practitioners and taxpayers posted on further developments related to correspondence examinations.

OIC Program Revisited

Sec. 7122 gives the IRS the authority to compromise a taxpayer’s civil or criminal federal tax debt prior to referral to the Department of Justice. Unfortunately, taxpayers’ use of the IRS offer in compromise (OIC) program has been in steady decline over the past several years. According to the NTA report, the number of OIC applications filed by taxpayers has declined from approximately 120,000 in fiscal year 2001 to about 60,000 in 2009; the number of offers accepted by the IRS has fallen during the same period from about 40,000 to 20,000.

Due in part to both the dramatic drop in offer applications in recent years and the significant impact of the current recession on American families, IRS Commissioner Douglas Shulman has taken steps to promote the use of OICs by taxpayers. Shulman is encouraging IRS employees to show more flexibility when negotiating OIC applications, including considering the taxpayer’s current income and potential for future income. The standard IRS practice when reviewing an OIC has been to take into account the taxpayer’s earnings in prior years.

While Shulman’s directives to IRS employees should prove helpful in increasing the number of offers accepted during the current economic downturn, the Obama administration believes that more needs to be done with the OIC program. In the administration’s fiscal year 2011 budget, President Obama has proposed the repeal of Sec. 7122(c)(1). This provision generally requires a taxpayer submitting a lump-sum OIC (i.e., an offer of payments involving five or fewer installments) to submit a payment of 20% of the offer amount to the IRS at the time of filing the offer application. (Low-income taxpayers are generally exempted from the 20% payment requirement.)

The AICPA supports repeal of the 20% payment requirement because it believes the requirement discourages the submission of a large number of legitimate offers, particularly since the government does not refund the 20% payment amount should the offer be rejected or not accepted by the government. At this writing, repeal of Sec. 7122(c)(1) is under active consideration by Congress.

EditorNotes

Benson Goldstein is senior technical manager (taxation) at the American Institute of Certified Public Accountants in Washington, DC, and is staff liaison to the AICPA ’s IRS Practice and Procedures Committee. For more information about this column, contact Mr. Goldstein at bgoldstein@aicpa.org.