Anticipating Tax Litigation… And the IRS (Part 1 of 2): Tax Filing and Maintenance Tips

Despite the relative rarity of an individual taxpayer’s file being brought to United States Tax Court or even audited, many taxpayers nevertheless fear the Internal Revenue Service (IRS) coming after them. This is not without good reason. Responding to an IRS audit alone can be time consuming and involves obtaining and compiling numerous documents. That burden – and cost – only increases when it comes to civil litigation or criminal prosecution.

Tax professionals, who work on compliance and tax planning, can help their clients avoid costly enforcement measures. If they are prepared, tax professionals and their clients can even anticipate what tax litigators and defense attorneys could ask for when preparing a case with the IRS. This article, which is part one of two in a series, offers some practical tips for tax professionals working in tax compliance and planning to better position their clients for possible civil or criminal federal enforcement action. It offers advice on preparation to best protect both client and preparer so that any case with the IRS can be resolved more easily, if not avoided altogether.

Creating a Client File

Under Internal Revenue Code (IRC) § 7602, the IRS may examine any books, papers, records, or other data which may be relevant to their inquiry into the correctness of a return, to make a return where none was made, and to determine the liability of a person. For that reason, it is paramount that taxpayers and their tax professionals possess a well-maintained audit file. The IRS may inquire into, for example, the correctness of a return through an Information Document Request (IDR) or more formal – and less frequent – IRS “summons” procedures. There is no requirement for probable cause for the IRS to believe a violation of tax law has occurred. In responding to the IRS’s IDR or summons, it is to the tax preparer’s and taxpayer’s advantage to have all information and documentation relevant to their case ready for submission. Failure to obey a summons or IDR can result in contempt proceedings under IRC § 7604.

Having a well-maintained audit file means a client’s documentation is correct, current, and complete. If a client’s file is well-maintained, not only can the client and tax professional timely respond to IRS demands, they can also properly respond to IRS information requests. The IRS agent reviewing a taxpayer’s case may request information pertaining to positions taken on a given tax return. With a well-maintained file ready, the tax professional and client can more easily review documentation and recall information that may not be documented but is nonetheless required for possible testimony under oath.

In terms of organizing a client’s file, it is recommended that information and documentation be sorted by each deduction claimed or item of income reported. It is best to not commingle generated workpapers, memoranda, or other materials relating to specific positions taken. Tax planning and other non-return issues are unrelated to the preparation and filing of the return, and they should be treated accordingly. If tax preparation materials and tax return materials are commingled in a single document, for example, and the IRS demanded the tax return materials, the entire document, including the tax preparation materials, would have to be provided to the IRS. As a result, the unrelated tax preparation materials could create subsequent IRS inquiries. Thus, by avoiding commingled documents, it will be easier in the future, sometimes years later, to separate documents in the file that are responsive to an IDR, summons, or subpoena.

Finally, the tax preparer confidentiality privilege does not extend to criminal matters. See IRC § 7525. If a tax preparer or client is worried their case with the IRS may go too far, or become a criminal matter, it is recommended that they get an attorney. Under a Kovel agreement, the attorney-client privilege covers communications from a client to a person hired by the attorney to represent the client. That can include accountants, provided the Kovel agreement is properly administered. Materials then gathered on behalf of the taxpayer in anticipation of litigation may not have to be surrendered to the IRS.

Documenting IRS Submissions

Despite improvements from funding received in the Inflation Reduction Act of 2022, the IRS is still understaffed and has a long backlog. In some cases, taxpayers’ items may even become lost after being sent to the IRS. That being the case, taxpayers involved in an audit or other tax controversy issue with the IRS should not necessarily relax from a long period of silence. The IRS may be continuing their work on the audit or, possibly, referring it for criminal investigation. To hedge against such dangers, taxpayers and their tax preparers should retain copies of anything they submit on paper to the IRS. Furthermore, a taxpayer’s confidentiality privileges with their tax preparer, and attorney-client privileges with their attorneys if they have one, can also work to their advantage.

To further protect their interests, materials sent to the IRS should be sent via Registered Mail or Certified Mail, and a return receipt requested. For the Registered Mail, the date of registration is treated as the postmark date and stands as prima facie evidence that the document was delivered to the address indicated. See IRC § 7502(c)(1). For Certified Mail, if the sender’s receipt is postmarked by the postal employee to whom the document is presented, the date of the U.S. postmark on the receipt is treated as the postmark date of the document or payment. See IRC § 7502(c)(2).

Many federal tax returns are required to be submitted electronically. A tax preparer should keep copies of all e-filed returns and the documentation confirming their transmission. For the purposes of its filing date, an e-filed document or return is typically treated as filed on the date of its electronic postmark. The IRS may take 24 to 48 hours to notify of a return’s acceptance/rejection; a copy of that notification should also be retained for proof of filing. Additionally, for the purposes of penalties and statutes of limitation, income tax returns and some information-reporting forms – such as Forms 3520, 5471, 5472, and FBARs – are not considered filed unless they are in compliance and filed with the correct office. Even if a tax preparer or client sends a tax return to an IRS agent at the agent’s direction, it will not be considered filed until it reaches the correct office.

While no methods can guarantee to keep the IRS at bay, taking certain filing and maintenance steps now can ensure that, should any issues with the IRS arise, those issues can be resolved more easily. Anticipating the sorts of things the IRS or a tax litigator may request only helps to demonstrate that the taxpayers has taken prudent care of their financial documentation. In the end, such steps may also save the taxpayer and preparer valuable resources, including both their time and money.