Monday, August 7, 2017

Tax Practitioners' Advice to Clients About the Audit Profile/Risk (8/7/17)

I thought readers might be interested in this recent article:  Michael B. Lang and Jay A. Soled, Disclosing Audit Risk to Taxpayers, 36 Va. Tax Rev. 423 (2017) (no link available).  The issue is whether tax professionals may advise clients as to their audit profile -- risk of audit.  There has been some confusion among practitioners about that issue because of the prohibition on considering risk of audit in assessing the merits of a tax return position.  The following is from the Highlight for the article:
When taxpayers file their tax returns, they are often worried about the prospect of an Internal Revenue Service (Service) audit. To date, the position of the Service and of professional organizations has been that tax return preparers cannot take into account audit risk in evaluating the merits of a return position. Some practitioners have broadly - and incorrectly - interpreted this regulation as a mandate against talking about audit risk with their clients. Taxpayers therefore often make their own assessment of their audit risk, relying on information sources such as the Internet and tax return preparation software. Given the uncertain reliability of such sources, it is appropriate to encourage more communication between tax return preparers and taxpayers on the subject of audit risk. 
This article argues that the Treasury Department and professional organizations should make it clear that tax return preparers may make full disclosure of Service audit risks to the extent this information is known. While this information cannot be used to evaluate the substantive merit of a particular tax return position, readily dispensing it would be emblematic of a transparent tax system and satisfy taxpayers' quest to more fully understand the tax return filing process. As such, the availability of Service audit risk information would be a marked improvement over the existing status quo.
Some key excerpts from the article (pp. 430-433 & 445-446, footnotes omitted):
III. Why Audit Risk Disclosure Makes Sense Today 
Outside the realm of calibrating potential penalty exposure, nothing in the Code, regulations, or professional standards precludes candid conversations on the topic of audit risk. Nevertheless, the myth of a universal prohibition of Service audit risk disclosure endures, making some tax professionals hesitate to provide audit risk projections. Aside from the myth itself, sometimes tax preparers' hesitancy reflects their lack of knowledge of the audit risk; in other instances, tax practitioners fear that aggressive clients might take untenable positions on their returns if they knew the unlikelihood of an audit. 
Notwithstanding this reluctance to disclose audit risk, legal and accounting ethical standards require the free flow of information between practitioners and their clients. n28 Cultural, technological, and social developments have also changed the tax preparation field, bolstering support for the proposition that tax practitioners should disclose audit risk to their clients. These developments, explored below, are threefold: (A) the availability of audit risk information, (B) more rigorous tax return submission and practice standards, and (C) more prevalent professional malpractice litigation. 
A. Ready Availability of Audit Risk Information 
Whether or not the tax profession or the Service cares to admit it, the availability of tax audit risk information is ubiquitous. Individuals can commonly find this information through the Internet and tax preparation software.  
As the Internet has evolved, it has become the primary source of information for many people, particularly the nation's youth. Within milliseconds, entry of a query can retrieve thousands of relevant documents that are directly on point. For example, a Google search of the phrase "IRS audit risk" delivers numerous articles on the topic. Some of the articles are informative; other articles are even interactive, allowing viewers to enter information and, in response, get individualized feedback based upon their personal circumstances. 
Another source of audit risk disclosure is tax software preparation packages such as TurboTax and H&R Block. These tax software preparation packages are widely used by the general public. In addition to helping taxpayers compute their tax liabilities, they all appear to offer another service: upon completion of the tax return preparation process, they assess Service audit risk and present this information to the taxpayer. For example, upon tax return completion, TurboTax sets forth a range from dark green to bright red with an indicator arrow; depending upon the data entered, this arrow will appear somewhere along this range, indicating the taxpayer's supposed audit risk.  
Whether the audit risk information that the Internet and tax software companies provide is accurate is an entirely different issue. Years ago, the Service developed computer algorithms, the Discriminant Function System, which produced a DIF score for a tax return. The DIF score is used to determine whether the tax return should be audited. To date, the Service has kept this information a closely guarded agency secret. The lack of  public accessibility to this vital information means that whatever is published on the Internet or presented to tax preparation software users is suspect, based entirely upon conjecture and speculation, rather than the Service's actual guidelines.
This is not to say that reliable tax audit information is entirely unavailable. On the contrary, every year the Service publishes reports that indicate critical data regarding those tax returns that are audited. This information is broken down based upon several different classifications, such as adjusted gross income and the kind of tax return (e.g., individual, corporate, or estate and gift). Other data indicate the average deductions in different categories for taxpayers with different levels of adjusted gross income. 
Those who thus publish Internet Service audit risk articles or write code for tax return preparation software production companies presumably extrapolate from the Service's published data to derive audit risk likelihoods. Whether the application of this information is accurate is virtually impossible to gauge. Therefore, as a practical matter, it would probably be better for tax practitioners - who are apt to be intimately familiar with each taxpayer's particular facts and circumstances - to provide audit risk information to their clients. 
* * * * 
V. Conclusion 
Taxpayers are constantly gauging risks and making important decisions based on such assessments. In their personal worlds, for example, if taxpayers suspect that their driving skills are lackluster, they may secure more life insurance or an umbrella automobile policy. Similarly, in terms of navigating business career advancements, they commonly weigh the advantages and disadvantages associated with various educational opportunities.In stark contrast, these very same taxpayers often cannot secure audit risk determinations from their tax advisers. 
Just as these taxpayers routinely make risk assessments in other spheres of their lives, they thirst for this information in the sphere of taxes; and if they cannot get it from their tax advisers, inevitably they will turn to less reliable sources. 
This analysis argues that full disclosure of audit risk be sanctioned and, furthermore, is appropriate when the tax adviser can provide a useful assessment. This is not to say that risk assessments should be used to determine whether (1) taxpayers have satisfied the tax return accuracy standards or (2) tax practitioners have met their professional standards; such standards must be satisfied independently of audit risk considerations. Once these standards are met, however, the Code and legal and accounting standards should expressly permit audit risk disclosure. This disclosure will enable taxpayers to better assess the sanctity of their tax return positions and, in addition, assess their associated degrees of comfort. 
Audit risk disclosure should yield several important by-products, including greater taxpayer compliance, fewer under-the-table shenanigans and eye winking, and stronger bonds cultivated between taxpayers and tax practitioners. Put somewhat differently, in this Age of Information in which we exist, the advice that tax practitioners render should be as complete as possible; it should not lack critical information that would help taxpayers make fully informed decisions.
JAT Comment:

1. I published an article with appendix in 2009 that dealt, in part, with related aspects of the issue of taking action that lowers one's audit profile and audit risk.  The concern was that such action might fall within the exaggerated sweep of the Government's claims for tax obstruction crimes -- particularly the Klein defraud conspiracy (18 U.S.C. § 371) and tax obstruction (§ 7212(a)).  Interested readers might want to take a look at the article and particularly the appendix with examples.  John A. Townsend, Tax Obstruction Crimes: Is Making the IRS's Job Harder Enough, 9 Hous. Bus. & Tax. L.J. 255 (2009), here, and the Online Appendix, here.

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