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.

Thoughts on the Corporate Audit Lottery (2/11/12)

The audit lottery is a gambit in which taxpayers claim tax benefits to which they are not entitled in the hope that the IRS will never audit the returns or, if audited, the improper benefits will not be discovered.  The audit lottery is simply an attempt to exploit the IRS's limited resources.  The IRS has limited audit coverage.  Most taxpayers are not audited and, when audited, tax benefits may not be reviewed.  The taxpayer wins the audit lottery if the IRS does not discover the improperly claimed benefits.

Taxpayers’ positions exploiting the audit lottery often are criminal in nature.  By criminal I mean that the taxpayer voluntarily violated a known legal duty.  This is often referred to as the Cheek definition of willfulness which is the standard for most tax crimes (e.g., tax evasion in § 7201, tax perjury, in § 7206(1) and aiding and assisting in § 7206(2)).  Taxpayers’ whose conduct is criminal are playing the audit lottery.  Very few of them would engage in that conduct if they knew they would be detected; hence, their conduct is explainable only because the probability of detection is sufficiently low that the risk / reward ration is quite favorable.  For reasons, I describe below, the audit lottery is not limited to criminal misconduct. Taxpayers merely taking super aggressive positions, positions they know are not likely to prevail but are not criminal, may also play the audit lottery.  In either event, both types of taxpayers seek to exploit the IRS’s limited ability to discover, understand and correct their erroneous tax benefit claims.

In this blog, I analyze the audit lottery through the perspective of the criminal tax regime and the civil tax penalty regime.  Both regimes offer penalties for misconduct with respect to claiming improper tax benefits.  The criminal penalty risks can usually be practically eliminated by sophisticated, well advised taxpayers, so that the only penalty risks to playing the audit lottery are the civil penalties.  Perversely, the civil penalties are too low to encourage aggressive taxpayers to forgo the audit lottery.  I therefore focus here on the civil tax penalties.