Everything, Everywhere, Audit Once

In the Best Picture Winner Everything Everywhere All at Once, the action kicks off in an IRS office while the main character, Evelyn, unsuccessfully attempts to substantiate her positions during an audit. Throughout the film, as she engages in fistfights, crosses through the multiverse, and tries to heal her family, the looming threat of losing her business due to an audit is as much of an existential threat to her life as the end of the universe. 

Most taxpayers would likely feel as lost as Evelyn crisscrossing the multiverse if faced with an audit. The audit process can be complicated and confusing, and require significant time and effort to successfully navigate. Taxpayers, especially small business owners, can be more confident in the positions they take if they understand their obligations to keep records and how the audit process works. 

IRS Audit Practices

The process begins when the IRS selects a tax return to examine (“audit”) to verify that the tax reported is correct. The IRS selects which returns to examine using a variety of methods, including: 

• Computer Scoring – Some returns are selected based on numeric “scores” determined by computer programs:
  • The Discriminant Function System (DIF) Score rates the potential for change, based on past IRS experience with similar returns, and
  • The Unreported Income DIF (UIDIF) Score rates the return for the potential of unreported income.

IRS personnel then screen the highest-scoring returns and select some for audit. The IRS identifies the items on these returns that are most likely to need review. Some returns are selected for audit due to specific concerns, such as:

• Information Matching – Some returns are examined because payor reports (e.g., W-2s or Forms 1099) do not match the income reported on the tax return.
• Related Examinations – Returns may be selected for audit when they involve issues or transactions with other taxpayers whose returns were selected for examination.

Examinations may be conducted by mail or in-person and include a review of the taxpayer's records. The IRS will issue Form 4564, Information Document Request (“IDR”), to inform the taxpayer which items on the return are being examined, as well as a list of documents that must be provided to substantiate the items in question. The auditor may send additional IDRs during the audit to request clarification or if additional information is needed. 

Adjustments to Income

The law requires taxpayers to keep books and records to support positions they take on a tax return.¹ When a taxpayer is unable to provide documents to substantiate return positions, the IRS will make adjustments to the taxpayer's return. While the IRS can make adjustments to decrease or increase taxable income, in an audit it is much more likely the IRS will be making adjustments that increase the taxpayer’s taxable income. 

These adjustments may include penalties and interest, and usually result in an additional tax liability for the taxpayer. As shown in the film, some items that the IRS may look to disallow include unreported income, large depreciation deductions, unsubstantiated charitable contribution deductions, and large business expense deductions. 

Penalties

Failure to properly report income does not just result in an increase to income tax liability – it may also result in hefty penalties being assessed on top of the increased income tax. 

Negligence Penalty

The negligence penalty is imposed if the IRS concludes that a taxpayer’s negligence or disregard of the rules or regulations caused the underpayment.² Negligence is defined as “any failure to make a reasonable attempt to comply with the provisions of this title.” Disregard is defined as “any careless, reckless, or intentional disregard.”³ Negligence includes the failure to keep adequate books and records or to substantiate items that gave rise to the underpayment.⁴ Strong indicators of negligence include instances where the taxpayer failed to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion.⁵ The IRS can also consider various other factors in determining whether the taxpayer’s actions were negligent.⁶ 

The Substantial Underpayment Penalty

The substantial understatement penalty applies if an individual taxpayer understates their tax liability by 10% or $5,000, whichever is greater.⁷  An understatement can occur when a taxpayer understates income or overstates deductions.⁸  However, the Internal Revenue Code provides that a penalty shall not be imposed “if it is shown that there was a reasonable cause” and “the taxpayer acted in good faith with respect to the understatement.”⁹ Reasonable cause and good faith may be demonstrated by providing substantiation for items reported and legal authority that supports the position taken on the tax return. 

The Notice of Deficiency

Taxpayers who do not agree with the proposed changes may appeal their case administratively within the IRS or proceed to U.S. Tax Court, U.S. Claims Court, or the local U.S. District Court, depending upon the nature of the dispute.¹⁰ If there is no agreement at the exam level, the taxpayer typically has 30 days to consider the proposed adjustments and their next course of action. If the taxpayer does not respond within 30 days, the IRS will issue a Statutory Notice of Deficiency, which gives the taxpayer 90 days to file a petition to the Tax Court.¹¹

The Notice of Deficiency is a taxpayer’s “ticket to Tax Court.” The 90-day period is fixed by law and the U.S. Tax Court cannot consider a taxpayer’s case if the petition is filed late.¹² Once a petition is filed, the IRS cannot collect any tax or penalties reported on the Notice of Deficiency until the Tax Court decision becomes final.

The challenge for any taxpayer protesting a Notice of Deficiency in U.S. Tax Court is that the IRS is entitled to a “presumption of correctness.”¹³ The burden of proof is generally on the taxpayer to dispute and disprove adjustments proposed by the IRS. The taxpayer should be prepared to advocate and provide support for their return positions. 

While there is not much anyone can do to avoid an existential threat to the universe, to avoid facing a difficult audit like the one Evelyn endures in the film, taxpayers should ensure they can substantiate the positions they take on returns. Taxpayers who take large deductions, especially when they are self-employed, should engage a trusted tax advisor to be confident that these will withstand a potential IRS audit.

In This Issue:

• The IRS Resumes Automated Collection Notices in 2024
• Affordable Care Act Mistakes Can Result in Costly IRS Penalties to Employers
• Desperately Seeking Subject Matter Experts: The IRS Looks to Outsource Revenue Agent Training

¹IRC Sec. 6001.
²IRC Sec. 6662(b)(1).
³IRC Sec. 6662(c).
⁴Treas. Reg. Section 1.6662-3(b)(1).
⁵Treas. Reg. Sec. 1.6662-3(b)(1)(i)-(ii).
⁶These factors include the taxpayer’s history of noncompliance; the taxpayer’s failure to maintain adequate books and records; actions taken by the taxpayer to ensure the tax was correct; and whether the taxpayer had an adequate explanation for underreported income. Internal Revenue Manual Section 4.10.6.2.1. 
⁷IRC Sec. 6662(d). For corporations other than S corporations or personal holding companies, there is a substantial understatement if the understatement exceeds the lesser of 10% of the tax required to be shown on the return (or, if greater, $10,000) or $10M.  For any taxpayer claiming an IRC Sec. 199A deduction, the 10% threshold is reduced to 5%.    
⁸IRC Sec. 6662(a).
⁹IRC Sec. 6664.
¹⁰The U.S. Claims Court and District Court generally do not hear tax cases until after the tax is paid and administrative refund claims have been denied by the IRS. The tax does not have to be paid to appeal within the IRS or to the Tax Court. A case may be further appealed to the U.S. Court of Appeals or Supreme Court if those courts accept the case.
¹¹This period is extended to 150 days for taxpayer’s residing outside the United States. See IRC Sec. 6213(a). 
¹²IRC Sec. 6213(a). See also Culp v. Commissioner, No. 22-1789 (3d Cir. 2023). Section 6213(a) gives most taxpayers 90 days from the date the IRS mails a notice of deficiency to file a redetermination petition with the U.S. Tax Court. 
After holding that the 90-day deadline is non jurisdictional, the Third Circuit found that equitable tolling—which pauses the running of a statute of limitations in certain circumstances—can apply to the deadline.
¹³Welch v. Helvering, 290 U.S. 111 (1933)