Some taxpayers take some comfort in the fact that fewer returns are audited by the IRS. This is small comfort for those who find themselves across the table from an IRS agent. Here are some tips on preparing and dealing with an IRS examination from former employees of the IRS.

The chances of your tax return being examined by the IRS have fallen to an all time low. Taking too much comfort in this and not being prepared for such an experience is much like a nonswimmer, without a life preserver, wading into a stream "averaging" only three feet in depth at the crossing point.

While the overall examination coverage by the IRS is very low, it concentrates at the extremes of the filing population, i.e., the largest corporations, wealthiest individuals, and individuals who fail to report income from Forms 1099 on one end and wage earners with no Schedule C or F income at the other end. Nevertheless, the strategies for avoiding your worst fears are in many respects similar at both ends of the spectrum.

In our discussion of the best strategies, we focus on steps in preparing for and in dealing with an IRS examination. While not all inclusive, the following should be considered in almost every situation of any consequence.

Plan Ahead

Begin today. Include as part of each important transaction a consideration of the documentation that will be necessary to defend your tax position in the event of an examination. For example, a taxpayer who operates a horse farm will predictably encounter a challenge upon examination by the IRS under IRC Sec. 183 on "activities not engaged in for profit." One key element to the successful showing of a profit motive is a documented business plan that, with certain assumptions, results in a future profit. Having such a plan before the beginning of operations or at the first of the taxable year under consideration could be the item that persuades the IRS to agree with the taxpayer.

Know the Specialization Programs

The IRS has initiated an industry specialization program and a market segment specialization program. The attached sidebar lists the industries in the latter program. Determine if your industry or trade is already targeted or likely to be included at some future point in these programs. Well-informed tax professionals know the industries already in the program, those currently under development, and are good at predicting those to be targeted in the future. Learn the issues in the industries being targeted and anticipate that issues in other industries may be applicable to yours. Avoid structuring transactions in a way that causes you to meet these issues head on.

An Ounce of Prevention

As in almost everything else, you get what you pay for in tax planning, record keeping, compliance, return preparation, and representation before and during an examination. There are numerous instances where a client's inadequate design of record systems and retention practices have caused insurmountable problems and unnecessary expense once an IRS examiner appears on the scene. In recent years, the IRS has relied more and more on producing revenue by challenging taxpayers who cannot document their positions by valuations, contracts, receipts, and contemporaneous documentation.

Don't Try to Delay the Process

Delaying an IRS agent or a large case examination team will only increase the number of issues and proposed deficiency, increase the costs of negotiation and settlement, and make resolution more difficult. The prime objective of any taxpayer regardless of size or type of return should be to move the process along and make certain that records, documents, and responses are delivered as quickly as possible. Do not be afraid to continually ask for progress reports as to the timetable for the various phases (initial inspection of books and records, requests for additional information, and proposed adjustments to income, etc.). Even for the individual who is examined in an IRS office audit context, it is important to be prepared to respond to all issues and conclude the examination in one visit if possible. Do not believe the standard IRS explanation that an examination is a routine audit. All returns are examined for a reason.

Retain All Options Until the End

During an IRS examination, a taxpayer should not agree to issues on a piecemeal basis except in extraordinary circumstances. It is good strategy to agree as to the underlying facts if there is no question as to intent or perception. The IRS uses the terms "agree" and "agreement" in concluding examinations. From a taxpayer's viewpoint, there should be no such concept. A taxpayer should retain all options until the issues have been presented, relationships between issues identified, penalty exposure determined, and related-party examinations have been concluded.

Try to Settle with Examiner

The best place to finalize any examinations is with the examiner. Not having an issue raised or having it eventually abandoned is the ideal means of settlement. Examiners have been known to do creative things to get "agreements." Although the IRS's official position is that this does not happen, they ignore the basic ingredient in any audit. All issues must have a factual basis and the examiner is the ultimate determiner of fact for resolved issues. In some cases, especially large corporate cases, the agreement looks a lot like an appeals settlement.

Not All Issues Can Be Settled with Examiner

Certain issues the examiner raises, however, are controlled centrally by the IRS and may not be resolved at the examiner's level. It is beyond the scope of this article to deal with this situation because there are so many strategies to pursue depending on the issues. Because these options range all the way from partial agreements to selection of the forum for litigation, the actions of taxpayers in response to information requests and statements of position can have a profound impact on the final results.

Stay Cool

Treat all IRS employees with courtesy and respect and, regardless of their actions, always be conservative in what you do or say. The advantage will always be with the person who keeps their "cool" in any dispute or negotiation. When things start to get out of hand, recess any meeting and bring in others with negotiating skills at the next meeting. Do not be afraid to ask for the participation of IRS supervisors or officials, but remember they may be more experienced and have an ability that exceeds the examiner's in identifying issues or government advantages.

You May Need a Specialist

Specialization in a complex world will often save time and money and more likely lead to success. Overwhelming the IRS with technical arguments, case law, and logic is frequently counterproductive.

IRS examiners who are being directed by others and are not thinking for themselves may merely accept materials provided in this context and pass it on to others who are trying to develop an overall litigation strategy. Specialists in practice and procedure, litigation hazards, and tax planning are becoming more of a necessary ingredient in any complex examination setting. Recognizing where the IRS is going and knowing its procedures are frequently the keys to a successful conclusion.

Get Agreement Beforehand

Closing agreements, advance pricing agreements, advance issue resolution, and other techniques may be used to provide finality to tax issues that are important in structuring matters such as sales and mergers or have an impact on some future events. In today's environment where pricing between U.S. entities and their foreign affiliates can have very severe financial consequences, taxpayers are taking advantage of new procedures for obtaining advance pricing agreements.

The IRS and Technology

The IRS is today In the process of "reinventing" itself. The changes that will occur in the next five to 10 years will change the way tax returns are filed and make it possible for the IRS to select returns for examination using information not previously available. The IRS has already stated it intends to require either electronic filing or the filing of tax returns in formats that can be input for processing by OCR (optical character recognition) or other scanning processes. The IRS admits there will always be a small percentage of returns requiring input in the traditional keypunch or transcription mode. However, the overall direction is the inevitable evolution of electronic filing in some media that will permit more precise identification of issues and fewer audits as they have been known in the past. The industry specialization program and the market segment specialization program are already identifying characteristics in returns that will more precisely identify issues that are more likely to produce additional revenue. This data is already being computer processed against returns for fliers in selected SIC (standard industry codes) to target returns for examination.

An analysis of current information of the number of returns examined, the net dollar yield as a result of the enforcement programs of the IRS, and the IRS's success rate In litigation brings into question how effectively examination resources are being used. If the changes currently in process are not successful in increasing compliance, we can only expect the day of a new tax system, such as the value added tax, will be hastened. In the meantime, only the well-informed or represented taxpayer will be able to undergo an IRS examination with a minimum of expense and hazard, avoiding burdensome procedures and unwarranted issues.

RELATED ARTICLE: IRS MARKET SEGMENT SPECIALIZATION PROGRAM

Air Charter(*) Architectural Services Art Dealers Attorneys(*) Auto Body Shops Auto Dealerships Auto Repair Shops Bail Bondsmen Beauty Shops/Barber Shops Bed and Breakfasts(*) Carwashing and Detailing Casino Gambling Cattle Check-Cashing Establishments Child Care Citrus Industry Commercial Banking Community Banks Construction, General Building Contractor Construction Industry Commercial Fishing Cooperative Housing Eating Places/Restaurants/Bars Electronic Components Emergency Care Clinics Employment Tax - Pizza Driver Entertainment Industry:

* Motion Pictures/Television

* Contracts - Audit Applications

* Foreign Athletes and Entertainers

* Theater - Live Performances

* Music (Nashville)(*) Extended Warranty Companies Federal Excise Tax, Coal Mining Financial Institutions Foreign Tourism Furniture Manufacturing Garment Contractor Garment Manufacturing Gas Distributors/Retailers(*) Grain and Milo Growers Grocery Grocery Stores Health Care Insurance Agencies Internodal Industry (Transport Containers) Jewelry Dealers Laundromats Life Insurance Liquor Stores Low Income Housing Credits Mining Activities (Small Scale) Ministers Mobile Cart Vendors/Caterers Mortuaries(*) Nursing/Rest Homes Oil and Gas Operators Parking Lots Passive Activity Losses(*) Pawn Shops Pizza Restaurants Plastic Surgeons Port of Houston Poultry Printing Real Estate Industry:

* Agents/Brokers

* Construction Recycling Reforestation Rehabilitation Tax Credit RTC Project (Forgiveness of Debt) Scrap Metal Seafood Purchases Selling Door-to-Door/Telephone Taxicabs(*) Timber Sales Tobacco Travel Agencies Trucking Industry(*) Used Auto Dealers W-8 Unreported Income Wine Industry

* MSSP Training Guides are available

A Steve Hidalgo, CPA, is national director, IRS Practice & Procedures with Ernst & Young LLP, Dallas, Texas. Walter T. Coppinger, CPA, is a consultant for Ernst & Young. Both authors are former employees of the IRS.