• Tax Law
  • Understanding Tax Law
  • Avoidance Versus Evasion
  • Federal Tax Disputes
    • IRS Audit
      • Who Is Audited
      • Audit Process
      • Taxpayer Rights in an IRS Audit
      • Result of an Audit
      • Appealing an Audit
        • U.S. Tax Court
        • U.S. District Court
        • U.S. Claims Court
  • California Tax Disputes
  • Resources

There is a saying that the only two sure things in life are death and taxes. Tax laws affect all people and touch most areas of life, so it would be helpful if tax laws were simple, clear, and easy to understand. Unfortunately, the tax system that exists has none of these characteristics. Often, writing tax legislation involves so much compromise and redrafting that by the time a tax bill becomes law, its intent and application are unclear. Other tax laws might be perfectly clear as written, but it may be difficult to know how to apply the law to a particular taxpayer. Finally, different courts in different jurisdictions may apply the same law to similar fact situations and reach completely different interpretations, each of which is valid in that particular jurisdiction.

Tax collectors have an important task because they collect taxes and help ensure that everyone pays his or her fair share. One of the most effective ways to encourage people to pay their fair share of taxes is the existence of the audit. People know that cheating will be punished because the threat of a possible audit hangs over every tax return submitted.

Given its complexity, this chapter cannot describe all aspects of tax law. Instead, this chapter explains some of the ways consumers can manage tax disputes with the federal or state government.

There simply are not enough resources for the government to calculate everyone's taxes or to audit every return filed. The tax collection system assumes that most taxpayers will be honest when reporting their income and calculating their tax obligations. The government has many ways of checking the accuracy of information the taxpayer provides. Employers provide the Internal Revenue System (IRS) with employees' earnings, and financial institutions report the interest income their investors and depositors receive. Still, there is a tension built into the system. Taxpayers want to pay as little tax as legally possible but tax collectors want to ensure that taxpayers pay as much as they are legally obligated to pay. The terms "tax evasion" and "tax avoidance" are frequently used interchangeably to describe this tension, but the terms have different meanings.

To avoid taxes is to use legal means to limit one's tax liability. It is perfectly acceptable for a taxpayer to try to avoid taxes. Federal and state tax codes describe many ways a taxpayer can lower his or her tax burden. There are many ways to structure income to pay minimum taxes. There is nothing illegal in taking advantage of loopholes or shelters to avoid paying taxes. Tax evasion is using illegal means to get around paying one's taxes. It is illegal to evade paying legitimately owed taxes. Most taxpayers are tax avoiders. It is the job of tax collectors to find the tax evaders.

The IRS is the arm of the federal government charged with collecting federal income taxes. For most consumers, the federal income tax is the largest federal tax paid. Although the federal government collects taxes on a variety of different items, such as telephone calls, airplane tickets, cigarettes, and imported goods, most consumers never challenge these taxes. For this reason, this section focuses on disputes with the IRS over the federal income tax.

IRS Audit

Pity the poor IRS agent. It is a safe bet that no one looks forward to being audited. Even if a taxpayer does nothing wrong, an audit--also called an examination by the IRS--can be confusing, frustrating, disruptive, and time-consuming. IRS auditors know their task is not a popular one. They do not try to aggravate taxpayers on purpose. They, too, struggle with a huge bureaucracy and must make do with outdated computers and a complex tax code with many gray areas.

The IRS audits approximately three million returns annually. About two million of those taxpayers end up paying more taxes to the IRS.

Who Is Audited

The IRS has three primary methods of selecting which returns to audit. The first method is random selection. By choosing to audit some returns at random, the IRS promotes better voluntary compliance with the tax code. Because every return has a chance of being selected for an audit, taxpayers are more likely to be honest. Relatively few of the returns selected this way contain significant errors, but the IRS uses the results of the random audits to measure compliance with the law and to update and improve the overall tax collection system.

The second method is a computerized process in which the IRS separates out returns that it believes contain errors or are fraudulent. The computer program is fine-tuned each year based on the experience IRS gains from applying the tax code. Most of the returns selected this way have some unusual characteristic that raises a red flag for auditors. For example, if the IRS determines that very large deductions for entertainment expenses often reach the level of fraud, the computer can be programmed to separate out returns with unusually large entertainment deductions. If the IRS learns from its random audits that many people misunderstand a particular application of the tax code, the computer can be programmed to separate out all returns relying on that application.

An important point about this second method of selecting returns is that it is completely impersonal--any return raising a particular red flag is tagged by the computer. If a taxpayer has a particular circumstance that gives him or her an unusually large, yet legitimate deduction every year, the computer will select the return for audit every year. IRS auditors try to avoid repeat examinations for the same issue. Thus, if the IRS examined a taxpayer's return for the same issue within the previous two years and found in favor of the taxpayer, the taxpayer should call this to the attention of the IRS. Often, the audit is terminated without further investigation.

The third method for selecting returns for audit compares information provided by the taxpayer with information from other sources. For example, if someone reports less income on his or her return than is reported on the W2 Form provided by the taxpayer's employer, the IRS will audit to clarify the discrepancy.

Audit Process

The audit process begins when the taxpayer receives a letter from the IRS stating that his or her return has been selected for further examination. The audit may be done entirely by mail if the IRS has only a few questions. It may be at an IRS office if the IRS has more substantial questions, or at the taxpayer's home or business (called a "field audit"). The taxpayer can request that the audit interview be transferred to another IRS district if a different location is more convenient for the taxpayer.

Under normal circumstances, the IRS may not audit tax returns filed more than three years ago. For example, the deadline for the IRS to audit a 1995 tax return, filed by April 15, 1996, is April 15, 1999. Under certain circumstances, the three-year limit is extended. The IRS can demand records as far back as six years if an audit reveals that the amount of income the taxpayer failed to report on his or her latest return exceeds by 25 percent or more the income reported. Also, the IRS has no time limit if the taxpayer fails to file a return or if it determines that the taxpayer deliberately filed a false or fraudulent return.

IRS auditors almost always want to see financial records that relate to the return they are examining. This raises a commonly asked question: How long should a taxpayer keep records relating to income tax filings? The answer is generally three-and-a-half years, because after that time, the IRS typically will not audit the taxpayer, as described above. A taxpayer should keep financial documents longer than three-and-a-half years if they might affect future returns. For example, a person should keep records of stock purchases until the stocks are sold, because profit or loss after the sale must be determined and reported on the next income tax return.

Taxpayer Rights in an IRS Audit

Some taxpayers claim they are made to feel like criminals in IRS audits. The audit procedure differs significantly from a criminal proceeding, but may provide fewer procedural safeguards for the taxpayer. Unlike a criminal trial in which a defendant is presumed innocent until proven guilty, in an IRS audit the taxpayer must prove to the IRS's satisfaction that the information on a return is correct. For example, if the IRS questions a deduction for business-related travel expenses, the burden is on the taxpayer to show that he or she really did incur the amount of travel expenses claimed. If he or she cannot document the expenses, the IRS can disallow the deduction without offering any evidence at all.

A person has the right to ask the IRS to cancel a penalty in some cases. If someone pays less tax than owed, and the IRS discovers and penalizes the taxpayer for it, the taxpayer might be able to have the fine canceled if he or she reasonably followed IRS advice in calculating taxes.

The first step in proving that bad advice from the IRS caused a mistake is to document what an IRS employee said in person, over the telephone, or by letter. It is important to write down any tax advice received over the telephone or in person, and to note the time, the date, and the name of the IRS employee giving the advice. The second step is to show that reliance on that advice was reasonable. Just because someone says what the taxpayer wants to hear is not sufficient reason for the taxpayer to rely on that information; reliance must be reasonable. Determining reasonableness is tricky, but the taxpayer should be aware that if a piece of advice seems too good to be true, it may not be true. If a reasonable person would seek a second opinion, then the taxpayer should also seek another opinion. Although the IRS may cancel a penalty for relying on bad advice, it is not obligated to cancel the interest accumulated on any additional tax the taxpayer may owe.

The taxpayer is obligated to answer only the questions the auditor asks. The taxpayer should not commit perjury, but he or she has no obligation to volunteer damaging information. If the taxpayer is instructed by the IRS to make documents available during an audit, it is best to have all these documents available for inspection in an organized and logical manner. In an audit conducted at home or at a place of business, the taxpayer does not have to give the auditor access to a copying machine or allow the auditor to take original documents back to IRS offices. The taxpayer should, however, make copies of the documents the auditor specifically requests and make a note of which documents the taxpayer has copied and provided. If an audit is by mail, the taxpayer should send to the IRS only copies of those items specifically requested. Documentation always should be sent to the IRS by certified mail with a return receipt requested.

Many taxpayers are concerned about the privacy of information they provide on a tax return or in an audit. The government is obligated to respect the confidentiality of information a taxpayer provides in the tax collection process, and anyone who prepares a return or represents the taxpayer also is obligated to respect the client's privacy. In limited circumstances, the IRS is allowed to share some taxpayer information with state tax agencies, the Department of Justice, or other federal agencies. During an audit or at any time the IRS asks for information, the taxpayer has the right to know why the agency wants the information, how the information will be used, and what may happen if the taxpayer chooses not to provide the information.

The taxpayer has the right to take someone along to an IRS audit interview. This could be an attorney, a certified public accountant, the person who filled out the tax forms, or an enrolled agent. Another person may represent the taxpayer in his or her absence during an audit interview, as long as the taxpayer files with the IRS a power of attorney form or a similar document.

The taxpayer has the right to tape record the audit interview. To do so, the taxpayer must inform the IRS in writing of the intention to tape the interview at least ten days in advance, and must supply the tape recorder. If the IRS decides to tape record an interview, it must inform the taxpayer at least ten days in advance. The taxpayer has a right to a copy of the IRS tape, but must pay for the copying expenses.

If at any point in the audit process the taxpayer feels that the proceeding is not going well, there are always three options. First, the taxpayer can agree with the IRS, pay additional taxes, and vow to be more careful when filing future tax returns. Second, the taxpayer can ask the IRS for a notice of deficiency and take the case to a federal tax court. Third, the taxpayer can pay the disputed amount, file a claim for a refund, and then take the case to the federal district court, the federal tax court, or the federal claims court.

Result of an Audit

A minority of taxpayers who are audited receive from the IRS a no-change report, which is a letter stating that the IRS accepts the audited return without changes. Only about 30 percent of those audited get a no-change letter. In even rarer situations, the IRS owes the taxpayer money after an audit. However, in most cases, the IRS determines that the taxpayer owes more money.

If the taxpayer owes more money, the IRS sends the taxpayer a 30-day letter and a copy of the audit report outlining the additional taxes owed. If the taxpayer agrees to the changes detailed in the audit report, he or she signs the enclosed form and sends it back to the IRS with a check within 30 days. If the taxpayer sends a signed form without a check, the IRS sends the taxpayer a bill, which must be paid within ten days. Either way, the taxpayer pays interest on the extra tax, calculated from the due date of the audited return to the billing date.

Another option outlined in the 30-day letter is the IRS's internal appeals process, which can be initiated by submitting, within 30 days, a written protest to the IRS requesting a conference with an appeals officer. If the amount of the additional tax is less than $2500, the protest does not need to be in written form.

If the taxpayer ignores the 30-day letter, the IRS sends a notice of deficiency, sometimes called a 90-day letter, because it notifies the taxpayer that he or she has 90 days either to settle the matter with the IRS or to file suit in one of three federal courts.

Appealing an Audit

If a taxpayer disputes the results of an audit, he or she can appeal the auditor's decision to a regional IRS appeals office or directly to a federal court. Appealing within the IRS is relatively straightforward and generally less expensive and time-consuming than going to court. If taxpayers go to federal court and win there, they sometimes can recover from the IRS some or all of their administrative and litigation costs, but only if they first use the IRS appeals process.

A taxpayer starts the IRS appeals process by requesting a conference through the IRS's local district director. The district director then arranges a meeting with one of the IRS's appeals officers, located in most major cities. The request for an appeals conference should state the exact elements in the auditor's report with which the taxpayer disagrees, the elements of tax law that support the taxpayer's case, and any facts that support the taxpayer's position.

As in any dealings with the IRS, the taxpayer may be represented or advised by an attorney during the appeals conference and may bring along witnesses to support statements of facts. This conference is an informal last chance to resolve a dispute before going to court. There is no guarantee what will happen, but quite often the IRS officers make some concessions at this point in order to avoid going to court.

If a taxpayer decides that the IRS's decision is unfair, unjust, or unreasonable, he or she can take the dispute to one of three federal courts, all of which operate independently of the IRS. Deciding whether to file suit in tax court, claims court, or district court depends on a number of legal and personal factors. Each court is guided by the previous cases that it has decided. As a result, a taxpayer's odds of success may be better in one court than in another. Most cases, no matter which court first hears them, ultimately can be appealed to the United States Supreme Court. The only exception to this right to appeal is cases heard under the "small tax case procedure" in tax court.

A taxpayer may go to court without first going through the IRS appeals process, but often a tax court judge will not hear a case unless it has been considered for settlement by a regional IRS appeals office. If a taxpayer goes to tax court without first going through the IRS appeals process and loses his or her court case, the tax court judge may fine the taxpayer up to $5000 if he or she determines that the lawsuit was a tactic to delay paying the IRS or that the suit was otherwise frivolous. In all three courts, the taxpayer has the burden of proving that the IRS is wrong. In other words, the court starts with the assumption that the IRS correctly interpreted the tax laws as they apply to the case. The taxpayer does not win unless he or she convinces the court otherwise.

U.S. Tax Court

The tax court hears only tax cases. One advantage to tax court is that the taxpayer need not pay the disputed tax amount first, which is not the case in the other two courts. In tax court the taxpayer does not have a right to trial by jury, so cases are heard by a judge who is experienced in tax law. If a taxpayer wants to take a case to tax court, he or she must file suit within 90 days after the IRS mails the notice of deficiency to the taxpayer's last known address. In general, tax court rules are less strict than those used in the other two courts.

If a dispute with the IRS is for an amount under $10,000, the taxpayer can go through the tax court's small tax case procedure, which generally is quicker and even less formal than the court's standard procedure. However, the decision of a judge who hears cases under the small tax case procedure is final, so if a taxpayer chooses this procedure, he or she loses the right to appeal the court's decision. Because the taxpayer does not need to be represented by an attorney in this procedure, it may be a good option in a dispute over smaller amounts, so any money won is not used to pay attorney's fees.

Finally, a taxpayer should be aware of what is often called the "tax court trap," which describes the authority of the IRS to impose even more fines based on any new information that it discovers about the taxpayer during a tax court proceeding.

Tax court is the most popular route for taxpayers, in large part because it does not require that the disputed tax be paid prior to filing. But tax court also can be a very unsuccessful route. IRS statistics show that only about five percent of the taxpayers who bring their cases in tax court win. The taxpayer success rate in the other two courts, however, is only marginally better--about 11 percent.

U.S. District Court

Of the three courts that hear taxpayer disputes with the IRS, only in federal district court is there a right to a trial by jury. To bring suit in district court, the taxpayer first must pay the disputed tax to the IRS and then claim a refund for that amount by filing the proper form with the IRS. If the IRS denies the refund request, the taxpayer then may sue the IRS in district court. The taxpayer has the right to sue for any amount of refund in district court, no matter how small. However, because the taxpayer usually is represented by an attorney in district court, going to district court may make sense only for larger monetary disputes.

If the IRS does not make a decision on a refund claim in six months, the taxpayer can go ahead and file suit in district court. The taxpayer has up to two years after the IRS rejects a refund claim in which to file suit in district court.

U.S. Claims Court

The federal claims court follows the same rules as the district court regarding filing lawsuits for refunds from the IRS. A taxpayer first must pay the disputed amount and then file a lawsuit in claims court for a refund of that amount. There is no minimum amount of a refund claim that can be litigated in claims court. However, claims court is not an option to seek a refund of a penalty relating to tax shelter abuse, or to recover a penalty assessed by the IRS for fraudulently preparing someone else's tax return.

The State of California assesses taxes on income, sales, use, excise, motor fuel, and property. California offers free tax help and information throughout the year by way of toll-free telephone services. Taxpayers also can get information in person at any of the district offices of California's Franchise Tax Board.

California's income tax system may be less elaborate than the federal government's, but disputes over it still arise. When the state audits a taxpayer's state income tax return, the procedure is similar to the procedure used in IRS income tax audits. Some audits are completed by correspondence, but others require an examination by a field auditor. A California taxpayer who is audited has the right to a fair examination and a written explanation of all changes made to the tax return as a result of the audit. If a taxpayer disputes the result of the audit, he or she may file a protest with the Franchise Tax Board. If dissatisfied with the decision of the Franchise Tax Board, the taxpayer may appeal to the California Board of Equalization.

Property taxes, which are levied, collected, and spent locally, are discussed in the Real Estate Law Chapter. The California Franchise Tax Board has no direct involvement in the appeal process of assessed value of property, upon which the property tax is based.

The rights that California taxpayers have in dealing with the Franchise Tax Board closely parallel their rights in dealing with the IRS. For example, the taxpayer has a right to have an attorney, accountant, or other person represent him or her at any meetings. The Franchise Tax Board must provide taxpayers with written information about their rights when they deal with the Board. If a taxpayer prevails in an appeal before the Board of Equalization and there is a finding that the Franchise Tax Board acted unreasonably, the taxpayer may be entitled to reimbursement for reasonable fees and expenses. For further information or for a copy of the Taxpayer's Bill of Rights, a taxpayer should contact the Taxpayer's Advocate Office.

For information on federal income taxes, the federal audit process or to order forms or publications, contact the Internal Revenue Service, (800) 829-4477 or (800) 829-1040; TDD (800) 829-4059.

For additional information on federal income taxes and the audit process, see:

Randy Bruce Blaustein, How to Cope with the IRS (Retirement Living Publishing Co., New York, NY 1991).

D. Larry Crumbley & Jack P. Friedman, Keys to Surviving a Tax Audit (Barron's, New York, NY 1991).

Patricia T. Morgan, Tax Procedure and Tax Fraud in a Nut Shell (West Publishing Co., St. Paul, MN 1990).

For information on California income tax, including free bulletins, contact the California Franchise Tax Board, P.O. Box 942840, Sacramento, CA 94240, or contact one of the Board's district offices by calling F.A.S.T. (Fast Answers about State Taxes) at (800) 338-0505 and entering code 214 for district office address information. Telephone assistance is available at (800) 852-5711 or TDD: (800) 822-6268. Taxpayers also may call the F.A.S.T. toll-free telephone service for general information or to order forms, at (800) 338-0505.

For information on California taxpayer's rights, including audit and appeals rights, contact the Taxpayer's Advocate Office, Franchise Tax Board, P.O. Box 1468, Sacramento, CA 95812-1468, (916) 845-4300 or fax (916) 845-6614.