San Francisco Examiner, Business Section, Tuesday, March 28, 1995

ROBERT L. SOMMERS - TAXMAN

How to Deal with IRS Demands

(Second of Two Parts)

Editor's note: In Sunday's Examiner, Robert Sommers explained taxpayers' rights when confronted with a potential; audit by the Internal; Revenue Service. Today: How to handle delinquent tax notices and audits.

WHAT should you do if you receive a notice of delinquent taxes from the IRS? First, don't panic. Remember you have rights, and take things one step at a time.

• First, assume you are right, and the IRS is wrong. Read your notice carefully. Which tax year(s) are involved? What information is the government requesting? If you used a tax preparer, contact him or her. If your tax preparer is unresponsive or you feel your preparer is covering up his or her mistake, immediately get a second opinion.
• Review the interest charge: It is estimated the IRS miscalculates interest charges 25 percent of the time. Determine whether interest is based on the correct year; then, check the amount. Calculate a rough estimate of interest at 1 percent per month. If you owe interest on $1,000 for two years, the notice should state approximately $240 in interest. The IRS cannot normally negotiate interest due.
• Check the penalties: Often, an IRS computer generates penalties that can be abated in full. A negligence penalty, for instance, does not automatically apply if the taxpayer is wrong -- the taxpayer must be negligent. Unlike interest, penalties are negotiable, so always try to get penalty charges excused.
• Put everything in writing: Avoid negotiating over the telephone, but if you do, immediately write a letter confirming your conversation. Keep copies of all your correspondence, and don't throw it away. As your case progresses, invariably the IRS will ask you for all copies of previous correspondence.
• Don't pay until you are certain the IRS is correct: Once you pay an erroneous statement, it is difficult to get a refund. As long as the IRS wants money from you, your bargaining position is stronger. But once you determine taxes are owed, and that the interest is calculated correctly -- and if you cannot reduce or eliminate the penalties -- then send in a check (marked with the tax year and your Social Security number). Keep copies.

Going through an audit

Generally, an IRS audit starts with an examination of your tax return for a specific year. Verification of income and expenses is often the initial focus. If you can satisfy the audit requested by proper documentation, merely sending the IRS the annual statement from your lender will suffice.

Otherwise:

• Remember the Taxpayer Bill of Rights: Familiarize yourself with the examination process. The IRS must inform you about the audit procedures and your right to be represented. If you meet the IRS agent alone, consider tape-recording your meeting. It could be valuable if the audit remains unresolved after your initial meeting and you hire a representative

  .

• Do you need a representative?: That is debatable at this stage. The answer depends on the nature of the audit, the issues involved (whether they are factual or legal) and the experience and personality of the taxpayer.
• Discuss the matter with a seasoned tax advisor. Generally, if the audit involves factual documentation -- verification of mortgage or medical expenses -- you might not need independent representation. But there is always the danger that you may inadvertently create an issue by saying too much or saying the wrong thing!
• If you have a problem substantiating your income or expenses, or if there is a legal issue involved, then retain a tax expert. Legal tax issues include:

2. Most tax shelter deductions.
3. Personal expenses versus business or investment expenses.
4. The appropriate tax year for income or deductions.
5. Classifying workers as independent contractors or employees.
6. Disputes involving the "character" of income, losses or expenses -- capital gains versus ordinary income, taxable income versus a non-taxable gift.
7. Classifying passive activities, portfolio interest and investment interest.

Your rights on appeal

If the auditor makes an adverse determination, the taxpayer may appeal. At this point, employ a tax expert. The appellate division of the IRS is experienced and pragmatic, and disputes are often compromised in a businesslike manner.

If the taxpayer presents a strong case, the appellate officer will invariably acknowledge the taxpayer's position and close the case. If the matter cannot be resolved, the IRS will then issue a notice of deficiency.

This is the final step in the administrative process and prerequisite to the assessment of additional tax. Once you receive a notice of deficiency, you have three choices: Pay the tax without further contesting it; petition the Tax Court for a redetermination of the tax within 90 days of receipt of the notice of deficiency; or pay the tax and sue for a refund in federal District Court or the Court of Claims in Washington, D.C.

If you do nothing, the IRS will assess and collect the tax once the 90-day period expires. Petitioning the Tax Court is your most sensible option. Once the Tax Court petition is filed, the IRS can't collect the alleged deficiency until a decision is final; the IRS will have its appellate branch try to settle the case before trial.

The drawback to the Tax Court is that its jurisdiction lasts only 90 days, beginning on the date the notice of deficiency is mailed. If you ignore this critical deadline (as too many taxpayers do), you are left with little recourse except to pay the taxes, penalties and interest in full (an impossibility if the amount is too high), and later sue for a refund in federal district court or the Court of Claims.

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