Can the IRS audit taxpayers year after year?
While the IRS has discretion to audit taxpayer returns for the same issues on subsequent years, taxpayers can invoke an IRS policy to try to suspend the repetition
Peter is a long-haul truck driver. The IRS audited his 2012 tax return, focusing on the expenses Peter deducted on Form 2106 (Employee Business Expenses) related to his truck driving gig – depreciation of his truck, highway and parking tolls, GPS, CB radio.
During his audit, Peter took the time to compile all of his invoices and receipts. He hired a tax professional to represent him, and the audit took months to complete.
The result: Peter came out of the audit unscathed. The IRS didn’t make any changes to Peter’s tax return, so he didn’t owe a penny to the IRS when the audit was complete.
But Peter isn’t feeling unscathed now, because he just received another IRS notice that says he’s being audited again. This time, the IRS is examining the same deduction issues on his 2013 return.
Is the IRS allowed to audit Peter again?
Yes, the IRS can audit Peter in subsequent years. But, according to Internal Revenue Code §7605(b), the IRS can’t subject a taxpayer to unnecessary examinations. In general, the IRS can conduct only one inspection of a taxpayer's books and records for any given year unless the taxpayer requests a second inspection or the IRS notifies the taxpayer in writing that an additional inspection is necessary.
Practically, this statute usually limits the IRS to auditing Peter only once per tax year. But it doesn’t limit the IRS from auditing Peter year after year for the same issues. This is a so-called repetitive audit – when the IRS has already examined the same items on a return in either of the two previous years, and the previous audit resulted in no changes or only a nominal change to the return.
The IRS Internal Revenue Manual (the internal operating manual for IRS staff) has a policy for terminating repetitive audits. For taxpayers and their tax professionals, invoking this policy may help avoid a full-scale audit if the IRS is taking up the same issues in a subsequent audit.
However, invoking the policy has certain limits, including the following:
The IRS must be auditing the same issues on the subsequent return as it examined on the prior return
If the IRS is auditing new or different items, the policy doesn’t apply. For example, if the prior-year audit related to Peter’s employee business expenses, and the subsequent audit relates to expense items for a rental property Peter owns, Peter and his tax professional couldn’t invoke the repetitive audit policy.
Even if the later audit also pertained to Peter’s employee business expenses, the IRS still might not apply the policy if the facts and circumstances of Peter’s business expenses have changed (Tucker, James Jr., (1983), TC Memo 1983-210).
The prior audit must have resulted in no change or only small changes
A no-change audit is simple to recognize, because the IRS didn’t make any adjustments. But when it comes to determining what constitutes a small or nominal change, neither the IRS nor the courts have provided a bright-line rule.
Instead, the IRS relies on the facts and circumstances of each case. That includes the relative size of an item in relation to other items on the return.
The ideal position for taxpayers is to have few items adjusted in the prior audit and no apparent changes to the year the IRS is proposing to examine. The prior audit report will provide the argument. For example, if the taxpayer has large deductions with small adjustments in the prior audit, the taxpayer has substantially reported his or her tax liability correctly.
Additionally, to bolster the argument to the IRS that auditing the return will prove fruitless, taxpayers should check their income sources to make sure that all items are reported on the return. Taxpayers can check by reviewing their wage and income transcript information. Many repetitive audit claims are undone when IRS examiners think there is unreported income on the return.
Ultimately, the decision is up to the IRS
Because the IRS policy to suspend repetitive audits is in the Internal Revenue Manual (rather than the tax code), it isn’t required by law. The IRS designed the policy to avoid unnecessarily using IRS and taxpayer resources.
In prior guidance, the IRS confirmed that this policy doesn’t compel it to terminate a repetitive audit. Instead, the IRS has discretionary authority to determine whether it should end the examination.
What should Peter do?
First, as soon as Peter receives the IRS notice explaining that he is under audit again, he should request that the IRS discontinue the audit (using the contact information on the notice he received). He should reference the IRS’ repetitive audit policy in his request.
When he makes the request, Peter should be aware that the IRS is going to ask for certain information to help determine whether the repetitive audit policy applies. The IRS will generally request:
- The prior year’s audit report or no-change letter
- Verification of where Peter filed the return(s) in question, and
- Verification of where the IRS completed the prior-year examination(s).
If Peter makes the request before his first scheduled meeting with the examiner, the IRS will generally determine whether the policy applies before any meetings happen.
The chances of success
Based on IRS records and the information Peter provides, the examining agent* will generally close the examination without any further action on Peter’s part if:
- The issues under examination are the same as those examined in either of the two preceding years, and
- There was no change or only a small change to Peter’s tax balance in the prior audit.
If the IRS approves Peter’s request, the IRS will send Letter 2681 (DO), Repetitive Exam Letter, to close the examination.
If the IRS denies Peter’s request, he can appeal the issue to the U.S. Tax Court. The Tax Court will review the IRS’ refusal to apply the policy. The court will use the highly discretionary “abuse of discretion” standard. This usually requires that the taxpayer demonstrate that the IRS acted arbitrarily (See, eg., id.). Peter may have better luck appealing an IRS denial with the examiner’s supervisor, to get the supervisor’s take on the situation before considering whether to pursue a Tax Court petition.
Ultimately, there’s no guarantee that the IRS will grant a taxpayer’s request based on the repetitive audit policy. However, for taxpayers whose situations fit, making the request is certainly worth the effort to avoid the worst-case scenario of an audit every year.
* An IRS group manager approval is necessary in office examinations. In field examinations, managerial approval is not required on repetitive audit cases.