Summary. An audit notice is not an accusation and is rarely a catastrophe, but the response in the first month determines how long it lasts and what it costs. This guide walks the examination from initial contact through appeals and litigation: the three types of examination and what each signals, how to answer an information document request without expanding the inquiry, and the representation and privilege issues that arise when the return preparer is also the explainer. It then covers the limitations period and extension decision, penalties and reasonable cause, the agreed and unagreed paths, Appeals, forum choice, employment tax examinations, and collection alternatives.

A construction contractor receives a letter opening an examination of its most recent corporate return. The letter includes an information document request with fourteen items, several of them broad: "all bank statements," "all records supporting cost of goods sold," "documentation of all officer compensation."

The controller, wanting to be helpful and to get it over with, sends everything. Three banker's boxes and a hard drive, including two prior years of records nobody asked for, the internal memo debating whether a family member's salary was reasonable, and the workpapers in which the outside accountant wrote "aggressive but defensible."

The examination was opened to look at one issue. It now covers three years, two additional issues, and a penalty question that the accountant's own workpaper supplied the evidence for.

Nothing here was dishonest. The controller simply did not understand the two rules that govern every audit: answer the question asked, and the scope of the examination is negotiable until you expand it yourself.

The first two weeks

1. Read the notice carefully. Identify the tax year or years, the entity, the type of examination, the assigned examiner and their contact information, and the response deadline.

2. Verify it is genuine. The IRS initiates examinations by mail, not by phone or email. It does not demand immediate payment by gift card or wire, and it does not threaten arrest. Scams imitating IRS notices are constant; confirm through the number on the official notice or through the taxpayer service line, not the number in the letter if anything seems irregular.

3. Do not call the examiner yourself. Have representation in place first.

4. Choose a representative. Circular 230 permits attorneys, CPAs, and enrolled agents to represent taxpayers. File a Form 2848 power of attorney so that all communications route through your representative. Consider whether the return preparer should be that representative — often they should not, because the preparer is a potential witness on how positions were developed and because the accountant-client privilege is narrow.

5. Preserve everything relating to the years under examination, and suspend any routine destruction. Records for open years should already be retained; confirm that they are.

6. Assemble the return file — the filed return, workpapers, supporting schedules, and any tax opinions or memoranda. Review it before the examiner does.

7. Assess exposure candidly. Identify the positions that are weak, the documentation that is missing, and anything that could raise a penalty or, in a serious case, a criminal referral. It is far better to know in week one.

What kind of examination is this

Correspondence examination. Conducted entirely by mail, addressed to specific line items — usually a mismatched information return, a questionable deduction, or a credit. The majority of examinations are of this type. Respond in writing, completely, with documentation, by the deadline, and keep proof of mailing. Many resolve on the first response.

Office examination. The taxpayer or representative meets the examiner at an IRS office. Broader than correspondence, usually confined to a few issues.

Field examination. A revenue agent conducts the examination at the taxpayer's place of business or its representative's office. This is the serious form for businesses, it covers the return comprehensively, and it can extend to related returns, related entities, and prior and subsequent years.

Specialized programs worth recognizing: employment tax examinations, often opened by a worker classification question; the Large Business and International division's issue-focused campaigns; partnership examinations under the centralized regime, discussed below; and research credit and transfer pricing examinations, which are document-intensive and expert-driven.

Why you were selected. Common triggers: the discriminant function scoring system; information return mismatches; a related examination of a partner, shareholder, employee, or counterparty; an industry or issue campaign; a whistleblower claim under § 7623; a large or unusual item relative to the return; repeated losses in an activity that may be a hobby; large cash transactions; and amended returns claiming substantial refunds.

Working the examination

Control the flow of information. Everything goes through the representative. The examiner should not be interviewing employees informally, and employees should be told — in writing — to route any contact to the representative.

Information document requests (IDRs). These are the mechanism of the examination.

  • Read each item literally and respond to what is asked. If an item asks for a schedule, provide the schedule, not the underlying system.
  • Negotiate scope. IDRs are drafted broadly. Examiners routinely agree to narrow them, to accept summaries and samples for voluminous material, and to extend deadlines for a taxpayer engaging in good faith. LB&I follows a formal IDR process with a defined enforcement path, and even outside it, a discussion before responding is standard practice.
  • Ask what the examiner is trying to establish. Understanding the issue lets you provide the responsive document rather than the entire file.
  • Produce organized responses with a cover memorandum, a Bates or index reference for each item, and a statement of what is being provided and what is not and why.
  • Never volunteer documents not requested. Producing the workpaper memorandum debating a position, as the controller did, hands the examiner the argument.
  • Track everything — a log of each IDR, the response date, and what was produced.

Deadlines matter. Requesting an extension in advance is routine and free. Missing a deadline without explanation invites a summons.

The summons, 26 U.S.C. § 7602, is the enforcement tool. It compels production of records and testimony, is enforceable in district court, and can reach third parties including banks — with notice to the taxpayer under § 7609 and a right to move to quash within a short window. The Powell factors govern enforcement: a legitimate purpose, relevance, the information not already in the Service's possession, and compliance with administrative steps. Once a Justice Department referral is in effect, the summons authority may not be used, § 7602(d).

Interviews. The examiner may want to interview officers or employees. Prepare them: answer the question asked, do not speculate, say you do not recall if you do not, and do not volunteer. A taxpayer has the right to have a representative present and, under § 7521(b)(2), to suspend an interview to consult a representative.

Privilege and the accountant problem

There is no general accountant-client privilege in federal tax matters. What exists is narrow.

Section 7525 creates a federally authorized tax practitioner privilege, extending the common law protections of confidentiality applicable to attorney-client communications to communications with a CPA, enrolled agent, or enrolled actuary — but only as to tax advice, only in noncriminal tax matters before the IRS and in noncriminal federal tax proceedings, and not as to written communications in connection with the promotion of a tax shelter.

What that leaves:

  • Return preparation communications are generally not privileged, because preparing a return is not legal advice.
  • The privilege evaporates in a criminal matter.
  • It does not apply in state proceedings or in litigation with third parties.

The attorney-client privilege and work product protection are broader and durable. Which is why a business with a genuinely contestable position engages counsel, and why counsel — not the taxpayer — engages the accountant to assist. A Kovel arrangement, from United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), extends the attorney-client privilege to an accountant retained by the lawyer to assist in providing legal advice. The engagement must be genuine: a Kovel letter papering an existing accountant relationship, where the accountant continues doing ordinary compliance work, will not hold.

Tax accrual workpapers. The Service's policy of restraint limits requests for tax accrual workpapers in most examinations, with exceptions where listed transactions are involved. Uncertain tax position reporting on Schedule UTP requires disclosure of positions for which a reserve was recorded, with a concise description — which effectively identifies the issues without waiving the analysis.

The practical structure for a business with a significant exposure: counsel leads; counsel engages the accountant under a Kovel letter for analytical work; return preparation and compliance work continue in the ordinary course and are understood to be unprivileged; and the privileged analysis is kept separate from the compliance file.

The limitations period and the extension decision

Assessment, § 6501(a): generally three years from the later of the due date or the filing date.

Exceptions:

  • Six years for a substantial omission of gross income — more than 25 percent of the gross income stated on the return, § 6501(e). Note that an overstatement of basis is not an omission from gross income for this purpose, United States v. Home Concrete & Supply, LLC, 566 U.S. 478 (2012) — a holding Congress subsequently addressed by statute for the periods it chose to reach.
  • Six years for certain foreign asset and information reporting omissions.
  • Unlimited where no return was filed, § 6501(c)(3).
  • Unlimited for a false or fraudulent return with intent to evade, § 6501(c)(1).
  • Suspended during the pendency of a notice of deficiency and for periods relating to certain listed transactions and unfiled information returns — notably, the period for the entire return remains open where a required international information return (Forms 5471, 5472, 3520, 8938, and others) was not filed, § 6501(c)(8).

The extension request. Examiners routinely ask taxpayers to sign Form 872 (a fixed-date extension) or Form 872-A (an open-ended extension terminable by either party on notice) as the statute approaches.

Whether to sign is a real decision.

  • Reasons to sign: the examination is not finished, and refusing usually results in an immediate statutory notice of deficiency based on the examiner's current position — which may be worse than the position after more development. Signing also preserves the opportunity to resolve at Appeals rather than in court.
  • Reasons to resist: an extension gives the examiner more time to find issues, and it extends the period for all items on the return unless the extension is restricted to specified issues.
  • The middle path: negotiate a restricted consent limiting the extension to identified issues, and a shorter period than requested. Both are commonly available and rarely offered unless asked for.

Refund claims, § 6511: the later of three years from filing or two years from payment, with the lookback limits of § 6511(b)(2) governing how much can be recovered.

Collection, § 6502: ten years from assessment, suspended during specified events including a pending offer in compromise, an installment agreement request, bankruptcy, and a collection due process proceeding.

Penalties and the reasonable cause defense

The accuracy-related penalty, § 6662 — 20 percent of the underpayment attributable to:

  • Negligence or disregard of rules or regulations;
  • A substantial understatement of income tax — exceeding the greater of 10 percent of the tax required to be shown or $5,000 (for a corporation, the lesser of 10 percent, or $10 million, with a $10,000 floor);
  • A substantial valuation misstatement, increased to 40 percent for a gross misstatement;
  • Transfer pricing misstatements; and
  • Understatements attributable to undisclosed foreign financial assets (40 percent) and to certain nondisclosed noneconomic substance transactions, § 6662(i) and § 6662(b)(6), the latter of which carries strict liability — no reasonable cause defense.

Defenses:

  • Substantial authority for the position, § 6662(d)(2)(B)(i) — an objective standard weighing the authorities supporting and opposing the treatment, roughly a 40 percent likelihood of success.
  • Adequate disclosure plus a reasonable basis, on Form 8275 or 8275-R, § 6662(d)(2)(B)(ii). A disclosed position at a reasonable-basis level avoids the substantial understatement penalty, which is the reason the forms exist and the reason they are so underused.
  • Reasonable cause and good faith, § 6664(c) — the general defense, established most commonly through reliance on professional advice. Reliance works only where the adviser was competent in the subject, was given all relevant facts, was not laboring under a conflict (the promoter of the transaction does not count), and the taxpayer actually and reasonably relied in good faith.

The fraud penalty, § 6663 — 75 percent of the underpayment attributable to fraud, requiring clear and convincing evidence of an intent to evade. Badges of fraud include understated income, inadequate records, failure to file, implausible explanations, concealment of assets, failure to cooperate, dealing in cash, and destruction of records.

Information return penalties under §§ 6721 and 6722, international information return penalties under §§ 6038, 6038A, 6038D, 6677, and 6679 (which are substantial and, for several, assessable without deficiency procedures), the failure to file and failure to pay additions under § 6651, and the estimated tax addition under § 6655 round out the exposure.

Supervisory approval. Section 6751(b) requires that the initial determination of a penalty assessment be personally approved in writing by the immediate supervisor of the individual making it. Litigation over the timing of that approval has produced substantial taxpayer victories, and regulations have addressed the question — but confirming that approval exists and was timely remains a standard defense step.

First-time abatement administrative relief is available for certain failure-to-file, failure-to-pay, and failure-to-deposit penalties where the taxpayer has a clean compliance history, and it is granted on request more readily than most taxpayers expect.

Closing the examination

The Revenue Agent Report (Form 4549 for income tax) sets out the proposed adjustments, the resulting tax, penalties, and interest.

If you agree, sign the waiver — Form 870 or Form 4549 — consenting to immediate assessment and collection. Note that signing Form 870 waives the right to petition the Tax Court, though it does not preclude a later refund claim. Payment stops the running of interest.

If you do not agree, the examiner issues a 30-day letter with the report and the right to file a protest with IRS Appeals.

The protest — required in writing for larger cases, with a small-case request available below a threshold — should include: the taxpayer's identifying information; the years and issues in dispute; a statement of agreement or disagreement with each adjustment; the facts supporting the taxpayer's position; the law and authorities relied on; and a declaration under penalties of perjury.

Write it as an advocacy document. Appeals officers read the protest before anything else, and a protest that concedes the indefensible and marshals authority on the rest establishes credibility for the whole case.

IRS Appeals is independent of the examination function and its mission is to resolve disputes without litigation on a basis fair to both the government and the taxpayer. Its distinguishing feature is authority to settle based on the hazards of litigation — the probability that the government would lose — which the examination function does not have.

Practical points about Appeals:

  • Prohibition on ex parte communications between Appeals and the examination function limits the examiner's ability to influence the conference outside the taxpayer's presence.
  • Appeals will generally not consider new evidence or new issues for the first time; it may return the case to Examination if substantial new material appears. Develop the record during the examination.
  • Settlements can be issue-by-issue or a mutual concession settlement across issues.
  • Fast Track Settlement offers a mediated resolution with an Appeals officer while the case remains in Examination, and it is substantially faster for cases with a narrow set of issues.
  • Post-Appeals mediation is available where a case does not settle.
  • Resolutions are documented on Form 870-AD or a closing agreement under § 7121, which is final and binding.

The statutory notice of deficiency — the 90-day letter — issues if the case does not resolve. From its mailing, the taxpayer has 90 days (150 if addressed outside the United States) to petition the United States Tax Court. This deadline is jurisdictional in the ordinary case and cannot be extended, though the Supreme Court's decision in Boechler, P.C. v. Commissioner, 596 U.S. 199 (2022), held the analogous collection due process filing deadline non-jurisdictional and subject to equitable tolling, and litigation continues over the deficiency deadline's character.

Choosing the forum

Three courts hear tax cases, and the choice matters.

United States Tax Court. The only forum where the tax need not be paid first. Judges are tax specialists. No jury. Appeal lies to the court of appeals for the taxpayer's circuit, and the Tax Court follows that circuit's precedent under the Golsen rule. Simplified small tax case procedures are available below a threshold, with no appeal.

United States District Court. Requires full payment of the tax and a refund claim. Jury trial available — the only forum offering one, which matters where the facts are sympathetic. Government represented by the Department of Justice rather than IRS counsel.

Court of Federal Claims. Also requires full payment. No jury. Appeal to the Federal Circuit, which can be an advantage or a disadvantage depending on that court's precedent on the issue.

Considerations: whether the taxpayer can pay; whether a jury helps; which circuit's precedent applies; whether the issue is one on which the Tax Court's own precedent is adverse; and the cost and duration of each path.

Attorney's fees may be recovered under § 7430 where the taxpayer substantially prevails, exhausted administrative remedies, and the government's position was not substantially justified, subject to net worth limits.

Employment tax and worker classification examinations

These deserve separate treatment because they are common, because they reach the owners personally, and because they frequently arise from a single unemployment claim.

What the examiner looks at: worker classification (contractors versus employees), officer compensation in an S corporation (whether reasonable compensation was paid before distributions), fringe benefits, accountable plan compliance for expense reimbursements, and the timeliness of federal tax deposits.

Classification applies the common law control test — behavioral control, financial control, and the relationship of the parties. Section 530 relief may bar reclassification where the taxpayer had a reasonable basis, treated all similarly situated workers consistently, and filed all required returns consistently — with the filing requirement being the most common disqualifier. Section 3509 provides reduced rates for unintentional misclassification, unavailable where Forms 1099 were not filed. The Voluntary Classification Settlement Program offers prospective reclassification with limited retroactive liability for eligible taxpayers.

The trust fund recovery penalty, § 6672, is the provision that makes employment tax exposure personal. Any responsible person who willfully fails to collect, account for, or pay over withheld taxes is liable for 100 percent of the trust fund portion. Responsibility turns on status, duty, and authority — signature authority, the ability to direct payments, and knowledge of the obligation. Willfulness means paying other creditors while knowing the taxes were unpaid; it does not require an evil motive. The liability is personal, survives the entity, and is not dischargeable in bankruptcy. A Letter 1153 proposing the penalty carries a 60-day protest period.

Partnership examinations under the centralized regime of the Bipartisan Budget Act operate differently: adjustments are determined and, by default, assessed at the partnership level as an imputed underpayment in the adjustment year, unless the partnership elects to push out adjustments to reviewed-year partners. A partnership representative with sole authority to bind the partnership must be designated, small partnerships may elect out if they meet the eligibility requirements, and the partnership agreement should address the representative's obligations and the push-out election. Many operating agreements still contain obsolete TEFRA tax matters partner provisions and should be updated.

Collection alternatives

If an assessment stands and cannot be paid:

  • Installment agreement — guaranteed, streamlined, or negotiated depending on the amount and the taxpayer's compliance history. Interest and the failure-to-pay addition continue.
  • Offer in compromise — doubt as to collectibility, doubt as to liability, or effective tax administration. Requires full financial disclosure, a nonrefundable application fee and initial payment absent low-income certification, and compliance with filing and payment obligations during and after. Acceptance rates are lower than advertising suggests, and an offer suspends the collection statute.
  • Currently not collectible status, which pauses collection without eliminating the liability.
  • Penalty abatement — first-time abatement, reasonable cause, or statutory exception.
  • Collection due process — a 30-day window after a Notice of Federal Tax Lien filing or a Final Notice of Intent to Levy to request a hearing, which suspends levy action, permits proposing alternatives, and allows challenging the underlying liability if the taxpayer had no prior opportunity, with review in the Tax Court.
  • Taxpayer Advocate Service assistance where the process has broken down or economic hardship exists.
  • Lien withdrawal, discharge, or subordination, which can be essential to a refinancing or sale.

A worked example

Halloran Fabrication, an S corporation, is selected for a field examination of its most recent return.

Week 1. Counsel engaged; Form 2848 filed. A hold issues. Counsel reviews the return file and identifies three exposures: officer compensation of $60,000 against $740,000 in distributions; a research credit claimed without contemporaneous project documentation; and $210,000 in "consulting fees" to an entity owned by the majority shareholder's brother.

Week 3. Initial conference. Counsel asks what prompted the selection and learns the return was scored, with the credit flagged. The examiner issues a fourteen-item IDR.

Weeks 3-4. Counsel negotiates the IDR: bank statements limited to two operating accounts rather than all accounts; cost of goods sold supported by a summary schedule with sample invoices rather than every invoice; officer compensation documentation limited to payroll records and board minutes. The workpapers are not produced, and counsel asserts the § 7525 privilege where applicable while recognizing its limits.

Week 8. Counsel commissions, under privilege, a reasonable compensation study and a contemporaneous reconstruction of the research credit projects from engineering records, time entries, and project files.

Week 14. The examiner proposes: reclassification of $280,000 of distributions as wages with employment tax and penalties; disallowance of the entire research credit; and disallowance of the consulting fees as not ordinary and necessary.

Week 16. Counsel concedes the compensation issue in part — agreeing to $190,000 of reclassification supported by the study — and contests the balance. On the credit, the reconstructed documentation supports roughly 60 percent of the claim. On the consulting fees, contemporaneous emails and deliverables establish that services were performed, and the amount is supported by a market comparison.

Week 22. The examiner's report accepts the compensation concession, allows 45 percent of the credit, and disallows the fees. Counsel files a protest to Appeals on the credit and the fees, conceding compensation.

Month 11. Appeals settles: 70 percent of the credit allowed and the fees allowed in full, on hazards of litigation. The accuracy-related penalty is conceded by the government because the taxpayer relied on a qualified adviser given complete facts, and because supervisory approval documentation was incomplete.

What produced that outcome: early identification of exposures, a narrowed IDR, documentation built before the report issued, a protest that conceded the indefensible, and a penalty defense developed in week one rather than at Appeals.

Frequently asked questions

Does an audit mean we did something wrong? No. Most selections are scoring-driven or arise from a related examination.

Should our accountant handle it? Often not. The preparer is a potential witness and the § 7525 privilege is narrow and disappears in a criminal matter. Counsel should lead where the exposure is significant.

Do we have to sign the statute extension? No. Refusing usually produces an immediate notice of deficiency. Negotiate a restricted consent limited to identified issues and a shorter period.

Can we just give them everything to speed it up? No. Volume expands scope, and unsolicited internal analyses supply the arguments against you.

How far back can they go? Three years generally; six for a substantial omission of income; unlimited for no return or a fraudulent return; and unlimited for the entire return where certain international information returns were not filed.

What if we cannot pay? Installment agreements, offers in compromise, currently not collectible status, and collection due process rights all exist. Address it rather than ignoring notices; the collection process escalates on a schedule.

What is the difference between Appeals and Tax Court? Appeals is an administrative settlement forum with authority to settle on litigation hazards. Tax Court is litigation, without prepayment of the tax.

When does this become criminal? Rarely, and the signals are visible: the examiner disengages abruptly, referrals to Criminal Investigation, or agents appearing unannounced. If any of that occurs, stop and engage criminal tax counsel immediately.

Conclusion

An examination is a managed process, and the taxpayers who do badly are usually those who treated it as either a formality or a catastrophe.

Three habits produce good outcomes. Control the scope — respond to what is asked, negotiate broad requests, and never volunteer analysis. Build the record during the examination, because Appeals will not accept new evidence and the courts review what was developed. And address penalties from week one, by identifying whether substantial authority existed, whether disclosure was made, and whether reliance on a qualified adviser given complete facts can be established.

The examination is also, reliably, an audit of the company's records rather than its honesty. The businesses that come through cleanly are those whose documentation was created contemporaneously, which is a decision made years before the notice arrives.

Recordkeeping that survives an examination

The single strongest predictor of a good examination outcome is whether the documentation existed at the time, not whether it exists now. Section 6001 requires taxpayers to keep records sufficient to establish the amounts shown on a return, and the regulations leave the form to the taxpayer — which means the standard is functional: can you prove the number?

Retention periods. Keep records supporting a return for at least the assessment period — three years generally, six where a substantial omission is possible, and indefinitely where no return was filed. Keep employment tax records for at least four years after the tax becomes due or is paid. Keep records supporting basis in assets — real property, equipment, and equity — for as long as the asset is held plus the limitations period after disposition, which for real estate frequently means decades. Keep corporate records, elections, and formation documents permanently.

The categories examiners actually test:

  • Travel, meals, and entertainment, § 274(d), which imposes a strict substantiation rule: amount, time, place, and business purpose, plus the business relationship for meals, contemporaneously recorded. The Cohan rule permitting an estimate does not apply to these categories. A credit card statement is not substantiation.
  • Vehicle use, which requires a mileage log distinguishing business from personal use. Reconstructed logs are routinely disallowed.
  • Officer compensation in an S corporation, supported by a reasonable compensation analysis, comparable data, board minutes, and a written employment agreement.
  • Accountable plans for expense reimbursement, § 62(c), requiring a business connection, substantiation within a reasonable period, and return of excess amounts. A plan failing any element makes the reimbursements wages.
  • Related-party transactions, supported by written agreements, market comparisons, and evidence that services were actually performed.
  • Research credit claims, requiring contemporaneous documentation of qualified research activities by business component, and contemporaneous time records or a defensible allocation methodology.
  • Charitable contributions, with the strict substantiation and appraisal rules of § 170(f), where a missing contemporaneous written acknowledgment defeats an otherwise valid deduction entirely.
  • Bad debts and worthlessness, requiring evidence of a bona fide debt and of the year of worthlessness.
  • Inventory and cost of goods sold, with a consistent method and supporting records.

Digital records are acceptable, and the Service's guidance on electronic storage requires that the system produce legible hard copies, index and retrieve records reliably, and be documented. The practical requirement is that the system be able to reproduce, years later, what was recorded at the time.

The reconstruction problem. Where records are genuinely lost through no fault of the taxpayer — fire, flood, a failed system migration — reconstruct methodically: bank and credit card statements, vendor duplicates, third-party records, and industry standards, with an affidavit explaining the loss. Reconstruction works for ordinary business expenses. It does not work for § 274(d) categories, which is why those are the first place an examiner looks.

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This guide is provided for general informational purposes and does not constitute legal or tax advice. Procedures, penalty amounts, thresholds, and program eligibility change, and the consequences of a missed deadline can be jurisdictional. Consult qualified tax counsel upon receiving an examination notice.