Audit defense strategies for common examination issues

by | Aug 28, 2025 | IRS Procedures & Controversy

Here’s what HIVE AI had to say about “Audit defense strategies for common examination issues”:

Audit Defense Strategies for Common Examination Issues

How IRS Exams Are Selected and Scoped

  • Returns are classified to determine the scope and where the case is worked: correspondence, office (TCO), or field (RA). RAs handle more complex cases and TCOs more limited issues; proper assignment is based on issue complexity and time expectations. Understanding this helps you gauge the likely depth of scrutiny and prepare accordingly 1
  • Examinations serve specific “purpose groups,” including Strengthen Compliance (e.g., R&D credit, digital assets), Preparer/Promoter, Research (e.g., NRP full-scope audits), Protection/Yield, and Coverage. Expect deeper development if your return has issues in these high-priority areas 1
  • NRP audits tend to be broader and more complete across many issues than risk-based audits; anticipate more mandatory issues and comprehensive documentation requests 2

Core Defense Framework That Works Across Issues

Control scope and process from day one

  • Request a clear list of issues and materiality thresholds; keep the exam anchored to those issues using the risk-analysis principles the IRS applies internally (fraud potential, materiality, corollary effects, accuracy of books/records, hours required). Reassess at the mid-audit “50 percent rule” to limit scope creep 3
  • Use the LB&I examination process best practices even for non-LB&I exams: identify knowledgeable personnel for each issue, negotiate reasonable IDR due dates, provide timely, focused written responses with supporting workpapers, and aim for early agreement on facts before arguing law. Provide written legal positions when responding to proposed adjustments (Form 5701) 4

Manage information requests and interviews

  • Confer on each IDR before issuance to keep it focused on the identified issue, negotiate realistic timelines, and deliver complete, organized responses. Where applicable, elevate informal claims for refund within 30 days of opening conference to keep them in-scope 4
  • Prepare key personnel for interviews. The IRS expects to talk to the taxpayer when practical, not just the representative; plan questions and responses in advance, grounded in your accounting systems and operational realities 5
  • Know the IRS’s authority to examine books and take testimony so you can respond appropriately while protecting privileges and confidentiality. Use protective orders or confidentiality measures for sensitive software/trade secrets when summons enforcement is involved 6 7

Build the factual record and spot fraud pitfalls

  • Document facts early and seek an “acknowledgment of facts” on unagreed issues; gaps in documentation are where adjustments and penalties gain traction 4
  • Address potential “badges of fraud” explicitly in your workpapers; don’t overreact to taxpayer procrastination alone, but act when documents appear altered or materially unreliable, as those require deeper development and can change case posture 8

Defending Against Indirect Methods and Bank Deposit Analyses

Common IRS techniques and how to counter

  • When the IRS uses bank deposits/cash expenditures methods, their own manual recognizes three primary defense categories:
    • The computation is inaccurate or flawed
    • The difference comes from a nontaxable source
    • The difference comes from prior-year accumulated cash/existing funds 9
  • Audit defense steps:
    • Rebuild the examiner’s schedule and reclassify deposits by source; identify loans, gifts, inheritances, inter-account transfers, redeposits/NSF items, and non-income items to remove from “taxable” inflows 9
    • Tie out accounting records to bank activity; reconcile timing differences and cash skims claimed by the IRS with third-party statements and loan documents 9
    • Prove nontaxable sources and prior accumulations with contemporaneous records: gift letters, loan agreements, cashier’s checks, prior-year cash-on-hand statements, and brokerage withdrawal confirmations 9

Industry-Focused Defense Tactics

Attorneys and professional services

  • Examiners will probe how the practice operates, responsibility for financial transactions, expected income and cost patterns, and accounting systems. Prepare to map fee flows (retainers, trust/IOLTA, reimbursements), internal controls, and reconcile bank/ledger activity to return positions. Use a tailored interview outline and anticipate follow-ups based on your own pre-audit analysis 5

Real estate: foreclosures and COD income

  • The IRS will examine Forms 1099-A/1099-C boxes for debt discharged amount, FMV, recourse status, and identifiable event code; be ready to challenge inaccuracies and support insolvency, qualified real property business indebtedness, or principal residence exclusions with worksheets and appraisals 10
  • Maintain a robust case file: interview notes, valuation support, basis computations, recourse/nonrecourse analysis, and insolvency computations to preempt adjustments and penalties 10

Excise tax: indoor tanning services

  • Expect IRS focus on undifferentiated payment cards, “free” tanning, bundled fees, red-light beds, group buying, franchise/multi-location reconciliations, and “tanning banks.” Defenses include reconciling POS/tanning software data to returns, segregating taxable vs. non-taxable items, and reconstructing revenue where needed with device logs and appointment records 11

Special Exam Contexts and Rights

Churches and exempt orgs

  • For church examinations, the IRS must provide advance written notice and allow time for a conference before beginning an exam. Multiple exam safeguards apply; a second exam within 5 years on similar issues requires high-level written approval, with specific timing rules. Use these to police procedural compliance and timing of inquiries 12 13

Summonses and sensitive data

  • If the IRS seeks source code or sensitive software in enforcement proceedings, courts can enter protective orders, and special statutory protections apply to software in the IRS’s possession. Raise these promptly if your systems are requested 7

Penalties, Burden, and Case Posture

Reduce penalties via process and documentation

  • Early, complete, and accurate responses aligned to risk/materiality reduce accuracy-related penalties; clear acknowledgement of facts and legal positions at the Form 5701 stage is key 4
  • Where the factual record is questionable (e.g., altered appraisals), anticipate deeper development; proactively replace tainted substantiation to avoid fraud development and preserve reasonable cause defenses 8

Know burden-shifting niches

  • In certain exempt-organization manager penalty contexts, the statute places the burden of proof on the government; use burden rules strategically in Appeals or litigation planning 14

Practical Playbook

Before the first meeting

  • Map the return to your books, bank accounts, and third-party reports; build tie-outs and exception logs
  • Assemble issue binders with statutes, regulations, and primary IRS guidance supporting positions
  • Identify witnesses with first-hand knowledge of each issue and pre-brief them on likely interview topics 5

Managing IDRs and submissions

  • Confer on scope, negotiate dates, and submit organized, cross-referenced responses with an executive summary, facts, law, and conclusion. Calendar follow-ups and memorialize agreements on facts 4

Mid-audit decisions

  • Use the IRS’s own risk-analysis checkpoints to suggest closing low-yield issues, deferring immaterial items, or resolving via issue resolution tools to conserve resources and reduce hazards of litigation 3 4

When the IRS proposes an adjustment

  • Respond to the initial write-up (e.g., Form 5701) with a concise legal memo: facts (agreed), applicable law, analysis, and conclusion; preserve alternative positions and protective claims where needed 4

Want tailored strategies?

Tell me your examination type (correspondence, office, field), the issues raised (e.g., R&D credit, cost of goods sold, 1099-C/COD, digital assets, bank deposits), and the current stage (initial IDRs, interview scheduled, Form 5701 received). I’ll outline a step-by-step defense plan, including documentation packets, interview scripts, and legal authorities to support your position.

Sources

1 – IRS IRM 4.1.5 Case Building, Classification, Storage and Delivery📄 Summarize
2 – IRS – Publication 5784 Estimation of the Underreporting Tax Gap for Tax Years 2014–2016 Methodology📄 Summarize
3 – IRS IRM 4.10.3 Examination Techniques📄 Summarize
4 – IRS – Publication 5125 Large Business & International Examination Process📄 Summarize
5 – IRS – Publication 5602 Attorneys Audit Technique Guide📄 Summarize
6 – Treasury Regulation 301.7602-1📄 Summarize
7 – IRC § 7612(c)📄 Summarize
8 – IRS IRM 4.8.2 Case Processing📄 Summarize
9 – IRS IRM 4.10.4 Examination of Income📄 Summarize
10 – IRS – Publication 5550 Real Estate Property Foreclosure and Cancellation of Debt Audit Technique Guide📄 Summarize
11 – IRS – Publication 6052 Excise Tax on Indoor Tanning Services Audit Technique Guide📄 Summarize
12 – IRC § 7611(b)📄 Summarize
13 – Treasury Regulation 301.7611-1📄 Summarize
14 – IRC § 7454(b)📄 Summarize

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