Friday, January 20, 2017

NRP Audits - The Honest Taxpayer's Worst Nightmare

An audit by the IRS of tax returns can be very intimidating. When the IRS audits a taxpayer they usually don’t look at every single line item on a tax returns, and they don’t’ look at every single receipt. This is particularly true when a taxpayer demonstrates maintenance of accurate and complete books and records. BUT, a regular audit is nothing compared to the dreaded National Research Project (NRP) audit. Its predecessor, the TCMP audit, or Taxpayer Compliance Measurement Program audit, was highly controversial.

TCMP audits produced many complaints. The TCMP program was postponed in 1994 due to political pressure; then, the program was completely eliminated in 1995 due to budget cuts implemented by Congress. However, the IRS was back at it a few years later under what it calls the National Research Project. It’s the same overwhelming and burdensome audit as the TCMP audit, just under a new name. These audits of randomly selected taxpayers are highly intrusive audits that look at, and require proof of, every detail reported by a taxpayer on their tax return. They often last longer than a normal audit because of the extreme level of detailed review.

According to the IRS, the purpose of the NRP is:

NRP provides the IRS with current, reliable data on filing, payment, and reporting compliance that will support strategic decisions about the placement and type of resources necessary to effectively address the needs of taxpayers. This is done in the most cost-effective and least burdensome manner possible.

To paraphrase, the IRS uses NRP audits to statistics that are analyzed to determine how to better catch those cheating on their taxes and to better allocate resources for that purpose. The problem is that individuals randomly selected for the audit are subjected to a grueling line-by-line, receipt-by receipt audit. Every aspect of the return is reviewed and verification of every single deduction is reviewed. You often hear these audits referred to as the “audit from hell.”

Thinking of NRP audits reminds me of the short story “The Lottery” by Shirley Jackson. According to Wikipedia “one of the major ideas of ‘The Lottery’ is that of a scapegoat, or someone who is blamed for society's evils and is banished in a sort of renewal ritual. The act of stoning someone [randomly selected] to death yearly purges the town of the bad and allows for the good.” This seems oddly fitting to the rational of randomly selecting sacrificial taxpayers for NRP audits in order to figure out how to better catch tax dodgers. It must be okay since it is done in the name of the greater good, right?

In order to develop reliable data from these audits, the IRS must review every detail of the tax return. These audits are not fun. The bad actors caught up in an NRP audit can be assured of owing a lot more in taxes. The average Joe does a pretty good job of reporting to the IRS and paying taxes. But, they are not perfect in saving every receipt, logging every business use of a vehicle, or expense of entertaining a client. The result is that not only do they have to reconstruct proof of expenditures in excruciating detail, they often end-up losing deductions because their proof does not perfectly comply with the Internal Revenue Code. In an ordinary audit, many Revenue Agents will allow an expense deduction when it is verified by proof consistent with the spirit of the Internal Revenue Code, even if that proof is not strictly compliant. Not the case with an NRP audit. The deduction is denied absent proof that strictly complies with the Internal Revenue Code.

While the purpose of the NRP audit is noble, it is a nightmare for those unlucky taxpayers who are selected. It’s interesting that the Internal Revenue manual section lists one of the program benefits as follows:

When a compliant taxpayer is unnecessarily or ineffectively contacted by the IRS, the public's perception of the effectiveness and fairness of the federal tax system is hurt. Additionally, compliant taxpayers want to know that the IRS is capable of ensuring that everyone pays their fair share of taxes. The IRS uses a variety of techniques such as document matching, correspondence and audits to verify that taxpayers accurately report their tax liability on their returns. The IRS should audit those returns most likely to have errors. Various methods are used to identify errors with the most common method using Discriminant Function (DIF) (sic) formulas to select returns for examination.

The Discriminant Index Function (DIF) referenced in the above quote is a scoring formula applied to tax returns to determine those that will be selected for audit.

It could be argued that the IRS’s effort to avoid unnecessarily contacting taxpayers by conducting the NRP audits to update the DIF is, in and of itself, an unnecessary contact. They are so intrusive that the positive public perception the IRS seeks to uphold is terribly undermined. Thus, conducting NRP audits is contrary to the stated benefit.

A better focus for the IRS would be to update its antiquated technology to better engage in matching internal records like 1099s and W-2s to a tax return to verify accuracy. The IRS could also utilize examinations selected under standard protocol and elevate those to NRP audits, rather than random selection of any taxpayer. At least in this manner those subjected to the rigors of an NRP audit are taxpayers who were already selected for audit under normal protocol. There are enough “no change” audits selected under normal selection procedures for use in comparison with audits that do result in adjustment that it seems like a reasonable and viable approach to developing accurate statistical data to update the DIF.

Unfortunately, there is no reason to believe the IRS is going to stop doing this. Taxpayers with the misfortune of being selected for an NRP audit are best served by engaging an experienced CPA or tax attorney; specifically, a tax professional with experience handling NRP audits. It’s best to select one with experience handling these types of audits. Next, the taxpayer needs to immediately begin assembling all records for the year or years under audit. Those records should be organized in a manner which can be easily followed and then matched to your tax return entries by the IRS Revenue Agent conducting the audit. Workpapers and accounting records used in preparation of a tax return are often very helpful and sometimes required.

No taxpayer ever really knows if and when he’ll be audited, so it’s best to stay prepared. Keep very good organized records, be diligent in keeping all bookkeeping up to date and accurate, do not comingle personal nondeductible expenses with business expense deductions, and use a highly regarded CPA to prepare your tax returns. Consult with your CPA on best practices for keeping required records for common problem areas like meals and entertainment, vehicle, travel, business use of home, etc. Raising the level of diligence will go a long way to help get efficiently through not only an NRP audit efficiently, but a regular audit as well. Doing so will eliminate a lot of stress and some of the cost associated with the audit experience.