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Tips for Handling IRS Notices & Exams

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Recently the IRS has been making life more difficult for traders. In 2009, it announced major new tax-exam programs on the upper-income. (Upper-income is defined as those making more than $250,000 per year.) Those making more than $1 million per year face even more scrutiny.

The IRS has indicated more audits are coming. There is more pressure on the IRS than in prior decades to “close the tax gap” and improve taxpayer compliance. Plus, advanced new IRS-computer systems seem trigger happy these days, sending out tax notices left and right, especially on Schedule C (used by sole proprietors).

IRS COST-BASIS REPORTING IS NEW FOR 2011
The big news for 2011 is new IRS rules for cost-basis reporting from securities brokers. The IRS felt compliance was very lacking on taxpayers and brokers reporting trading gains and losses for securities, and it wanted brokers to report cost-basis and holding period information, designating short-term vs. long-term capital gains and losses.

Taxpayers are forced to deal with a challenging new tax form 8949, which captures the beefed-up Form 1099-B cost-basis and holding period information. We expect many taxpayers and brokers will make errors on Form 8949 and 1099-Bs and key reconciliations — the purpose of Form 8949 — will be off. That will invite IRS tax notices and perhaps tax exams. Random tax notices will likely occur to measure compliance with the new rules.

The IRS also announced closer examination of pass-through entities, C-Corps, global businesses (on transfer pricing), and foreign offshore accounts.

TAX NOTICES AND EXAMS
If the IRS or your state’s department of revenue contacts you with questions or a notice of tax due, or to schedule an exam, don’t panic or reply on your own. Consult a trader tax professional and proceed under this person’s advice, either representing yourself (the inexpensive approach) or by engaging the expert as your tax representative, with power of attorney. Your direction should depend upon your financial resources and the complexity of your case.

EXAM RECONSIDERATION IS UNLIKELY
Traders can reply to the IRS with a “reconsideration” request, asking the IRS to close its exam before it gets underway. If the exam was prompted because a trader filed a Schedule C with a loss, even though the trader had trading gains in excess of expenses, the trader should be able to get the exam closed (assuming he or she easily qualifies for trader tax status). Other types of notices or exams can be closed with little work, too.

EXAMS, APPEALS, AND TAX COURT
If you have a difficult agent and supervisor in the exam process who refuse to understand the nuances of trader tax, it’s often wise to “agree to disagree” at the exam level and take your case to the next level — the appeals process.

The last resort is tax court — often an expensive and more grueling process than a tax exam. If you go to tax court, you must show you acted in one manner or another contemporaneously and that you didn’t change your position in hindsight, which costs the IRS a lot of money.

This is an excerpt from Green’s 2012 Trader Tax Guide • Copyright © 2012