Federal tax procedures

Taxation and Regulation (REG) · US CPA · 6 min read

Welcome to Federal Tax Procedures!

Hi there! If the idea of an IRS audit or legal tax battles makes you feel a bit nervous, don't worry—you are not alone. Think of this chapter as the "Rulebook for the IRS." We are going to learn how the IRS selects people for review, what happens if you disagree with them, and how long the government has to come looking for more tax money. Understanding these rules is essential for the CPA exam because it’s the framework that keeps the tax system moving fairly. Let's dive in!

1. How Returns Are Selected for Audit

The IRS doesn't have the resources to check every single tax return. Instead, they use a "filter" system to find the ones that look a little "off."

Common Selection Methods

Discriminant Function (DIF) System: This is a computer program that assigns a score to every return. The higher the score, the more likely the return has an error or "red flags" (like very high deductions compared to income).
Information Matching: If your employer says they paid you \$50,000 (Form W-2), but you only reported \$40,000, the computer catches it instantly.
Economic Reality Audits: If someone reports \$10,000 in income but just bought a \$2 million mansion, the IRS might ask some questions!

Types of Audits

Correspondence Audit: This is the most common and least scary. It’s handled entirely by mail. They might just need a copy of a receipt you forgot to attach.

Office Audit: You go to a local IRS office to meet with an agent about a specific issue (like your business expenses).

Field Audit: The IRS agent comes to your home or place of business. This is usually the most comprehensive type of audit.

Key Takeaway: Audits aren't always because you did something wrong; sometimes, the computer's math just doesn't match your math!

2. The Administrative Process (The "I Disagree" Steps)

What happens if the IRS finishes their audit and says, "You owe us \$5,000," but you think they are wrong? Don't panic! There is a step-by-step process to follow.

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Step 1: The Revenue Agent's Report (RAR)

After the audit, the agent gives you a report. If you agree, you sign it, pay up, and you’re done. If you disagree, you move to the next step.

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Step 2: The 30-Day Letter

The IRS sends you a formal letter giving you 30 days to request an "Appeals Conference." This is your chance to meet with an independent IRS Appeals Officer who is trained to settle cases without going to court.

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Step 3: The 90-Day Letter (Statutory Notice of Deficiency)

If you can't reach an agreement with the Appeals Officer (or if you ignored the 30-day letter), you get the "90-Day Letter." You now have 90 days to either pay the tax or file a petition with the U.S. Tax Court.

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Quick Review: Think of the 30-day letter as the "Let's Talk" letter and the 90-day letter as the "See You in Court" letter.

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3. Taking the IRS to Court (The Judicial Process)

If you can't settle with the IRS internally, you head to the court system. There are three "Trial Courts" you can choose from. This is a favorite topic for the CPA exam!

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1. U.S. Tax Court

The "Pay Later" Court: This is the only court where you can litigate before paying the tax.
No jury—only specialized tax judges.

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2. U.S. District Court

You must pay the tax first and then sue for a refund.
This is the only court where you can request a jury trial.
Analogy: Think of the District Court as a "local" court where a jury of your neighbors might be more sympathetic to you.

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3. U.S. Court of Federal Claims

You must pay the tax first.
Located in Washington, D.C. No jury. Usually handles high-dollar, complex claims.

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Mnemonic Aid: Remember T-T. Tax Court = Ticket to avoid paying first.

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Key Takeaway: If you don't have the money to pay the IRS right now, the U.S. Tax Court is your only option to fight them.

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4. The Statute of Limitations (The "Timer")

The government doesn't have forever to audit you... usually. The "Statute of Limitations" is the time limit for the IRS to assess additional tax.

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General Rule: 3 Years. Usually, the IRS has 3 years from the date the return was filed (or the due date, whichever is later).
25% Understatement: 6 Years. If you forgot to report income that is more than 25% of your gross income, the IRS gets 6 years.
Fraud or No Return: No Limit! If you commit fraud or simply never file a return, the IRS can come after you 50 years from now. There is no statute of limitations for "bad actors."

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Example: If you filed your 2023 return on April 15, 2024, the IRS generally has until April 15, 2027, to audit you. But if you hid a massive \$100,000 bonus, they might have until 2030!

5. Penalties and Interest

The IRS uses penalties to encourage everyone to play by the rules. Here are the big ones to know:

Failure to File Penalty

This is for being late with the paperwork. It is 5% per month of the tax due, up to a maximum of 25%.

Failure to Pay Penalty

This is for being late with the money. It is 0.5% per month of the unpaid tax, up to 25%.

Important Rule: If both penalties apply in the same month, the Failure to File penalty is reduced by the Failure to Pay penalty. The IRS doesn't "double dip" at the full rate.

Accuracy-Related Penalty

If you are negligent or significantly understate your tax (but it wasn't full-blown fraud), the penalty is 20% of the underpayment.

Fraud Penalty

If the IRS can prove you intended to cheat, the penalty is a massive 75%.

Quick Formula for Penalties:
$ Penalty = (Unpaid Tax) \times (Penalty Rate) \times (Months Late) $

Key Takeaway: It is much more expensive to forget to file than it is to forget to pay. Even if you don't have the money, you should always file your return on time!

Final Summary Checklist

Before you move on, make sure you can answer these:

Which letter gives you 90 days to go to Tax Court? (Answer: The 90-Day Letter/Notice of Deficiency)
Which court allows a jury trial? (Answer: U.S. District Court)
How long is the statute of limitations if you omit 30% of your income? (Answer: 6 years)
Which penalty is higher: Failure to File or Failure to Pay? (Answer: Failure to File - 5% vs 0.5%)

You’ve got this! Tax procedures are just about knowing the "rules of the road." Keep practicing these timeframes and court names, and you'll be ready for exam day!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is the Discriminant Function (DIF) System in the context of IRS audits?

The DIF System is a computer program that assigns a score to every tax return to identify potential errors or "red flags" for audit selection.

How do Correspondence, Office, and Field audits differ in their scope and location?

Correspondence audits are handled by mail for minor issues, Office audits occur at an IRS facility for specific topics, and Field audits are comprehensive reviews at the taxpayer's home or business.

What is the purpose of the Revenue Agent's Report (RAR)?

The RAR is a report issued by the IRS agent after an audit that details the proposed adjustments to the taxpayer's tax liability.

What is the significance of the IRS 30-Day Letter?

The 30-Day Letter notifies the taxpayer of their right to request an administrative appeal with an IRS Appeals Officer within 30 days.

What is the 90-Day Letter, and what are the taxpayer's options after receiving it?

The 90-Day Letter (Statutory Notice of Deficiency) gives the taxpayer 90 days to either pay the tax or file a petition in the U.S. Tax Court.

Why is the U.S. Tax Court unique compared to the other trial-level tax courts?

It is the only court where a taxpayer can litigate their case before paying the disputed tax deficiency.

What are the defining characteristics of the U.S. District Court for tax litigation?

The U.S. District Court requires the taxpayer to pay the tax first and sue for a refund, but it is the only court that allows a jury trial.

What is the general statute of limitations for the IRS to assess additional tax?

The general statute of limitations is 3 years from the later of the date the return was filed or the return's original due date.

When does the statute of limitations for tax assessment extend to 6 years?

The statute of limitations extends to 6 years if the taxpayer omits items of gross income that exceed 25% of the gross income reported on the return.

How is the Failure to File penalty calculated and capped?

The penalty is 5% of the unpaid tax for each month the return is late, up to a maximum of 25%.

What is the rate for the Failure to Pay penalty?

The penalty is 0.5% per month of the unpaid tax, up to a maximum of 25%.

What is the penalty rate for civil tax fraud?

The penalty for tax fraud is 75% of the portion of the underpayment attributable to fraud.

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