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The Terrible Tale of the Rookie IRS Auditor

Our series of Accounting Horror Stories continues for a second year, this time with a chilling account of an inexperienced IRS agent doing an audit.

Oct 2nd 2019
CPA
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Accounting horror stories
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Accounting horror stories

For the most part, all of the IRS agents and auditors I’ve worked with have impressed me with their competence and depth of knowledge. The exception was one agent I worked with who did not appear to have any practical knowledge of the mechanics of filling out a tax return. I met him when one of our clients was being audited.

Through my career, I feel fortunate that I worked with compassionate professionals who balanced tax issues with understanding of and sympathy for the taxpayers’ situations. More often than not, they really tried to help our clients fulfill their tax obligations in a fair and reasonable manner.

The business in question was an S-corporation, which I’ll call “HealthCo,” that operated fitness centers scattered across state. HealthCo was part of a group of related businesses that shared a common owner, with a superstar CFO overseeing the finances for all of the various entities.

HealthCo had lots of stuff going on. An installment note was being paid out to a former shareholder, who had absconded with stock certificates when he left town. Every year or two, another location would be added. One of the entities in this group of related companies did the construction for the entity that held the properties.

HealthCo had five shareholders: two minority shareholders who actually ran the business, the husband and wife who had founded the company, but were largely absent from operations, and a local businessman, who was the common owner of the other related businesses.

The auditor I worked with – I’ll call him “Kevin”– was a nice enough guy. He asked for all the appropriate information, and I supplied it. It was never clear to me what – if anything – Kevin was looking for. Maybe HealthCo just drew the short straw for a random audit.

Our firm did the financial statement audit for HealthCo, so the financials were in great shape. I provided Kevin with the trial balance, transaction details from several accounts, documentation of bank loans and transactions with the especially with shareholders, and other items as he requested them.

My first inkling that Kevin was a rookie came when he called one day and said we were going to have to amend the tax return because the calculations were all wrong. There was a problem with Schedule M-1, which reconciles between book and tax income. It didn’t work. Oh, and the fixed assets and depreciation were wrong too. Those numbers didn’t roll forward correctly.

Mystified, I asked him to show me what the problems were, so he sent me an email with his reconciliations attached. I glanced at his reconciliations, and saw, that yes indeed, he couldn’t get the numbers to tie out. “That’s weird,” I thought.

But since Kevin worked for the IRS, and must therefore be an expert in tax law and tax calculations, I was willing to accept that he was right and there had to be an issue on our end. Our workpapers for the tax return included roll-forwards for equity and fixed assets, but I couldn’t find any problems there.

Maybe there was a glitch in the software? That seemed highly unlikely, but, again, maybe Kevin, being an IRS agent and all, had found a bug in the software. So I teased apart all the reconciling items in Schedule M-1, and created my own reconciliation. My reconciliation worked. Hmm…

I took a closer look at Kevin’s M-1 reconciliation. His numbers – which he had lifted right off the tax return – were right, but his formulas were wrong. He clearly had no idea how the reconciling items worked. He had added things that should have been subtracted and subtracted things that should have been added. So of course, his reconciliation didn’t work.

Suspicious, I looked at his fixed assets roll-forward. Sure enough, he didn’t understand how all the lines on Form 4562 worked. The year under audit was a year when 100 percent bonus depreciation was in effect, so there was a big number in Section II where that gets reported.

His roll-forward for the cost of the fixed assets was off by exactly that big number, which was both the cost of those additions and the depreciation expense for those additions. Apparently, he had no clue how bonus depreciation worked. He had included that big number in the accumulated depreciation, but not in the cost of the assets. I was flabbergasted, to say the least.

How could the IRS send an agent out in the field who had apparently never prepared an S-corp return or who had never studied tax returns to see how the numbers flowed?

I felt sorry for him, so I responded to his email by attaching my own reconciliations, which included clear explanations of how the lines on the tax forms worked. I never heard back from him about the need to amend that return or about those reconciliations.

While there were a few expenses on that tax return that Kevin could perhaps have legitimately disallowed, and a few positions that he could have challenged (but didn’t), the audit came back with no changes. The best result of all for our client, and I definitely won’t complain about that.

But my experience with Kevin made me wonder how he did on his other audits. Specifically,

  • Did he miss fraudulent transactions he should have caught?
  • Did he raise a stink about issues that were really his own mistakes, as he did with us?
  • How does that reflect on the IRS as a whole, if they send agents out in the field who don’t understand what they’re auditing?

I never saw Kevin again after that audit, so I don’t know what happened to him. My guess is that he didn’t last long with the IRS. HealthCo, on the other hand, is still thriving, a decade after that audit.

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