EXPLAINED: IRS audit "insurance" - no more fear of an audit?

[Michael Plaks]

This is a follow-up to my recent post about IRA audit myths. In this long sequel, I will discuss hiring audit and "IRS audit insurance."

1. DIY IRS audits.

Can you defend yourself against an IRS audit without hired help? Absolutely. I personally know quite a few people who took on the IRS and emerged victorious.

Here is when it makes sense to DIY:
⦁ the amount of money at stake is not large
⦁ you believe your tax return was accurate
⦁ you have good records and supporting documentation
⦁ the issues under audit are relatively straightforward
⦁ you're not afraid of the IRS
⦁ you're organized
⦁ you have skills to persuade people
⦁ you can keep your cool in adverse situations
⦁ you have time

You don't need to hit every item on the above list, but the more the better.

Here is when you may benefit from being represented by a professional:
⦁ the amount of money at stake is large
⦁ you are not sure whether your tax return was accurate
⦁ your records and documents are incomplete or missing
⦁ the issues under audit are complex and controversial
⦁ you are afraid of the IRS
⦁ you are disorganized
⦁ you don't have good persuasion skills
⦁ you may lose your cool under stress
⦁ you don't have time or your time is very valuable

The more of the above applies to you, the more reasons you have to consider hiring help.

2. How much does it cost to hire IRS audit representation?

Same question as - how much does it cost to hire a contractor/event planner/therapist/divorce attorney/business coach? (I noticed that my examples have been accidentally arranged in a somewhat logical sequence.) The answer, of course, is: it depends. Depends mostly on the complexity of the task and the level of the helper.

Replying to a simple request by the IRS to prove a few specific numbers may cost you a $1,000 if done by your budget tax preparer. A similar response by a CPA or an EA who specialize in IRS representation may cost you $2,000. Same service can be $4,000 with a tax attorney. (This old thread discusses the differences between between CPAs, EAs and tax attorneys.)

Representing you in a full-scope audit of your business income and expenses cannot be under $5,000 no matter who takes the job, and it will go much higher for complex issues, large businesses, bad documentation, and so on. Usually, although not always, you get what you pay for.

3. Audit insurance concept

When something may happen down the road that costs more than we're able (or willing) to pay, we use insurance. What's the premise of insurance? It is basically a gamble. Ironically, you gamble that something bad will happen to you, and insurance companies gamble that everything will be alright.

If nothing bad happens, the insurer wins his gamble: they keep your premium, and they don't have to pay you anything. In case of a bad but insured event, you "win": for the modest cost of your premium you receive a much larger insurance payout, and you don't have to cover the damages out of your own pocket.

IRS audit is one of those events that could cost you dearly if things go wrong. And yes, there's IRS audit insurance. To understand what it does and does not do, we need to reflect on how other insurance works:

⦁ does it guarantee that bad events won't happen? as in - we won't get diabetes or won't get into an accident?
⦁ does it pay to restore things to where they were before? as in - will we become as healthy as before or will it bring back our pet lost in a fire?
⦁ does it pay for consequences of bad events? as in - will it pay my salary if I quit or lose my job due to my illness? will it pay for my relocation if I have to move due to a threat of repeat flooding or repeat wildfires?
⦁ does it have limitations, exclusions and pre-existing conditions?
⦁ does it restrict my choice of restoration/treatment providers?
⦁ can I buy insurance after the accident already happened or when it is imminent, such as an incoming hurricane?

4. Audit insurance does not prevent audits

Anybody who "guarantees" that you won't get audited is a liar. The IRS states here in black and white that some audits are random. How do you guarantee against this?

Next, let's consider the most typical route to an IRS audit: the IRS computer flags something strange, and an IRS human reviewer decides that it warrants an investigation. You have W2 income of $200k and a rental portfolio with losses. Normally this income is too high to apply any losses against W2 income. But you claim REPS (Real estate professional status) and suddenly - voila! - your losses are allowed against W2!

Will the IRS computer flag using rental losses against high W2 as unusual? You bet. Will the IRS employee recognize that you claimed REPS? If they know where to look for this indicator (and you can't count on their technical knowledge!) - yes. Will they leave you alone at this point, having noticed REPS? Maybe and maybe not.

If they were competent enough to notice REPS, they may be competent enough to know how to qualify for REPS. And qualifying for REPS while having a full-time W2 job is next to impossible. How often does someone check the REPS box on their taxes without bothering to learn the rules? Pretty often. And the IRS knows. They may want to verify whether you qualify. Welcome to an audit!

Tell me again how you guarantee that this will NOT happen.

5. Audit insurance does not guarantee that you win an audit

It would have to be an enormous rock for you to hide under if you have not heard about "no-brainer" lawsuits that were somehow lost in the courtroom. When there was "no way" to lose this case. Yet it was lost.

Any audit, save for the most trivial ones, deals with uncertainty. Uncertainty of facts, uncertainty of documentation, and uncertainty of legal interpretation. On top of that, living and breathing people are involved in the process on both sides, and people are the most unpredictable creatures.

They can be ignorant, they can be mean-spirited, they can be under all kinds of influences and pressure, they can simply be too tired this day or fresh out of a fight with their spouse. Even the most unbiased and knowledgeable tax experts in the country, aka US Tax Court judges, sometimes make head-scratching decisions that defy explanation.

You can't beat this with insurance.

6. Audit insurance does not ensure quality representation

First issue: personnel. Who is going to do the talking? Who is going to do the writing? Who is going to do research? Who is going to do data organizing? Even if your audit insurance specifies a competent licensed person, such as a CPA/EA/attorney as your representative, all the supporting tasks are often delegated. Sometimes to interns. And sometimes to overseas VAs.

Second issue: effort and motivation. Even the most qualified person can apply themselves 110% to the task oh half-*** it. Or quarter-*** it. It depends first and foremost on the person's integrity, and it's a scarce commodity these days. Then we have motivation. If the job is done under insurance, your representative is definitely not making their regular rate, whether hourly or flat. They are doing it for much less. You can connect the dots.

On top of financial motivation, we have all the usual human factors: overload, exhaustion, physical ailments, mental health. And the common joke is only partially a joke: it does matter what they had for breakfast.

Third issue. These days we have a brand new and scary threat to the integrity of legal representation: AI. More than one attorney has already been caught and reprimanded for delegating their job to ChatGPT, sometimes with drastic consequences for their clients. I expect this to become an epidemic. The temptation to cut corners with AI is very strong, and the mechanisms to curb/control it are practically non-existent.

7. Audit insurance never pays your taxes if you lose

I hope you're not surprised to read this one. Let it sink in. Your taxes are always your responsibility. If you lost an audit, and the IRS determined that you owed them an extra $10k in taxes - these are taxes on the income you previously made.

Your income = your taxes. You always pay it out of your pocket, never out of the insurer's pocket.

8. Audit insurance never pays your interest if you lose

If you owe taxes to the IRS, you also owe them interest. By clearly written law, the IRS is prohibited from removing or reducing interest.

So don't try to negotiate interest. You can't, and they can't, even if they wanted to. Which they do not.

No audit insurance product that I have seen covers interest. And it makes sense.

9. Audit insurance may cover IRS penalties

It totally depends on the contract you sign with insurance provider.

Unlike interest, IRS penalties are negotiable and are often removable. Your representatives count on their ability to get the penalties removed or at least reduced.

It is common, although certainly cannot be assumed, that your audit insurance will pay those penalties that they were unable to remove. One notable exception is the 20% penalty for substantial understatement of taxes. This penalty is directly tied to the amount of extra taxes assessed by the IRS and is therefore unpredictable and is commonly passed on to you.

Even if penalties are covered, there're often dollar limits and exceptions. Read the terms carefully.

10. Audit insurance is NOT regulated

Speaking of conditions and exclusions - nobody regulates audit insurance. Health insurance is controlled by federal law. Auto and property insurance is controlled by state law. Audit insurance is the Wild West. Providers are free to do whatever they want.

No two audit insurances are the same or even comparable. You really have to read and ask questions, otherwise you may have unpleasant surprises when the IRS knocks on your door.

11. Audit insurance usually does not include challenging an unsuccessful audit

If you lost an audit, it is not the end of the road. At a minimum, you have an option to request a reconsideration by the IRS Appeals. In the internal IRS hierarchy, Appeals officers are far better trained and more competent than the Compliance officers aka auditors.

More importantly, unlike the auditors, Appeals officers are specifically trained in tax law. If your issue involves differences in interpreting or applying the law, it makes sense to contest your audit in front of Appeals. The success rate at Appeals is favorable, as long as you have your ducks in a row. Or at least in some kind of formation.

If the IRS broke their rules or procedures along the way, and it does happen, you can request assistance from the Taxpayer Advocate Office - a semi-independent department of the IRS that is somewhat similar to customer service.

And, if less drastic measures fail but you feel strongly about your case, you can take the IRS to court. The US Tax Court is the standard venue for litigating the IRS, but there are other courts that take tax-related cases, all the way up to the Supreme Court potentially.

Audit insurance may or may not cover Appeals. If covered, it may be free or involve extra cost. It may be limited in many different ways. Again, read your terms.

As to litigation - it is never covered by insurance.

12. You cannot buy audit insurance when notified about being audited.

Should not be surprising. In health insurance, this is called pre-existing conditions. Otherwise, we would only be buying insurance when already in trouble and in need of help.

So, if you already received an audit notice, it is too late to buy audit insurance.

13. How much is audit insurance?

It depends, of course. What is included and what is excluded. How complex is the return covered. How long does it last. Who provides representation. And a lot of other specifics.

As a rule of thumb, audit insurance offered by the tax firm that prepared your tax return could be 10-20% of what it would cost to hire this firm for full representation.

Example: $750 insurance vs. $6,000-$8,000 audit representation fee.

14. Cost v. benefit

It's sad how often investors hire IRS audit representation without cost/benefits analysis and how often these services are being sold without such analysis.

Let's say the IRS challenges 5 of your deductions. Remove them and recalculate your taxes. This is an equivalent of losing the audit completely. How much will you owe? Let's say $10,000 before penalties and interest.

Here is the what-if assuming the representation fee is $6,000:

⦁ if you don't challenge the audit at all, you pay $10k to the IRS
⦁ if you hire representation and lose, you pay $10k to the IRS plus $6k to the CPA
⦁ if you hire representation and win, you save $10k but pay $6k to the CPA, for a net $4k win

Considering that winning is not guaranteed, and it may only be a partial win - paying for representation is debatable in this example. I personally would not, but you may see it differently.

However, a $600 audit insurance instead of the $6,000 fee would be an excellent investment in this example. If only we could know in advance...

15. Cheap audit insurance from TurboTax, H&R Block and other national providers.

Adding Intuit audit insurance to the tax return you prepared on TurboTax is merely $60. Considering that hiring a CPA/EA for audit representation would cost you at least $5,000 and buying an audit insurance from private tax firms is at least $500 - we must agree that $60 is a real bargain.

Is it, though? Yes and no.

These large national chains do not keep CPAs/EAs/attorneys on their payroll specifically for audit representation. They hire it out, on as needed basis. I talked to some people who are contracting with Intuit to provide audit representation.

The fee they receive from Intuit varies based on several factors, but it's in the 3 digits. Regular hourly rate of an experienced CPA/EA for audit representation is at least $200, often a lot higher. So they are paid for less than 5 hours of their time, sometimes for 1-2 hours. Even if we assume they are working a discounted hourly rate, they simply don't have adequate time for full-effort representation.

What DO they do, then? - I asked them. They collect documents from the client and present it to the IRS, with some minor dressing up. Then they communicate to the client what the IRS decided to do. No digging, no research, no creative presentation, no extended fights. There is no time allocated for any of that.

Is it getting the best possible outcome? Defniitely not. Picking the low hanging fruit, at best.

Could the client accomplish the same result without this help? Maybe. If they have the needed documents and can organize them, can speak the IRS language, conduct themselves professionally - likely yes.

Is the insurance valuable then? Compared to its nominal cost, probably yes. Even if you're able to do the same job yourself, your time alone would certainly cost you way more than $60.

The real unknown is: could you do better on your own than these poorly motivated intermediaries?