Which Factors Lead to an Income Tax Dispute Resolution Procedure?

The IRS may initiate an examination through correspondence (often a simple request for documentation) or through a formal audit notice that specifies which items on your return are under review. The agency selects returns for examination based on statistical sampling, specific industry or income-level targeting, or detection of patterns that suggest underreporting. Once notified, you have the right to representation and the opportunity to provide documentation supporting your reported position. The examination process can range from a brief correspondence audit to a comprehensive field audit involving interviews and extensive record review.

State tax authorities often initiate disputes independently or in coordination with federal determinations, particularly when federal adjustments affect state taxable income. The New York State Department of Taxation and Finance, for example, may audit income tax returns based on federal examination results or on state-specific risk factors. State disputes follow procedures similar to federal disputes but may have different appeal processes and different statute-of-limitations periods. Understanding both the federal and state dimensions of a dispute is critical because a resolution at one level does not automatically resolve the other.

After the initial examination, if you disagree with the examiner's proposed adjustments, you may request an appeals conference with the IRS Appeals Office, which is a separate administrative body designed to provide an impartial review. The Appeals Office considers both the hazards of litigation (the likelihood that the IRS would prevail if the case went to court) and the strength of your factual and legal arguments. This stage offers an opportunity to settle the dispute without proceeding to formal litigation. If you do not reach agreement at Appeals, you may pursue litigation in the Tax Court, District Court, or Court of Federal Claims, depending on whether you have paid the disputed amount.

In practice, the burden of proof in tax disputes operates differently depending on the stage and the nature of the issue. During examination, you generally bear the burden of substantiating deductions and credits you claimed; the IRS need not prove you are wrong, but rather must show a reasonable basis for the adjustment. From a practitioner's perspective, this means that contemporaneous written documentation, such as receipts, invoices, contracts, and bank records, becomes your primary defense against proposed adjustments. If the IRS asserts fraud or substantial understatement, the burden may shift, but only after the agency presents sufficient evidence to support that allegation. Courts in the Southern District of New York and other venues often require that documentation be both contemporaneous and specific; delayed or reconstructed records may receive limited weight, particularly when the taxpayer had reasonable opportunity to maintain records during the relevant tax year.

A dispute arises after a return has been filed and questioned; compliance, by contrast, involves evaluating your reporting methodology, entity structure, and deduction strategies before or during the current filing season. If you are in dispute, the focus is backward-looking: what documentation supports what you reported? If you are addressing compliance, the focus is forward-looking: what changes to your reporting or business structure will minimize future exposure? These are not mutually exclusive. A taxpayer may simultaneously defend a prior year return in dispute while restructuring current year reporting to ensure compliance going forward. Addressing both dimensions often requires separate but coordinated strategies.

The IRS generally has three years from the date you file a return to assess tax, though this period extends to six years if substantial income is omitted and may be unlimited if fraud is involved. State tax authorities have their own statute-of-limitations periods, which vary by state. Once you receive an examination notice, the statute of limitations may be suspended during the examination and appeals process, but it resumes once the administrative process concludes. If you are considering litigation, you must file a petition in Tax Court within ninety days of receiving a notice of deficiency, or you must pay the disputed amount and file a refund claim before pursuing a refund suit in District Court or the Court of Federal Claims. Missing these deadlines eliminates your right to litigate.

Your immediate priority upon receiving an examination notice should be to locate and organize all records supporting your reported position: bank statements, invoices, receipts, contracts, contemporaneous business records, and any communications with advisors regarding the items in question. If original records are unavailable, reconstructed records (such as bank statements obtained from your financial institution or credit card company records) may provide some support, but are generally weaker than contemporaneous originals. Courts may infer unfavorable facts if you fail to produce records that would reasonably be expected to exist. Before any formal hearing or appeal, ensure that your factual record is as complete and well-organized as possible, and consider whether any additional evidence (such as expert opinion on industry-standard practices or third-party verification of claimed expenses) would strengthen your position.