Preparing for an IRS Audit After a Big Settlement or Bankruptcy Reorganization

Preparing for an IRS Audit After a Big Settlement or Bankruptcy Reorganization — How to Get Audit-Ready in 2026

Hook: If you just closed a multi-million dollar settlement or completed a Chapter 11 reorganization, you’re not alone in fearing an IRS audit. Major liquidity events are red flags to revenue agents and advanced analytics engines: the IRS is more resourced and data-driven in 2026 than ever before. This guide gives finance teams, taxpayers, and their advisors a prioritized, practical plan to preserve records, validate tax positions, and engage counsel to reduce audit risk and exposure.

Why settlements and reorganizations draw IRS attention in 2026

In recent years the IRS has increased enforcement capabilities and information matching. Funding provided through prior congressional appropriations accelerated data integration, automated information reporting, and risk-based analytics. The result: large settlements, complex bankruptcy plans, and non-cash consideration are screened earlier and with more precision. Settlement proceeds, cancellation of debt, basis adjustments, and allocations among parties all create taxable events or reporting mismatches that commonly become audit triggers.

What to know up front (the most important steps, first)

1. Stop and assemble a central audit file. Create an immutable, indexed audit binder (digital + hardcopy) immediately. Time and disorganization amplify risk.
2. Identify tax consequences for each item of consideration. Cash, stock, warrants, assumption of liabilities, structured payments — each may be taxed differently.
3. Engage experienced tax counsel early. A lawyer with bankruptcy and post-settlement tax audit experience preserves privilege and steers disclosure strategy.
4. Preserve privileged communications and work product. Direct communications with counsel, privilege logs, and proper document handling reduce waiver risk.
5. Run a pre-audit self-review. Use an internal or third-party audit readiness review to identify weak positions you can fix or document before an examiner does.

Immediate documentation checklist — what auditors will want first

Below is a prioritized list to collect and organize. Keep separate folders (electronic & physical) and an index for each topic.

• Settlement documents: fully executed settlement agreement, exhibits, closing statements, allocation schedules (how proceeds were split among claims), mediation briefs, and escrow instructions.
• Court orders & judgments: final orders approving settlement or plan confirmation, stay orders, releases, and any ancillary docket entries.
• Payment records: wire confirmations, escrow disbursement ledgers, payment schedules, and 1099s/1098s issued or received.
• Tax returns & amended returns: filed returns for years affected, proposed amended returns, and correspondence with tax preparers.
• Bankruptcy filings: Plan of Reorganization, Disclosure Statement, schedules of assets and liabilities, trustee reports, creditor matrices, and tax claims filed in the case.
• Basis and capital accounts: pre- and post-event capital account calculations, stock basis worksheets, and supporting ledgers.
• Allocation memoranda: backup showing how damages, interest, attorney fees, or punitive elements were allocated to taxable/ non-taxable buckets.
• Correspondence with counterparties: settlement negotiations (limited to non-privileged items), letters agreeing to tax treatment, and closing memoranda.
• Financial statements and workpapers: audited statements, management accounts, and any third-party valuations used for allocation or basis determinations.
• Expert reports: valuation reports, forensic accounting analyses, and solvency/insolvency opinions.

How to validate common tax positions you’ll be asked about

Auditors focus on classification and computation. Be ready to show why you treated an item as capital, ordinary, excluded, or tax-free.

1. Character of settlement proceeds

Document the nature of each claim resolved (e.g., breach of contract, personal injury, punitive damages) and the basis for any nondiscrimination allocation. Damages for physical injuries may be excluded from income under IRC §104(a)(2), but emotional distress and punitive damages generally are taxable. Have contemporaneous legal analysis and factual support explaining the allocation.

2. Attorney fees and gross-up arrangements

Show how attorney fees were reported: whether paid out of proceeds, treated as a deduction by the claimant, or reported on a Form 1099. For contingent fees, document the fee agreement and basis computations showing whether a net or gross reporting approach was used.

3. Non-cash consideration and valuation

If the settlement used stock, warrants, or property, produce the valuation methodology, independent appraisals, and contemporaneous board or creditor approvals. Demonstrate why the values used meet the fair market value standard and how tax basis was set.

4. Cancellation of debt and bankruptcy exclusions

Cancellation of debt (COD) can generate income under IRC §61(a)(12). But if the discharge occurs in bankruptcy or the taxpayer is insolvent, exclusions under IRC §108 may apply. Provide bankruptcy court filings, trustee schedules, computations of insolvency, and a reconciliation showing the excluded amount vs COD recognized.

5. Reorganization tax-free treatment

For corporate reorganizations, supply plan documents showing continuity of interest, continuity of business enterprise, and any shareholder consideration required for tax-free treatment under IRC §368. Keep board minutes and shareholder notices evidencing the required corporate actions.

Privilege, document handling, and communication strategy

How you handle documents between now and an audit notice can determine whether key protections survive:

• Engage counsel as soon as tax consequences are identified. Communications with counsel about tax advice are protected by attorney-client privilege and work product doctrine.
• Label privileged materials and isolate non-privileged factual documents. Maintain a privilege log and avoid forwarding privileged drafts to third parties who do not have the same privilege (that risks waiver).
• Control electronic discovery risks. Implement litigation hold protocols for email, Slack, and document repositories. Preservation letters to vendors and trustees should be issued immediately.

"When in doubt, document the 'why'—not just the 'what.' Examiners want to see thought processes and support, not just outcomes."

When to engage counsel, and whom to hire

Timing matters. Hire tax counsel before preparing disclosure positions or responding to IRS inquiries that could waive privilege. Here’s how to choose and engage the right team:

• Look for combined expertise: bankruptcy tax experience, corporate reorganizations, and audit defense. A team that pairs a tax attorney, forensic accountant, and valuation expert is ideal.
• Ask about IRS and DOJ contact experience. Counsel familiar with Appeals, Large Business & International (LB&I) divisions, and criminal tax prosecutors will anticipate escalation risks.
• Define roles and billing arrangements up front. Consider fixed-fee scoping for the audit-readiness phase and contingency or cap structures for extended defense.
• Get a privilege protocol. Your counsel should draft and implement a protocol that protects communications and creates a defensible preservation plan.

Running a pre-audit readiness review (step-by-step)

Before an examiner arrives, perform a concise self-audit using this checklist. Even a 2-3 day focused review can change outcomes.

1. Map exposures: Identify all tax years and items affected by the settlement or reorganization.
2. Gather evidence: Use the documentation checklist — focus on any gaps in the chain of custody or valuation support.
3. Quantify and model: Compute alternative tax outcomes if the IRS re-characterizes items. Include worst-case penalty estimates.
4. Consider voluntary corrections: If errors are material, evaluate filing amended returns or using voluntary disclosure channels to reduce penalties.
5. Plan communications: Draft a factual chronology, a one-page executive summary of tax positions, and a response protocol for initial IRS contacts.

What the IRS will ask and how to respond

Expect information requests targeted to: the source and allocation of proceeds, valuation support, tax basis reconstructions, and any prior inconsistent reporting. When responding:

• Provide well-organized exhibits aligned to the request. Numbered exhibits and a table of contents speed review and reduce follow-ups.
• Avoid volunteering extra information. Answer narrowly to the questions asked, and consult counsel before disclosing privileged analyses.
• Use cover letters to frame factual positions. A short summary of your conclusions and the evidence provided helps reviewers see your logic.

Penalty mitigation and reasonable cause

If the IRS proposes adjustments that create penalties, build a mitigation plan:

• Document reasonableness of positions (relied on counsel, conflicting authority, good-faith interpretation).
• Show remedial steps taken upon discovery (amended returns, corrected information forms).
• Prepare a reasonable cause packet that ties facts to the legal standard.

Practical case vignettes (anonymized)

Vignette A — Post-settlement reporting mismatch

A mid-market company settled a shareholder derivative claim for $8.5M, paid in a combination of cash and restricted stock. The taxpayer classified part of the payment as capital return to shareholders. A pre-audit review uncovered weak valuation support for the restricted stock. The company engaged a valuation expert, re-calculated basis, filed amended returns for a favorable net effect and furnished the valuation to the IRS. The early expert engagement shortened the audit and limited penalties.

Vignette B — Chapter 11 discharge and COD issues

A taxpayer emerged from Chapter 11 with a debt discharge. The original tax preparer did not include a bankruptcy exclusion analysis. A readiness review prepared insolvency and bankruptcy worksheets under IRC §108 and documented trustee schedules. That documentation formed the backbone of the response when the IRS questioned COD reporting — leading to a narrow adjustment and no penalties.

2026 trends & predictions — what to expect next

As we move through 2026, expect these developments to matter:

• Greater automation of matching and faster exam starts. The IRS will continue to automate information matching, which means discrepancies (like inconsistently reported settlement amounts or unfiled 1099s) will generate faster examiner attention.
• Heightened focus on noncash and crypto consideration. Settlement structures involving digital assets or tokenized property will attract specialized exam teams. Keep detailed chain-of-custody and valuation reports.
• More cross-border scrutiny. International reorganizations and transfers will be checked against treaty and BEPS-style reporting; be prepared for data requests from LB&I and international units.
• Alternative dispute resolution gains traction. The IRS Appeals and other ADR pathways are being used more often — effective pre-audit negotiation and settlement strategy can still yield savings.

Checklist: 30-day readiness playbook

1. Day 1–3: Launch audit binder, issue litigation hold, engage counsel.
2. Day 4–10: Collect core documents and hire valuation/forensic experts as needed.
3. Day 11–20: Run pre-audit tax position review, prepare executive summary and penalty analysis.
4. Day 21–30: Decide on voluntary corrections or amended returns; finalize privilege protocol and response templates.

Actionable takeaways

• Don’t wait for an IRS notice. Proactive preparation materially reduces risk, cost, and penalties.
• Document why, not just what. Examiners look for rationale and contemporaneous support for tax positions.
• Preserve privilege. Early engagement of tax counsel protects critical analyses and gives you control over disclosure.
• Use experts wisely. Timely valuation and forensic accounting work can close evidentiary gaps and shorten audits.

Final considerations: timing, cost, and reputation

Audits stemming from settlements or reorganizations can be expensive and reputationally sensitive. However, proactive organization, early counsel engagement, and a focused readiness review typically reduce audit length, exposure, and potential penalties. In 2026 the margin for disorganized responses is smaller: the IRS’s improved data tools mean small mismatches become big issues quickly.

Next steps — how we can help

If you’re managing the aftermath of a settlement or restructuring, prioritize a 30-day readiness review. We provide targeted audit-preparation services that pair tax counsel, forensic accountants, and valuation experts to construct defensible positions and protect privilege. Reach out for a confidential consultation and an immediate checklist tailored to your transaction.

Call to action: Don’t wait for an IRS letter. Contact our audit readiness team today for a fast, prioritized review and start building your defensible record now.

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