Tax Audits
What is an "audit"?
Every taxpayer is very much afraid of an IRS audit. It's looked upon as a horrible thing, and rightly so, because the purpose of the audit is to get additional funds from you. Even if you have all your receipts and all your documentation and you go there by yourself, the tax auditor is going to tell you some things that may not be 100 percent in-keeping with the way the rules are.For example, let's say you have unreimbursed automobile expenses because you use your car for work. You would go the audit and say, "These are my automobile expenses." They're going to say, "Well, do you have a log of each day, where you drove and how many miles it is?" And you'll say, "No, I don't have a log. I don't keep track of that." Then the auditor will tell you, the uninformed taxpayer, "I'm sorry. Section 274 says that it's not deductible. We're not going to allow you any of it." Whereas if you were represented by a tax preparer, the tax preparer would argue that there's other ways of proving the mileage that you drove and that it would be deductible. I would strongly advise every taxpayer not to go by themselves to an audit.
What types of audits are there?
Regarding IRS audits, there are different types of audits now. The most contact that you'll have would be what they call a CP2000, which is a correspondence audit even though they say it's not an audit; but they do a computer matching of W-2's, 10-99's, and 10-98's with the items reported on your return, and if they're unable to match it, they send you a letter saying, 'We show that you didn't report this on your return, and this is how much money you owe, and this is an underpayment penalty as well.' You can do that by mail, show them that it was reported, or if not, say 'hey, I'm sorry, I made a mistake, I'll pay the tax and the interest, but it was an honest mistake - I didn't get the K-1 or the 10-99 or I moved, so please don't asses the penalty.' - That'll work. They also now have in-office correspodence review audits, where the IRS will question one or two items on your return and ask you to mail in substantiation of those items. That, and the first one, a tax payer could probably do by themselves. The third type is where it's an office audit, where they require you to come into their office and bring the substantiation with you. In that type of audit, you definitely should be represented by someone. The final type of audit is the field audit, that's where the Internal Revenue agent comes to your place of business, or your home - looks around, walks around, asks questions, and questions you about it. You should definitely be represented by a CPA or a road agent.
How does the IRS decide who to audit?
The reason for an audit varies. Most times you will be told it's just a random selection, the luck of the draw or some reason like that - but that's not really true. The IRS uses a very sophisticated scoring system to determine which returns to audit and which returns not to audit. If a complex system uses a different scoring which is based on your income, total income is reported on your return.
How can I avoid an audit?
The best way one can avoid an audit is to always report all of your income. It's a big mistake not to report all your income. When I was an Internal Revenue agent, we did not have this 1990 reporting system where the income was matched up to the return, and we found, that at that time, in the early 60s, if you didn't report your income and it didn't go in the bank account then the chances are we wouldn't find it. However, if we did find it, then we didn't like it at all and the taxpayer paid dearly for that. On the other hand, those taxpayers who claimed deductions that are perhaps a little in excess of the amount that they can prove, the worst possible cases, they will pay a little tax and a little interest but it won't be any catastrophic results for doing that.
What are some tax filing "red flags" that can trigger an audit?
Another factor to be considered in the audit of returns is whether the expenses that you're claiming for a particular category are much higher than the average expenses claimed in that category by people in your position. Another item that they would look for in an audit would be unusual expenses that are way out of line. I once had a client who proved absolutely he had $120,000 in legitimate deductible automobile expense. However, in preparing the return, I refused to put down the $120,000, because that number itself was too large without something else to call part of it.
I got an audit notice - what should I do?
If you're a single person working on a job, you're not going to get an audit notice if you report all your income. If you have a substantial business involvement or entities that you're involved with, you're going to already be represented by an enrolled agent or a CPA. You should immediately forward the audit notice to them. Sign a power of attorney and let them take care of it for you. Don't call the IRS on your own - let your CPA take care of it.
How can I prepare for an audit?
To prepare for the audit, you'll need to assemble substantiation of the items questioned, which means cancelled checks, receipts, and other information regarding the items questioned. Bring those to your tax preparer - hopefully in some kind of orderly manner to save him the trouble of going through all your stuff and categorizing it - and that will simplify the preparation for the audit.
What's the statute of limitations for audits?
Regarding audits, the statute of limitations is three years from the time your return is filed. After three years, unless there's an omission of 25 percent or more of your gross income, the statute is closed. However, if you omit 25 percent or more of your gross income on your return, then the statute of limitation is six years. So, in most cases, four years is long enough to keep your records. If you're running close to the line, I'd suggest six years. However, be advised that if there is tax fraud involved, then there is no statute of limitations on it.
What is "tax fraud"?
Tax fraud would be a taxpayer who deliberately undertakes to defeat the tax laws through subterfuge and phony means, and an intentional desire to do something fraudulent or dishonest: having secret bank accounts or not reporting your income, for example.
What are the most common reasons for audits?
Some of the common areas are low net profit on Schedule C with a home office expense being claimed. So, for example, if you're self employed and you gross $150,000 and you net $10,000, that's sort of very suspect and that would be ripe for audit. Generally they want you to net 50% of your gross on a Schedule C. Another example would be a client who has a long history of problems with the IRS regarding not properly filing and paying the payroll taxes, not being a willing complier with the IRS code. There, you're apt to get audited more often based on attitude. The third one that recently comes to mind is not a return that I prepared but a new client that saw on TV or in a magazine or newspaper, some firm that was telling them how they can avoid paying taxes by creating trusts and offshore accounts and going through a whole scenario of obviously fraudulent behavior. This guy, who was duped into paying them a huge sum of money to put into this was audited by the IRS because of it. And I found that by going along and agreeing that yes, this guy was duped, and that yes, we want to do the right thing, I was able to work out a very favorable settlement for him so that he was able to immediately get rid of these entities and pay the proper taxes that were due and the IRS was happy to forgive and forget.
What are some tips for dealing with IRS from an insiders' prospective?
The civil service, especially the Internal Revenue Service, has a very tough job to do. Nobody likes to pay taxes. What I noticed from my experience, when I was in my early twenties in a large group doing major cases, is that being a civil servant and conscientious, I found some CPA's and lawyers treated me in a disrespectful manner. They sort of looked down on me and gave me a hard time, so I did the same to them. Those people that were cooperative, that were pleasant to me, I gave an easier ride.
