Important Facts about Tax Audits
"An IRS Audit." Those words can often strike fear into the minds of normal law-abiding citizens. Knowing some of the basic IRS principles can help to take the fear out of an audit and even make you feel as if you are comfortably ready to go through with the process.
The problem with the audit is that if you are found to have done something wrong on your tax return, it is usually a year or two after the return was filed. The idea that you may owe additional taxes, and then penalties and interest on top of the taxes, can be quite disconcerting.
Understanding even the most basic steps in an IRS audit can help you.
Common "Triggers" of Audits.
Certain items when claimed in a tax return will almost certainly "trigger" some concern, which may lead to an audit. These most common include,
- Huge swings in income;
- Large capital gains in any year;
- Substantial itemization of deductions;
- Your occupation, where cash is rampant; and
- Your occupation, where there is propensity to receive potentially untraceable revenues.
Step One: Receiving Notice
Typically, the first step in the process as far as you are concerned is that you receive a different color notice in the mail, certified mail, or registered mail, from the Internal Revenue Service. The IRS has never released information about who it selects for an audit and why these persons, or entities are selected. We know that there are certain random selections each year that apparently have no basis on the return for any questionable items. They were selected simply because they were drawn.
Otherwise, it is clear that certain items in returns will "red flag" a return for an audit. One of the more recent examples is a claim for various "home office" deductions, for instance where a person would attempt to deduct 20% of the value of their home, because that is where they did some of their work. Actually, the home office rules have become quite popular now, and they are also fairly clear in their enforcement. But, before the popularity of "home offices", deductions for these expenses routinely produced an audit.
Another item that often "red flags" a return for an audit is a huge difference in income from past years. The IRS will most assuredly be interested in why you have all of a sudden made 20 times your past annual income, or 20 times less than your past annual income. The IRS, although not in public statements, will be looking at the increase, and especially earlier years to see if the income grew in the years before the return, but was not reported. In the case of reporting 20 times less income, the IRS will almost certainly conduct a rigorous investigation to determine why they are not receiving their share of the taxes for that return, as they had in the past.
Step Two: Decide Whether to Retain Professional Assistance
There are advantages to having help and some advantages to not having help. It is rumored to be an advantage not to have help, so that the IRS might have the "poor citizen really did not know what he/she was doing" attitude. Many believe that this prompts the IRS to "go easier" on the person than if they had a CPA or lawyer. We express no opinion on this, as it probably varies from auditor to auditor. We believe that if there is a question of several thousand dollars or more, you ought to seek help as fast as possible.
Advantages of Professional Help:
- Less stress on you;
- Someone to blame and to "take the heat;"
- Little or no missed work time;
- Settlement opportunities on problem items may be better;
- Help if you really know problems on the return exist; and
- Potential shield from charges of wrongdoing if fraud exists.
Delaying an Audit
One area where a professional can help is in delaying the audit, if necessary. Many auditors like the feeling of surprise, and frown on delays. Other auditors will readily grant one or more, so long as the requests are not abusive. If you have a real documentation issue, and it involves several hundred dollars or more, and you know you can obtain the documentation, you ought to request a delay and be sure to give yourself a little extra time. Be sure not to volunteer the reason for the delay, just simply state that it has to do with procuring some of the information noted in the Audit Notice
Disadvantages of Professional Help:
- More cost and bills to pay especially if IRS finds problems;
- Sometimes only a specific item is in question and the amount is small; and
- If you did your own tax return you may be comfortable enough to handle the audit on your own.
Step Three: Preparation for the Audit
Once you know how you will proceed, it is important to commence pulling together the materials you will need. These include:
- The return in question;
- The actual IRS Notice of Audit;
- Past years returns;
- All documentation for items, especially deductions.
Perhaps one of the best ways to proceed is to focus on the IRS Notice of Audit and attempt to learn what exactly they are looking for in your return. Many audits are general, but many are also specific, in that a specific item, such as a change in income or a deduction, aroused their attention. While you ought not to assume that satisfying them on this item alone is enough, you might be able to limit the audit, if you can produce a substantial amount of documentation on the specific item, such that it lends credibility to every other item on the return.
Additionally, you should focus on each item of your return for the year in question. Try to produce support or documentation for all of your income and all of your itemized deductions. Look at your income and see that W-2s, 1099s and other documentation are in place. Try to justify all income on your return with documents of paper that indicate the source of all your income. You may then check your bank statements for the entire year, and determine how much money followed through your account, or accounts. The IRS will usually do this. If the income flowing through your bank account(s) [including your investment accounts and others] is essentially equal to the income you reported on your return, you can often feel as if the documentation will support your claim of income.
What if the money flowing through the account(s) is substantially more than that claimed on your return? The IRS might ask for account information, and if they do, you can be almost certain that they will analyze the money flow. Once they discover this discrepancy, they will request verification for the other money flowing through your account(s), that they will deem "income" and make you prove otherwise. What you can do before the audit [remember do not volunteer information, just be prepared when they ask] is to analyze the difference between the total deposits and the claimed income on the return, and try to figure out where the additional money came from. For example, it may be that it is a tax exempt gift from a relative, for example, and does not have to be income. This gift can be up to $ 10,000 per person per year.
Be sure to provide documentation, and find the source of the "extra money" before the audit, if necessary. If you cannot explain it and be sure that it would not be considered income under the Internal Revenue Code, you might be forced to amend your return and claim it as income, thereby inflating your tax liability, along with interest and penalties.
If you find a discrepancy of a thousand dollars or more, you ought to be seriously concerned, since there are criminal penalties for intentionally not reporting income. This does not mean that we are suggesting that this was done. The IRS has the burden of proving that income was underreported, and that, in effect, a fraud was committed. It is important that you should know that considerable legal troubles can arise from not reporting income that should have been reported. In fact, you may wish to consult with a lawyer, experienced in audit and tax matters, before discussing your return with a CPA. You may need the combination of both professionals to help you, if there is the threat of criminal or substantial civil penalties.
Step Four: Analyze Your Record-keeping and Documentation Thoroughly
Be sure to have appropriate documentation for all items on the return. If you do, you might be able to have a confident feeling during the audit. If you do not, and the problem areas result in additional taxes, penalties and interest, you may want to consult a professional well in advance of the audit to help you either examine your potential liability and prepare for the audit and/or assist you in the audit.
For additional information regarding specific documentation that you should retain, see Recordkeeping on the Internal Revenue Service Website. The IRS Publication 552, Recordkeeping for Individuals, lists the kinds of records you should keep for tax purposes as well as providing information on where to find information on specific areas.
Step Five: Results of the Audit
During the audit, the auditor will usually give you a good indication of where any problems areas are and what your potential liability is. It is important to maintain your demeanor and to avoid excessively aggressive behavior. That type of behavior usually never works, whereas a nice attitude and cooperation usually works to your benefit.
Once the audit results are rendered, you will be given an explanation of what your rights are in the event that you disagree with the audit results. As with any legal process, there are specific time limits and serious procedural requirements. You must comply with these, even if you disagree with the audit results, or you will lose your rights to appeal to a higher administrative official or even the Tax Court.
Because you will be treading on ground that will be extremely unfamiliar and often intimidating, it is wise at this juncture to consult with either your CPA, or a tax litigation lawyer, or preferably, both. They will be able to assess your chances of success at higher levels. Many auditor decisions are considered arbitrary and can be successfully contested. But you must understand procedures and the applicable law, or you will not be successful. Contrary to popular belief, judges are not always sympathetic to the person who represents their own case in court, without legal advice.
If you are facing and audit and would like an attorney’s assistance, please contact member services. We’re here to help, and we can help match you to an attorney that will suit your needs.