With over thirty four years working as a Certified Public Accountant, providing professional tax preparation advice, preparing thousands of tax returns, and representing numerous clients before the IRS, I have just about seen it all. Despite the fact that we’ve just ended the tax season for this year, audits of those tax returns just filed might take a complete year to sixteen long months to show up in the Internal Revenue Service system for analysis. So let’s talk about what may cause an Internal Revenue Service audit, and how to shield and protect yourself in the future.
Now before we begin I would like to point out that we are not talking about leaving genuine deductions on the table, or not taking advantage of every potential lawful tax planning strategy available. Tax avoidance is completely legal and I would argue your financial responsibility to yourself as well as your family. Tax evasion on the other hand, can get you in to some hot water. It’s very important to understand the difference. Believe it or not, it was tax evasion that ultimately sent Al Capone to Alcatraz, and not the St. Valentine’s Day Massacre.
“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934).
There are varying opinions on the subject of what may trigger an audit. In its 2010 Data Book, the IRS offers some interesting stats. About 1.1% of 142 million individual income tax returns filed were audited in 2010. Of those, almost 1/3rd were lower income returns claiming the earned income tax credit. This was because the earned income credit can actually create a tax refund over the tax withholding a taxpayer may have.
This is effectually being compensated by the government, for having a lower income and dependent children. As you can imagine, this is an area that is largely abused. For returns having non-business income of $200,000 to $1 million, there is a 2.5% chance of audit, raised to 2.9% for returns with business activities. By far though, returns having an income over $1 million, the audit rate was close to 8.4%.In regards to business tax returns, only 1.4 percent of the smaller corporations with overall assets of $250,000 to $1 million dollars were audited. This rate heightened to 1.7% for assets of $1 – $5 million and to 3% for assets reaching upwards of $5-10 million. If you have above $10 million in assets, the audit rate rose to 16.6%. For partnership and S corporation returns, the audit rate was 0.4%. From an audit perspective, operating your small business as a Sub S Corporation, Partnership or Limited Liability Corporation LLC has obvious advantages over filing as a Sched. C (self-employed).
When my firm prepares a tax return for either an individual or business, I will always explain to our clients that I am assuming the return will be audited, despite the fact that the chance is pretty small.
We organize our work papers, supporting tax documents, reconciliations, and receipts in an organized, indexed order, electronically catalog and categorize these items, and begin to prepare the returns. We will ask questions. Many questions. Probing and detailed questions that can sometimes seem unusual, but are designed to tease out the most obscure details that we might be able to employ to take every legal tax deduction or favorable tax position achievable. If there is eventually an audit, we are more than prepared to provide the Internal Revenue Service Agent with absolute support for every item on the return. More importantly, that same procedure guarantees that I have turned over every stone, and saved every possible penny for my clients.
Even if you may have complete support and documentation for all the deductions on your return, to be audited is a losing proposition. You will still have to devote a great deal of time just preparing for the examination, and the stress and anger associated with this process can take its toll. Regrettably With the IRS, you’re guilty until proven to the contrary, and even a entirely innocent remark can open up a can of worms. The best thing to do is to hire a tax expert to represent you, and to avoid any personal contact where possible. Even if you walk away with no adjustment, in the end, it can be quite and expensive process.
In the end, you don’t want to be audited no matter how confident you are of your return, so what can you do to help your return get through the system unscathed? As it turns out, quite a bit.
- Report Every Form 1099. Payers of interest and dividends or brokerage firms that place your stock trades, send a copy of your Form 1099 to the IRS computer. If you fail to include the exact figures on your return, the computer will flag the return and you will receive a love letter from Uncle Sam explaining the error of your ways.
- Report Mortgage Interest Per Form 1098. When you pay interest on your home mortgage, the bank also reports the interest amount to the IRS on Form 1098. These figures must agree with your deduction. If you own a second home, there are rules as to the maximum amount of mortgage interest that can be deducted.
- Report Form K-1 Income. If you are a member of a partnership or a Subchapter S corporation, or if you are a beneficiary of a trust or estate, your share of income or loss is reported to you, and to the IRS, on Form K-1. As with Forms 1099, failure to report the same income numbers will flag your return.
- Real Estate and Form K-1 Losses. If you have rental real estate and lose money, the amount of loss you can actually deduct is limited. Likewise, if you are a passive investor in a partnership or S corporation, your losses may be limited or suspended. The ability to deduct those “passive” losses is contingent on your “tax basis”, how much you have at risk, whether or not you materially participate, and other complex rules. Deducting such losses when not allowed is a sure way to earn some unwanted attention from the IRS.
- S Corporation “Reasonable Compensation”. If you own an S corporation, make sure the company pays you a fair market wage for what you do. The IRS wants to see wages, because wages are subject to FICA and Medicare taxes whereas “distributions” from an S corporation are not. If you take too much in distribution and little or no wages, then the IRS radar screen will signal trouble.
- Sole Proprietorship Business – Schedule C. Schedule C is used to report income and expenses for your unincorporated business. It is also exponentially increases the likelihood of your return being audited, because business deductions are often an area of abuse. In addition, many people will try to take a hobby or pastime, claim it is a business, only to write off the costs associated with that hobby. Bear in mind that the IRS assumes you’re in business to make money. Showing a loss year after year might make the IRS question whether your business is legitimate or worse, just how you are managing to cover your living expenses.
- Business Expenses – To be considered a legitimate business expense, an expense must be both “ordinary and necessary in carrying your trade or business.” Deductions that seem out of place or not ordinary for your trade or business, might call attention to your return. Travel and entertainment and car expenses are chief culprits and always heavily scrutinized by the IRS.
- Home Office Deductions – If you use part of your home for business, you may be able to take a home office deduction. However, to qualify for the home office deduction, the IRS says you must use the part of your home attributable to business “exclusively and regularly for your trade or business.” That means your home office must be your actual office, not just a spot in your home where you sometimes do work, and it must be exclusively work space and not used for other purposes. Generally, the deduction is based on the size of your home office as a percentage of the overall house, with expenses prorated accordingly.
- Charitable Donations. If you make cash contributions, make sure you have receipts to back them up. High charitable deductions in relation to a taxpayers overall income, is usually a red flag. If you make non-cash contributions, you will need to file Form 8283 with specific details of the items donated and the organizations receiving them. Large non-cash donations may require an independent appraisal attached to the return. Excessive valuations are a sure bet to generate unwanted attention from the IRS.
- Using Too Many Round Numbers – your tax return is not the place to use “estimated” numbers. In fact, too many round numbers on a tax return implies guesses or exaggerated tax deductions – all of which will simply not add up in the eyes of the IRS.
These are just a few of the more common items of course, so it is important to always consult your tax advisor on your specific circumstances, or to use good judgment if you prepare your own tax returns. Good preparation during the year will save you time and money come tax time.