How To Deal With An IRS Audit To Avoid Penalties
FAS CPA & Consultants
What Is An IRS Audit?
An IRS audit is the process of reviewing your tax return. The audit is the result of discrepancy of information received by the IRS and the information that you have reported on the tax return.
What triggers an audit is the continuous misreporting of transactions for a period or several years that the system of the IRS realized or discovered that there is a misreporting of income or an over reporting of expenses and because of any of these 2 options or a combination of the 2 the consequence of this is the trigger of an audit and this could be to a person and to the business. That’s one of the reasons the IRS audits someone.
Many times, the taxpayer not even knows that he is underreporting or over reporting, don’t know that they have inflated expenses or deflated income, they don’t know how to read a financial statement and are not interested in knowing otherwise they will do their taxes by themselves, especially if they don’t have a qualified CPA, tax attorney or enrolled agent.
Accountants or tax preparers must help clients and maximize their returns they inflate or overreport the expenses or omit some income with the objective of getting the maximum return. Same thing with business, reducing the revenue or the sales and increasing the expenses with the only objective of getting a larger amount of refund or reducing the amount the taxpayer must pay to the IRS.
The second reason an audit is triggered, this specific tax preparer they usually have many clients so when the IRS checks the approved check, they discover there is one single route for this reporting, so they go to the route belonging to the tax preparer and then they are going to audit the rest of the clients of that same tax preparer. So sometimes you get audited when you’re not supposed to get audited because the IRS discovered one client that has misreported information and belongs to that same tax preparer.
The third way you get audited happens when the IRS discovers a misreporting with another client this is for example when a client dies and there is the final tax return to be filed, the IRS requests information to support whatever is on the state return and many times the person representing the deceased client is not familiar of the IRS forms and when there is a lot of taxes to pay, the revenue is in charge of reviewing the state tax return.
Many documents are given without knowing to the revenue officer and in that documentation, there is information incriminating another party so even though the other party was not supposed to get audited there exists information that provoke an audit as well.
Whenever you receive a letter from the IRS, is not an audit there are letters is just to let you know that the IRS found something in your report that is not supposed to be there or that the records of the IRS are not as the ones that you presented. If there is no answer to that letter, the IRS will send another letter that is a bill saying how much you owe because you didn’t answer and then you must decide if you pay that or you send your documents to the IRS saying that you owe less or another amount, but you have to say something.
Now when the IRS audits you, they send you a large file with very single amount that’s reported on your tax return and what the IRS has computed and why is there a difference there and they are asking you to accept or sign but is never advisable to sign without consulting first with a qualified attorney, CPA or enrolled agent specialized in the IRS and debts resolutions because once you sign that document there is nothing else you can do, you can’t go back.
How the IRS will decide to Audit you
Every year many taxpayers receive a letter from the IRS audits to start the process of an audit. Many believe that because of bad luck or God’s punishment, they have to face the IRS. If you want to avoid this drama, panic and the emotional effect of an IRS audit, make sure your return doesn’t include any of the topics below.
This is a summary of situations for which the IRS decides to audit you:
⇒ You Earn over a Million: If you make over: If you make over a million a year, your chance the IRS audits you increase from 0.84% to 8.42%.
⇒ Filing for Estate Tax: This is not the typical state tax return you file if you live in NJ or NY. Estate Tax is for high-network individuals who received an inheritance and file a return to report the income that such inheritance produced.
⇒ Taking Losses on Rental Properties: You can only deduct rental losses if you are a broker, a landlord or a real estate professional and if you have spent 50% of your working time and 750 hours every year participating in real estate.
⇒ Early Withdrawals from Retirement Accounts: Retirement plans and IRAs are liable to a 10% penalty in addition to the regular income tax payment. Many taxpayers try to omit the penalty and that calls an IRS audit.
⇒ Holding Money Offshore: If you don’t inform the IRS of your foreign bank accounts for any individual or compound balance over $10,000, the offshore bank itself will do it directly to the IRS. File FBAR report by April 15 and avoid being audited and penalized up to $10,000.
⇒ Charitable Deduction: The IRS keeps a check on the average donations of every person of every income level and if your donation exceeds that amount then you can expect the IRS to be suspicious but if you have nothing to hide then you have nothing to worry about an IRS audit.
⇒ Not Reporting All of your Income: If you have many sources of income make a file and keep a record of everything to avoid confusion and an IRS audit if you forget to report something.
⇒ Business Losses: If you are in business, either as a self-employed or as a company, you are in business to make money. The IRS will audit your reporting losses.
⇒ Alimony Payments: If you divorce and the judge decrees you give a pension to your spouse until she dies or remarries, you can deduct the payments. Any other payment must be named as alimony on the divorce decree to be deductible or you can face an IRS audit.
ODDS
It seems that one of the things Americans fear the most, is an IRS audit, and understandably so. Despite the universal fear, audit numbers are down to an all-time low. More than 150,000,000.
As a rule the IRS audits the traditionally non-compliant taxpayers:
⇒ Small Business Payers.
⇒ International Payers.
⇒ High-Wealth Payers.
⇒ Earned Income Tax Credit fraud schemes.
Audits are not the only way the IRS scrutinize tax returns. Some algorithms employed result in automated checks on filings. The automated under-reporter program (IRS CP2000) matches income and IRS information, ad red flag discrepancies, for which explanations requests are automatically generated. This system outnumbers audits by 3.1 to 1.
The budgetary constraints have even impacted the automated checks. Despite these IRS CP2000’s not being audited, it enhances the IRS’s ability to challenge taxpayer’s returns. When combined (rates for CP2000 matching and returns challenge), the odds of the IRS challenges you come to 1/35 rather than the audit odds of 1/161.
What’s The Damage?
It is costly to be audited. More than 90% of all taxpayers (individuals) who undergo and IRS audit, will face an additional payment; for an old fashioned field audit, this extra payment – and shock to the system – will come up at an average of $21,918. The same average for a “mail audit” will be less, and averages out at $6,014.
A CP2000 is also not cheap. During 2017 the IRS collected and average of $2,033 per notice issued, for a whopping extra revenue of $6.7 billion. What’s more, over and above the additional taxes payable, the IRS also charge penalties (for inaccuracy) of 20% on top of the same.
What Can I Do to Beat The ODDS?
Sometimes the odds are the odds, especially for higher-wealth taxpayers and international taxpayers whom the IRS believes returns likely contain errors and omissions. For the rest of us, full disclosure is the way to go. Report all wage and income documents; never omit any documentation.
When hiring a tax professional, they would do some due diligence by investigating your tax returns for previous years and request a post-filing review during the summer before the CP2000s go out in November. Any unreported income found and disclosed with an amended return, can help you to avoid accuracy penalties.
For those of you who do receive a CP2000 notice, it might be the right time to visit your local tax professional.
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What Happens If IRS Audits You?
If the IRS audits you, they are going to give you a plan of action. When there is an audit the first step is giving you the justification for the audit, it’s usually a document depending of the returns, if there are 2 returns of the company and the individual, and also depending of the years, if there are multiple years. There is what is called the statute of limitations, meaning that you can only be audited 3 years back, except for misreporting of income and every single year is open to an audit. If there is no misreporting of income on the tax return, then the IRS can only audit you 3 years back including the year you are filing.
If in those 3 years you have provided the information to the IRS and the numbers of the IRS are different, they are going to send you a letter for each year that the records are different. Every letter will be between 5 to 10 pages will tell you what you reported in the personal return and in the company return, the second column will be the numbers that the IRS is recognizing and at the end will say your numbers and tax owed and our numbers and taxes owed and that’s the amount that you owe. That will be per year. If you have an LLC or S Corp you will receive one letter for the business and the individual, remember that the business is passed through entity and the letter will include the personal and the individual return.
Once you get that the IRS is serious and they want that money, at that point you have two options, agree with them, and sign the document and write a check or set up a payment plan and satisfy the IRS. But remember whenever that happens, they are going to include penalties and interest and if you receive any refund, you will add to it. In addition to that, because of the misreporting of income or over reporting of expenses now you must pay taxes, so on top of the refund you have to give back there is a portion of tax that you have to pay and because you didn’t pay them on time now you have to pay interest and penalties.
Can You Go To Jail For IRS Audit?
No you can’t go to jail for an IRS debt If you owe money for yourself, it means that if you are in audit or the IRS sends you a letter and this is because of your individual tax return, this is exclusively because you are not able to pay the taxes that are reported on your income personal tax return and this is exclusively yours and no one else, there is no third party involved there is no money of anyone but yourself and only your debt then no you can’t go to jail for any reason.
But the IRS will collect the debt in any way or another, the IRS will garnish your salary meaning that it will withhold, it will force you employer to withheld 10% of your salary, the IRS will kidnap your bank account up to the amount that you owe and or the IRS will place a lien on your property and neither of this 3 the lien, the garnishment or the kidnap of your account will be removed unless you pay your debt.
That’s why is very important that if you’re not able to pay your debt with the IRS do a payment plan. Is very easy to do a payment plan if you owe less than $25,000 you don’t even need automatic debits if you owe more than $25,000 up to $$50,000 you need automatic debits, but they are not going to ask for any financial information at all.
Let’s say that you have a company and whenever you have a company you have employees and you have to pay payroll and within payroll you have payroll taxes and they must be paid to the IRS but if the owner of the company doesn’t do the payments that they are withholding from the payroll tax of the employee plus the amount the employer needs to contribute that are 7.65% from the employee and 7.65% for the employer that is Social Security and Medicare so they combine 15.2% of all the salaries paid to the employee. So, 15.2% of your gross salary needs to pay to the IRS. If that 15.2% is not given to the IRS in a monthly basis and you can’t keep doing that through the years that is a felony because you are withholding and using money from somebody else. And this happens many times for companies, small businesses are not able to pay to the IRS the payroll tax that is Social Security and Medicare withheld from the employees because there is not enough cash and if they do that through the years the IRS is going to come after them criminally. And then the business owner is going to go to jail.
The payroll taxes belong to the IRS, the US Treasury to Medicare and the Social Security, but remember this payroll taxes is not yours, the misappropriation of funds is a crime and because is a crime is punishable with jail and at that point you do go to jail because you have committed a crime so be careful, if you are the owner and you cannot sustain a business because you can’t pay payroll taxes better fire everybody and work 24 hours a day and 7 days a week until you can get your employees back, or move the office to your home and minimize your expenses and start from scratch, many small business started from home instead of not complying with your obligations with the IRS because they are going to go after you and the person who is not reporting the payroll tax timely and this is sustained through the years the IRS will come after you and the person is going to jail.
What Happens If You Get Audited And Fail?
There is a case where you report as an individual and you have a business and the business is claiming expenses but the business doesn’t have the invoices for the expenses so if you don’t the invoices for the expenses you cannot prove your deductions and because you cannot prove your deductions you are not able to claim your deductions and they now the profits of the income are larger than before, you have more profit now because you have less expenses therefore your taxes are going to be larger because you are not able to prove the expenses the IRS is going to disallow the expenses at that moment you fail because you fail to prove the expenses that you claim in your tax return in the company tax return or even in the individual tax return if this an individual tax return and you are claiming credits and you are not able to support those credits with evidence the IRS is going to disallow those credits, is going to ask to return the refund and you’re going to have to pay taxes on top of that return because you owe them because those credits created a fictitious refund and you’re not entitled to that.
So, at that point is when you fail the audit you failed to prove that the deductions that you were claiming were true, were real and because of that failure you are going to pay more taxes. Many times, the reason of the credits, the reason of the expenses is the refund. Whoever did the refund created all this expenses and provided all the information with the objective of getting a larger refund and now all those expenses and all those credits are disallowed now you have no refund. But in addition, that you have no refund now you must pay taxes because you have income now, income that needs to be taxed and the taxes need to be paid. So, the consequences of failing in that return is the return, you have to give back the refund, you have to pay taxes because now you have more income and in addition to that you also have to pay interest and penalties.
How To Prepare for an IRS Tax Audit
Individual taxpayers who are under audit by the IRS may attend the audit in person without any assistance from a tax professional. However, this can be a dangerous mistake. Although not officially stated, it is the job of an IRS Revenue Agents to conduct an audit with an eye toward finding additional tax owed. With so many gray areas in tax law and considering the tax code’s complexity, an individual who chooses to go it alone is a sitting duck. Without extensive tax education and experience, the examiner can (and sometimes will) say anything to find additional tax due on the return. Without the necessary knowledge, the taxpayer is powerless to refute the agent’s rationale.
Selection of Returns for Examination
Unreported Income
The IRS performs matching functions to reconcile information reported on Forms 1099 and W-2 with information reported on the taxpayer’s return. If income reported by the taxpayer does not meet or exceed amounts reported to the IRS, the taxpayer will receive either a bill for tax on the difference or an audit notice.
1099 Reclassification
The IRS conducts joint employment audits with state tax agencies to determine whether workers classified as independent contractors are in fact employees. One initiative looks at employers who issue both Forms 1099 and W-2 to the same employee in the same year, while a second examines employers issuing more than five 1099-MISC forms exceeding $25,000 each to contractors with no other source of income.
Schedule C, Profit or Loss From Business
Issues associated with sole proprietorship are common audit triggers. The IRS has several approaches to achieve an increase in income tax, as well as the assessment of self-employment tax.
⇒ Unreported income. There is a relatively high potential for unreported income from cash transactions with sole proprietorship. The IRS will examine the taxpayer’s bank records to detect deposits that are unaccounted for, compare revenue and expenses of similar businesses, and in some cases will perform a “lifestyle” audit to reconstruct income based on changes in the sole proprietor’s net worth based on the valuation of assets.
⇒ Significant losses reported on Schedule C or losses continuing over two or more years may increase the chance of an audit. If the IRS is successful in reclassifying an activity as a hobby instead of a for-profit business, loss es will be disallowed.
⇒ Bartering. The fair market value of products and services received through bartering can be considered business income if the products or services rendered are associated with the sole proprietorship. If the sole proprietor trades through a barter exchange program, the program will issue Form 1099-B, Proceeds from Broker and Barter Exchange Transactions.
Audit Procedures
The IRS uses the Automated Underreporter (AUR) Soft Notice to encourage taxpayers to self-correct income reporting with minimal burden and resources. Notice CP 2057 is issued to certain taxpayers with apparent under-reported income. The form informs the taxpayer that there appears to be a discrepancy with the income types listed but does not provide them with any type of calculations. It instructs the taxpayer to file a Form 1040X to correct their return if the information shown on the notice is correct. The IRS does not directly follow up these notices but taxpayers that repeat their behavior will be identified in the following tax year.
Examination by Mail
The taxpayer receives Notice CP 2000 from the IRS disclosing proposed changes. The taxpayer typically has 30 days to respond and has three options to the IRS proposals:
⇒ To agree with all the…
⇒ To partially agree with the…
⇒ To dispute all the changes proposed by the IRS.
The taxpayer is allowed to sign an authorization that enables another party to represent him or her in connection with the Notice CP 2000. The authorization is part of Notice CP 2000, and a separate power of attorney is not required.
Examination in Person
The revenue agent will send a letter to the taxpayer requesting that the taxpayer phone the agent. At that time, the date, location, and agenda for the first meeting will be set. The taxpayer has the right to request that the examination take place at a reasonable time and place that is convenient for both the taxpayer and the IRS.
Audit Strategy
The best way to prepare for an audit is to put oneself in the auditor’s shoes. Take the perspective that you are looking for anything possible to increase the tax liability on the return. This is an area where a qualified tax preparer can be invaluable.
Pose tough questions and “throw out” any questionable deductions. Make sure any issue raised during an audit is something that has already been considered. If the pre-audit function is performed properly, the actual audit will be more comfortable, and you will be prepared for any negative adjustments.
Audit Video
The IRS has created a video web page to assist taxpayers preparing for a small business audit. Go to the IRS website at www.irsvideos. gov/audit.
Requesting a Different Auditor
A taxpayer or taxpayer’s representative has the right to request a different auditor if the current one seems uncooperative, too busy, or too inexperienced to properly consider the issues under examination. The request should be made to the auditor’s supervisor by phone or in writing and should include a detailed explanation of the reasons for the request.
Take It Seriously
Any comments made to an IRS employee that could be interpreted as a threat to the employee will be taken seriously and fully investigated. Do not to joke around with IRS employees during an examination.
Repeat Examinations
If a return was examined for the same items in either of the two previous years, and no change was proposed to the tax liability, contact the IRS immediately and the examination will likely be discontinued. This policy is in accordance with IRC section 7605(b), which states that no taxpayer shall be subjected to “unnecessary examinations.”
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Tips to Avoid an IRS Tax Audit
The word TAX AUDIT may send shivers down your spine. But, there’s nothing to worry about if you’re honest and have filed your taxes correctly. You can’t stop the IRS from auditing your taxes. However, you can take some precautionary measures to avoid an IRS tax audit on your tax return.
Know the IRS tax audit selection process
If you are being selected for a tax audit, it doesn’t mean there’s a problem. The IRS uses a computer program known as the Discriminate Income Function (DIF) to compare your deduction with those of others in the same income bracket as yours. Don’t get scared with this and miss out the deductions which you are entitled to. Just keep documentations ready for backup purposes in case of emergencies. If your account gets selected for an audit, you’ll be notified by the IRS via mail. Remember, the IRS won’t break this news through the telephone.
Whether or not you’ll get selected for a tax audit is pure “luck.” However, check out the remaining tips to avoid being audited.
Check out whether or not you’re a target
Your chance of being selected for a tax audit mostly depends on your profession. That is, if you’re a doctor, lawyer, accountant, or if you’re in a cash-only business (like a hairdresser, bartender, waitress), you’re more likely to be selected. It’s because chances of tax cheat may probably happen in these types of profession. So, in this case, you need to be extra cautious (especially with your deductions) while filing a tax return.
Check your calculations
You will be first on the list of tax audit if you’ve filled out the papers with wrong figures (erroneous calculations will also affect your IRS tax refund). The tax system is already complex. Don’t invite extra complications by entering incorrect data or making mistakes in calculation. Double check your numbers before submitting your tax return. Even better, wait for all your bank and investment statements, income reports and other financial statements before starting the paperwork.
Provide explanations for inconsistencies
If you think that your tax return may raise an audit flag, produce forms, worksheets, receipts, etc explaining the cause. For instance, if your charitable deduction is higher than in past years, you must provide explanations for it. Also, consider presenting copies of canceled checks.
Know what triggers a tax audit
You may be questioned if your account shows bad debt expenses, home office deductions, medical expenses, casualty losses, and business travel, entertainment, and meal expenditures. However, having proper documentation will help you deal with an audit better.
Avoid filing an amended return
Generally, when people file an amended return it means they want to correct the errors or/and they want to take more advantages of their return. That’s why when you file amendments to your return your account comes to notice of the tax auditors. So, to avoid being selected for a tax audit, try to file your tax return correctly the first time.
Form LLC if you’re self-employed
Self-employed and small business taxpayers have more chance of being audited. In fact, small businesses are IRS’s favorite targets of a tax audit. In this scenario, self-employed taxpayers have a breathing space. That is, they can form a limited liability company (LLC) as it’s less frequently audited by the IRS.
Fill out the exact numbers and be neat
Write neatly, and put the exact figures instead of rounding them off while filing a tax return. Hence, the IRS agents can review your return without much stress. Make sure your state tax returns are matching the federal ones.
Be honest
Always remember (especially when you’re dealing with your finances), “honesty is the best policy.” Fill out your papers with 100% honesty to reduce the chances of a tax audit. You’ll be in danger if the IRS finds out that you’ve tried to mislead it.
Leave no blank space
You may think that it’s better to leave an empty space than to fill out the form with inaccurate information. Never do that. Leave nothing blank as it’ll make room for a tax audit. Even if it’s a simple dash or zero write it down to fill out any blank space. Even if you did your taxes correctly, there’s no guarantee that you won’t get selected for a tax audit. The above tips may lessen your chance of being selected, but that doesn’t mean you can avoid it fully. However, provide proper documentation and don’t hide anything from the IRS if you’re ever chosen for an audit.
Red Flag you Should Avoid to The IRS Not Select You For An Audit
Sometimes the IRS officers choose to audit taxpayers who have family links to others being audited or because they found some errors on the tax return. It is certainly a situation you don’t want to fall into because any inaccuracies can lead to a penalty charge of 20% of the disallowed amount for filing a refund claim with errors. In other cases, if the tax return is classified as ‘frivolous’ you may have to pay a penalty of $5,000. These are yet, the least of the problems an IRS audit can bring to you. More serious development of the situation can lead to criminal charges for tax evasion or fraud. So to make sure you won’t go through this stressful experience, avoid these red flags any IRS officer would pick up.
Too many deductions
One of the most common reasons for and IRS audit is too many deductions on the taxpayer’s return. Too many means “higher than average” in relation to the person’s income. These deductions can come from real estate interests, contributions to charities and charitable trusts, and student loan interests. For example, if a taxpayer earns $100,000 a year and they claim a deduction of $35,000 for charity, then the likely outcome of this is an audit.
Too many expenses claimed for a side hustle
There’s a difference between having a business as your main or substantial source of income and having a hobby from which you make some extra money on the side. For example, if you make some small gifts in your free time and then sell them on an online platform or to your neighbors, that’s not a business. Modern slang classifies it as a ‘side hustle’. In this type of scenario you can only claim expenses up to the amount you earn from the activity. If you claim more, that automatically becomes a red flag and can get you an IRS audit.
Taking money out of your retirement account too early
The law allows you to withdraw money from your retirement account before you are 59 years and half on three occasions:
⇒ If you are buying your first home.
⇒ If you have emergency medical expenses.
⇒ If you are paying qualified educational expenses.
In any other instance, you will be penalized with a 10% charge on top of the withdrawal fee. Because of that, many taxpayers decide to not report taking money out of their retirement account. This is a big mistake. The likelihood that the IRS will find out that you made a withdrawal is very high and you encounter a double trouble – pay your penalty, plus get audited for filing an incomplete tax return.
Too many business expenses
Business owners who claim too many unreimbursed employee expenses are also waving a red flag to the IRS. Until last year, the law allowed up to 2% for such expenses to be deducted from the adjusted gross income. With the new tax plan, that deduction is eliminated but the changes will apply for your tax return due April 2019.
It will be unwise to try and squeeze in as many employee expenses as possible in this year’s tax return just because you won’t be able to take advantage from the deduction afterwards. The officers will notice the surge in expenses claim on the return and this could be a cause for an IRS audit.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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