How the Audit Begins: The IRS Letter

If you get a letter from the IRS, open it immediately. Apparently, you are worth auditing and the letter is physical proof of it. The worst thing you can do is do nothing. It won’t go away. This seems obvious, but I can’t count on my fingers and toes recounted stories of clients bringing in the IRS letter unopened after it’s been sitting around for weeks/months. If you do not act within a specific period of time, you are essentially accepting whatever the IRS says. You can be pretty confident, this is not good for you.

What is an Audit?

You’d have to have lived under a rock not to know that an audit is the government’s way of keeping tax payers honest. What you may not know is we have what the government calls a “voluntary system of tax compliance.” This doesn’t mean taxes are voluntary. Just ask Wesley Snipes (see below: Tax Evasion).What this means is the IRS trusts you to understand your tax obligation, to follow the laws, file timely and accurate returns, and pay the taxes you owe. A tax audit is the hammer the IRS has broad authority to use to make sure every tax payer follows the law and pays the appropriate amount of tax.

Our tax system is complicated because we live in a complex financial economy. Our tax system applies to every person and enterprise. The Code must take into consideration everyone’s method of making income and at the same time consider every tax dodge, every manipulation, and avoidance scheme that has ever been created in the last 100 years since the 16th amendment was passed.(see below: Tax Scams) Guys like me(CPAs) get paid to make sure that clients get every benefit the tax code has to offer. The tax code can be either a Christmas tree or a hammer; it just depends on one’s understanding of the code and who’s interpreting it.

Are You Worth Auditing?

Before you lose sleep over whether the IRS is waiting outside your door to nab you, look in the mirror and ask yourself, “am I worth auditing?” The short answer is, and totally unsatisfying, “Maybe.” The IRS is the biggest “for profit” activity in the world. It generates over $2 trillion dollars in revenue per year for the government. Like any efficient business(IRS collects about $200 for every $1 it spends), the question is “does it make economical sense to pursue you?” If you have low income, or your return is simple or all your income is W2, and you haven’t seen your picture in the post office under “Wanted”, chances are you aren’t worth a Field or Office audit and aren’t being considered for a Criminal-Investigation Audit, but that doesn’t mean the IRS isn’t watching. If you are low hanging fruit that can be easily plucked then it’s possible you could be audited through correspondences(mail), regardless of your situation. Also you could win the “audit lottery” and win one of the IRS’ random audits. Lucky you! These are audits the IRS randomly performs just because they can.

The way to look at a deduction and risking an audit is through a risk vs.reward calculation. When weighing even a lawful deduction, taken against the return as a whole, is it worth the risk of an audit? By keeping good records, things generally work out for most people, but no one has zero probability of an audit. By the way, no one can accurately explain the audit selection process. It is largely a statistical process, so when asked, “What prompts an audit?” the safe answer, like in all tax questions, is, “it depends.” Statistical just means, there are just lots of factors the IRS considers for who gets audited and like magic eggs, names just pop out.

Summary of IRS Audit Red Flags

I use the term “Red Flags” because it’s a common reference, though the notion that there is one specific thing that gets you audited is ingrained in the national psyche. Red Flag up. Red Flag down. This is the wrong way to think about the IRS audit. Getting audited is a culmination of things that leads the government to believe an investigation is warranted. It generally isn’t just one thing, though it might/could be(an associate is getting audited, so the IRS invites you to the party.)

Even though the audit selection process is largely statistical there are factors that are speculated to weigh more heavily in the likelihood of being audited. The IRS has never provided a determinative list of factors that are considered for audit selection. This lack of definition of what makes a good audit candidate is part of the IRS “mystic” and it keeps the bad guys guessing, along with everyone else. It’s like the “eye in the sky” in a casino. You never know who and when someone is watching what you are doing.

In summary, the accepted and generally acknowledged Audit “Red Flags” are:

• Mistakes on the Return
• High Income/Big Income Changes
• High Expenses Relative to Income
• Home Office(Abuses)
• Perpetual Business Loses
• Missing Income
• Misrepresenting Passive and Capital Losses
• Business of a Certain Type(arguably)
• Underpayment of Taxes
• Erratic or Unusually Large Charitable Gifts

These are the main categories and are the ones that affect most people.

IRS Audit Red Flag #1: Mistakes on the Tax Return

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The biggest and most common audit red flag is mistakes. A real mistake, something like incorrect calculation, omitting required information or filing an incorrect form or formatting your data improperly, is easy for the IRS computer to catch and they are irrefutable. A true mistake is just that; a mistake. It’s stupid. It’s totally preventable and it gets you audited almost every time. Regarding audit, the IRS logic with all aspects of audit is, “if there is one, there must be more, so let’s investigate.” This road leads the IRS to misinterpretations of the tax code, as mistakes. The “gray” begins.

Don’t confuse mistakes with alleged misinterpretations. Remember, mistakes are irrefutable. This is where it gets sticky and where tax professionals can be worth their weight literally in gold. The IRS has its own language. It’s called, Treasury Regulations and Publications. Treasury Regulations are authoritative(citable), whereas Publications are not authoritative and are IRS interpretations of interpretations. The Treasury Department is funded by Congress to the tune of $13 Billion per year to enforce and interpret the Tax Code(created by Congress). Think about it. The Treasury/IRS has both the responsibility to interpret the law and enforce it. Many times the IRS gets it wrong. That’s why there are so many court cases. The Treasury regulations, which are maybe 12 million words and growing and are probably 3 times the size of the actual Tax Code, are the IRS’ interpretation of the Code. Regulations are the result of years of law, precedent, US Supreme Court, Appellate Court and Tax Court decisions all being interpreted by bureaucratic manifestations. Bureaucrats make mistakes, so the courts, not the IRS, has the last word in tax. Most people don’t realize this.

Whether you make a mistake or not, is black and white. A misinterpretation on the other hand is “subject to interpretation.” Most people have no idea what’s in the tax code or the Treasury regulations, so if the IRS says you’ve made a mistake, you generally take it on face value; most tax payers total exposure to tax law maybe an article in USA Today or a Suzy Orman blog or what the anonymous, seasonally hired Turbo Tax guy told them when they ask a question over chat. It’s important to know the difference between a mistake and an alleged misinterpretation. The line between “misinterpretation” and “correct application” is based on another term of art the IRS loves, “Facts and Circumstances”. A well reasoned argument supported by code or precedent, backed up by good documentation often wins the day with an audit alleging misinterpretation. Also knowing what to say and when to say it goes a long way to winning in an audit. The moral of the story: It’s not what you know about taxes, it’s what you don’t know that gets you audited. Though easier said than done, don’t make a mistake and you won’t start down this road in the first place.

IRS Audit Red Flag #2: High Income/Big Income Swings

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This is obvious. People earning big amounts per year are the most likely audit candidates. Why? Willy Sutton said it about banks, from the IRS point of view, “that’s where the money is.” Remember the IRS is a for profit operation and they need to maintain their 200:1 income to cost ratio. If you report a high amount of income, the IRS is more likely to audit you. That’s just the way it is. What more can you say? Make less money? No way. Just keep good records. Don’t be overly aggressive on your return and just keep doing what you’re doing. It will work out.

Big Income swings begs the question, why? Incorporating explanations in the return sometimes can save you from an audit. Keep good records and don’t mess around with the gray lines, such as those surrounding passive activities(see below).

IRS Audit Red Flag #3: Excessive Expenses

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Excessive Expenses is the flip side of High Income. What is “excessive” you may ask? Who knows? One thing IRS may look at in audit, “do the expenses match the life style?” If you are a sole proprietor (Schedule C) and the expenses you claim are equal to or greater than income, the IRS will ask the question, “if all the money is consumed in expenses, how do you live?” Excessive expenses are where many people get in trouble with self preparation software. The software will allow you to fill in the box with anything you want and the software isn’t smart enough to ask you, “Does it make sense?”

The tax code is full of definitions of what is and isn’t a deductible expense. Often the definitions are not clear or defined in the negative, “what isn’t a deduction” Often what is a deduction is left to professional judgment, facts and circumstances and logical connection to business. Most people are not familiar with the technical definitions and interpret by common usage. The IRS calls these people “lunch” and eats them alive. Keep good records(have you got this yet?). Be ultra-conservative regarding entertainment expenses and meal expenses and don’t confuse the definition of personal living expenses with expenses actually and directly linked to the pursuit of business.

IRS Audit Red Flag #4: Home Office

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Regarding Home Office, the term of art is, “regular and exclusive use.” If you have no other office and you claim a room that generally is fine, but it’s not a sure thing. If you claim your whole home/too much of your home or deduct rent for an office somewhere else, you are asking for an audit. Also if you are a W2 employee, unless you are remote, as the wise guys say, “forget about it.” If your business loses money, “forget about it.”

IRs Audit Red Flag #5: Losses on Your Schedule C

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Ignoring the fact of, “how you pay your bills if your primary business loses money year after year”, or the begged question, “if you lose more money than you make, why do you do it?”, if you lose money year after year the IRS immediate believes it’s not a business and it’s probably a hobby. The IRS encourages hobbies for the mental health of the population(I’ve known many tax payers who’ve taken up basket weaving after losing an audit), but they don’t let you deduct hobby losses against other income. There are some very famous cases of artists and equestrians and ranchers winning this argument against the IRS regarding business vs. hobby losses, but as Bruce Springstein opined, “The highway’s jammed with broken heroes on a last chance power drive…” If you report losses on your Schedule C, year after year, you are asking for an audit. You may win the battle, but lose the war. Once a return is open for audit, the IRS can audit the whole thing or multiple years. Unless you are really sure of your ground, don’t claim business losses every year. This is not an area for self-preparers. In order to win here, case law and facts and circumstances are keys to success.

IRS Audit Red Flag #5: Missing Income

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Here like nowhere else does the logic, “if there is one, there must be more” play in. The IRS receives copies of 1099s, W2s and notes from ex-spouses. Not reporting income is asking for an audit; something as small as a 1099 for $500 could rain terror down upon your head. Keep good records. If you run a business use a good accounting program, such as Quickbooks to keep track of all your income. Don’t depend on 1099’s. Often 1099’s are erroneously filed under your tax payer ID, which is going cause you a problem without good records. While you are spending your Saturday afternoon inputting invoices, keep chanting, “concurrent records are more authoritative than subsequent records.”

IRS Audit Red Flag #6: Misrepresenting Passive and Capital Losses

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The simple rules: Passive losses are deducted against passive gains. Business losses are deducted against ordinary income. Capital losses are deducted against capital gains and under limited circumstances against ordinary income. That’s the easy part. If you have no idea what I’m talking about, don’t do your own taxes. Generally, if you rent property and you are not a real estate professional, it’s passive losses; if you invest in stocks and you are not an investment professional(licensed stock broker, etc.) it’s capital losses; if you run a business and lose money its active losses. If you want to go into this gray area, get ready for an audit. Keep good records and document your ground with code, regs and court cases. Otherwise, stick to the simple rules and generally this won’t be an issue.

IRS Audit Red Flag #7: Business of a Certain Types are Audit Targets

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Some CPAs think this to be an old wives tale. They espouse any business is just as likely to be audited as any other if they meet a certain risk profile. I’d say, “it depends.’ If you are a cash business, you are probably more likely to get audited than other businesses. If you are in Real Estate or Sales, being feast and famine types of businesses, it would seem you are more likely to get audited. Also in these types of business, given that a lot of the expenses are “soft” and difficult to objectively verify, makes them a target for audit. What I say to clients is this, if you are in business, keep very good records. If you travel or use your car, keep all receipts and keep logs of who you visit, when you visit and the purpose of the visit. If you don’t like to keep records, that’s fine, but then don’t deduct the expense. Showing the IRS that you are a regular(obsessive) record keeper will make for short, winnable audits should the worse happen. If you are in Real Estate, Sales, Cigarette/Tobacco, Liquor or a cash business, just assume you are being watched. Every night say to the mirror, “Forewarned, forearmed; to be prepared is half the victory.”

IRS Audit Red Flag #8: Underpayment

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This one is obvious. If you owe the IRS $X and you pay $Y, and $Y is less than $X, and you give no explanation, the IRS is going to ask you, “what gives?” Expect an audit. Don’t underpay and wait for the IRS to come after you. If you can’t pay what you owe, tell the IRS(or better have a CPA or Lawyer make the call) and make an arrangement. Either an Offer in Compromise or an Installment Agreement are common options. If you file and say nothing, and don’t pay you will get a call from the IRS. Paraphrasing a line from the Terminator, starring Arnold Schwarzenegger, “They’ll find you! That’s what they do! That’s ALL they do! “ Melodramatic? Maybe. But its the truth.

IRS Audit Red Flag #9: Erratic or Unusually Large Charitable Gifts

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One of the generous aspects of the tax code(“generous” and “tax code” in the same sentence!) is the deduction a tax payer gets for charitable giving. If you never give and one year you decide to give, that’s great, but keep very good records and make sure you get a letter or formal documentation from the charity. Consider your whole tax return and ask yourself, “do I care if the IRS pokes around looking for justification” The larger the donation the better the supporting documentation and possibly explanation on the return. Make sure the charity is a 501 category charity and is approved.

If you give money to some homeless guy on the street who is down and out, that is not deductible. If you give money to a 501 category charity that uses a large portion of the donated money for private jets and high rise apartments in New York, that is deductible. If you want the deduction make sure you understand the rules. Very important, if the donation is very large relative to your income, be prepared to answer the question, “how did you afford to give so much?” and “how did you afford to live afterward?” Document! Document! Document!

I hope you found this discussion of IRS audit and red flags helpful. Drop me a line if you have questions or comments.

Wesley Snipes and Tax Evasion

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Source Wikipedia http://en.wikipedia.org/wiki/Wesley_Snipes: On October 12, 2006, Wesley Snipes, Eddie Ray Kahn, and Douglas P. Rosile were charged with one count of conspiring to defraud the United States and one count of knowingly making or aiding and abetting the making of a false and fraudulent claim for payment against the United States. Snipes was also charged with six counts of willfully failing to file federal income tax returns by their filing dates.[14] The conspiracy charge against Snipes included allegations that he filed a false amended return, including a false tax refund claim of over US$4 million for the year 1996, and a false amended return, including a false tax refund claim of over US$7.3 million for the year 1997. The government alleged that Snipes attempted to obtain fraudulent tax refunds using a tax protester theory called the “861 argument” (essentially, an argument that the domestic income of U.S. citizens and residents is not taxable). The government also charged that Snipes sent three worthless, fictitious “bills of exchange” for $14 million to the Internal Revenue Service (IRS).[15]
The government also charged that Snipes failed to file tax returns for the years 1999 through 2004. Snipes responded to his indictment in a letter on December 4, 2006, declaring himself to be “a non-resident alien” of the United States; in reality, Snipes is a birthright U.S. citizen.[16] Snipes said he was being made an example of and was unfairly targeted by prosecutors because of his fame in connection with the federal tax fraud investigation.
On February 1, 2008, Snipes was acquitted on the felony count of conspiracy to defraud the government and on the felony count of filing a false claim with the government. He was, however, found guilty on three misdemeanor counts of failing to file federal income tax returns (and acquitted on three other “failure to file” charges). His co-defendants, Douglas P. Rosile and Eddie Ray Kahn, were convicted on the conspiracy and false claim charges in connection with the income tax refund claims filed for Snipes.[17][18]
On April 24, 2008, Snipes was sentenced to three years in prison for willful failure to file federal income tax returns under 26 U.S.C. § 7203.[19][20][21] Kahn was sentenced to 10 years in prison and Rosile was sentenced to four and half years in prison.[22] The United States Court of Appeals for the Eleventh Circuit affirmed Snipes’s convictions in a 35-page decision issued on July 16, 2010.[23][24][25] Snipes reported to federal prison on December 9, 2010, to begin his three-year sentence,[26][27] and was held at McKean Federal Correctional Institution, a federal prison in Pennsylvania.[28] On June 6, 2011, the United States Supreme Court declined to hear Snipes’ appeal.[29][30][31] Snipes was released on April 2, 2013.[32]

Tax Scams

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People even deny that the 16th amendment is lawful. They generally call these people “Federal Prisoners.” Also see, “sovereign citizen movement”, or books such as “Cracking the Code”, by Peter Eric Hendrickson. If you follow the wrong tax advice, you will go to prison for tax evasion. See Wesley Snipes above. FYI, Peter Hendrickson’s scheme is number five on the IRS’s 2007 list of the “Dirty Dozen Tax Scams.”