What Happens if My Income Taxes Have Errors and I get Audited?

Now that the tax filing deadline for 2021 (to file 2020 tax returns) has almost passed, taxpayers throughout the nation have already had the pleasure of tracking down W-2s, 1099s, and various documents showing income and other financial transactions. But what if a taxpayer decided that he or she would simply skip reporting 1099 income from one or more sources because when he or she put the numbers into his or her preferred tax program, it generated a huge tax bill? The reason a 1099 may generate a seemingly huge tax burden is two-fold. First, recipients of 1099s are typically independent contractors meaning that they are also responsible for self-employment taxes typically paid by the employer. Second, their failure to withhold taxes throughout the year means that the full amount of tax is now due. To make matters even worse, the taxpayer or taxpaying entity may even have had a quarterly reporting obligation and additional penalties and interest have been included in calculations. Omitting a 1099 is almost a sure way of drawing an audit because the IRS will compare the total revenue reported on the taxpayer’s schedule C to the total of the 1099’s issued on the taxpayer’s social security number or the business’s EIN number.  This process is also carried out where 1099’s are issued to an entity a taxpayer owns an interest in.  If the net income reported is less than the sum of the 1099’s at least a correspondence audit is almost guaranteed as this process is automated and the audits are computer generated.   If a large amount of unreported income is detected a criminal investigation could be sparked as any underreporting of income of at least $10,000 will require the auditor to consult with a technical fraud specialist whose sole job it is to work up civil audits for potential referral to the IRS criminal investigation division.  The mission of the criminal investigation division is to investigate and criminally prosecute tax cheats.

What Happens if I Get Audited?

If you have never been the subject of a Federal of State tax audit, you are very likely in a state of mild to severe emotional crisis, are not sleeping well at night and are ultra-concerned about how the IRS or the State will go about conducting their audit and you are wondering why you were selected for audit. There are three types of audits that the IRS or State Taxing Authority may utilize, depending on the facts and circumstances of your case. After representing clients in correspondence, office & field audits, eggshell and reverse eggshell audits, and civil audits that spill over into criminal tax investigation for the last 30 years, my client’s have typically had the following universal concerns:

How much additional tax penalties and interest will I ultimately face?

• Ultimately our firm can protect you from a lot, but no reputable tax professional can protect you from the tax you should have paid in the first place. Valid auditor adjustments that increase reported income or decrease claimed deductions or credits will result in an assessment of additional tax, at least a 20% negligence penalty if greater than $5000 is assessed and interest back to original filing date of the returns at issue.   Auditors take the position is that ANY deposit into ANY account you own, or control is income unless you can prove it is not (I.E., borrowed funds).   ALL expenses are treated as nondeductible personal expenses unless you can substantiate / prove a valid deduction was claimed.
• To substantiate an expense, you must prove the expense was ordinary and necessary to running your business under IRC 162. You must additionally prove how much you spent through a cancelled check or via a debit or credit card transaction in addition to providing a detailed receipt to show the agent exactly what was purchased. Expenses paid in cash with absolutely no substantiation / receipts are routinely disallowed.

Will the State also audit me if I am audited by the IRS? .. visa versa

• If you are audited by the IRS, we will routinely amend your State tax returns to reflect the results of the Federal audit. Most States require that you amend to reflect the results of an IRS audit within six months of the federal audit ending or face additional penalties.
• If you are audited by a State taxing authority, we recommend you voluntarily amend your Federal tax return or risk facing additional penalties from the IRS as State and Federal taxing authorities routinely share information with each other.

How many years will they open for audit? Are they only going to look at the tax year(s) listed on the initial audit letter?

• If the IRS or State Taxing authority hits “pay dirt” in the audit by locating noncompliance that leads to additional tax assessments in a tax year they are auditing, they will routinely expand the audit to at least two if not three of the open tax years to audit.
• IRS auditors will be fired if they blow a statute of limitations and that makes some auditors hesitant to open the oldest tax year to audit. If they do, they will be pushing hard to obtain a statute extension of at least one year from the audited taxpayer.   If you refuse the statue extension most auditors will assess any non-reported income they identify and then disallow all your expenses in response to your refusal to extend the statute.    They will quite often then issue a 90-day letter.   You at that point will have no choice but to either file a tax court petition or allow the assessment to go final by not objecting to the 90-day letter.   The tax court petition will get you into the IRS appeals process.  Upon presenting substantiation for your expenses that the auditor did not examine, the appeals agent will ordinarily push the issue back down to the auditor.

Are they going to audit every entity that I own an interest in?

• It is highly likely that if you own at least 50% of an entity and the IRS has previously identified significant noncompliance in any entity that you own or in the filing of your personal return that they open all such entities that you own. If the auditor notices significant noncompliance in any entity that flows onto your personal return through a high-level facial review of the flow through return, they can open entities that you own less than 50% of at will.   Non flow through C Corporations that an audited client owns a significant interest can be subjected to Federal of State audits in the same manner.

Is the IRS or State Taxing Authority only going to look at the 2 or 3 issues that they mentioned in their initial correspondence?

• The 2 or 3 issues listed on the initial auditor’s correspondence are the issues that have been statistically identified as most likely being misstated by the taxing authority’s differential audit analysis software. The auditor will begin the audit with those 2 or 3 items.  If they hit pay dirt in finding noncompliance in those items, they will expand the scope of the auditor to every income or expense item that comes to their attention as containing potentially containing noncompliance.

Is the IRS or State Taxing Authority going to show up at my business or my home without notice?

• Ordinarily auditor’s will not randomly show up at your business or your home without prior written or oral notice. If they show up without warning and start questioning your employees, vendors, neighboring businesses, or your customers, you are probably dealing with an eggshell or reverse eggshell audit and you should hire appropriate counsel accordingly.   If you notice they are contacting third parties without giving you notice, they are digging through your trash or an auditor and their manager, a court reporter or chief counsel accompanies the auditor you are also most likely not dealing with a standard civil audit.

If I am unable to substantiate / proof the positions I took on my tax returns, will I face civil fraud penalties or criminal tax prosecution?

• If the IRS or State Taxing Authority identifies significant noncompliance that leads to tax assessments of at least $30,000 in total and starts asking “why” questions that focus on the intent of the taxpayer in taking the tax return positions under audit, the risk of a civil fraud penalty or criminal tax prosecution go up exponentially. If the auditor starts comparing the information provided to the original preparer versus the information that currently exists in the client’s books this risk also increases.  $30,000 of tax loss equates to one year in jail under the federal sentencing guidelines and achieves the deterrent effect the federal government seeks in prosecuting tax cheats. If the taxing authority has the evidence required to support the assessment of a civil fraud penalty, it by default has the evidence it needs to support a criminal tax prosecution.  If you know for a fact your noncompliance is equal to or more than $30,000 you need to have a dually licensed Criminal Tax Defense Attorney & CPA like those at the Tax Law Offices of David W. Klasing represent you in your audit to have the best chances of protecting your liberty and your net worth and continuing ability to earn a living.

How long will this audit take?

• Audits vary in length from as little as 2 or 3 months in a simple correspondence or office audit to 2 to 3 years where several entities require a complete reconstructive accounting to figure out your noncompliance and extensive negotiation is necessary to get you through the audit, eggshell audit, or criminal tax investigation without facing criminal prosecution.

How much will your firm charge me to represent me in my audit?

• Audits are by far the hardest engagements to accurately quote because we quite often do not know if we are dealing with an easy to stamp out campfire or an out-of-control multiple front raging forest fire. We do our best at the outset of an audit to quote a low end and a high end estimated fee range, but audits routinely come in either under or above the quoted estimated fee range.  We put our clients on a revolving retainer agreement and bill weekly by email listing what work was done on the audit and by whom, what their billing rate was and how much remains in the retainer account.  When the account gets low on funds, we request a refresh. We are not the cheapest audit representation firm on the planet but firmly believe you get what you pay for.   Please review our testimonials page to see what our clients have to say about us.  We employ the most educated, experienced, and talented Tax Attorneys and CPAs that we can find.  Employees like ours are in high demand and require above industry compensation packages to retain.  We spare no expense in training our staff to achieve the best audit results possible in each individual client’s individual facts and circumstances.  David W. Klasing has a 10 AVVO rating which is the highest an attorney can achieve.  The excellence he demands of himself he also demands to be achieved in his management staff or developed in his very capable lower-level staff.

Do I have to let the auditor tour my business, come to my home, or interview me?

• State and Federal auditors will often request to tour your business to identify what internal controls you have in place and to gain an understanding of your business that will enable them to plan the audit in a manner most likely to detect any noncompliance.
• If they insist on touring your home, they could be looking for a safe that contains a suspected cash hoard where you run a cash intensive business. Alternatively, they could be attempting to reconcile the history of reported income versus your observed standard of living.

If I have failed to report income, claimed expenses or credits that I cannot substantiate / prove, will I face a civil fraud penalty or criminal tax prosecution?

• That is always a possibility. The trick is getting through the audit without your representative or your self-making a criminal admission or lying to a federal agent which is felony in and of itself.  Our firm is either extremely good or very lucky but to date we have never had an audit client get criminally prosecuted.  Where possible it also helps to explain any noncompliance in terms of negligent rater than willful behavior.   We also will attempt to keep our client’s from being interviewed where possible as 70% of communication is nonverbal.  Your words can be saying one thing but the sweat running down the sides of your head and muscles twitching uncontrollably can be saying quite another.

Is the IRS or the State following me, tapping my phones, digging through my trash and what exactly do they know about me?

• A great deal of audit representation is art and not science. After representing clients in audits for nearly 30 years now, I (David W. Klasing) have developed a sixth sense as to what auditors’ agendas are all about and what their next move potentially is, especially where I have dealt with the same auditor, or their manager, on multiple audits.  Client fears like those listed above are usually unwarranted unless the client is facing an eggshell, reverse eggshell, or criminal tax investigation in which case those fears are warranted.
• Clients are often under the impression that the auditor knows every sin they have ever committed. The truth of the matter is that auditors are busy people and do not have unlimited budgets to pry into every aspect of a taxpayer’s life.  However, if you are facing enforcement action from any other federal or state investigatory or regulatory or law enforcement entity, you could very likely be dealing with governmental agents that are freely sharing information with each other.
• A criminal tax prosecution is exponentially easier to prove than almost any other type of white-collar / other crime. Hiring the right representative to handle your high risk multi governmental agency audit can go a long way towards quelling the additional risk raised in these scenarios.  The Tax Law Offices of David W. Klasing have learned to play well with other representatives our clients have or will hire and stick to and excel at our areas of expertise.

Is just ignoring the IRS a good strategy when I cheated on the return under audit to avoid criminal tax prosecution?

• Absolutely not! A representative that advises this approach is likely to be prosecuted for obstruction of justice and you are likely to be prosecuted for following that advice as a co-conspirator.   I have been a frequent attendee at the ABA’s criminal tax educational seminars over the last decade.  This issue has been exhaustively discussed and lectured on by the highest level of the IRS, the Criminal Investigation Division of the IRS, and the Income Tax Division of the U.S. Attorney’s Office and the Criminal Tax Defense Bar.  Your representative is either ignorant or immoral.  Give us a call to flesh out your legal options.

Does hiring the Tax Law Offices of David W. Klasing, or any attorney for that matter, send the signal to the taxing authorities that I am a tax cheat?

• That is certainly what many CPAs, EAs and CTEC certified preparers want you to believe. Ironically, these same professionals are putting you at risk as anything you communicate to them is compellable in a court of law because these lesser qualified professionals lack attorney client privilege and can be forced to testify against you under a courts contempt power whether they want to or not.  Consequently, these professionals are likely to become government witness number one against you in a subsequent criminal tax prosecution even where they did not prepare the original returns that are under audit.
• The Tax Law Offices of David W. Klasing routinely represent clients in standard civil audits, where the clients did not cheat, simply to keep the taxing authorities guessing on what type of issues are clients have when faced with an audit.
• Is their any reason I should not hire the original tax preparer to represent me where I cheated on the original return that is under audit?
• Absolutely! The original preparer has his or her own reputation to protect with the Federal and State taxing authorities.  The original preparer is required to retain any documents he or she used to prepare the original returns including notes he or she took from your tax interview with them.  This type of incriminating information is much more likely to be discovered by an auditor in an audit where you cheated on the return under audit even where the original preparer assisted, encouraged, or facilitated that fraudulent endeavor if you unwisely choose to have the original preparer represent you.  I do not care what promises they make you or how much you trust the original preparer, they are the absolute worst choice to represent you when you know for a fact you cheated on the return under audit.

Why should I hire an attorney to represent me in my audit?

• Only an Attorney can offer you the attorney client privilege. An Attorney that represents you through your audit is also in the best position to obtain a civil resolution to an audit where you know you cheated.   Even if no criminal issues are present, an Attorney is in the best position to argue an appeal or any unacceptable positions taken by the auditor where they make a mistake as to the law or the facts at issue.
• Attorneys unlike all other tax professionals are specifically trained in the art of persuasion and legal analysis and procedure. A dually licensed Tax Attorney and CPA like those at the Tax Law Offices of David W. Klasing is absolutely one of the best choices you can make to represent you in an audit.

Please consider booking a one-hour consultation on the following link: https://klasing-associates.com/contact-us/ and we will be happy to discuss all the above issues with you and more!  Let us help get you sleeping again at night and get your high-risk audit out of your life!

What Can I Expect from an Audit?

An audit by the IRS can take a number of forms. It may be conducted by mail which is known as a correspondence audit. Typically, correspondence audits are ordered for matters where there was a relatively minor mistake or error. However, correspondence audits can reveal much more concerning issues. Audits may also be conducted in-person in the field at the taxpayer’s home or office. In general, audits conducted at a taxpayer’s home or business can mean that agents are looking for assets and other signs of fraud. Clearly, this is not a good sign and in-person audits typically suggest a major tax problem.

Facing an Audit When You Intended to Commit Tax Fraud

When you face an audit and know or strongly suspect that you evaded taxes, intentionally filed a false return, or engaged in any array of fraudulent behavior you face a scenario that is known as an “eggshell audit.” The general concept of an eggshell audit is a taxpayer is selected for an audit when he or she knows that there are major improprieties or tax crimes in his or her files. The taxpayer thus faces a situation where he or she does not wish to unnecessarily disclose or tip the agent off regarding underlying fraud. However, the taxpayer must simultaneously worry about making false or misleading statements in furtherance of the fraud. In certain scenarios, such conduct may create new grounds for obstructing the administration of the U.S. Tax Code. However, the worst-case scenario a taxpayer could face is that false statements made to an auditor are viewed as a “last affirmative act of fraud.” The presence of a last affirmative act of fraud could give rise to felony tax evasion charges under a Spies’ evasion theory. Tax evasion can be punished by a federal prison sentence, fines, restitution, and interest.

Facing an Audit When You Merely Made a Tax Error

If you merely made a tax error, you still face the potential for tax consequences. While it is significantly less likely that you will face criminal tax proceeding, there is always the possibility that agents will misinterpret statements, transactions, and behavior. In other circumstances, mistakes of law can produce harsh, inequitable outcomes. Thus, even if you think your matter is a routine audit, it is important to have a representative who can set ground rules to prevent the audit from going off the rails. Similarly, it is important to proceed professionally and tactically to reduce the odds or confusion or inadvertent disclosures of damaging information. Furthermore, working with a tax attorney from the outset means that you will be well positioned for tax litigation or a tax appeal if it is required.