There are fewer things scarier than receiving a letter from the IRS. It begins, as it always does, with those ominous words: “Dear Taxpayer.” The letter will go on to explain that you were one of the unlucky ones to be “served” by the Service because your tax return was selected for audit.
Why were you chosen? Well, the IRS selects returns to audit not “at random,” but (often) according to well-defined scoring system. Every tax return is “scored” using the IRS’s “Discriminant Function System” or DIF. The IRS describes this scoring process in the following way:
“Computer programs give each return numeric ‘scores’. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.”
Naturally, we all desire to know the details of the DIF: how it specifically “scores” returns; which items are weighted more heavily; and the like. Unfortunately, little of that is known to the public. We do know that certain deductions result in higher scores. Some think, for example, that if you take the so-called “home office deduction” that your return’s audit likelihood is significantly increased. Alas, we know no such thing. If you are entitled to the home office deduction, you should take it.
Some of the most common issues that get audited include the following: the total amount of gross income reported; the trade or business deductions taken; bad debts; net operating losses; capital loss carryforwards; depreciation; and capital expenditures.
This entry discusses what to do when you are NOT entitled to certain deductions you took; or you under-stated (or failed to report) your income; and you received a letter from the IRS addressing you as “Dear Taxpayer.” In short, this post discusses what to do when you cheated on your taxes, you know it, and your return was selected for audit.
The first advice is simple and well-known: Recognize that “Anything you say can and will be used against you . . .” — not necessarily in a court of law, but by the IRS. You are not under arrest, even though it may feel that way. You do not want to “go it alone” when you face an audit under these circumstances. It is best to utilize an intermediary—namely, an experienced tax attorney. More on that shortly.
The second tip is to discern what sort of audit you are dealing with. There are three basic kinds of tax audits: Correspondence Audits, Office Audits, and Field Audit.
A Correspondence Audit is where the IRS’s computer system has flagged something in your return that it deems an error, and they send you a letter about it. Maybe the computer thinks you underreported your income (thus understating your tax liability). Did you transpose numbers on your return, writing $27,000 rather than $72,000? Maybe you claimed too many dependents. Whatever it is, the IRS is writing to inform you that you owe more tax. Maybe the IRS is correct about the issues raised; but maybe it is not. These computers generating these reports are not perfect. Most of correspondence audits are generated by an IRS computer trying to match information it receives from third parties against the income and deductions you report. For example the IRS gets K-1’s from the flow through entities you have investments in (S-Corps, Partnerships & LLC’s), 1099K’s that report the amount of debit and credit card payments to your business, 1099-Misc income and 1098 mortgage interest statements. If the IRS computer cannot determine that you have properly reported these items of income or deductions a correspondence audit will result.
The Office Audit is much more serious than a correspondence audit. In part, this is because of the increased exposure to interview and six year statute of limitations if a 25% understatement of income or open ended statute of limitations if fraud is discovered or admitted by the taxpayer. Anytime the IRS wants to meet with you to discuss certain irregularities in your tax return(s) the exposure for tax crimes goes up exponentially. The IRS may ask you to bring to a meeting a list of specific documents, and to be prepared to discuss them. The IRS will seek to confirm the amount of your reported gross income (the IRS often looks to see if you understated your income). They will inquire how you obtained your figures for gross receipts; whether it reconciles to your bank statements and other sales records. The will ask about expenses paid in cash or income received in cash and about your payroll substantiation and 1099 reporting on independent contractors. If you took larger deductions, you should be prepared to substantiate them.
The Field Audit is by far the most extensive and intrusive of the three types of audits. It involves the IRS coming to your home or business to tour your business facilities, and interview the taxpayer and random members of the taxpayer’s business in search of unreported income or overstated deductions. The will thoroughly review your business records and financial statements. The IRS’s agents are generally well-trained, and are capable of spotting almost all of the “common” tax fraud tactics and associates “badges of fraud”. The IRS will review each type of deduction; consider capital gains issues, and more besides. Often the IRS field agent will also be a CPA.
Fourth, recognize that maintaining improper or disorganized records is not helpful to taxpayers. While it may be difficult to “piece them together” to see the big picture, if the IRS gets confused, practically speaking, it will simply assert a tax liability, shifting the burden of proof to you to show otherwise—thus requiring you to “piece together” those records yourself. In short, the sloppy records plan actually can backfire on a taxpayer—so get organized! Even where you have valid business deductions you must “prove them or lose them”.
Fifth, call your tax lawyer. You do not want to go through an IRS or FTB, EDD or BOE audit alone especially where you cheated on the original, or worse yet, amended, position that is being audited. Adding a buffer between you and the IRS can be hugely beneficial in preventing the IRS from obtaining criminal admissions rather than just evidence of negligent accounting and tax preparation. When the IRS comes after someone, the taxpayer is typically out-gunned. The IRS competently deals with complex tax and accounting matters all day / every day. Most taxpayers are, by contrast, concentrated on growing their business, surviving, or enjoying their life. To equalize the playing field, it is best to work with an experienced tax attorney, who can also protect you with the attorney-client privilege, which protects your communications. Having a tax attorney that is also a CPA with over 20 years of tax controversy experience with a master’s degree in taxation further skews the odds in your favor.
To illustrate the importance of retaining a tax attorney to defend you during an audit, consider the possible consequences if you do not. Suppose the IRS reviews your documents, or you make a statement about your financial statements or tax returns that peeks the IRS agent’s interest—and his or her interest would not have been so peeked if that statement or document were presented differently. Suppose also that the agent desires to inquire further into the matter, and decides that it warrants reviewing “related” tax returns. Now you are looking at not one, but two or more tax years! Essentially, it has compounded the scope and exposure of the audit by a factor or three! Or suppose your individual audit were investigated; but now, because the agent’s interest was peeked, he decides to audit your business’ returns as well. And it gets worse: your state returns (e.g. California return for California residents) could also be audited. As a general rule, the IRS shares with the state that you are being audited. What a nightmare.
Also remember that your original preparer can be your worst enemy in the situation where you cheated on your original return and now find yourself under audit. The CPA, EA or CTEC certified preparer often makes the bulk of their income from tax accounting and preparation and thus they have a strong motivation to protect their reputation with the taxing authorities at the expense of your reputation. They will often be government witness number one to establish your willful tax evasion where you provided them incomplete or worse yet a cooked set of books that they relied on the prepare your return. Moreover, you do not have attorney client privilege with the original preparer and anything that you said to them can be used against you in a court of law. Lastly even where a preparer made an error in preparing your return they are not likely to throw themselves under the bus to protect you.
For all of the reasons stated above you should seriously consider hiring the Tax Law Offices of David W. Klasing to represent you if you ever come under audit by any California or Federal Taxing authority. Hiring our firm can make all the difference between paying the proper amount of income taxes in the year under audit you were legally required to originally and a 20% negligence penalty as opposed to doing jail time, paying a $250,000 penalty and paying for the cost of prosecution where convicted of a tax crime because you let the original preparer represent you or worst yet, represented yourself.