How to Survive a Tax Audit When You Fudged the Numbers
For years you thought that “fudging” or “playing” with the numbers to reduce your income tax obligations was a victimless crime. After all, you may have assumed that in light of the billions — or the more than $1 trillion in fiscal year 2015 – of dollars in tax revenues collected by the IRS, they wouldn’t miss a portion of your income tax contribution. Unfortunately, your assumption proved incorrect and you are now facing an audit. While most taxpayers are concerned about audits because it could result in owing significantly more in taxes, you may be particularly worried about the potential for a federal prison sentence due to tax evasion. If you cheated in multiple, subsequent years this risk only increases because it can show a pattern of noncompliance that triggers red flags for tax evasion.
Why Was I Audited?
There are an array of reasons as to why a taxpayer gets audited. However the bulk of audits are due to automatic DIF scoring. If you fall outside of the acceptable statistical range, you will be scored according to how severe your differential is from the norm. The IRS will proceed to audit those taxpayers falling outside of acceptable ranges starting with the worst and working towards those with lesser DIF scores until the yearly audit budget is exhausted.
There are an array of other reasons why a business or an individual might raise red flags for an audit. One such reason is due to a 1099-K audit. The 1099-K shows electronic transactions processed by credit card companies, banks, and debit card processors. The IRS can compare the total income you report versus the amount they calculate from the sum of all your third-party 1099-Ks. Consider for instance a restaurant that reports $1.2 million in income but has 1099-Ks indicating just over $1 million in electronic receipts. This ratio is highly unlikely for a cash intensive businesses like a restaurant and gives rise to a potential inference that the restaurant is skimming cash or otherwise underreporting. Since a mere $10,000 of unreported income can result in referral to a fraud analyst who may decide to pass your matter to IRS criminal investigations, a scenario of this type is particularly frightening for a tax payer or a business owner.
What if The IRS Wants to Come to My Home or Business?
An IRS auditor who wants to come to your home or business often signifies a very significant problem. If they are asking to come into your home or workplace it is most likely to take a visual inventory of your assets and belongings. They may be looking for expensive art work, luxury furniture, fancy cars, expensive technical or computing equipment, or anything that would significantly inflate your net worth beyond what can reasonably be expected for your historical reported income. They may provide a cover story of “wanting to measure your home office” if you took home office deductions, but do not believe their claims. There are other means you can use to prove the information they are seeking without opening your doors to a wholesale audit of your belongings.
What if My Books and Records Are a Mess?
If the IRS agent decides that your books and records are in such a state that it is impossible for the audit to proceed, some tax payers might mistakenly consider this a good thing. Unfortunately a situation like this is only likely to create significant problems for the taxpayer and set up an uphill battle. Rather than reconstructing your records, the agent will simply assess you on any and all income that was deposited into your bank account. Next, they will disallow all expense that you claimed as non-provable. In any case, this will significantly increase the amount of taxable income you have and result in a much larger tax bill. If you wish to overturn this determination, the taxpayer must prove that stated expenses are allowable and present a set of books that can withstand significant audit scrutiny.
If the taxpayer wishes to fight the determination, reconstructive accounting by a financial professional is typically necessary. An amended tax return filing may even be necessary if the difference between the original and new return is significant. In any case, the burden of proof is always on the taxpayer. In many cases, only a reputable and experienced team of tax professionals can satisfy an auditor that whatever mess existed with the original accounting that caused the original return to be misstated, has been corrected in the revised accounting, and that ultimately the revised return position is the correct position.
What if I Know I Cheated on My Taxes and the IRS Wants to Speak With Me?
If you know that you made misstatements or engaged in inaccurate reporting methods on your taxes and have been contacted by any agency including the IRS, California Board of Equalization (BOE), California Franchise Tax Board (FTB), or the California Employment Development Department do not face the audit alone. All too often taxpayers think that they can fix their tax problems by making additional inaccurate or implausible statements to the examining agency. Other taxpayers may think that they can talk their way out of a situation. Unfortunately the taxpayer forgets that the auditor does this for a living and implausible statements made on the basis of charisma or confidence simply won’t carry the day. Rather, the taxpayer is more likely to compound their liability and trigger a criminal investigation due to the presence of one or more badges of fraud.
If the taxpayer knows that there are tax filing errors and potential improprieties on their tax form, the most prudent thing they can do is to establish a layer of separation between themselves and the auditing agent. A tax attorney can serve as a buffer and prevent the examining agent from obtaining criminal admissions from your conduct and statements. Since the most difficult element regarding criminal tax penalties for the IRS to prove is intent, taking the taxpayer out of the equation eliminates the possibility that you may provide the evidence their audit is designed to find. Aside from circumstantial evidence of intent, the only direct evidence they can obtain that you intentionally cheated will come from your own mouth.
Circumstantial evidence is the only other way the IRS and other agencies can prove criminal intent regarding taxes. Circumstantial evidence includes the information contained in your tax records and books, things your employees may say, and evidence that may arise from a third-party. Luckily, circumstantial evidence is typically seen as less persuasive than direct evidence. While you cannot control the circumstantial evidence the IRS may find, you can prevent providing direct evidence to agents and auditors. Remember, no matter how smart you are, you are outgunned and fighting against the resources of an entire agency.
What Can I Do if I am Facing an IRS Tax Audit?
First of all, if you are facing or suspect an IRS audit, you should not discuss your behavior with anyone. Do not tell your neighbor, best friend, or even your priest that you think you may have cheated on your taxes. These individuals have a financial incentive to report you and serve as a government witness through the whistleblower bounty program.
Furthermore, if you are facing an IRS tax audit, the type of tax professional you seek assistance from is extremely important. Some taxpayers and businesses owners are tempted to go back to their original accountant. Others may consider speaking to a CPA. However, this decision is fraught with consequences that can exacerbate your situation further should the IRS or state tax agency decide to subpoena your accountant or CPA and compel them to testify under the threatened penalty of contempt of court. In other words, what you tell an accountant or a CPA is generally unprivileged and subject to discovery in court. That means anything you disclose to these individuals regarding possible criminal intent can come out in court. Since you do not want to create government witness #1 against you in a criminal tax matter, you must take a different approach.
In contrast to the weak and unevenly recognized accountant-client privilege, attorney-client privilege is robust and recognized in all state and federal courts. Nearly anything that you disclose to a tax lawyer is protected and confidential and cannot be used against you provided that the attorney-client privilege is maintained and protected. The attorney-client privilege permits a taxpayer to speak frankly regarding mistakes, error, and other acts so that the tax attorney can prepare a defense to the audit techniques and other tactics you are likely to face. Furthermore, if you work through a tax attorney, consulting accountants can receive derivative attorney-client privilege and confidentiality through what is known as a Kovel letter.
When Do I Need an Experienced Tax Lawyer and CPA?
David W. Klasing is a dual credentialed attorney and CPA with Master’s degree in taxation. David is also a former public accounting auditor who managed a staff of 15 while dealing with sophisticated audits including private placements, IPOs, employee benefit plans, non-profits and for profit entities. David understands the auditing methodology and process utilized by the IRS. Often times, he can anticipate and prepare for where the auditor is attempting to take the investigation before the auditor actually takes it there. Using his educations, training, knowledge and experience he can stay several steps ahead in the audit process and mitigate the civil and criminal consequences you may face.
If you are facing an IRS, FTB, BOE, or EDD audit going it alone is simply not a prudent course of action. You may compound your liability and furthermore, these agencies share information and may trigger a subsequent audit by a different agency. Contact the Tax Law Offices of David W. Klasing by calling 800-681-1295 or contact us online.