How to Survive a Tax Audit as a Contractor When You Cheated on Your Federal (IRS) or California Income (FTB), Payroll (IRS/EDD) or Sales Taxes (CDTFA)

For years, as a contractor, you may have thought it was a victimless crime to “play” with the numbers to illegally reduce your income, payroll, or California sales tax obligations. You may have assumed that considering the billions—or the more than $3 trillion in the fiscal year 2019—of dollars in tax revenues collected by the IRS or State of California, they wouldn’t miss a portion of your income, payroll, or sales tax contributions. Out of the blue, you receive a letter from the IRS or state of California, beginning, as it always does, with those ominous words: “Dear Taxpayer.” The letter explains that you were one of the unlucky contractors to be selected for audit for the IRS, California Franchise Tax Board (FTB), California Employment Development Department (EDD) or California Department of Tax and Fee Administration (CDTFA).

While most contractors 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 or California prison sentence due to tax evasion. If you cheated in the years selected for audit and in multiple previous or subsequent years, your federal or State criminal tax exposure only increases because multiple years of noncompliance can show a pattern of compliance behavior that can trigger the taxing authorities to look for the telltale signs or “red flags” for tax evasion called badges of fraud.

This article discusses what to do when you are NOT entitled to certain deductions you took, or you under-stated (or failed to report) your income, or you claimed credits that you were not entitled to and you receive a letter from the IRS, FTB, CDTFA or EDD addressing you as “Dear Taxpayer.” In short, this post discusses what to do when you cheated on your taxes, you know it, and your returns are selected for audit.

If you are a contractor and find yourself in the unfortunate situation of receiving a federal or California audit notice, and know for a fact that you cheated on the returns under auditdo not contact the original preparer thinking they will take one on the chin and take responsibility for the problem even if they painstakingly instructed you how to go about cheating. To the contrary, they are likely to become government witness number one against you if the government even hints at seeking criminal tax charges. No matter how long you have been using them, or how much you believe you can trust them, the preparer will burn you in a heartbeat rather than face criminal tax prosecution or preparer sanctions themselves for aiding and abetting income, sales, or payroll tax evasion. In addition, anything you say to them can be compelled from them when they are forced to take the witness stand against you under the federal or California judge’s contempt of court powers.

Preparers are also keenly aware that they are a much desirable criminal or civil target than you are if they indeed aided and abetted your income, sales, or payroll tax evasion which surprisingly many prepares are perfectly willing to do thinking they will secure a competitive advantage against other more reputable and ethical tax preparers in the same field. Moreover, it is common knowledge that the federal or California taxing authorities are ordinarily much more interested in taking a dirty tax preparer out of the game than one of their clients as it scares other preparers into playing by the rules which does more to promote tax compliance than merely focusing on the individual taxpayer at issue. Matter of fact, one of the highest risk audits you can face is an eggshell or reverse eggshell audit where your preparer is under criminal tax investigation.

We advise you to seek legal guidance from a dually California licensed Tax Attorney and CPA immediately if you or your business entity (S Corp, C Corp, LLC, Partnership etc.) has received an audit notice from the IRS, California Franchise Tax Board (FTB), Employment Development Department (EDD), or California Department of Tax and Fee Administration (CDTFA) concerning a tax audit. Depending on what the federal or California auditor finds, an examination of your business and personal tax filings could lead to devastating outcomes, including an unexpected tax assessment, costly accumulated interest, and/or substantial civil penalties—none of which even begins to approach the danger involved in an IRS or California criminal tax investigation. If the government believes there is strong enough evidence to prosecute you for tax evasion or related offenses successfully, you will be at risk of jail time, loss of your contractor’s license if convicted in addition to much higher financial fines and criminal restitution.

Why Was I Audited?

Why were you chosen for an IRS audit? Well, the IRS selects returns to audit not “at random” but (often) according to a well-defined scoring system. Every tax return is “scored” using the IRS’s “Discriminant Function System” (DIF). There is an array of reasons as to why contractors get audited. 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.

One reason could be that you may have improperly included estimates that are overstated, nondeductible costs, or allowances for contingencies in the total estimated costs figure that reduced the percentage of completion. This may have resulted in the understatement of the corresponding income to be reported on the contract.

Or you may have improperly allocated costs from contracts that are still in progress to completed contracts that accelerated the expense recognition. An unusually low gross profit on a job could have indicated an improper job allocation to the IRS.

What Sorts of Issues Does the IRS Look for During a Construction Industry Tax Audit?

The IRS leaves no stone unturned when scrutinizing business books and tax returns. During an audit of your construction company, issues the IRS may focus on / include:

• Delinquent tax filings
• Improperly claimed tax credits
• Inflated business deductions
• Misclassified workers
• Missing or mismatched books and records
• Unfiled tax returns
• Unpaid tax liabilities

The IRS audits construction companies so frequently that it has even developed a construction tax guide strictly for examinations within this industry. The IRS is extremely meticulous in its approach and has a deep understanding of all vulnerable areas.

For instance, the IRS agrees that small construction contractors have more flexibility in electing accounting methods for their long-term contracts. However, the IRS may still subject small contractors to alternative minimum tax for those contracts that are not computed on the percentage of completion method. The IRS warns that the choice of a proper accounting method, the appropriate computation of each accounting method, and the alternative minimum tax consequences must be considered by each contractor. 

You must accept the fact that the IRS knows all the tricks of the trade. It is aware that contractors may improperly be using the cash method of accounting or using an improper method of accounting if gross receipts have already been offset with expenses other than returns and allowances so that only the net amount is reported as gross receipts on the tax return. If, for example, a contractor delayed his billings or structured the billing entitlement in the contract in an attempt to defer reporting of gross receipts, you can rest assured that the IRS will catch it.

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 federal or California taxing authority, including the IRS, FTB, California Department of Tax and Feed Administration (CDTFA), or EDD, do not face the audit alone. 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 and California taxing authorities. 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 dually California licensed Tax Audit Attorney and CPA.

All too often, contractors think they can fix their tax problems by making additional inaccurate or implausible statements to the examining tax agency. Contractors may believe that they can talk their way out of a situation. Unfortunately, in our experience, contractors often forget that the auditor does this for a living and have often received training in fraud detection and investigation. Implausible statements delivered with tons of charisma or confidence won’t carry the day. Instead, a contractor is more likely to compound their civil liability and or trigger a criminal tax investigation due to the presence of one or more badges of fraud in their fact pattern that they try and explain away only to create greater suspicion with the auditor because their explanations that do not make logical sense when viewed with a grain of salt within the big picture.

Suppose you know that there are tax filing errors and potential improprieties on your federal or California income, payroll, or sales tax returns. In that case, the most prudent thing you can do is to establish a layer of separation between yourself and the federal or California tax auditor. We have decades of experience and specialized training enabling us to serve as a buffer and prevent the examining agent from obtaining criminal admissions from your conduct, 70% of communication is nonverbal, and verbal or written statements. Since the most challenging element to prove in any criminal tax prosecution brought by the IRS or California taxing authorities is intent, potentially taking you, your spouse, your business partner and your staff out of the equation (without engaging in witness tampering) eliminates the possibility that you, or they, may provide the evidence on intent their audit is designed to uncover. Aside from circumstantial evidence of intent, the only direct evidence they can obtain that you intentionally cheated will come from your own mouth or the testimony of others.

Gathering circumstantial evidence is then the only available means the IRS and California tax agencies have available to attempt to prove your criminal tax intent. 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 or California taxing authorities may uncover, you can prevent providing direct evidence to the auditors. Remember, no matter how smart you are, you are outgunned and fighting against the resources of a well-trained and experienced federal or state taxing authority that has a deep bench and practically unlimited access to their own specially trained and experienced legal counsel.

Discerning What Sort of Audit You Are Dealing With

There are three basic kinds of tax audits: Correspondence Audits, Office Audits, and Field Audits.

A Correspondence Audit is where the IRS’s or California’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). Perhaps the IRS or California is correct about the issues raised, but maybe it is not. These computers generating these reports are not perfect. Most correspondence audits are generated by an IRS or California computer trying to match information it receives from third parties against the income and deductions you report. For example, the IRS and California 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 or California computer cannot determine that you have correctly reported these items of income or deductions, a correspondence audit will often result.

An IRS or California FTB, CDTFA or EDD Office Audit is much more serious than a correspondence audit. In part, this is because of the increased exposure to interviews and six-year statute of limitations if a 25% understatement of income or open-ended dawn of time statute of limitations if fraud is discovered or admitted by the taxpayer. Anytime the IRS or California wants to meet with you to discuss certain irregularities in your tax return(s), the exposure for tax crimes goes up exponentially. The IRS or California taxing authority may ask you to bring a list of specific documents to a meeting and be prepared to discuss them. The IRS, FTB or CDTFA will seek to confirm the amount of your reported gross income. They will inquire how you obtained your gross receipts figures and whether you have reconciled your bank statements and other sales records. They 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 significant 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 searching for unreported income or overstated deductions or credits. They will thoroughly review your business records and financial statements. The IRS, FTB, CDTFA and EDD agents are generally well-trained and can spot almost all the “common” tax fraud tactics and associated “badges of fraud.” The IRS and FTB will ordinarily review each type of deduction, consider capital gains issues, and conduct a deep probe. Occasionally the IRS, FTB, CDTFA or EDD field agent will also be a licensed CPA.

What Can I Do if I am Facing an IRS, FTB, CDTFA or EDD Income, Sales or Payroll Tax Audit?

First of all, you should not discuss your current or past tax reporting behavior with anyone. Do not tell your neighbor, best friend, employees, business partner or even your priest that you think you may get caught cheating on your income, employment, or sales taxes. These individuals have a financial incentive, hidden motive, or conflict of interest that may cause them to report you and serve as government witnesses through the various voluntary disclosure or whistleblower bounty programs and can be compensated up to 25% of whatever the taxing authority dings you for. They can also potentially be forced to testify against you.

Furthermore, the type of tax professional you seek assistance from is critical. Some taxpayers and business owners are tempted to return to their original accountant. Others may consider speaking to a CPA that was not involved in preparing the returns at issue. 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. You must take a different approach since you do not want to create government witness #1 against you in a criminal tax matter.

In contrast to the weak and jurisdictionally dependent, unevenly recognized accountant-client privilege, the attorney-client privilege is robust and recognized in all state and federal courts. Nearly anything that you disclose to a Tax Lawyer, or the Kovel accountants he works with, are 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, errors, and other intentional acts so that the Tax Attorney can prepare a defense to the audit or criminal tax investigation 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.

The CPAs and CPA candidates that the Tax Law Office of David W. Klasing employs are all Kovel Accountants that receive extensive on the job training and supervision in effectively fulfilling that roll to provide you the highest levels of protection.

Why Do I Need an Experienced Dually California Licensed Tax Lawyer and CPA to Protect Me?

At the Tax Law Office of David W. Klasing, we represent commercial contractors, construction lenders, construction managers, heavy construction contractors, highway contractors, materials suppliers, residential construction developers, subcontractors and surety companies. We also represent parties that build, design, or fund construction projects in California. If you are concerned about an upcoming federal or California income, employment, or sales tax audit, we are here to provide answers while shielding you and your business from life altering assessments of tax, penalties and interest and any effectively mitigating any related criminal tax exposure.

We are conveniently positioned across California to serve builders, suppliers, and developers statewide with satellite tax offices conveniently located throughout Northern and Southern California. To arrange a reduced-rate initial consultation regarding a civil, criminal, California, or federal tax matter, contact our tax firm online or call the Tax Law Office of David W. Klasing 24 hours, seven days a week, at (800) 681-1295.

If you have failed to file a tax return for one or more years or have taken a position on a tax return that could not be supported upon an IRS or state tax authority audit, eggshell audit, reverse eggshell audit, or criminal tax investigation, it is in your best interest to contact an experienced tax defense attorney to determine your best route back into federal or state tax compliance without facing criminal prosecution.

Note: As long as a taxpayer that has willfully committed tax crimes (potentially including non-filed foreign information returns coupled with affirmative evasion of U.S. income tax on offshore income) self-reports the tax fraud (including a pattern of non-filed returns) through a domestic or offshore voluntary disclosurebefore the IRS has started an audit or criminal tax investigation / prosecution, the taxpayer can ordinarily be successfully brought back into tax compliance and receive a nearly guaranteed pass on criminal tax prosecution and simultaneously often receive a break on the civil penalties that would otherwise apply. 

It is imperative that you hire an experienced and reputable criminal tax defense attorney to take you through the voluntary disclosure process. Only an Attorney has the Attorney Client Privilege and Work Product Privileges that will prevent the very professional that you hire from being potentially being forced to become a witness against you, especially where they prepared the returns that need to be amended, in a subsequent criminal tax audit, investigation or prosecution.

Moreover, only an Attorney can enter you into a voluntary disclosure without engaging in the unauthorized practice of law (a crime in itself). Only an Attorney trained in Criminal Tax Defense fully understands the risks and rewards involved in voluntary disclosures and how to protect you if you do not qualify for a voluntary disclosure.

As uniquely qualified and extensively experienced Criminal Tax Defense Tax Attorneys, KovelCPAs and EAs, our firm provides a one stop shop to efficiently achieve the optimal and predictable results that simultaneously protect your liberty and your net worth. See our Testimonials to see what our clients have to say about us!

Here is a link to our YouTube channel: click here!

More Commonly Asked Tax Audit Questions

• How should Tax Audits be Handled by Criminal Tax Counsel?
• How to survive audit when I cheated on return being audited
• What is an eggshell audit?
• What is a reverse egg shell audit?
• Why is a reverse egg shell audit dangerous for a taxpayer?
• Warning signs of a criminal referral from an IRS audit
• Effective tax defense counsels goals in an egg shell audit?
• How are the 4 goals and outcomes 1 and 2 best obtained?
• What are the possible outcomes of an egg shell audit?
• Is it my right to know why I was selected for examination?
• What can I do to prepare for an audit?
• What is an IRS civil examination?
• How IRS decides which tax returns are audited
• What are my appeal options if I disagree with IRS?
• What are my basic taxpayer rights if the IRS audits me?
• Options if I am unable to pay at the conclusion of audit
• What a 30 or 90-Day Letter from the IRS means
• What is involved with appealing disagreements?
• Rights to disagree with IRS tax auditor’s findings
• Can I stop the IRS from repeatedly auditing me?
• Can I have the examination transferred to another area?
• Can I record my IRS interview and is it a good idea?
• How many years of returns are at risk during an audit?
• Common reasons for the IRS to conduct a tax audit
• How to avoid negative consequences from an IRS interview
• Have to agree to interview by taxing authority directly?
• Are all audits the same?
• What should I do if the IRS is investigating me?
• What if I don’t respond to a taxing authority audit notice
• Your rights during an IRS tax audit
• Risks of attending an IRS audit without a tax lawyer
• Most common audit technique used by taxing authorities
• Don’t go into an IRS audit without representation
• Why hire an attorney to represent me in an audit?
• Why hire David W. Klasing to represent me in an audit

California Sales Tax Questions and Answers

• Common issues encountered during sales tax audit
• What is a sales tax audit?
• Disagreeing with business audit conclusions
• Timeline to file Petition for Redetermination?
• What should Petition for Redetermination contain?
• Is the appeals conference formal or informal?
• Appeals Division’s Decision and Recommendation
• Are a mark-up percentage and a profit margin the same?
• Problems with the mark up audit
• Can State Board of Equalization ignore my business records
• What is a sales tax deficiency determination?
• Business being audited for sales tax. Should I be worried?
• Audit determined fraud to avoid sales and use tax
• Definition of “sale” for California Sales Tax
• What do California sellers need to know about sales tax?
• How do I apply for a sellers permit?
• What are my obligations as a permit holder?
• What is sales tax?
• What is tangible personal property?
• What is a sale?
• What are total gross receipts?
• What is use tax?
• Who is responsible for paying the use tax?
• Who is a retailer engaged in business in California?
• Who is a qualified purchaser?
• Do I need a Certificate of Registration Use tax?
• Do I need a Use Tax Direct Payment Permit?
• What types of sales are exempt from sales tax?
• How are Internet Transactions Taxed?
• How is California sales or use tax determined?
• What is the statewide sales and use tax rate?
• Are there other local and district sales and use taxes?
• Total sales and use tax rate calculation
• How to protect against successor liability in California
• Recourse when issued California sales tax liability notice
• CA Sales Tax liability extend to purchasers/successors?
• Waiting Until Audited to Take Action on Tax Matters
• Sales tax records needed in California
• What are California’s sales and use taxes?
• Why does the State of California audit businesses to ensure compliance with sales and use taxes? How does the State determine whether to audit my business?
• The BOE reviews the purchase invoices of my business

Questions and Answers for Criminal Tax Representation

• When tax defense counsel parallels tax crime investigation
• Guilty of tax obstruction by backdating documents?
• To be found guilty of tax obstruction must a person actually be successful in impeding the IRS’s functions?
• Help! The Document I Gave the IRS Had False Information
• Tax crime aiding or assisting false return IRC §7206(2)
• What is the crime known as tax obstruction § 7212?
• What is the difference between tax perjury and tax evasion?
• What is the tax crime commonly known as tax perjury?
• What is a Klein Conspiracy?
• Increased possibility of civil action in IRS investigation
• Am I Guilty of Tax Evasion if the Law is Vague?
• What happens if the IRS thinks I committed tax crimes?
• What are ways to defend against a tax evasion charge?
• Difference between criminal tax evasion and civil tax fraud
• What accounting method does the IRS use for tax fraud
• Can I Change Accounting Method to the Accrual Method
• What is the willfulness requirement for tax evasion?
• I didn’t know I committed tax fraud. Can I get off?
• Concealed assets from IRS. Can I avoid tax evasion charges
• How government proves I willfully engaged in tax evasion
• What is the venue or court where a tax crime case is heard?
• Must the IRS prove tax crimes beyond a reasonable doubt?
• Is it a crime to make false statements to the IRS?
• Will the IRS overlook my tax evasion if it’s minor?
• Failed to tell IRS about my nominee account
• Audit risk with cash based business transactions
• How to defend a client charged with tax evasion
• Is it tax evasion if I didn’t file income tax return?
• Government says I attempted to evade my taxes. Now what?
• I forgot to pay my taxes or estimated tax. Is this a crime?
• Government proof I “willfully” failed to pay taxes
• 5 Ways to Respond to Tax Evasion Charges
• Being audited after using a tax professional
• Rules for what an IRS agent can do while investigating me
• How tax preparers, attorneys and accountants are punished
• How the IRS selects tax crime lead for investigation
• How does the IRS prosecute suspected tax crimes?
• Does IRS reward informant leads for suspected tax crimes?
• How the government proves deficiency in a tax evasion case
• Do prior tax crimes factor into new IRS tax convictions?
• Requesting conference before investigative report is done
• Requesting conference after IRS Special Agent Report
• What are my rights during an IRS criminal investigation?
• Avoid prosecution for tax crime with voluntary disclosure?
• Defense tactics that make it hard for to prove willfulness
• How a tax attorney can stop your criminal tax case?
• What can you generally tell me about tax crimes?
• Continuing filing requirement with investigation pending
• Federal criminal code crimes that apply to tax issues
• Penalty for making, subscribing, and filing a false return
• CID special agent’s report for criminal prosecution
• What is the discovery process in a criminal tax case?
• What the IRS includes in indictment for tax case
• What is the hardest element of a tax crime to prove?
• IRS methods of gathering evidence to prove tax crime
• What does a grand jury do in IRS tax crime prosecution?
• Failure to keep records or supply information
• Failure to make a return, supply information, or pay tax
• What is attempting to evade payment of taxes?
• What is income tax evasion and how is it punished?
• What is attempted income tax evasion?
• What is the crime of failure to pay tax? What is punishment
• Crime of making or subscribing false return or document
• Criminal Investigation Division investigation tactics
• Tax crimes related to employment tax forms and trust funds
• Tactics to defend or mitigate IRS criminal tax charges
• How the IRS generates leads about suspected tax crimes
• What is the crime ”evasion of assessment” of tax?
• Specific examples of “attempting” to evade tax assessment
• What is the so-called Spies evasion doctrine?
• Does overstating deductions constitute tax evasion?
• Is it tax evasion if my W-4 contains false statements?
• IRC §7201 attempt to evade vs. common-law crime of attempt
• What are the penalties for Spies tax evasion?
• How government proves a taxpayer attempted tax fraud
• What is a tax that was “due and owing.”
• What is evasion of assessment for tax liability?
• Is evasion of assessment different from evasion of payment
• Does the IRS have a dollar threshold for tax fraud?
• What is the IRS burden of proof for tax fraud convictions?
• Are Tax Laws Constitutional?
• What is the source of law that defines tax evasion?
• Does section 7201 create two distinct criminal offenses?
• Does tax evasion definition include partnership LLC
• What if I helped someone else evade taxes?
• Is it illegal to overstate deductions on my tax return?
• Is it illegal to conceal bank accounts from the IRS?
• Do later losses justify prior deductions?
• Common reasons the IRS and DOJ start investigations
• What is the Mens Rea component of tax crimes?
• What is a proffer agreement and what are the risks?
• Why to have an attorney to review a proffer agreement
• Why enter into a proffer agreement?
• Limited use immunity from proffer agreements
• Difference between civil and criminal fraud allegation

Questions about delinquent payroll taxes and trust fund recovery penalty

• What happens if an employer continues to incur new payroll tax liabilities?
• California Employment Taxes Basics
• How Does the IRS Develop an Employment Tax Fraud Case from the First Indication of Fraud to a Criminal Indictment?
• Can more than one person be considered responsible by IRS
• How unpaid employment tax payments are allocated
• When a corporate officer is considered a responsible party
• Examples of trust fund recovery penalty determinations
• Failing to pay employment taxes after notice is given
• How to determine responsible person for trust fund recovery
• Assessing trust fund recovery penalty and option to appeal
• What is the trust fund recovery penalty?
• What are the penalties for failure to pay employment taxes
• When am I considered liable for company’s employment taxes