Call Now (800) 681-1295

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)

Table of Contents


    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:

    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.

    BBB Rating

    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

    California Sales Tax Questions and Answers

    Questions and Answers for Criminal Tax Representation

    Questions about delinquent payroll taxes and trust fund recovery penalty

    Tax Help Videos

    Representing Clients from U.S. and International Locations Regarding Federal and California Tax Issues

    tax lawyers

    Main Office

    Orange County
    2601 Main St. Penthouse Suite
    Irvine, CA 92614
    (949) 681-3502

    Our headquarters is located in Irvine, CA. Our beautiful 19,700 office space is staffed full-time and always available for our clients to meet with our highly qualified and experienced staff of Attorneys, Certified Public Accountants and Enrolled Agents. We also offer virtual consultations and can travel to meet with clients in one of our satellite offices.

    Outside of our 4 hour initial consultation option, we do not charge travel time or travel expenses when traveling to one of our Satellite offices, or surrounding business districts, where it is necessary to meet personally with taxing authority personnel, make court appearances, or any in person meeting deemed necessary for the effective representation of a client. To make this as flexible, efficient, and convenient as possible, David W. Klasing is an Instrument Rated Private Pilot and Utilizes the Firms Cirrus SR22 to service client’s in California and in the Southwest by air. Offices outside these areas are serviced via commercial jet airlines. None of these costs are charged to our clients.

    Satellite Offices

    (310) 492-5583
    (760) 338-7035
    (916) 290-6625
    (415) 287-6568
    (909) 991-7557
    (619) 780-2538
    (661) 432-1480
    (818) 935-6098
    (805) 200-4053
    (510) 764-1020
    (408) 643-0573
    (760) 338-7035
    (602) 975-0296
    New Mexico
    (505) 206-5308
    New York
    (332) 224-8515
    (512) 828-6646
    Washington, DC
    (202) 918-9329
    (702) 997-6465
    (786) 999-8406
    (385) 501-5934