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

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On November 22, 2019, the U.S. Attorney’s Office for the Western District of Washington published a post on its website with the following headline:

King County Dentists sentenced to prison and fines for eight-year tax-cheating scheme

The pair owned dental practice where they falsely inflated expenses and hid income to avoid more than $460,000 in income taxes

This article will inform you how you can potentially save yourself from becoming a similar headline. It discusses what to do when you are NOT entitled to certain deductions you took, or you under-stated (or failed to report) all of your income, or you claimed credits that you were not entitled to, and you receive a letter from the IRS, the California Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA), or the California Employment Development Department (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 subsequently selected for audit.

Suppose the IRS has issued you an administrative summons in furtherance of its investigation into whether you excluded gross receipts from the operation of your dental practice on your federal income tax returns. The summons seeks documents used in the ordinary course of your dental practice. In particular, the summons seeks your daily sheets reflecting what payments you received from individual patients, in what form such payments were received, and any outstanding balances remaining on each patient’s account. The IRS claims that the existence, authenticity, and possession by you of these daily sheets have been confirmed by other sources familiar with your dental practice.

This is where we come in.

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.) have received an audit notice from the IRS, FTB, EDD, or 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 dental license if convicted, in addition to much higher financial fines and criminal restitution.

Why Was I Audited?

Dentists get audited for a wide variety of reasons. You must accept the fact that the IRS, FTB, EDD and CDTFA knows all the tricks of the trade. Consider for a moment that in many dental practices, payments are processed electronically through third-party payors like insurance companies. While insurance payments exist in the dentistry industry and are fairly common, insurance coverage is less prevalent in this industry compared to other medical practices. Thus, many Dentist s may develop annual cash payment plans that entitle a patient to certain services throughout the course of the year. Typically, these services involve a check-up, a cleaning, and a certain number of fillings and other services. While these plans certainly expand a dentist’s market and provide improved access to care for patients, the IRS FTB, EDD, or CDTFA will, unfortunately, interpret their cash nature as increasing the potential for and the likelihood of abuse.

A Dentist who owns the building where his or her practice is located can often experience issues when he or she then leases the space back to the practice. Absent involvement in the practice, this income should be characterized as passive. However, the failure to consider and account for Treas. Reg. § 1.469-2(f)(6), which states that, under certain circumstances, income must be characterized as non-passive, can lead to red flags being raised and the potential for significant penalties and fines.

Some of the most common payroll related issues the IRS and EDD audit over include employee leasing, paying employees in cash, filing false payroll tax returns, and failing to file payroll tax returns (“pyramiding”). Pyramiding is when a business withholds taxes from its employees but intentionally fails to forward them to the IRS. After a liability accrues, the individual starts a new business and begins to accrue a new liability. Some employers withhold taxes from their employee’s pay checks and use the funds for their personal expenses.

IRS’s Focus on Catching Fraud

An important part of the IRS’s strategies to foster voluntary compliance of dentists with the tax laws is through the periodic ongoing recommendation of criminal tax prosecutions and/or civil fraud penalties against Dentist s caught committing tax evasion. This includes the IRS’s Fraud Referral Program under IRS’s Small Business/Self Employed Division (SB/SE), which requires the identification and development of potential criminal fraud and civil fraud penalty cases to be considered in all examinations involving Dentists. If an IRS auditor discovers badges of fraud in your audit, the procedure is for the examiner to consult with his or her group manager and then contact a Fraud Referral Program advisor as soon as possible for technical guidance and advice. The sole job of the Fraud Referral advisor is to work with the IRS auditor to develop the audit for hand off to the criminal investigation division of the IRS which has a 90% conviction rate once it completes a criminal tax investigation.

The IRS announced on March 5, 2020, the creation of the Fraud Enforcement Office to be led by Damon Rowe, a veteran of the IRS Criminal Investigation Division. The new Fraud Enforcement Office was created to further efforts by the IRS to detect and deter fraud while strengthening the National Fraud Program. Through additional training, resources, and applied analytics, the IRS aims to thwart emerging threats in fraudulent tax filings and related evasive activities aimed at misleading the IRS. The National Fraud Program is a program within the IRS’s Small Business/Self Employed Division (SB/SE) responsible for coordinating the establishment of nationwide fraud strategies, policies, and procedures to increase enforcement.

What Sorts of Issues Does the IRS Look for During a Dental Practice Tax Audit?

The IRS leaves no stone unturned when scrutinizing a dental practice’s books, records, and tax returns. During an audit of your dental practice, issues the IRS will likely focus on / include:

Significant deviations or inconsistencies from the previous year’s income tax filings
Claims for deductions or tax credits that are out of step with norms and appear overstated in statistical comparison to other similar dental practices
Misclassified workers
Missing or mismatched books and records
Unfiled tax returns
Unpaid tax liabilities
Cash receipts that do not tie out to information supplied by third parties
Audit procedures designed for cash intensive businesses

The IRS is extremely meticulous in its approach and has a deep understanding of all vulnerable areas.

The California State Board of Equalization is responsible for collecting and enforcing sales and use tax laws in the state. Typically, when a Dentist’s office makes retail sales of certain products, implements associated with oral care or oral hygiene use, sales tax issues can arise. California state law mandates that the sellers of retail goods obtain a seller’s permit. However, should the retail goods be consumed through the course of practice and not through sale, this requirement is waived. Additionally, sales and use tax reporting obligations can arise through the rendering of professional services, typically in the context of non-taxable sales and services. In any case, many Dentist s’ offices are both consumers and sellers of retail products. This can often lead to a complicated analysis where confusion and improper action are possible. However, even inadvertent failures to comply with sales and use tax obligations can be met with aggressive CDTFA enforcement action and significant penalties.

What if I Know I Cheated on My Taxes and the IRS Wants to Speak with Me?

If you are a Dentist 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 audit, do 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 more desirable criminal or civil target than you are if they indeed aided and abetted your income, sales, or payroll tax evasion, which surprisingly many preparers 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. As a matter of fact, one of the highest risk audits you can face is an eggshell or reverse eggshell audit where your preparer is under a criminal tax investigation.

At the Tax Law Office of David W. Klasing, we are California Tax Attorneys & CPAs with a long record of success representing Dentists in civil and criminal audits, Appeals & Litigation before the IRS, FTB, and Office of Tax Appeals (OTA). Equipped with over 20 years of business bookkeeping and accounting experience, including more than a decade of public accounting auditing experience, our California Tax Lawyers & CPAs can protect and advise your small or large business on all of the issues impacting your profits.

A field audit begins with a Revenue Agent sending a letter specifying the tax returns selected for audit, the day and time the audit is to begin, and the records the Revenue Agent wishes to examine. As soon as you get any kind of tax audit notice from the IRS, FTB, EDD, or CDTFA, a good first step is to consult with an experienced, dually California licensed Tax Attorney and CPA immediately. You may have an accountant who regularly prepares tax returns for your company. However, consulting with a Tax Lawyer about the process and your particular facts can be an extremely shrewd initial step. It will certainly pay to have a dually California licensed Tax Attorney and CPA handle the audit from the start, rather than (as is common) waiting to bring in a Tax Lawyer at the conclusion of the audit for the ensuing administrative or court appeals. The Tax Lawyer is often able to head off trouble early and thus truncate the entire process even if the issues at hand are purely civil in nature. If the case involves potential allegations of tax fraud, a dually licensed Tax Audit Defense Attorney & CPA is an absolute must if you seek to secure the highest odds of avoiding a criminal tax prosecution.

A large percentage of criminal tax cases originate through referrals from civil auditors in normal civil audits. If an IRS, FTB, EDD, or CDTFA auditor discovers badges of fraud in your audit, the auditor can simply hand the case to the relevant Criminal Investigation Division. The typical Dentist often has no idea that the IRS, FTB, CDTFA, or EDD believes there has been a criminal violation and begins quietly building a criminal case that often is undetected and thus undefended until the criminal tax investigation is well underway and thus nearly impossible to dissuade.

What are Your Next Steps if Your Dental Practice is Facing an Audit?

If a Dentist or dental practice has been selected or targeted for an IRS or state tax audit, the most important thing the Dentist or dental practice can do is to remain calm but proactive in their approach to the issue. The first thing a Dentist or dental practice should do is to locate and hire an experienced Tax Attorney who understands audit practices and procedures and can formulate a strategy to answer these potential eventualities. The Tax Lawyer understands audit processes and procedures and can work to set ground rules for the audit that can guide the process and protect you from a potential worst-case scenario even if the auditor detects factors that warrant additional scrutiny. Furthermore, and perhaps most importantly, the Tax Attorney serves as a buffer between you and the auditing agent. This ensures that the Dentist does not accidentally make statements that put the auditor on guard or inadvertently make inconsistent statements that are interpreted as a sign of fraud. Furthermore, the Tax Attorney is likely to protect you from seemingly innocent requests – like a meeting at your home or office – that can be used to gather additional information that may later be used against you.

If your books and records are a mess, it is especially important that you call dually licensed Tax Lawyer & CPA. In situations like these, the auditor will commonly determine that it is impossible for the audit to proceed, and he or she will often simply assess your taxes on all income deposited into your accounts and summarily disallow all expenses. In short, this will significantly increase your tax liability and, furthermore, place the burden on you to prove any deductions you wish to defend as valid. This is an unenviable position to find oneself in, and taxpayers typically require a reconstructive accounting of their books and records to remedy or mitigate the situation.

David Klasing is a former public auditor and dual-licensed Tax Attorney and CPA who understands and can anticipate federal and state auditing practices and methodology. He can use this knowledge to develop responsive strategies to the issues you face. All of the Tax Lawyers and CPAs of the Tax Law Offices of David W. Klasing are experienced in federal and state tax controversies and can fight for you in an aggressive and strategic manner, and most have a master’s degree in taxation and have a decade or more of experience.

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 Dentist and Dental Practices state-wide 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 defence 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, Kovel CPAs 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!

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.

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Why Was I Audited?

IRS’s Focus on Catching Fraud

What Sorts of Issues Does the IRS Look for During a Dental Practice Tax Audit?

What if I Know I Cheated on My Taxes and the IRS Wants to Speak with Me?

What are Your Next Steps if Your Dental Practice is Facing an Audit?

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

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