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Tax Audits: IRS and State Audits

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    Taxpaying individuals and small businesses in the State of California are subject to numerous tax requirements. A suspected failure to meet any of these requirements could result in an audit. Even if the taxpayer actually did nothing wrong, an audit could cause a number of personal and professional consequences, so it is important to take them seriously.

    Further, audits could lead to criminal tax investigation if the investigating agent suspects that willful tax violations may have occurred. You likely will not be notified if this happens, so it is important to be on the lookout for potential signs, such as your auditing agent not responding to you.

    Whether you are facing a state or federal audit, suspect you are being investigated for potential criminal tax offenses, or even concerned about the prospect of government action waiting around the corner, the time is now to get the help you need. Pick up the phone and call (800) 681-1295 to get qualified answers from the Dual Licensed Tax Lawyers and CPAs at the Tax Law Offices of David W. Klasing.[vc_column width=”1/3″ el_class=”tldr”]

    Table of Contents

    Tax Audits – IRS & State: Page Contents at a Glance

    With both the federal and California state governments facing significant financial challenges and budget deficits, tax authorities are looking even closer at potential cases of tax fraud. Whether you’re facing a California audit vs. federal audit, the right representation is a necessity for a successful defense.

    Numerous tax situations can potentially lead to an audit. These include inadvertent or willful errors when calculating payroll taxes, income taxes, sales taxes, foreign asset holdings and taxes related to the underground economy.

    Whether you’re facing IRS vs. California tax problems, criminal prosecution is always a possibility, as are interest payments and penalties for back taxes owed, especially if the IRS or California tax authority determines the taxpayer willfully made an error when filing.

    If you receive an audit notification, whether it’s from the IRS vs. California tax authorities, contact the Tax Law Offices of David W. Klasing to schedule a 10-minute call with an experienced tax attorney. When facing a California audit vs. federal audit, or both, having a dually licensed Tax Attorney and CPA can be a significant advantage for you.

    Tax Audits: IRS and State Tax Audits

    The IRS has had its budget reduced by 1.2 billion dollars over the last five years. This has resulted in an 11% loss in its workforce, amounting to 13,000 lost employees. You might be thinking that this would result in a climate where an IRS audit is less likely to morph into a federal criminal tax investigation for federal tax fraud, resulting in prosecution, because of a reduced likelihood of being chosen for an audit in the first place.

    That assumption would be incorrect.

    State Audits vs. Federal Tax Audits

    The federal government and the government of California, by way of example, are in dire straits financially. California has been rumored to be close to declaring bankruptcy as a result of the effects of the 2008 collapse of the housing bubble and the associated problems this created on Wall Street, resulting in the largest financial bailout in history and over a 14 trillion dollar federal deficit. When the taxpaying public is not making money, tax revenues decline. Worse yet, when they are incurring record losses, tax revenue all but dries up!  Consequently, California’s auditing, criminal investigation and collection efforts have all ramped up in response.

    Like the federal government, California also has criminal statutes and criminal investigation departments aimed at quelling fraudulent schemes involving, payroll, income taxes, and the underground economy. In addition, California routinely investigates fraud involving sales taxes. California routinely shares information with the federal government regarding the results of its audits and criminal investigations and vice versa so any “fire” lit by an audit or investigation is virtually ensured to spread.

    An Increase in Tax Audits

    As a combination of both Tax Attorney and CPA who has handled literally thousands of federal and state audits over my career and has focused the majority of my practice on criminal tax issues over the last seven years, I have observed a steadily increasing amount of criminal tax investigations disguised as plain-Jane civil audits. The U.S. Justice Department has just lifted its three-year hiring freeze, and at a recent ABA Criminal Tax Symposium, a representative of the Tax Division of the Justice Department made it clear that business was better than ever within the Tax Division and that they were looking to hire.

    It is imperative for the federal government to maintain tax compliance when the level of income tax audits is steadily declining. Consequently, it is logical that the federal government would turn to its other mechanism for encouraging tax compliance by more vigorously prosecuting tax offenders for tax crimes. It is well known to the government that a large percentage of U.S. taxpayers file tax returns and remit income tax payments to a great extent out of fear of criminal prosecution and incarceration. It takes a constant stream of highly publicized tax crime prosecutions to maintain the “fear level” within the taxpaying public.

    Tax Deficiencies In A State Audit vs. Federal Audit

    In any federal or state income tax audit, there are a few very common reasons for concern when large adjustments are proposed by the government. The first concern is over the sheer financial strain of defending an audit and then coping with the assessed taxes, penalties, and interest. The second, and in my opinion much more serious concern, surrounds why the income tax deficiency arose in the first place.

    Where the income tax deficiency arose because of willful actions on the part of a taxpayer to intentionally understate their tax liability, an audit can rapidly turn into a taxpayer’s worst nightmare. Imagine the most common of situations where the taxpayer misled their tax professional into understating their tax liability. This is ordinarily accomplished by supplying the tax preparer a “cooked” set of books that support the understated tax liability. The taxpayer is now faced with a situation where they have to produce the “cooked” set of books in order to support the fraudulent position taken on the tax return. As a tax professional, I can tell you from experience that there are always tell-tale signs when a set of books has been “cooked.”  The “cooked” books alone could conceivably support a criminal conviction for a tax crime.

    What Triggers a Federal Tax Audit?

    The IRS looks for a number of key factors that determine whether they will institute an audit against an individual taxpayer or small business. Complex revenue streams, dealing primarily in cash, and rounded numbers on returns are just a few examples of identifiers that typically concern the IRS.

    However, by far the most common trigger of an audit is the failure to file your return correctly or on time. While some mistakes may be harder to identify, there are some easy ones (such as not filling out a schedule where required) that can jump off the page. If the IRS knows that you have made at least one mistake on your return, this gives them reason to suspect that there may be more errors, or even that the inconsistencies might be intentional.

    There have also been several types of red flags that have been introduced in recent years in response to developments in alternative income streams. Most prominently among those is perhaps the rise in popularity of cryptocurrencies. At first, the federal government struggled to adapt to the changing times. But now, the IRS is very strict about taxpayers disclosing their capital gains from their Bitcoin and other crypto holdings. The required disclosures may be complicated, so you will want the help of a Dual Licensed Tax Attorney and CPA if you are not sure whether your records and filings on gains and losses from crypto transactions are solid. Otherwise, you may end up facing an audit, which may make matters much more complicated.

    The IRS can use mistakes from your past returns to initiate an audit as well. Even if you had gotten away with some inconsistencies in the past, that does not necessarily mean that you are free and clear. There may be ways that you can prevent past mistakes from causing an invasive and time-consuming audit by disclosing mistakes, but only if you act immediately and contact a Dual Licensed Tax Attorney and CPA right away.

    What Triggers a State Tax Audit?

    Just like the IRS, the California Franchise Tax Board (FTB) will look for certain red flags that might indicate that an audit is warranted. These do not need to be explicit signs of criminal tax evasion or other willful activity. It is possible that the FTB could trigger an audit on a person or small business that fits the description of common examples of noncompliance.

    Small businesses with multiple parent or subsidiary entities may draw the attention of the FTB for tax auditing. The FTB is also more likely to audit small businesses that have a much higher proportion of independent contractors than employees, as may employees are often misclassified as independent contractors in favor of the business for which they work. Businesses that meet most of their payroll obligations in cash can also provoke additional government scrutiny, so it is important that cash businesses keep accurate, detailed, and extensive records.

    If you accepted tax relief or government benefits through any of the state’s targeted relief programs meant to combat the effects of the COVID-19 pandemic, you are also more likely to be audited by the State of California. As time passes, it is becoming clearer just how many beneficiaries of these programs misappropriated loan funds and improperly claimed tax relief provided by these programs, both on the state and federal level. Therefore, it is entirely possible that the FTB may audit you despite your having obtained and used these benefits appropriately.

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    Types of Tax Audits

    There are three different forms that a federal audit can take: mail, office, and field. The type of audit that the government will use will depend on what they are investigating, as well as the level of complexity involved.

    Mail audits are the least invasive and serious form of audit. You can likely comply fully with a mail audit without ever having to speak with an IRS agent and merely submitting additional documentation. However, if the IRS doesn’t get what they want from a mail audit, it could trigger a different, more serious form, like an office audit, which would require you and your lawyer to show up to a local IRS office with the documentation and potentially submit to questioning.

    Field audits are the most serious form of audit and consist of IRS agents coming to your home or place of business to seek out the documentation they require. These audits also last the longest and can do the most damage to your professional reputation and ability to secure credit.

    How a Tax Audit Works

    Audits are prove-it-or-lose-it situations. Expenses have to be supported by proof of the method the expense was paid and a receipt from the vendor. Any expense that is fabricated will ordinarily not be supported and thus lost. Additionally, it will become readily apparent where personal expenses were deducted as a business expense when the “payees” are examined or where the receipts are examined. Auditors routinely reconcile the cash deposited to a taxpayer’s business accounts and personal accounts and any excess deposits over the revenue reported per the returns will be treated as an adjustment to income unless the taxpayer can prove the income came from a nontaxable source. They also routinely look for fraudulent reporting patterns found in audits within the same industry in the past.

    What Happens if You’re Suspected of Tax Fraud?

    Where tax fraud is suspected in an audit, the government will routinely try and determine whether the taxpayer acted alone or acted in concert with the tax preparer. An inherent conflict of interest thus routinely surfaces where the taxpayer that committed the tax fraud chooses to hire the same tax professional that prepared the return that is being audited to represent them. Ordinarily, a tax professional is not under a duty to closely scrutinize a set of books provided by a tax client in order to prepare a tax return. However, It will rapidly become apparent to the tax professional during an audit that their client provided them a cooked set of books where the positions are taken on the return relate directly back to the set of books at issue and the positions are taken begin to get picked apart by the auditor.

    It is also common knowledge amongst tax preparers that where a preparer is proven to have conspired with and/or aided and abetted a client to understate their tax liability, they are a much larger target for criminal prosecution and conviction than the clients he or she serves. It is commonly understood that the government promotes increased tax compliance by taking dirty preparers out of the game and by maintaining a healthy fear of prosecution within the tax preparation industry as a whole. It is also understood that the government can easily obtain a federal injunction to prevent a tax preparer from representing clients in tax controversies or preparing returns without much in the way of due process, making such action nearly indefensible.

    Can a Tax Audit Turn into a Criminal Tax Investigation?

    If the government discovers during the audit process that there is reason to believe criminal tax violations such as fraud or tax evasion may have occurred, they are obligated by their own operating procedures to refer the case to the relevant criminal investigations department. This applies for both state and federal audits.

    However, there is no obligation for the auditing agent to notify the taxpayer that they are referring the case for criminal investigation. While the agent cannot intentionally deceive the taxpayer, the target of a criminal tax investigation may not realize their circumstances for a while, potentially up until they are facing an arrest warrant.

    If you were being audited by the FTB or the IRS and the agent in charge of your case has suddenly become quiet or hard to reach, this may be a sign that your case has been transferred into a criminal investigation. At this point, it is vital for your defense that you reach out to a Dual Licensed Tax Lawyer and CPA as soon as possible for the help that can be critical when you need it most.

    Secure the Proper Defense

    For reasons discussed above it is a patently bad idea for a taxpayer that knows that he or she cheated on a tax return to hiring the original preparer to defend them. The original preparer is likely to throw their client under the bus in order to protect their reputation and livelihood. The tax preparer is also likely to be forced by the government to be witness number one in any subsequent criminal prosecution of the taxpayer. Moreover, any tax preparer, including an attorney by the way, that preparers and signs a tax return can be compelled to testify as to any communication with a client regarding positions taken on that return.

    Taxpayers who have committed a tax fraud and find themselves in the terrifying position of being audited need the services of qualified criminal defense counsel from the outset of the audit. Only an Attorney can protect the client communications necessary to mount a proper audit defense. The loss of one’s liberty coupled with the devastating financial ramifications, social embarrassment, and shame – and possible loss of professional licensing for being convicted of a felony – are life-altering events that can quite often be avoided with the proper representation.

    Tax Audit FAQ

    How do I know if I’m being audited?
    The IRS will notify you by mail.

    Can you be audited even after your tax return has been accepted?
    Yes. Under normal circumstances the IRS can audit for up to 6 years. Longer in extreme cases.

    Why would the IRS audit you?
    The IRS will audit any taxpayer they suspect of not being forthcoming about their income.

    Can the IRS audit you ever year?
    The IRS will audit you if they suspect that your tax filings are not accurate. If they suspected this every year, they would audit you indefinitely.

    The following videos provide valuable information about tax audits.

    Tax Help Videos

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