When you apply for credit, you may be tempted to exaggerate the amount of your income. This can help you qualify for a loan or an increased credit card limit. However, exaggerations can come back to haunt you if you’re audited by the IRS.
This is what happened to Carol Tescott, a self-employed massage therapist in Florida. Unfortunately, Carol seems to have been a bit negligent about her taxes. In fact, she filed no returns at all for six straight years. Eventually, the IRS caught up with her and conducted an in-depth audit of the years in question.
To figure out how much back taxes Carol owed, it had to determine what her income had been during the years she failed to file returns. Carol refused to provide the IRS with any information, and she appeared to have absolutely no records of her business income and expenses.
In these circumstances, the IRS makes a best-estimate of the taxpayer’s income and prepares a substitute return to assess the back taxes. Fortunately for the IRS, back in 2007, Carol applied for a line of credit with the JP Morgan-Chase Bank. She listed her annual income for 2007 on the credit application. The IRS discovered this application and used the income amount listed on it as Carol’s income for the year for tax purposes.
Carol objected, claiming this was not a reasonable basis for computing her income. She said she exaggereated the amount of her income on the application in order to get a larger credit line. The IRS said “tough luck” and used the amount anyway. Carol appealed to the tax court which held that it was reasonable for the IRS to reconstruct a taxpayer’s income from self-reported income figures supplied by the taxpayer on a loan application. (Trescott v. Comm., T.C. Memo 2012-321.)
The moral is that the IRS has lots of ways to find out about your income, including statements you make on loan applications. Keep this in mind whenever you list your income in writing. What’s good when applying for a loan may not be so good when you’re trying to get through an IRS audit.