Surviving an IRS Tax Audit
Smart tax-audit tips
Frederick W. Daily, J.D.
December 2012, 3rd Edition
Worried about escaping an audit intact? Then you need Surviving an IRS Tax Audit.
This book explains what to say, what to do, even what to wear, so that a visit from the auditor doesn't turn into a disaster.
With material pulled directly from IRS training manuals, this essential manual exposes the tricks of the auditor's trade. It provides you with a profile of People Most Likely To Be Audited (small business owners and contractors, step carefully!) and discusses whether or not the IRS can examine your "lifestyle" during an audit, rather than stick to the tax return. It also suggests three steps to take when an unreasonable auditor goes too far.
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Frederick W. Daily
Frederick W. Daily spent over 35 years of experience as a tax attorney, helping individuals and small business owners make smart tax decisions and stay out of trouble with the IRS. He has been featured as a tax expert on Good Morning America and NPR, and in publications across the country including Money Magazine, U.S. News & World Report, Newsweek, the New York Times, and the Chicago Tribune. He is the author of Stand Up to the IRS, Tax Savvy for Small Business and Surviving an IRS Tax Audit.
1. Audit Overview
- A. What's an Audit?
- B. Do You Have to Know Tax Law to Win an Audit?
- C. Timing of Audits
- D. Why You Were Selected for Audit
- E. Audit Goals
- F. Your Rights During an Audit
2. Correspondence Audits and Other IRS Notices
- A. Correspondence Audits
- B. Service Center Automated Adjustment Notices (Not Real Audits)
- C. If You Are Billed for an Audit You Didn't Know About
3. Office Audits
- A. Call to Schedule the Audit
- B. Prepare for the Audit
4. Field Audits
- A. Call to Schedule the Audit
- B. Prepare for the Audit
5. How an Auditor Prepares for an Office or Field Audit
- A. Taxpayer Interview
- B. Information Document Request
- C. Summons
- D. Third-Party Contacts
- E. IRS Files
- F. Other Government and Private Records
6. Attending an Office or Field Audit
- A. Who Should Attend the Audit?
- B. What to Bring to the Audit
- C. How to Behave-Playing It Cool at Your Audit
- D. Negotiating With an Auditor
7. Ending an Office or Field Audit
- A. Slowing Down an Audit
- B. Extending an Audit
- C. Rushing a Field Audit
- D. When the Audit Is Over
8. Appealing Your Audit
- A. How to Appeal an Audit
- B. How the Appeals Office Works
- C. Preparing Your Presentation
- D. Meeting the Appeals Officer
- E. Limits on IRS Settlements on Appeal
9. Going To Court
- A. When Not to Go to Tax Court
- B. Tax Court Small Cases
- C. Tax Court Regular Cases
- D. Other Federal Courts
- E. Bankruptcy Court
- F. Appealing to Higher Courts
10. Help Beyond This Book
- A. Finding and Using a Tax Pro
- B. Researching Tax Questions
What’s an Audit?................................................................................... 2
Do You Have to Know Tax Law to Win an Audit?............................ 5
Timing of Audits.................................................................................... 6
Audit Notices for Years More Than Three Years Past................... 6
Audit Notices Sent Toward the End of the Three-Year Period..... 7
Why You Were Selected for Audit...................................................... 8
You Didn’t File a Tax Return............................................................... 8
Computer Selection........................................................................... 10
Market Segment Specialization Program...................................... 13
Other Methods of Face-to-Face Audit Selection........................... 14
Audit Goals.......................................................................................... 17
Your Rights During an Audit............................................................. 19
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Billy Bob and Peggy Sue Valley consider themselves the average American family. They have two kids, Bart and Lisa, and a ranch home. They are the proud owners of “Valley’s Old Tyme Grub House,” a Western-theme restaurant and souvenir shop.
Billy Bob sings in a semiprofessional country and western group whenever anyone asks. Peggy Sue operates a ScamWay dealership, a part-time home-based side business, selling propane cooking accessories. Bart, age 12, helps out at the restaurant to earn his allowance. Lisa, age 14, does some babysitting in the neighborhood. Life has its ups and downs, but basically all is good. That is, until a letter arrives at the Valley house with the return address identifying the sender as the Internal Revenue Service. Billy Bob opens the letter late one night after closing down the restaurant. He yells to Peggy Sue who is in the kitchen, “Hon, better come on in here. We need to talk about something. And, bring me a beer, please?”
We call them audits; the IRS prefers examinations. Whatever term you use, it describes one of life’s most dreaded experiences—the IRS probing into your financial affairs.
Note: This book deals with individuals and small business owners. Audits of entities such as corporations, nonprofits, as well as estates, pension plans, and special institutions are beyond the scope of this book.
What’s an Audit?
An audit is the process by which the IRS determines whether you properly reported all of your income—the money you made—and took the correct deductions, exemptions, and credits. If the IRS determines that you erred somewhere, you will be assessed additional taxes, interest, and, usually, penalties. An assessment is the formal entry of a tax liability in your records at the IRS Service Center.
Over 1.5 million individual tax returns are audited in some fashion by the IRS every year. And, the audit rate is on the rise—it has doubled since the year 2000!
Owing without an audit. Sometimes, the IRS reviews your tax return and determines you made errors in reporting your income or claiming deductions, exemptions, or credits, but does not audit you. Instead, you simply get a billing notice (called an adjustment) for the additional amount the IRS believes you owe. If you’ve received such a bill from the IRS, see Chapter 2.
To determine if you’ve properly reported your income and claimed your deductions, exemptions, and credits, Congress has given the IRS wide powers to examine your financial papers and records. IRS auditors can even ask other people about your financial affairs to determine if you are playing it straight with the IRS.
IRS Publication 17, Your Federal Income Tax, explains the audit process—from the IRS’s point of view. It’s available on the IRS website at www.irs.gov.
The vast majority of tax returns are accepted by the IRS without question. Then why, you are no doubt wondering, did you get audited? While your chance of being formally audited in any one year is only about one in 90, the odds in your taxpaying lifetime are closer to 50%. As your income increases, so does your audit likelihood. If you earn over $200,000 per year, your audit odds triple. Similarly, your likelihood of audit rises if you are self-employed. (See “Why You Were Selected for Audit,” below, for more details on how audit victims are selected.)
In addition, the reality is that you can expect your audit to cost you money—over 88% of people who are audited owe additional taxes. A few people come out of an audit entitled to a tax refund, but don’t count on it. The amount of money the IRS assesses in audits averages 32 times more than the amount the IRS gives back.
Furthermore, contrary to what you might have read, the burden of proving that you correctly reported your income and claimed your deductions, exemptions, and credits is on you, not the IRS.
With your audit notice, the IRS may have provided a checklist of items—typically deductions from your income—that the auditor will be investigating. You must demonstrate that the information on your tax return related to those items—and anything else the auditor raises—is correct. Think of the IRS as the “Show Me” state of Missouri. Critics have said that this means you are guilty until proven innocent.
Proving the correctness of your tax return is not always easy. The IRS wins well over 80% of all audits—mostly because people cannot verify what is on their tax returns. IRS auditors even admit that the biggest reason for this is poor record keeping, not dishonesty.
Once you’ve gotten over the shock of receiving an audit notice, various thoughts may be running through your head:
Why was I picked for an audit?
Did I make an enemy somewhere?
Does the IRS suspect me of doing something wrong?
Is the IRS going to put me in jail if they find out I’ve been cheating?
Will the auditor discover the money I made from playing the organ at weddings?
I lost my records in a move last year—what am I going to do?
Was I entitled to claim my mother as an exemption?
Will the IRS question my home office deductions?
Did I figure my business deductions correctly?
How will I ever pay the bill if I lose?
Should I hire a tax professional?
After reading this book, you should have answers to all of these questions. You will know why you were picked, how to prepare, what to do when you meet the auditor, and what to do if the audit goes wrong. This chapter explains how the IRS selects taxpayers to be audited, what your goals should be, and the rights every taxpayer has in dealing with the IRS. Chapters 2, 3, and 4 cover the different kinds of audits. Chapter 5 gives you a look at how an auditor prepares for an audit. Chapter 6 tells you what to do, and what not to do, when you meet an IRS auditor. Chapter 7 tells how audits are wrapped up and when to declare victory or throw in the towel. Chapters 8 and 9 guide you through filing an appeal—and even taking the IRS to court. Chapter 10 provides resources beyond the book.
Do You Have to Know Tax Law to Win an Audit?
The audit process is a child of the Internal Revenue Code, or tax code, which contains thousands of pages of Congress at its worst—complex, contradictory, and confusing language reflecting various economic, social, and political goals of the past 15 decades. In addition, tax law is found in another 100,000 pages of IRS regulations, revenue rulings, letter rulings, manuals, and official publications. Finally, thousands of federal court decisions tell us how the tax laws should be applied in individual cases.
You will never understand the tax laws. Few people do. Only tax professionals—tax lawyers, accountants, and enrolled agents, with their years of special training and experience—come close. Even they tend to know specific areas of tax law, not the entire body of legal material.
But not knowing the tax laws may not be as much of a disadvantage as you might think. Tax law is so voluminous and complex, most auditors don’t know it well either. Moreover, the training and experience level of IRS personnel is declining, while the law is getting more complex. So, auditors normally stick to predictable audit issues we cover in this book.
A minority of taxpayers with highly complex taxes will face specially trained auditors. Examples include investors in so-called tax shelters, real estate partnerships, family trusts, and beneficiaries of charitable foundations. Even so—if you’re prepared and grounded in the audit basics, you’ll come out okay most of the time, experiencing the minimum damage. And if you don’t like the outcome of your audit, you have several options for appealing. The auditor does not have the last word. (See Chapters 8 and 9.)
In a few hours, you can learn the tax law fundamentals you will need for your particular audit issues. Or you can call on a tax professional for help. Specific information on various tax issues is available in Chapter 10.
You can succeed in an audit without knowing any tax law. Many audit issues are factual, not legal. A factual issue is whether or not you incurred a business-related expense, such as “advertising.” A legal issue is whether or not you were legally entitled to deduct that business expense.
Timing of Audits
The IRS is powerful, but not without limit. After getting over the shock of reading “we have selected your federal income tax return for examination,” look carefully at the year or years on the audit notice. In general, after you file a tax return, the IRS has only three years to begin and end an audit of that return. If you filed it before the due date, April 15, the three years start running from April 15. If you filed on extension to October 15, the three start running from that date.
If you were audited within the last two years and the IRS made no more than a thousand dollars or so in adjustments or issued a “no change” report, you should not be audited again. If you are, call the IRS and ask that the audit be canceled. Explain that you’ve already been audited recently and that the outcome was no or minimal tax owing. If the IRS employee is not aware of the IRS policy against repeat audits, ask to speak to a manager. This might not work, but it’s worth a try.
Audit Notices for Years More Than Three Years Past
If any year on the audit notice is more than three years past, the IRS may have goofed. To check if it’s a mistake, call the IRS and ask that the audit be canceled because of the three-year rule. If you’re told that the audit is no mistake, head for a tax pro’s office pronto.
In three situations, the IRS has more than three years to complete an audit of your tax return. So keep reading if you’re being audited for a return filed more than three years past or are worried about an audit expanding into years gone by.
If the IRS believes that you understated your income by 25% or more, the IRS has six years to complete an audit of your return.
If the IRS believes that you filed a fraudulent return, there is no time limit for auditing that return. Tax fraud is conduct meant to deceive the IRS, such as using a false Social Security number. A really big mistake—even a stupid one—isn’t fraud if it wasn’t deliberate. Because the burden of proving fraud is always on the IRS, the IRS seldom audits returns after three years, even if the IRS believes that fraud is evident. So if the IRS just caught you doing something questionable, the IRS may expand the audit to returns filed within the last three years, but isn’t likely to go back further.
If you did not file a tax return, the IRS has forever to audit you. That’s because the audit time-limit period, called the statute of limitations, starts running only if you file a tax return. As a practical matter, however, if you didn’t file a return for a specific year and the IRS hasn’t audited you within six years of the return’s due date, you may have escaped the audit net. So if it’s 2012 and you received an audit notice for your 2009 tax return, you probably don’t need to worry about the IRS expanding your audit to cover 2001, when you never got around to filing.
Audit Notices Sent Toward the End of the Three-Year Period
Most likely, your audit notice is dated somewhere between 12 and 18 months after you filed your return, assuming the IRS isn’t accusing you of understating your income by 25% or more or of fraud.
Remember that the IRS not only has three years to begin an audit of your return, but must complete the audit within three years of the filing date. On top of that, the Internal Revenue Manual directs auditors to complete audits within 28 months of when you filed your tax return. This allows the IRS an additional eight months to process any appeal.
Essentially, this means the IRS system is set up to allow auditors between ten and 16 months to open and close an audit. Sometimes, it is in your interest to slow down the process, and this book provides you with tips on how to do so. By delaying an audit, the auditor may face the 28-month deadline without having delved too far into your financial affairs.
Why You Were Selected for Audit
Like you, the Valleys want to know why they are being audited. Are they merely unlucky, or are more sinister forces at work?
There are nearly ten reasons why any one tax return is selected for further examination. This section explains each one. Knowing why you were chosen will help you prepare for the task ahead.
You’ll never know for certain why the IRS got you. Still, there may be some clues. If you know what the IRS suspects, you can better prepare—or get professional help early on. An experienced tax pro can spot probable audit issues.
You Didn’t File a Tax Return
As mentioned, the IRS has forever to audit if you didn’t file a tax return, although you are likely to hear within three years of when the return was due. Still, it may seem odd that the IRS can check your correct income and exemptions, deductions, and credits if you never filed a return. In reality, the IRS cares only about your income—the IRS doesn’t grant you more than a single exemption and the standard deduction if you didn’t file a tax return. You may be entitled to much more by filing a return, of course.
The IRS knows at least some of your income from data reports— 1099 and W-2 forms—filed by those who paid you money. If the IRS’s records show that you earned at least $7,250, the IRS computer looks to see if you have filed a tax return reporting the income. If there isn’t one on file, the IRS can calculate your tax liability—in effect, file a tax return for you. The IRS handbook called the Internal Revenue Manual directs the auditor to write up a “reasonable and substantially correct” tax return, which is a license for IRS invention and creativity.
Individuals. In addition to W-2 and 1099 forms, IRS auditors rely on tables from the Bureau of Labor Statistics (BLS). They use BLS data to estimate your income and living expenses, particularly if the W-2 and 1099 forms on file show an impossibly small income for where you live, such as on Park Avenue in Manhattan. BLS tables show minimum funds necessary by ZIP code for living a simple lifestyle, taking into account the geographic area, family size, and standard of living. If your income is below what the BLS tables say you need to earn to live where you do and support your family, the IRS will assume you earned enough to make up the difference.
Self-employed. IRS auditors may rely on published industry information to estimate a business owner’s income. For instance, trade publications for U.S. auto parts retailers show average gross sales and profit margin. If Simon neglected to file a tax return, the IRS can ballpark how much Simon’s Auto Parts World made based on the published information.
After an auditor guesstimates your income and minimum deductions for the year and your tax liability, the IRS mails an examination (audit) report to your last known address. In other words, if you didn’t file a tax return, you are probably looking at an audit report, not an audit notice. Essentially, the IRS has selected income and deduction figures for you, completed a return, audited it without your participation, and sent you the report.
If you receive the report, you can either sign it or contact the auditor and refute it with your own figures. Alternatively, you can file an original tax return with the auditor, which is probably your best bet. The IRS may not accept the return without seeing support for your numbers, in effect auditing the return.
If you don’t sign the audit report or file your own return, the IRS must issue a notice of deficiency. This gives you 90 days to contest the IRS report in tax court. (See Chapter 9.) You do not have the right to appeal this IRS decision within the IRS, as you normally are allowed following an audit. (See Chapter 8.)
The IRS computer is to blame for two-thirds of all audits. Each year, your tax return data is sent to the IRS National Computer Center. There it is analyzed by a computer program called the Discriminant Function (DIF). Every tax return receives a numerical DIF rating—the higher the score, the more audit potential the return has. The DIF formula is super secret—few people even in the IRS know how it works or why a return gets a particular score. Outsiders guess that hundreds of variables on a tax return are compared to statistical models by this software program. Here is my take on what goes into the DIF scoring.
Ratios. Are you claiming more deductions than most similarly situated taxpayers? The chief component of IRS DIF scoring is likely to be how close your tax return is to the norm of others with similar deductions. According to Professor Amir Aczel (author of How to Beat the IRS at Its Own Game, Four Walls Eight Windows Press), the IRS is most likely to audit returns with a high ratio of certain types of deductions to income. Three tax return schedules are critical to this process:
Schedule A, itemized deductions such as medical expenses, unreimbursed employee expenses, state taxes, mortgage interest, and charitable contributions
Schedule C, profit and loss for unincorporated small businesses, and
Schedule F, profit and loss for farms.
Aczel claims that as deductions exceed 50% of income, your audit likelihood rises. He lists precise ratios based on a study of 1,200 audit cases. For instance, self-employed people filing Schedule C are seldom audited when deductions are below 52% of their gross receipts. But, they are often audited when they claim expenses of more than 63% of their gross receipts. If you include a Schedule A with your tax return, Aczel claims you are most audit-safe when deductions are less than 44% of your gross income.
While Mr. Aczel’s book is interesting, don’t use it as a manual to avoid a tax audit. If you are entitled to a deduction, take it, no matter what the chances of audit. Just be sure to keep good records backing up why you took the deduction.
Other factors. According to the IRS Manual, only significant items are to be reviewed at an audit. What’s significant depends on the IRS’s overall view of the return as well as particular questionable items. Factors likely to figure into the audit scoring process—and most likely to be looked at in your audit—include the following:
Comparative size of an item to the rest of the return. For example, a $5,000 deduction for medical expenses on a tax return reporting $25,000 in income would be significant, but not on a $100,000 return. Other red flags would be $19,000 of mortgage interest deduction on a return showing $18,000 of income or $32,000 of unreimbursed employee expenses on a return with income of only $17,500. These kinds of expense-income discrepancies offend common sense and stand out, although there may be a perfectly reasonable explanation for each.
An item on the return that is out of character for the taxpayer. For instance, a plumber claiming expenses relating to a business airplane would cause suspicion. So would a taxpayer over age 65 who claims four minor dependent children.
An item that is reported in an inappropriate place on the return. For example, $2,000 of credit card interest deducted along with business expenses is suspect. The IRS is concerned that you have improperly deducted your personal VISA interest charge as a business expense. Similarly, self-employment income simply listed as “miscellaneous” income without another form or schedule. Here, the IRS is watching out for someone who is trying to avoid paying self-employment (Social Security and Medicare) tax.
Evidence of intent to mislead the IRS on the face of the return. Tax returns with missing schedules or forms not completely filled in raises an IRS audit picker’s eyebrows. So does the “occupation” box left blank, or a stated occupation that does not match what the IRS has on record.
Your gross income. The IRS goes after higher earners. The more your annual income exceeds $100,000, the more your likelihood of audit increases. The IRS simply believes that when you move into a high income bracket, you are more likely to cheat than when you are in a low income bracket.
Self-employment income. The IRS targets people who are in business for themselves. Self-employed people are four times more often audited than are wage earners. Primarily, the IRS is scrutinizing Schedule C of sole proprietors.
Losses from businesses and investments claimed on your tax return. The IRS may want to know how you paid your bills while losing money. Most likely to be audited are taxpayers reporting a business loss of more than a few thousand dollars. Losses from stock investments in privately held small companies also raise IRS eyebrows.
Approximately one in ten tax returns—those with the highest DIF scores—are initially computer-selected for face-to-face audit consideration. IRS classifiers (human beings) then look at this batch and screen out nearly 90% of them, or refer them to the correspondence (mail) audit section. Sloppiness catches a classifier’s attention. A messy return, especially if handwritten, stands out. A classifier may think you don’t take your record-keeping and tax reporting responsibilities very seriously. Round numbers—claiming $5,000 for business advertising, $2,000 for transportation, and $1,500 for insurance—are a dead giveaway that you are estimating, not reporting from records. If you estimated on your return, you still may be able to prove your deductions are close to the estimated figures; just be aware that the round numbers will cause the auditor to look closely at your work.
The final say-so on who gets audited in person is made at local IRS district offices by examination group managers. These people supervise and assign auditors to specific cases, often according to the auditors’ experience and expertise. Examination group managers also decide whether you’ll be audited at the IRS office (see Chapter 3), or elsewhere by a more rigorous field audit (see Chapter 4).
Examination group managers effectively establish their own mini-DIF scoring process. They consider income and spending patterns of their communities—for instance, more people have business car expenses in L.A. than in Manhattan. People in Kansas have more tornadoes—and casualty losses—than people in Idaho. Income in the Alaska fishing industry can fluctuate significantly season to season. Michigan workers strike more often than do workers in Texas.
Market Segment Specialization Program
According to IRS insiders, the Market Segment Specialization Program (MSSP) is the wave of the future. Each MSSP audit focuses on a specific industry or group of taxpayers believed to be not fully complying with the tax laws. The IRS provides specialized training to its agents and publishes an Audit Technique Guide (ATG) for each group. The IRS has issued over 70 ATGs and has more in the works.
ATGs are available to everyone. If you fall into one of the targeted categories, you can assume that your return was selected for audit for this reason. Assume that the auditor is familiar with the ATG for your occupation or group.
The ATGs thus published cover different occupations and businesses, including architects, attorneys, entertainers, health care workers, ministers, real estate brokers and agents, retailers, taxicab drivers, tour bus operators, truckers, workers in the music industry, fishermen, and owners of air charter companies, auto body shops, auto dealerships, bars and restaurants, beauty and barber shops, bed and breakfasts, commercial fisheries, garment manufacturing companies, gas stations, grocery stores, high tech businesses, laundromats, mortuaries, pizza parlors, wineries, and more.
Audit Technique Guides are available from many different sources, including the following:
Law libraries and some large public libraries
Tax professionals, if they do significant audit representation work
IRS offices (only for reading on the premises)
IRS website (www.irs.gov) for downloadable versions of most guides, and
IRS Taxpayer Services, 800-829-1040, to order by mail.
Other Methods of Face-to-Face Audit Selection
Besides being selected by the IRS computer scoring program or as part of the MSSP, there are seven possible ways to get into the audit soup.
Local projects. The IRS encourages local IRS district offices to initiate special audit projects. Selections are based on IRS personnel perceptions of who in the community plays fast and loose on their taxes. Recent local projects have targeted real estate investors claiming passive-type losses, roofing contractors, agricultural co-ops, professional gamblers, spouses who deduct or receive alimony, and people whose mortgage loan applications show different income than reported on their tax returns. (Under information sharing programs, mortgage lenders report certain information on mortgage applications to the IRS.)
National projects. Periodically, the IRS national office decides that certain occupations merit audit attention. Past targets include airline pilots, attorneys, car dealers, morticians, and physicians. Perennial audit targets are operators of cash business, such as bars and laundromats, and owners and employees of gambling establishments. This program is being phased into the MSSP audit, described above.
The IRS has several clues to your occupation. Forms W-2 and 1099 filed by others in prior years might indicate it. Also, you must state your occupation and sources of your income at one or more locations on your tax return. And, if self-employed, you must include a four-digit business identification code on your tax return; these codes are listed in the IRS instructions for preparing Form 1040 tax returns. Some people have shown creativity here, such as Pam the prostitute, who wrote she was in “public relations.” Pam was audited and fined by the IRS, which was upheld in court when Pam challenged the IRS action. Misstating the source of your income is illegal, even if you report all of it. Presumably the reason is that it makes it impossible for the IRS computer to score your tax return for audit consideration. But even if you left this information blank, the IRS obviously found a way to audit you.
Prior and related audits. Audit lightning can strike twice. One IRS examination can lead to another—if the first produced a tax bill of at least several thousand dollars. Happily, a repeat is not a sure thing. I’ve seen people get hit with an enormous audit bill and never hear from the IRS again. Sometimes the IRS is looking at the same issue, and sometimes the IRS is looking at a new one.
In addition, you might be audited if you’re a partner, limited liability company member, or shareholder in a business that is audited, or if some of your co-owners are audited. If the IRS found problems during your co-owners’ audits, the IRS is likely to look into the same issues with you.
Criminal activity. Like grapes, trouble with the U.S. government often comes in bunches. If you are investigated for drug dealing, gambling, or financial crimes, the IRS may be called in. The tax code requires that you report all income—legal or otherwise. The tax law is morally neutral—it doesn’t care if you earned your riches as a Mafia hit man, prostitute, or drug dealer, or through any other illegal employment, as long as you declare it.
If you don’t want to disclose the source of your income, you should talk to a lawyer about a so-called Fifth Amendment tax return. On the first page of the Form 1040 return, write, “I am claiming my Constitutional right against self-incrimination.” Where you must list your income, do so, but the write the words “Fifth Amendment” where the return requests the source of your income and where it asks for your occupation. Don’t try this without the assistance of a tax lawyer.
Filing a Fifth Amendment tax return may keep you out of the criminal investigation division of the IRS, but it undoubtedly increases your audit potential. If you filed a Fifth Amendment tax return and that’s the return under audit, see a tax attorney.
Amended tax returns. Most people file amended tax returns to get money back. You may file an amended tax return within either three years of the date you filed the original return or two years of the date you paid the tax. The IRS has the discretion to reject an amended return if you would be entitled to a refund. Before sending the refund, the IRS may audit you. And here’s the catch: Everything on the return—not just the items amended—is fair game for the audit.
Amending a tax return doesn’t extend the time the IRS has to audit. The IRS normally has three years from the original filing date to audit a return. If you’re considering filing an amended return, you might logically conclude that you should wait until close to the end of the three-year period from when you filed the original return so that the IRS has little time to audit you. In that situation, however, the IRS may accept the amended return only if you agree to extend the three-year audit limit period. Normally, you should agree to an extension of around one year.
Informants’ tips. Most paranoid people feel that the world is ganging up on them. If you just received an audit notice, you might be worried that a disgruntled ex-spouse, business associate, or former employee turned you in to the IRS. Worried about a tattletale you may be, but your worries should be short-lived. Fewer than 2% of audits result from people finking on others. The IRS rarely spends any serious time following up most tips, particularly anonymous ones. The IRS has found that many leads aren’t provable and are motivated by spite. Reports of major cheats are most likely referred to the IRS criminal investigation division, not the audit department. So if your ex-bookkeeper is the only one who knows about your questionable business travel deductions, you might be heading down the wrong road if that’s the issue you think will be the focus of your audit. Instead, focus on the common business concerns discussed in Chapter 3 and Chapter 4.
Geography. Kansas gets tornadoes, Florida gets hurricanes, and California gets earthquakes. Similarly, some state residents get more than their fair share of audits. The examination rate is 150% higher than the national average in Nevada, but 150% lower than that average in Wisconsin. Other high-audit states are Alaska, California, and Colorado. Low-audit states include Illinois, Indiana, Iowa, Maryland, Massachusetts, Michigan, New York (excluding Manhattan), Ohio, Pennsylvania, and West Virginia. Oddly, the second lowest audit rate locale is the District of Columbia, the seat of the federal government.
What’s more, how you come out of an audit depends on where you call home, too. Your chances of getting away without owing a nickel are twice as good in Las Vegas (32%) as in Manhattan (15%).
Although moving now won’t change the fact that you already have received an audit notice, if you have the choice, you could relocate after the audit to lower your chances of future audits.
As mentioned at the beginning of the chapter, you have two goals in every audit. Always keep them in mind.
(1) To minimize financial damage. Accept the over 80% chance that your audit will end with a tax bill. Aim for damage control—keeping your tab as low as possible. I’m not saying to go in with a defeatist attitude, but at the same time don’t have unrealistic expectations. In a recent year, audits resulted in additional taxes and penalties of $19 billion owed to the IRS, and only about $600 million in refunds—a ratio of 32 to 1 against taxpayers.
(2) To prevent expansion. One way to minimize the financial damage (your first goal) is to prevent an expansion of the audit. An auditor can examine any open tax year if such an examination is likely to be fruitful—that is, result in more money owed. Open tax years are those for tax returns filed within the past three years. The limit is extended to six years if the IRS believes you are guilty of underreporting your income by 25% or more, or forever if you are suspected of outright fraud.
Expansion most frequently occurs when during the audit, the auditor sees something such as an improper deduction that might be present on tax returns other than the one under audit. You might hang yourself by showing the auditor something related to an open tax year. For example, in November 2012, Noreen is audited for 2010. The auditor asks to see Noreen’s business check register for 2010. Noreen cooperatively hands it over, failing to edit out the portions that relate to other years. The auditor nonchalantly rummages through the information for 2009 and 2011, the other open tax years. The auditor finds a few things she believes are questionable, and expands the audit into those years.
Never show the auditor anything related to a year other than the tax year being audited. This is the one rule to follow to minimize expansion of the audit. In the example above, Noreen could have photocopied the check register for 2010 before the audit, or offered to send it to the auditor after the audit meeting. The best way to avoid showing unrelated documents to the auditor is simply not to bring the unrelated documents with you to an office audit or not to have them on your premises during a field audit.
Don’t File a Tax Return While Under Audit
Here’s one way to minimize expansion of your audit: Don’t file a tax return while an office (Chapter 3) or field (Chapter 4) audit is in progress. This rule does not apply if the IRS is conducting a correspondence audit (Chapter 2). If you file your return during an office or field audit, the audit is likely to be expanded to include that return.
When April 15 rolls around, file a request for an extension to October 15. If the audit is still alive on October 15, consider not filing your tax return until the audit is completed. If you’ve paid all taxes due, you won’t incur any penalties or interest for not meeting the extension deadline. If you owe money, send in your payment before October 15 with a letter requesting the payment be applied to that year’s tax account. If you didn’t read this in time and already filed your tax return, politely decline to give a copy to the auditor if he or she asks. But do not lie and say you haven’t filed the return.
Your Rights During an Audit
IRS Publication 1, Your Rights as a Taxpayer, should have been included with your audit notice. (If you didn’t receive a copy or misplaced it, you can find a copy on the IRS website at www.irs.gov.)
The following are the most important provisions related to audits:
You have the right to be treated fairly by IRS personnel. If an IRS employee is not professional, prompt, and courteous, you have a right to speak to a supervisor.
You have the right to have a representative handle your audit. The representative must be designated to practice before the IRS—such as a tax attorney, accountant, or enrolled agent—and have a written power of attorney from you. With a few exceptions, auditors (or collectors) can’t force you to appear or even speak to you after you hire a representative.
You have the right to sound-record the audit. Taping would most likely cause the auditor to work even harder. For this reason, tax professionals don’t do it and neither should you.
You have the right to avoid repeat audits in certain circumstances. If you were audited within the last two years and the IRS made adjustments of $1,000 or less, you can’t be audited again for the same items. If you are audited a second time, complain to the IRS appointment clerk or the auditor. There is one exception: The IRS can audit again for self-employment and small business items, such as vehicle and entertainment expenses, equipment purchases, and employee benefits.
You have the right to have proposed adjustments explained. The audit report you receive after your examination is typically vague and written in IRS-ese. If you don’t understand something, ask for detailed explanations by phone or in person. If the auditor doesn’t explain things to your satisfaction, insist on talking to her manager.
You have the right not to be forced to incriminate yourself. This Constitutionally guaranteed right applies whenever you deal with a government agency, including the IRS. For example, if your income comes from kiting checks, the IRS can’t demand details on the source, as long as you report the money on your tax return. But you can’t lie to the IRS. If you don’t want to list your occupation as “bad check artist,” file a Fifth Amendment return (discussed above).
You may appeal your audit in most cases, but this is not an absolute right. (See Chapter 8.)