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Handling an IRS Audit

October 11, 2011 By

Every year, the IRS audits many taxpayers. In 2010, about 1.6 million were audited for the 2009 tax year. This represented 1.1% of all taxpayers. Many of those audited were high income earners. The IRS audits taxpayers for various reasons: some taxpayers are audited out of a random draw, some are audited because they have suspicious and red-flag transactions on their tax returns, and some are audited because they have items that do not coincide with the IRS’s cross-referencing system.

Most of the audits that the IRS undertakes are letter audits – the IRS sends a letter to a taxpayer asking them to mail back various support documentation for items in their tax returns. Besides the letter audits, the IRS can also conduct a physical audit at your office or business premises. They can also ask you to visit the nearest IRS office to provide various documentations to have your audit conducted.

If you happen to be one of the targets of an IRS audit this year, you should properly prepare and provide the information needed to avoid further investigations. Below are some tips that can help you go through an IRS audit successfully:

Preliminary Review of the IRS Letter to Understand what is Needed

The first step you will need to take when contacted by the IRS is to review what the IRS auditor is asking for and try to understand why they are asking for the documentation or further information. The IRS has a system that matches off entries that you indicate in your tax return with entries from third party documentations. Most letter audits from the IRS are sent due to a mismatch of information from this cross-referencing system. Therefore, check to see if you indicated the correct amounts in your tax returns or if you missed out on anything. Some inquiries are straightforward and by mailing the relevant documentation, the IRS auditors are usually satisfied.

Professional Help

From your preliminary review of the IRS audit contact, you can then determine whether you need some professional help from a tax attorney or from a tax preparer. If you do not have the information that the IRS is looking for or if you find the nature of the inquiry as too complex to figure out on your own, you can consult with a tax professional. The professional will help you draft a response to the IRS or will accompany you to the IRS office for a physical audit.

Do Not Volunteer Information

This is one area that many taxpayers fail in when undergoing an IRS tax audit. When you are asked for specific information by the IRS, only provide the specific documentation or answers that they are seeking. Providing more information only sets you up for further probing. This is another reason why you may need a professional to assist you while responding to the IRS.

Do not be too Quick to Pay

If the IRS determines that you have back taxes due from their audit, do not be in a rush to pay off the taxes. You can always negotiate your position. The IRS can be wrong and therefore, always ensure that you have verified the new standing (you can enroll the aid of a professional). You can always challenge the IRS in tax court if need be, and many taxpayers have indeed, won over the IRS in many cases.

 

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Support Records You Should Retain in Case of an IRS Audit

August 26, 2011 By

Filing your taxes can be such a demanding process and it is quite a relief when the process is over and done with. However, it would be counterproductive to successfully file your taxes only to be unable to prove them in case of an IRS audit because of missing documentation. Therefore, it is important to retain various documentation as long as they are needed. Various support documentation for your tax returns will be required for several and specific periods of time. Some of the documents that you will need to keep are:

  • Tax Return Acknowledgment – A tax return acknowledgment is your evidence that you indeed, filed a tax return. If you sent your tax returns by registered mail, you should keep the IRS acknowledgment receipt for as long as possible. If you submitted returns electronically, print the returns acknowledgment from the IRS website. The IRS can seek an audit for as far back as they wish if you did not file any returns at some point or if you have no evidence for such returns. Therefore, it is advisable to keep these returns acknowledgments as long as possible.
  • Exemption and Deduction Documentation – If you had any tax exemptions or deductions that you claimed in your returns, you should keep any support documentation for at least 3 years (because the IRS may audit your tax returns up to 3 years after your returns). However, if you understated your earnings in your returns by 25% and over, they can seek an IRS audit up to 6 years after returns.
  • Property Purchase or Sales Documentation – If you made a property purchase or sale, you should keep all the sales records, including your sales contract, legal documentations, receipts, invoices, and any other relevant documents. A property purchase or sales IRS audit can go back 4 years and therefore, you should retain these documents for at least that period. Furthermore, such purchase documentation will be needed for property gains tax reduction if you ever sell the property.
  • Bank Records – You should also keep all bank related documentation such as bank statements, credit card statements, electronic banking print outs, and money transfer documentation for at least 3 years from time of filing.
  • Investments Related Records – Besides bank records, you should also keep any securities and investment related documentation such as stocks records, brokerage statements, insurance and mutual funds records, investment product documentation, and any receipts for payments made to these investment managers for the same period of at least 3 years.

It is advisable to keep a storage area where you keep these records that can be required in case of an IRS audit. You can also keep an electronic copy of the documentation for quicker referencing.

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Red Flags that Can Get You an IRS Audit Notice

August 11, 2011 By

It is almost impossible to be completely proof of an IRS audit. However, people with simple and straightforward tax returns, withheld employment income, standard deductions, and no special credits will be least likely to be audited by the IRS. This is because the IRS will generally place emphasis on taxpayers with various income, credits, and tax deductions that are known to be prone to fraud or erroneous claims (which are considered red flags). Therefore, the way you file your tax return can increase the chances of being selected for an IRS audit. Here is a list of some of the known IRS red flags for audits:

Professions That Deal a Lot with Cash

One of the red flag areas is professions that deal a lot with cash transactions. Most of these transactions make tax evasion or fraud easier since auditing or keeping track of the trail (or record) of money in cash is quite difficult most of the time. These professions include house gardeners, taxi drivers, bartenders, painters, casinos, hair dressers, and other similar vocations. These jobs will usually have a lot of unreported or underreported incomes. The IRS will therefore, ardently scrutinize the returns of such taxpayers, whose chances of facing an IRS audit are higher.

Erroneous Entries and Additions

Another area that can easily lead to an IRS audit is erroneous entries and addition errors. If you add or exclude a zero at the end of a given figure, it makes all the difference when it comes to taxes due. Therefore, the IRS quickly isolates such returns and takes investigative actions. If they are simple addition errors with no tax consequences, the IRS will make corrections with no follow-up audit. On the other hand, if the error leads to erroneous tax payments, then an IRS audit is almost inevitable. Therefore, double check the figures you claim and check your math before submitting your returns.

Contractors and Consultants

Contractors and consultants including lawyers, dentists, IT consultants, motivational speakers, accountants, and such-like professions, also fall in the “red flag” category of income earners. The deductions and credits for these professionals are usually slightly complicated, and thus, they are prone to a lot of IRS reviews and examinations. Furthermore, there are generally a sizable amount of incomes made by these professions that goes unreported. Therefore, the IRS scrutinizes the returns of these taxpayers. If you fall in this category, ensure that you keep good record of incomes made, business expenses, and any other deductions that you seek to claim.

Large Cash Transactions

Another red flag for the IRS is a tax return with large cash transactions. Transactions that exceed $10,000.00 will normally be flagged as suspicious transactions. These transactions include gambling earnings or losses, funds transfers, foreign currency exchanges, or even charitable donations. Therefore, if your tax return has some high-value transactions, ensure that you have proper support documentation, in case of an IRS audit.

Offshore Incomes

Offshore incomes are one of the areas that have been identified as a major source of unpaid taxes and has therefore, will be marked for extra scrutinizing by the IRS. Hence, if you have foreign income, ensure that your documentation is accurate. Also, ensure that you file the FBAR Form by the due date to avoid any penalties and audits. If it is your first time reporting foreign income, be sure that the IRS is notified of when your offshore accounts were opened and the nature of the business. Furthermore, it is always encouraged (and required) to have all the documentation ready for review.

Losses under Schedule C

Business losses, losses due to hobbies, and any other losses you wish to include under Section C of your tax returns is another red flag item. If it is a hobby or new business, the IRS will need to see an “intent for profit” to allow a loss deduction.

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How to Handle IRS Audit Extension Requests

August 3, 2011 By

For many taxpayers, tax season and beating the tax deadline can be a hectic hassle. The collection of various receipts, tax forms, and compiling of all the tax data can be quite a taxing process, no pun intended. It is always a relief once you successfully file your tax returns and put it all behind you. However, if you think that just filing your tax returns is a hassle, then you don’t want to know the headache you will face if you fall in the hands of IRS auditors.

Statute of Limitation for IRS Audits

The IRS has a right to audit any taxpayer within a statutory limitation period of three years. In case the IRS has evidence to show that the taxpayer understated their incomes by over 25%, they can audit tax returns up to 6 years. If on the other hand, a taxpayer did not file a return or they were involved in outright fraud, the IRS has a right to audit as far back as they wish. The statute of limitation protects the taxpayers from indefinite auditing and therefore, any taxpayer who filed taxes to the best of their knowledge can be free from tax worries after the third year.

The IRS Can Request for an Extension

However, in spite of this statute of limitations, the IRS can contact a taxpayer and seek an extension of the limitation period. The IRS has to contact you within the statutory time limit to seek an extension. For example, the IRS can contact you on the second year and request you to allocate more time beyond the 3 year limit to enable them conduct an audit on your taxes. The IRS requests for an extension when they suspect that you paid less taxes in a given year and they feel that they will run out of time to conduct an audit within the 3-year limitation period.

Taxpayers Right to Refuse or Limit Extension

The taxpayer has a right to refuse an extension. He or she also has a right to limit any permitted extension to some specific aspects of a tax return or to a limited time period. You can, for example, limit the extension to one year or limit the extension to Schedule D of the 1040 Tax Return Form. When the IRS contacts you seeking an extension, they will always make you aware of these rights before requesting the extension.

What to do In Case the IRS Contacts you for an Extension

Why would anyone agree to an extension to get audited? It may appear like an IRS trap of some sort… However, in as much as it is your right to refuse an IRS audit extension, it is always best to agree to the extension. By the time the IRS contacts you for an extension, they will usually have preliminary evidence that indicate that you owe back taxes. They are therefore, seeking the audit to prove these preliminary evidences. Therefore, if you turn down the request for an extension, the IRS will most likely send you a notice assessing extra taxes. However, if you agree to an extension, you will have time to prepare for the audit and you can fight your case against any back taxes.

How to Prepare for the Audit

Once you agree to an extension, you will need to take the time to prepare for the audit. To ensure that you are prepared for any IRS audit, it is always advisable to keep proper tax records. Therefore, depending on the year that the IRS is seeking an audit, you can gather the required support documentation. If your records are not in good shape, the extension is an ideal time to gather and request for any records from any third parties that may have the copies of documents that you need. You may also consider consulting with a tax professional to help you prepare for the audit.

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Ways of Avoiding an IRS Audit

July 20, 2011 By


The IRS has a legal right to audit any of your tax returns for up to three years after you have filed them. The time frame is also extendable for up to 6 years if the IRS determines that you understated your income by over 25%. The IRS can also audit any tax year with no time limitations in the case of a fraudulent tax return or if there was no tax return made. Therefore, if you are a taxpayer and have been filing returns, you are subject to an IRS audit at any point in time. IRS audits need not be gruesome. However, an audit is inconveniencing and can lead to new tax liabilities, including various penalties and interests, if the audit reveals that you made an error on your returns. Unfortunately, this applies even for errors that were not intentional. Therefore, it is best to do all you can to avoid an IRS audit.

The IRS conducts various different types of audits. Some audits are done to verify information that is not clear while other audits are conducted if the IRS suspects irregularities with your tax returns. The IRS also conducts random spot-check audits to various taxpayers every tax year. For the latter, there is very little you can do to avoid an audit since it is a random pick and you can always fall in the sample group. All you can do is ensure that your support documentation is always ready in case you are earmarked for such an audit. However, these random audits are much rarer, especially for individual tax returns and returns for lower income earners. However, for the other types of IRS audits, there are various steps that you can take to avoid them. Some of these steps are:

  • Carefully Include All Your Incomes – The IRS has a system that checks all the entries made by various tax returns. If you received a gambling winning or made some money from a sideline activity, the person or entity that paid for the income will report it as an expense on their end. Therefore, if you do not report such an income, you can be sure of an IRS audit or a letter requesting for explanation. If the IRS finds mismatching information in later years, you may need to pay for any interests and penalties that may have accrued from neglecting to include the income in your returns. Therefore, always keep a record of all your income and be sure to include them in your taxes.
  • Provide Full and Clear Information – The IRS will always seek further clarification, especially for incomes and deductions made on tax returns that are not clearly delineated. Therefore, ensure you provide proper information and put entries in the right places.
  • Avoid Red Flag Deductions – The IRS warns against claiming various red flag deductions but does not explain which deductions are considered “red flags.” Therefore, it is up to the taxpayer to deduce what a “red flag” deduction is. In other words, do not claim deductions that are obviously going to raise eyebrows, such as claiming a business expense that is noticeably a personal expense or deductions for rental income for property that is only partially used by the owner.
  • Crosscheck Your Returns – Errors of overstating or understating can cost you a lot in terms of penalties and interests. Therefore, ensure that you crosscheck the math, entries made, and the amounts indicated on your returns.
  • Scrutinize Your Preparer – If your tax preparer is found having filed returns for another client that were erroneous, and especially so if they claimed fictitious deductions, then you are most likely going to be audited. Therefore, verify the dependability and integrity of your tax preparer before taking up his or her services.
  • Consider Form Inclusions – Various forms, such as Form 5213 (filled when converting a hobby into a business to keep the IRS from conducting an audit in the first 5 years of business), may get you audited immediately after the 5 year audit break. Therefore, you should ensure that your tax claims are reasonable and provable. The IRS has a way of identifying returns that deviate from normally-expected numbers. If you earn a low income for example, making a large donation that does not correspond to your income will get you easily audited. Therefore, carefully examine the entries you make and forms you attach to your taxes.
  • Change Your Business Model – Operating as an S-type corporation highly reduces your chances of being audited as compared to filing returns for your business under individual returns under Section C. Therefore, consider changing your business to an S-Corporation to lower your chances of being audited.

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How Long to Keep Your Records, In Case You Get Into IRS Trouble

June 30, 2011 By

Tax record keeping can be, well, taxing. However, it is important. The IRS created Publication 552: Recordkeeping for Individuals to help guide taxpayers in keeping their records. They request that you keep them “in an orderly fashion,” but not necessarily in any particular order.

The basic review period for the IRS is three years. However, if the IRS suspects that you have filed incorrectly, such as underreporting, they can knock on your door up to six years later! If they think you incorrectly reported a worthless stock or other bad investment, they have seven years to initiate an investigation.

You likely keep records on your income, expenses, home payments, and your investments and if you do not owe back taxes, you should keep these records for at least three years. However, if you have failed to report more than 25 percent of your income, you should keep these records for at least six years. If you file a claim for a credit or a refund after you filed your return, you should keep your documents for at least three years or for two years after you file the claim. If you file a claim for worthless securities, you should keep your paperwork for at least seven years. If you file a fraudulent return or fail to file a return (which would be extremely inadvisable), you should keep these records indefinitely.

The records you should keep regarding your income should include your Forms W-2, 1099, and K-1, bank statements, and brokerage statements. For any expenses you have, keep sales slips, invoices, receipts, and canceled checks, or other proofs of payment. If you own a home, it is important to keep closing statements, purchase and sales invoices, proof of payment, insurance records, and Form 2119 if applicable. If you made any investments, you should keep brokerage statements, mutual fund statements, and Forms 1099 and 2439.

If in doubt, keep all records for as long as you can as long as you can somehow make space for them. Also, be advised that it is best to shred or destroy these documents when you decide to get rid of them because they contain very important personal information that should not fall into the wrong hands.

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Types of IRS Audits

June 7, 2011 By

The tax season is over and unless you filed for an extension, most people have put their taxes behind them and are back to their usual business. However, even if you filed your taxes on time and are sure that your returns were accurate and reflected the true status of your taxes, the taxes of the past year or that of other previous years could still need revisiting in case of an audit by the IRS. The IRS has a legal right to audit your tax returns up to three years after you filed a return. They can also audit up to 6 years back if your taxes were understated by over 25% of what should have been due. The IRS can also request for an audit indefinitely if no returns were made or if there was fraud, intentional omission of information, or provision of incorrect information. Therefore, irrespective of the category you fall in, you need to be aware that the IRS can legally conduct an audit for returns you submitted years ago. Therefore, it is always advisable to file away and store all the relevant support documentation for any year of tax return at least for four years.

The IRS conducts 4 different types of IRS audits depending on whether it is an individual, small business, or large corporation.

Taxpayer Compliance Measurement Program Audit

The Taxpayer Compliance Measurement Program (TCMP) audit is a random audit performed by the IRS to either individuals or businesses. The IRS picks a sample of returns from various groups of people and entities and performs an audit to prove the information provided in the tax return forms. This type of audit is more common with people who earn more than $1 million a year, businesses that are considered having red flags, and other categories of taxpayers that are known to have a high rate of tax evasion. However, the TCMP audit can be carried out on any taxpayer. This type of audit is rare. However, since you can be subject to these audits that are randomly picked, it is always advisable to be ready with all your tax documentation and answers to all information provided in your tax returns.

IRS Correspondence

The most common type of audit by the IRS is a correspondence audit. In this type of audit, the IRS sends a letter to the taxpayer requesting various documentation that support information provided in their tax returns. The IRS could seek the information to cross-check the returns, especially in a case of documentation mismatch. For example, if you claim deductions based on a donation, the IRS expects to receive a donation entry from the charity’s returns. If they do not match such information, they will most likely request for supporting documentation. The IRS will also send a letter to inform you of any penalties and interests that they have been charged to your account and they will give you an opportunity to challenge such charges. If you have documentation to prove the contrary, you can forward it to the IRS and they will review and reverse the audit.

IRS Office Audit

Another type of audit is the IRS office audit. This is common especially for small businesses whose form and manner of business is not considered “regular” and require some further review. Small businesses tend to attract IRS attention because a lot of devious individuals claim to run a small business in order to receive deductions for extravagant personal purchases and such. In this case, the IRS sends you a letter and asks you to go to the IRS local office with certain documentation to explain various entries in your tax returns.

IRS Field Audit

This type of audit is more common with larger businesses and corporations. A team from the IRS is sent to the taxpayer’s office to carry out a live audit of business processes and various tax related documentation. The IRS corresponds with the business and arranges a date to come and perform an audit. The IRS gives ample notice to allow you to prepare the various documentation requested and to enable you to arrange for resources, such as an employee, to guide the auditors through the process. The audit is performed to enable the IRS to better understand the way the business is operated, especially with more specialized and less common businesses. They can also perform the audit if they suspect any form of tax “exploitation.”

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Common Causes of IRS Audits and How to Prevent Them

June 2, 2011 By

The IRS has made it clear that it is increasing audits so as to close the tax gap. The tax gap is considered to be the difference between what the IRS receives and what it expects to collect. The great news, however, is that the tax gap will not be reduced with random IRS audits (for the most part). Audits are usually triggered by a certain patterns or suspicious items on your tax returns. Some of these causes include:

Exclusion of a Form 1099 or Other Income

The IRS claims that more than 60% of underreported personal income tax relates to income generated through self-employment and business. Therefore, these individuals are considered a priority when it comes to ensuring that they comply with the rules. In this case, make sure that the amounts in your return and Form 1099 are correct because the IRS will match these two amounts and investigate whether or not the numbers add up.

Inflation of Home Office Deductions

If you utilize part of your house to carry out your business, you are eligible for a deduction in the related costs as a home office deduction. To qualify, you are required to use that part of your home set aside for business exclusively and frequently for your trade. This means that your home office must really be an office and not just an idle room in your house. Here, you will work out the deductions according to the size of your house. Be sure to get accurate measurements and be careful not to exaggerate the size of your office.

Mentioning Too Many Losses on a Schedule C

When filing a Schedule C, there is always a temptation to exaggerate the losses on your tax return. Remember that the IRS holds the assumption that you are in business to make money. Therefore, filing losses every year will have the IRS question the seriousness in your business.

Claiming Unreasonably High Charitable Deductions

Charitable deductions are among the most popular deductions claimed on personal income tax returns. Many taxpayers consistently make huge donations to charitable beneficiaries. If you are among them, ensure that your donations have been calculated accurately and that the pricing of non-cash donations are sensible.

Making Use of Too Many Round Numbers

Your tax return is not supposed to be an approximation. You should file your exact items of income and losses. Do not round the numbers. If the IRS realizes that some numbers look as though they have been “cooked up,” then you shall have some problems answering their questions when they ask you for proof.
Keep in mind that the tax law does not state that you should pay more in taxes than you have to, so make sure you claim genuine deductions on your tax return. Also, ensure that you report expenses and income correctly.

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You Have the Right to Remain Silent – Even for an IRS Audit

April 21, 2011 By

The Internal Revenue Service is scary, and they know it. Reports of abuse of power have come from ill-treated taxpayers have come through the IRS for years. However, you do have rights with the IRS, and dealing with tax problems does not have to be a fearful endeavor. Here is a declaration of your rights which matter when faced with an IRS audit.

You do have the right not to meet with the IRS at all. You cannot refuse to cooperate with no repercussions, but you can conduct your correspondence through the mail. If you are to be audited, ask for a correspondence audit so you can avoid having to take off work and endure the stress of an in-person meeting where you might say something you should not. If you do meet with the IRS, you have the right to record any of these meetings to ensure that you are not mistreated and the rules are not changed. If you would like to exercise this right, you simply have to notify the IRS ten days in advance that you wish to record it.

You also have the right to eliminate penalties if you can show that you acted in good faith and not in a way intended to avoid the IRS. Along the lines of the negotiation process, you have the right to make an installment agreement with the IRS. Even though they want their money now (and they want all of it), you have the right to pay it on terms that are less of a burden on you. In order to negotiate an Installment Agreement, you will need IRS Form 433-A, the Financial Statement which asks you for your income, expenses, assets, and liabilities, and helps you figure out how much you realistically can pay.

You also have the right to challenge IRS notices. The Government Accounting Office has released statistics revealing that up to 48 percent of IRS notices are “incorrect or incomplete”. However, there is no incentive for the IRS to clean up their act because most taxpayers just hand over a check. Instead of doing that, if you think your notice falls within that 48 percent, you can challenge the notice.

You also can appeal any decision made by the IRS. Just as in any other legal case, you can argue your side again if you do not believe that the outcome was fair. Your appeal rights last for 30 days after the initial decision of an audit, although you may actually have to wait a year or so before coming before a judge. When deciding whether or not it is worth the stress, keep in mind that IRS statistics show that 64% of cases on appeal turn out in the taxpayer’s favor.
If you choose to exercise your right to take the IRS to court, you can represent yourself or use Taxpayer Advocate Service. If you choose to represent yourself, make sure you are aware of the associated risks. The IRS may easily trip you up and the penalty for losing may be very harsh. No matter how much you read, the IRS knows more about the Internal Revenue Code than you do. Because of these associated risks, you may want to get a tax attorney or use the Taxpayer Advocate Service to aid you in your case.

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Income Tax Audit and the Truth about Cheating the IRS

March 3, 2011 By

The 2010 Taxpayer Attitude Survey for income tax audit and the truth about cheating the IRS came through with surprising results. 87% of the subjects felt that cheating the IRS was wrong. It is the responsibility of the taxpayer to be honest and “It is everyone’s personal responsibility to report anyone who cheats on their taxes,” stated Jonathan Berr in IRS Surveys About Cheating – and The Results Are Hard To Believe. Only 8% of the total felt that it was okay to cheat on their income taxes. These results were paneled from 1,000 phone calls to randomized taxpayers here in the United States.

IRS income tax audits presumably result from those 8% who feel that it is okay to cheat on their tax returns. When some taxpayers fill out their individual tax returns, they under-report their total AGI (Adjusted Gross Income) levels. This in turn causes a $345 billion deficiency in the Net Tax Gap with hopes to only recover a rough estimate of $55 billion. This is where the IRS income tax audit comes in; when taxpayers fail to report their taxes or falsely claim less than what was really earned. This is a criminal felony which may end in prison time and up to a $25,000 fine for falsifying or failing to file tax returns (up to six years worth of unfiled taxes).

An income tax audit can be preformed for many reasons:

  • Randomized audits to ensure the taxpayer is in compliance with the U. S. Tax Law
  • Tax evasion
  • Tax fraud
  • Taxpayer inconsistencies
  • Mistakes on tax returns that do not coincide with previous years.

To avoid an income tax audit, always be honest, upfront and willing to work with the IRS. Correcting mistakes may be as simple as showing proof that a taxpayer built an office in their home and claimed it for a deduction (for example), whereas if in the previous years, there was no office. Working with the IRS can save a taxpayer grief and expenses as the IRS is reasonable and willing to compromise.

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