With more than thirty five years serving as a CPA, offering professional tax planning counsel,preparing many thousands of tax returns, and representing numerous clients before the IRS, I’ve just about seen it all. Even though we have just finally completed the tax season for this year, audits for those returns just filed may take a full year up until 17 long months to appear in the Internal Revenue Service system for examination. So let’s proceed now with what might trigger an Internal Revenue Service audit, and how safeguard and protect yourself going forward.
Now before we begin I want to point out that we are not talking about leaving genuine deductions on the table, or not taking advantage of all conceivable legal tax planning strategies available. Tax avoidance is absolutely legal and I would argue your fiscal responsibility to yourself as well as your family. Tax evasion on the other hand, can bring you some serious trouble. It’s very important to know the difference. Believe it or not, it was actually tax evasion that caught and sent Al Capone to Alcatraz, not the St. Valentine’s Day Massacre.
"Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934).
There are many opinions regarding what can and cannot trigger an audit. In its 2010 Data Book, the IRS offers some fascinating stats. About 1.1 percent of 142 million individual income tax returns filed were audited in 2010. Out of all of those, almost one third were lower income returns claiming the earned income tax credit. This was actually because the earned income credit can in fact create a tax refund over and above the tax withholding, if any, a taxpayer may have. This is effectively being compensated by the government, for having a lower income and dependent children. This is an area with great abuse as you can imagine. For returns having non-business income of $200,000 to $1 million, there is a 2.5% chance of audit, raised to 2.9% for returns with business activities. But by far, for returns with an income over one million, the audit rate was around 8.4%.
As for business tax returns, only 1.4 percent of these smaller corporations with overall assets of $250,000 to a million dollars were audited. This rate increased to 1.7% for assets of $1 to $5,000,000, and to three percent for assets reaching up to five to $10,000,000. Over ten million in assets, the audit rate jumped to 16.6%. For partnership and S corporation returns, the audit rate was 0.4 percent.
From an audit pont of view, operating your small business as a Sub S Corp. or partnership or Limited Liability Corpoartion LLC has an apparent advantage over filing as a Sched. C (self-employed). When my firm prepares a tax return for either an individual or business, I will always explain to our clients that I am assuming the return will be audited, despite the fact that the chance is pretty small.
We arrange our work papers, supporting tax documents, reconciliations, and receipts in an organized, indexed order, electronically catalog and categorize these items, and then we’ll begin to prepare the returns. We ask questions. Numerous questions. Prying and detailed questions that can sometimes seem odd, but are designed to tease out the most obscure details that we may be able to apply to obtain every legal tax deduction or favorable tax position achievable. If there is ultimately an audit, we are more than organized to provide the IRS agent with entire support for every entry on the return. And most importantly, that same procedure ensures that I have turned over every possible stone, and saved every last penny for my clients.
Even though you might have absolute support and documentation for every deduction on your return, being audited is a losing proposition. You will still have to spend a good amount of time just preparing for the scrutiny, and the stress and annoyance associated with the process can leave its mark. Sadly With the IRS, you are pretty much guilty until proven otherwise, and even a totally innocent comment can open up the flood gates. The best thing to do is to hire a tax professional to represent you, and avoid personal contact where possible. Even if you walk away with no adjustment, in the end, it is an expensive process. In the end, you don’t want to be audited no matter how confident you are of your return, so what steps can you take to help your return get through the system unscathed? As it turns out, quite a bit.
Report Every Form 1099. Payers of interest and dividends or brokerage firms that place your stock trades, send a copy of your Form 1099 to the IRS computer. If you fail to include the exact figures on your return, the computer will flag the return and you will receive a love letter from Uncle Sam explaining the error of your ways.
Report Mortgage Interest Per Form 1098. When you pay interest on your home mortgage, the bank also reports the interest amount to the IRS on Form 1098. These figures must agree with your deduction. If you own a second home, there are rules as to the maximum amount of mortgage interest that can be deducted.
Report Form K-1 Income. If you are a member of a partnership or a Subchapter S corporation, or if you are a beneficiary of a trust or estate, your share of income or loss is reported to you, and to the IRS, on Form K-1. As with Forms 1099, failure to report the same income numbers will flag your return.
Real Estate and Form K-1 Losses. If you have rental real estate and lose money, the amount of loss you can actually deduct is limited. Likewise, if you are a passive investor in a partnership or S corporation, your losses may be limited or suspended. The ability to deduct those “passive” losses is contingent on your “tax basis”, how much you have at risk, whether or not you materially participate, and other complex rules. Deducting such losses when not allowed is a sure way to earn some unwanted attention from the IRS.
S Corporation “Reasonable Compensation”. If you own an S corporation, make sure the company pays you a fair market wage for what you do. The IRS wants to see wages, because wages are subject to FICA and Medicare taxes whereas “distributions” from an S corporation are not. If you take too much in distribution and little or no wages, then the IRS radar screen will signal trouble.
Sole Proprietorship Business - Schedule C. Schedule C is used to report income and expenses for your unincorporated business. It is also exponentially increases the likelihood of your return being audited, because business deductions are often an area of abuse. In addition, many people will try to take a hobby or pastime, claim it is a business, only to write off the costs associated with that hobby. Bear in mind that the IRS assumes you're in business to make money. Showing a loss year after year might make the IRS question whether your business is legitimate or worse, just how you are managing to cover your living expenses.
Business Expenses - To be considered a legitimate business expense, an expense must be both "ordinary and necessary in carrying your trade or business." Deductions that seem out of place or not ordinary for your trade or business, might call attention to your return. Travel and entertainment and car expenses are chief culprits and always heavily scrutinized by the IRS.
Home Office Deductions - If you use part of your home for business, you may be able to take a home office deduction. However, to qualify for the home office deduction, the IRS says you must use the part of your home attributable to business "exclusively and regularly for your trade or business." That means your home office must be your actual office, not just a spot in your home where you sometimes do work, and it must be exclusively workspace and not used for other purposes. Generally, the deduction is based on the size of your home office as a percentage of the overall house, with expenses prorated accordingly.
Charitable Donations. If you make cash contributions, make sure you have receipts to back them up. High charitable deductions in relation to a taxpayers overall income, is usually a red flag. If you make non-cash contributions, you will need to file Form 8283 with specific details of the items donated and the organizations receiving them. Large non-cash donations may require an independent appraisal attached to the return. Excessive valuations are a sure bet to generate unwanted attention from the IRS.
Using Too Many Round Numbers – your tax return is not the place to use “estimated” numbers. In fact, too many round numbers on a tax return implies guesses or exaggerated tax deductions – all of which will simply not add up in the eyes of the IRS.
These are just a few of the more common items of course, so it is important to always consult your tax advisor on your specific circumstances, or to use good judgment if you prepare your own tax returns. Good preparation during the year will save you time and money come tax time.
Anthony Caruso, CPA has practiced as a Florida Accountant and Investment Advisor for over 30 years. Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning. Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.