Wednesday, January 21, 2015

The Dreaded IRS Audit...The Reality


There is a fear of an IRS audit.  People have heard all kinds of stories and have many ideas about what will cause an audit and how to avoid it.  For example some fear that taking a deduction that they are entitled to will make them the target of an IRS audit.  I have also heard clients say both that filing on time will prevent an audit and also that filing an extension will avoid an audit.  So what is the reality of IRS audits.  

Who gets audited and why


The IRS audits aroud 1% of tax returns they receive.  That sounds like random selection but there are things that increase your chances of selection.  Ordinary taxpayers with ordinary income and deductions if audited are usually just a random and very unlikely selection.  In fact none of my cleints that can be described this way have ever been randomly selected for an audit.  Most audits are triggered by the unusual or areas of suspect by the IRS.  The IRS itself indicates there are randomly selected audits but most of these are based on a statistical formula.  Here is a quote from irs.gov.
When returns are filed, they are compared against “norms” for similar returns. The “norms” are developed from audits of a statistically valid random sample of returns. These returns are selected as part of the National Research Program which the IRS conducts to update return selection information.
So if you claim a deduction that is outside the statistical norm your return is more likely to be selected for an audit.  

Other reasons the IRS selects returns for audits are "document matching", when the information on your return does not match the information reported by others.  

The other reason given by the IRS is:
Related examinations - returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit.

The Statistics


According to a Forbes article, based on IRS statistics from 2010, 30% of audits in that year were for people that claimed the Earned Income Tax Credit (EITC)...an area identified as abusive by the IRS. At a training session provided by the IRS a few years ago they mentioned abusive tax schemes in this area and the IRS were taking a closer look at it.  

Summarizing other findings mentioned in the Forbes article, your chances of being audited increased due to higher income, especially if your income exceeded $1 million.  Also, it appears audit risk increases with non-business income over $200,000 and even more if you had business activity in addition.  

So appears that if you do something unusual or have more income you are more likely to be audited.  

Experience with audits


Very few of my clients get audited but here are some common audit situations according to my experience.  The most common audits that I have seen are brought in by people that have prepared their own returns and have improperly reported or neglected to report securities (usually stocks) transactions.  What happens is the information on the tax return does not match what is reported. What was reported to the IRS was the gross amount of the transaction and now they also get the basis information in most cases but the IRS is looking to see if the gross amount reported matches what is on the tax return.  

So the taxpayer may have lost money or broke even on a trade and they don't report it or they report the net amount.  The IRS computer catches that the return doesn't match the information received and sends out a letter that the taxpayer owes taxes on the gross amount.  It is simple to fix by filing a proper amended return showing the gross amount and also subtracting the basis and costs.  These notices cause much anxiety but almost never are as bad as they sound and can easily be rectified.  For example I have had new clients bring in notices indicating that they owe tens of thousands of dollars only to find when we amended the return that they did not owe any at all or very little when the basis was taken into account on the amended return.


I did have a client audited for a statistical oddity.  My client received notice of an audit by mail of their moving expenses.  This client qualified for the deduction for a move from Hawaii to the mainland which is a statistically large moving expenses.  The audit requested that the client provide supporting documentation.  The client was upset but when they realized everything had been done properly on their tax return and they could provide what the IRS asked for everything was fine and the deduction was allowed.  Now here is the real problem, the IRS notice said the deduction had been disallowed and the client owed the tax on it.  It wasn't until the end of the notice that it indicated if she could provide supporting documentation the return would be changed back to as filed...and it was.  The problem is the emotion from reading the beginning of the notice that you owe money that caused the client to be unable to understand the rest of the letter.  Fortunately she sent me the letter and we got it resolved. 

Notification of an Audit


Note that the example above was an audit by mail not a case where the IRS comes to your home.  So many audits such as this one are handled through the mail.  Interestingly you can be notified of an audit by a telephone call but it is confirmed by a letter and never by email.  Here is what the IRS indicates about a notification by telephone.
So be very careful of both telephone and especially emails indicating you are the subject of an IRS audit.

Irony


It is ironic, most of the time the people with the fear of being audited because of an allowed deduction actually qualify for the deduction and the ones that really want to take the deduction don't really qualify for it.  The lesson is if you qualify for a deduction and can support it you should not be afraid to take what you are entitled to.  However, if you are not entitled to it you should have integrity and not take it.  

The other irony, is the information published about audits that does not come from the IRS.  Where does this come from?  Like the Home Office Deduction making a return more likely to be audited.  I have not found that information anywhere from an IRS source.  It is ironic because the net benefit from most of these deductions is very small.

The other irony is the CPA that teaches a course about audits whose clients get audited all the time. Why would your clients be audited all the time if only around 1% of returns are audited.  I think the answer is obvious.

Documentation


As a CPA I am, of course, very interested in IRS audits.  How do I keep my clients from getting audited and what do I do so that they will be OK if they get audited.  So here is what the IRS says about documentation in the event of an audit:
The law requires you to retain records used to prepare your return. Those records generally should be kept for three years from the date the tax return was filed. 
The IRS does accept some electronic records. If records are kept electronically, the IRS may request those in lieu of or in addition to other types of records. Contact your auditor to determine what can be accepted to ensure a software program is compatible with the IRS's.

 So keep proper documentation for your tax returns.

In researching this subject I also found this Kiplinger article to interesting on 14 IRS audit red flags. It provides more specifics but in general agrees with what I have written here.

The CPA Superhero wants to help you to succeed in business, life, and in retirement.  While my main business is preparing tax returns, I also work with clients to setup accounting systems to start, manage and develop their business(es) and develop and implement a financial plan. Contact me using my information below to schedule a free introductory consultation up to a half hour. 

Jeff Haywood, CPA

The CPA Superhero
972-439-1955
jeff.jhtaxes@gmail.com

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My posts contain general information that does not fit every situation, they are not all inclusive, and as always for your tax situation everything "depends on facts and circumstances."  In addition, the information/IRS requirements are always subject to change.  So call me to talk about your specific facts and circumstances and what you want to accomplish.