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IRS Tax Audit CPA discusses tax audit prevention | IRS red flags

Wilmington NC CPA firm offers IRS tax audit representation

Gary Bode, CPA: IRS tax audit avoidance is always better than being audited. But if you need IRS tax audit representation, please consider calling us at (910) 399-2705.

IRS tax audit CPAs know tax audits can’t always be avoided. The IRS selects some tax returns randomly, to help establish statistical baselines for internal benchmarking. Luck of the draw can’t be helped. But there are things you can do to help avoid a non-random IRS tax audit while preparing your return. So I’ll offer some tips on how an IRS tax audit CPA approaches tax preparation for Clients. I believe tax audit avoidance starts with expert tax preparation. We discuss surviving an IRS tax audit elsewhere in this blog site. But here I’m just talking about audit prevention and IRS red flags. As of this date we’ve never had a return be audited. We’ve been asked to produce a mileage log and verify a non employee expenses, but that’s it.

For help avoiding tax audits, or a free consult, consider calling Gary, an IRS tax CPA at (910) 399-2705.

Explain Unusual Items on your Tax Return

The IRS uses statistical analysis to red flag returns that fall outside normal limits. They compare your 2015 tax return to your prior returns, and, other tax payer returns they consider like yours; same zip code, some occupation, etc. If they audit a 2015 tax return in 2017 they would also compare the 2015 return to both 2014 and 2016. When we think something might trigger an IRS red flag, we get the facts and then explain it proactively on the return to hopefully avoid a tax audit. Usually I include supporting documentation too. I try to imagine myself as an IRS agent having four minutes to decide good pile / bad pile. Our tax program can upload PDFs when e-filing. I imagine that kicks your return out of the automated system more frequently, but that’s better than the automated system starting you down the path to an IRS tax audit

Simplistic IRS red flag example

Let’s say you make $30,000 a year and in the past 10 years you’ve never itemized deductions. Your tax returns are mundane and routine. But in 2014 you donated $200 each to 50 different charitable organizations for a total of $10,000—you’re bound for some good Karma!  All contributions were funded by a gift to you from your sweet Uncle Max. These donations would probably trigger a red flag with the IRS because:

  • The $10,000 is high for a person making $30,000 per year. You just couldn’t afford it.
  • 33% of income going to charities is high at any income level.
  • The $10,000 of charitable organization contributions is inconsistent with your activity in earlier years.
  • Folks in your zip code might average $250 of charitable contributions.

But these $10,000 of charitable deductions are legitimate deduction and you should take them. Now you could just list this as a lump sum on Schedule A and let it trigger a tax audit. But what we would do is:

  • List each charity by name and amount given.
  • Provide an explanation that the donations were funded by a familial gift.
  • Perhaps upload the 50 receipts with your tax return when e-filed.

The IRS only requires proof of cash donations to a charity when they’re over $250, so technically you wouldn’t have to keep records. But of course, prudence dictates keeping all the cancelled checks with a copy of your tax return for at least seven years. If the above proactive measures didn’t head off a tax audit, you’d still be bulletproof.

If you’d like a free consult on IRS tax audit representation, please consider calling us at (910) 399-2705.

Include all Information on your Tax Return

We all get a plethora of tax forms, usually, by mail containing information that has to be included on this year’s tax return. From employers, banks, mortgage companies, student loan administrators, colleges, brokerage houses, etc.  W-2, Form 1099-MISC, Form 1099-B, Form 1099-C, Form 1099-A, etc. What do they all have in common?  The IRS also gets a copy. Leaving off any of the information from these tax formsforms usually triggers a tax audit, albeit a low level, IRS correspondence tax audit. Probably a CP2000 Notice, which generally doesn’t even generate penalties. The IRS tax audit starts off innocently enough through a CP2000 Notice  “proposing” changes to your tax returns. Changes usually mean additional tax due but sometimes CP2000 generates a refund. Usually this is a no harm, no foul situation if you agree with the CP2000 Notice or amend your tax return immediately.

Losing money year after year with your Schedule C business venture

Some folks turn their hobby into a Schedule C business. And the IRS requires you file Schedule C if you had any 2015 income. But generally you have to turn a profit in three of the last five years. Otherwise that’s what the IRS calls hobby income. They would only allow losses to the extent of the income, in other words a zero profit Schedule C, instead of the deductible loss. But like many IRS issues there can be mitigating circumstances based on multiple IRS factors. I’ve also seen cases with S Corporations where it never turns a profit or gets audited.

An IRS audit triggered by a minor state issue

Let’s say the State audits your company’s unemployment tax returns and finds discrepancies. They could call the State Department of Revenue which eventually includes the IRS. Lots of audits start with mismatched payroll records between the company’s payroll related tax returns and what’s stated on the actual tax return. I always reconcile payroll to make sure the numbers tie.

Abating IRS tax audit penalties

Sometimes CP2000 doesn’t ask for penalties. But if you procrastinate past the deadline,  penalties accrue. However we often get rid of these penalties. Here’s how, you pay them and then write requesting a refund based on penalty abatement. If you haven’t had IRS problems in the past this usually works. Explain unusual circumstance if true. The IRS is open to a good sob story. They understand life happens. To me the IRS doesn’t seem to be as punitive as Folks think, they just want to stay in compliance. So the penalty abatement isn’t a gimme, but if you ask for it, most of the time you’ll get it. This is especially true with IRS install agreements (Form 9465) where you’ve shown good faith with timely payments.

Poking the bear

All tax audit CPAs see Clients deliberately annoy the IRS tax auditor. Most IRS employees are professional and non judgmental. Even if they don’t have direct power over you, they can just make phone call and make your life miserable for years. Be professional and polite.

Don’t shoot yourself in the foot during IRS tax audit

All tax audit CPAs see Clients shoot themselves in the foot. The number one rule in being an IRS tax audit CPA is to contain the audit to the matters specified by the IRS. You don’t want the IRS to scrutinize other areas of your audited tax return or expand the IRS tax audit to other preceding or subsequent tax years. And yes they can audit the same return more than once for a different issue.

Shooting yourself in the foot a second time during an IRS audit

I had a Client where the IRS nailed him on a blatant tax issue. I got some penalty abatement. So when he prepared the next tax return he did the same thing despite my explaining to him the IRS tax reporting requirements  to him carefully. Guess how I found that out.

Don’t Make Math Errors

If you opt for self tax preparation, use a tax program. Check your data entry twice. Tax software programs like Intuit TurboTax or H&R Block’s Tax Cut will help keep math errors down. The IRS will send you a CP2000 Notice. Not a big deal, but CP2000 is a low-level IRS tax audit. Low level audits can expand.

Don’t procrastinate

The IRS has a generous timeline. If you’re being audited don’t squander valuable defense time by burying your head in the sand. Every IRS tax audit CPA sees cases that could and should have been dealt with months ago. This turns a simple error into a big deal generating penalties and CPA fees. And that’s not even counting soft factors like taxpayer stress.

Sometimes an IRS tax audit generates  refund

If you messed up a tax issue enough to warrant an IRS audit maybe you messed up on other areas that could potentially generate a refund if you’re within the three rule time limit. I think a good IRS tax audit CPA reviews the entire return in question and at lest a year of subsequent and earlier tax returns.

Hand written tax returns

I think this is an IRS red flag for audit selection, at least now in 2015 where free tax software is available. Plus the IRS has to manually enter your tax return for their computers. Data entry mistakes happen. Many times hand written tax returns look sloppy implying sloppy data as well. Again, some states now have a surcharge for not e-filing and you can’t e-file a hand written tax return.

IRS hot topics

Foreign bank accounts and foreign individuals owning businesses is now a hot IRS topic that can generate $10,000 fines for omitting an innocent report the taxpayer was unaware of. For example the old FBAR is now called FinCen 114 and gets submitted to the criminal division of the IRS. I use a tax database and multiple subscriptions to stay abreast of current IRS issues. Another hot topic example: is your subcontractor actually an employee?

The IRS has what I call promotions every year. Like when does a subcontractor become any employee? Or how much salary should a S Corporation officer shareholder take.

Report all Income

The IRS believes over 200 Billion dollars of income goes unreported on tax returns. They call that the tax gap. This occurs mostly through cash transactions. While the IRS is under-staffed and can’t audit all tax returns, they’re not stupid. They pull in all kinds of information from off shore banks, tax returns from people linked to you, casinos, etc. Their infamous “lifestyle” tax audits  impute your income from the way you live. And they use showcase cases; that’s why you see celebrities going to jail for tax fraud.

Do you have some type of specialized tax issues in 2014 that you don’t understand?

During the Recession I became proficient with cancelled debt tax reporting regulations. Here are some common cancelled debt scenarios:

  • Having a rental property foreclosure.
  • Obtaining a loan modification for your primary residence.
  • Settling credit card debt for less than full payment.
  • Having student loans forgiven because of permanent disability.
  • Rental property short sale.

With cancelled debt, both you and the IRS receive a Form 1099-C, Cancellation of Debt. The amount in box 2 of Form 1099-C automatically becomes taxable income unless you can exclude through some provision of form 982, Reduction of Tax Attributes. If you look at the Form 1099-C instructions, the Form 982 instructions and IRS Publication 4681 you’ll see cancelled debt tax reporting is complex. Plus the potential tax is often significant. There can be future tax consequences when using Form 982 to exclude cancelled debt. Some tax software doesn’t handle cancelled debt at all. Others do, but not as automatically as say a W-2; you need to understand the numbers, and the process, to use a manual workaround.

So, you should recognize that it sometimes is prudent to hire a professional. Specifically us. Even President Obama implied the amount of tax you pay depends on the quality of your CPA.

Do your homework

There’s usually no one single place you can go on the IRS website to get complete information on any topic. Let’s use a foreclosed rental property example to understand the tax reporting requirements for cancelled debt.

  • Read the 1099-C instructions. You’ll see they’re for bankers.
  • Read the Form 982 instructions. You’ll finds lots of holes and excess information.
  • Read Publication 946 (2014), How To Depreciate Property.
  • Read the Form 4797 instructions to understand the gain or loss on the “sale” of the rental property.
    • Tax software doesn’t always handle Form 4797  well.
    • Check the depreciation figures manually across all tax returns that reported the rental property.
    • Depreciation can be dropped when you switch tax preparers or tax software.
    • Look at the purchase and sale HUD statements to check if settlement costs are included in the Form 4797 calculation.
  • Read the Form 8582 instructions and look for prior disallowed losses on the rental property that can be deducted in the year of sale. Prior disallowed losses are allowed in the year of sale. But again, these carry forwards can get lost.
  • Read Publication 4681.
  • Read the Schedule E instructions or the Form 8825 instruction to help find rental property disposition issues.
  • Read the appropriate IRS Audit Technique Guides (ATG). These are the actual handbooks the IRS issues to auditors. They tell you exactly what the auditor looks for and how they look for it. They’re on the IRS web site.
  • Use a tax database, maybe at your local technical school’s library.
  • Your bookstore has several books that explain rental property foreclosure cancelled debt better than the IRS instructions.
  • Call the IRS.

Are all tax returns treated equally?

The IRS says no. Their computers handle some issues automatically. But I’ve many cases where long-term blatant errors in tax preparation where the IRS did nothing. The IRS, in my opinion, probably finds these errors but has insufficient resources to pursue them. Why? Well on a low-level return the IRS might have a shot at an extra $200 of taxes. But there are plenty of other tax returns where they could potentially asses thousands of dollars of additional taxes. They sorta kinda say this is true on their own literature. Some tax returns are more equal than others.

E-file your tax returns

Some states are already assessing surcharges if you don’t e-file. The IRS makes you fill out an extra tax form if you don’t e-file. E-file makes it easy to look for potential IRS tax audit issues.

Use a Professional Preparer

We’re not talking about Liberty Tax Service, Zip Zap, H&R Block, or Jackson Hewitt where the tax preparers are not expert and have to rely on the software.  We’re talking CPAs, Enrolled Agents, and Tax Attorneys. Some Folks say an IRS signature helps avoid an audit, but I’ve never seen that in any IRS literature. However I’ve had many IRS Agents who are pleased to work with a tax professional instead of the client directly.

Keep good records

Keep all your back returns and essential documentation for at least seven years. Most IRS tax audits involve earlier tax return issues. Legitimate information sometimes can’t be reproduced leading to having additional taxes assessed. If you’re a Corporation, document tax issues in the minutes.

Be Honest

Having a CPA work all the legitimate tax angles is better than making up expenses or not reporting income. We see folks who just enjoy the thrill of sneaking one past the IRS and then worry about a tax audit every day when the mail arrives.

Please consider calling us at (910) 399-2705 if you need a free initial consult on an IRS tax audit, or any other accounting / tax issue. 

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