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"Why am I being audited by the IRS?"

There have been many stories involving the Internal Revenue Service in the media lately:

  • Owner of South Kitsap Drive-In Pleads Guilty to Tax Evasion, www.kitsapsun.com, Mar. 5
  • Man Sends Message to Bank, IRS with a Bulldozer, www.wlwt.com Feb. 18
  • Tax Protester Crashes Plane into IRS Office, www.wsj.com Feb. 19

Recollections of stories like these can trigger apprehension in anyone who receives notice that their business or personal income tax return has been selected by the IRS for examination. If a taxpayer has good accounting records, maintains receipts and has a qualified tax professional prepare the return, the audit process should be nothing more than an inconvenience. If a taxpayer takes risky positions, aggressive deductions or has poor accounting records, the examination experience can be a time-consuming and very expensive ordeal.

According to the IRS’ 2009 Data Book, last year over 1.4 million individual returns were audited, which is roughly 1 percent of the total individual tax returns with a 2009 filing requirement. 77 percent of these audits were “correspondence audits” wherein taxpayers could simply mail the requested information to the IRS. The rest of the audits were conducted in person at the local IRS office, CPA’s office or taxpayer’s place of business.

Examination of Returns

A tax return may be selected for examination on the basis of computer scoring. An IRS computer program called the Discriminant Inventory Function System assigns a numeric score to each individual and some corporate tax returns after they have been processed. The higher the “DIF” score, the higher the potential an examination of the return will result in a change to the income tax liability. A return may also be selected based on the questionable treatment of an item and/or information received from other sources on potential noncompliance with tax law (such as newspapers, public records and individuals).

Red Flags

Aside from the “DIF,” nobody can predict with certainty whether a return will be selected for examination. However there are certain items that may increase the likelihood of examination if present on an income tax return:

  • The Earned Income Tax Credit (35.6 percent of all 2009 audits were for an EIC claim)
  • Large deductions for meals, travel and/or automobile expenses for a business
  • Inadequate or no compensation for a shareholder of an S-Corporation
  • Hobby is claimed as a legitimate business
  • “Real estate professional” with substantial rental losses
  • Large unreimbursed employee expenses on schedule A
  • Office in the home

The lowest hanging fruit will generally be the areas of automobile, travel, meals and entertainment expenses. For meals to be deductible there needs to be a legitimate business purpose with the expectation of increasing revenue or business for the deduction to be qualified. The IRS sets forth specific requirements for substantiating deductions for travel, meals and entertainment which include maintaining actual receipts, mileage logs and journals. Tax returns claiming these deductions are selected for examination because an auditor can deny deductions where the taxpayer does not maintain original receipts or other concurrent substantiation. Business travel to resort destinations is also scrutinized for legitimacy and business purpose.

If you receive notice that your return has been selected for examination, contact your income tax professional. If you personally prepared your income tax return, consider contacting a tax professional. IRS notices are pretty specific regarding which items they wish to look at, but will request access to virtually all of your accounting records for the period in question. On-site audits can range anywhere from a couple hours to several days. Once the IRS begins their investigation, they can expand the scope of the audit to include other deductions or tax years if the initial investigation leads them to believe more tax revenue will result from those efforts.

An individual’s behavior during an audit can affect the outcome of the process. If a taxpayer provides evasive answers or exhibits signs of deception (perceived by the auditor) during the initial interview process with the auditor, those behaviors may impact the scope of the audit.

Statute of Limitations

Maintain accounting records supporting your return for three years after the tax return has been filed, unless fraud is involved to which there is no statute.

Penalties

Penalties assessed for increased tax liabilities resulting from audits can range anywhere from 20 percent of the underpayment up to $100,000 for willful failure to pay tax and file a return. Taxpayers who fraudulently claim the EIC cannot take the credit for the next 10 years.

(Editor’s Note: Chris Mutchler is a CPA and Certified Fraud Examiner and works for Southard, Beckham, Atwater and Berry and can be reached at (360) 876-4491 or cmutchler [at] sbabcpa [dot] com)

 
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