Taxpayers are selected for an audit for a variety of reasons. Some are chosen due to a document mismatch, such as a return that is missing 1099’s or W-2’s. The IRS computers usually spot missing documents based on the social security number (SSN) or employer identification number (EIN) on the document. Others taxpayers are selected for audit due to statistical irregularities, such as unusually high charitable contributions or business expenses. Sometimes audits are based on a general geographic area (like a city) or particular industry (such as cash-based businesses, like nail salons) that the IRS wishes to examine in more detail. Or, it could be that someone filed a whistleblower claim against the taxpayer. Whistleblower claims occur when someone informs on a person or business to the IRS, suggesting tax fraud or other tax irregularities.
Types of Audits
Field audits are performed at the taxpayer’s home, place of business, or their accountant’s office. These audits are usually very detailed and tend to be performed by the most highly trained auditors at the IRS. Some field audits are performed by specialists in certain industries. During a field audit, the auditor will review financial records, meet with employees and tour the premises. This can include a home office.
Expect the field auditor to examine bank statements and accounting records, at a minimum. The auditor will also be looking for discrepancies between the taxpayer’s lifestyle and the income reported on the tax return.
Office audits (sometimes called “desk audits”) take place at the IRS office near the taxpayer’s location. We typically see office audits in cases of issues with itemized deductions, business expenses and business income. The auditor will request specific information to be brought to the office. Office audits typically require one meeting, unless follow up meetings are required.
Correspondence audits are done solely through the mail and are the most common type of audit. Over 70% of audits are correspondence audits. The process begins with a letter announcing the audit, typically containing an initial list of requested information. Unusually the letter provides a 30-day period to respond.
Alternatively, a correspondence audit may start with IRS Notice CP2000 which the the IRS uses when information from a third party source (such as a 1099 or W-2) does not match the information the taxpayer reported on their tax return. Notice CP2000 is also called a Notice of Underreported Income. The taxpayer should respond promptly to the Notice CP2000. Usually, the taxpayer has 30-days from the date printed on the notice to respond.
The IRS will send a follow-up notice to taxpayers who do not respond to Notice CP2000, or if the IRS does not accept the additional information provided. This second notice is called a Statutory Notice of Deficiency. The Statutory Notice of Deficiency provides detailed information about why the IRS proposes a tax change and how the IRS determined the change. The notice tells the taxpayers about their right to challenge the decision in Tax Court if they choose to do so. It is critical to respond to this notice within the required time period, in order to preserve legal rights.
Preparing for the Audit
We believe that it is important to establish a friendly, non-hostile environment when working with IRS auditors. The staff at the IRS are people too and we find that having a cooperative relationship with the auditor helps to resolve the audit efficiently, with less expense and generally with a better outcome.
We also believe that IRS audits should be handled by professionals, such as experienced CPAs, tax attorneys or Enrolled Agents. While hiring a professional is expensive, the risk of a “do it yourself” audit typically exceeds the savings in fees. Audits are fraught with emotions and fears and it is easy for an untrained taxpayer to take the audit in a bad direction.
If the auditor wants to interview the taxpayer, we almost always represent the taxpayer at the interview. This requires the CPA to be very knowledgeable about the client’s situation in order to be able to answer all the questions of the auditor. Careful preparation is required.
Our philosophy of audit preparation is to be prepared for everything. That means that we tie out or validate every number on the return, not just the numbers that the auditor asks about in their initial request. We also review the IRS wage and income transcripts, to see if there is any income left off the tax returns that the auditor might know about. This way, there are no surprises and we are prepared for whatever comes up during the audit.
We find that this approach works well with most auditors and allows us to bring the audit to a favorable conclusion with the least amount of pain and expense.
Providing Information to the Auditor
Information is requested by the auditors in their opening letter, followed by one or more Information Document Requests. Your CPA or other representative is required to submit records and information to the IRS if requested by an auditor. This includes all documentation or backup that supports the numbers on the tax return.
However, planning and strategy memos are “privileged information” and are not required to be provided to the IRS along with other documents for the audit.
Documentation relating to an audit must never be destroyed. This is considered interfering with the ability of the IRS to do its job and is subject to significant penalties.
Also, never make a false statement or provide a false document to an IRS auditor. This is serious offense and will trigger significant penalties.
Receipts and Other Documentation
Taxpayers are required by law to maintain books and records. This includes receipts and, in the case of a business, bookkeeping and accounting records. This is one of the reasons that a business should maintain some kind of accounting software, such as QuickBooks Online, or hire a bookkeeper.
Bank statements and credit card statements are typically the first documents that the IRS will request. They do not provide definitive proof of the nature of a deposit or an expenditure, but they are a good place to start.
The burden of proof is on the taxpayer to show that they are entitled to a deduction. Receipts are the best proof of an expense. Even if expenses were paid for in cash, the IRS will still require receipts to substantiate deductions.
If W-2’s or 1099’s are not available, your CPA can obtain Wage and Income Transcripts from the IRS, which will provide missing earnings and tax withholding information. However, these transcripts do not show state tax withholding.
If records are not available, then the taxpayer will need to reconstruct expenses using a reasonable method. We like to use the Form 433 method that the IRS uses to reconstruct expenses for collection purposes. This way, pushback from the IRS is unlikely.
The “Cohan Rule” allows taxpayers a deduction where expenses are estimated based on a reasonable method. The taxpayer should disclose to the auditor that they reconstructed expenses and how it was done. The Cohan Rule does not apply to specific situations where estimates are not allowed, such as travel, entertainment and business gifts.
Hobby Loss Audits
Losses from a hobby are not deductible against other income. A hobby loss audit is when the IRS believes that an an activity which is continually losing money is really a hobby and not a business. The intent of the taxpayer is important in a hobby loss audit.
The IRS looks at 9 factors to determine if an activity is really a business or a hobby. Expect that the IRS will focus on these 9 factors during a hobby loss audit. These factors are:
- Is the activity conducted in a business-like manner?
- The expertise of the taxpayers and/or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that the assets used in the activity will increase in value
- Success of the taxpayer in carrying on similar or dissimilar activities
- Taxpayer’s history of income or losses with the activity
- Amount of occasional profits, if any from the activity
- Financial status of the taxpayer
- Elements of personal pleasure or recreation from the activity
Cash-based businesses are a hot-button issue for auditors at the IRS.
During an audit of a cash-based business, the IRS will look at sales tax returns, bank deposits, point of sale (POS) records, and 1099s received to make sure that all cash income was reported on the tax return. On the expense side, the auditor will look for evidence of payment (usually receipts) to justify deductions on a return. They will also check to make sure that the expenses are ordinary and necessary for this type of business and in line with industry statistics.
In addition, IRS auditors of cash-based businesses look for indicators of unreported income, such as:
- Excessive lifestyle
- The business continues to operate despite losses every year
- Bank deposits continue to increase despite losses or low income
- No income is reported yet debt decreases year after year
- Unusual margins or sales for this type of business
Conflicts of Interest
Audits of married couples or businesses with multiple owners may result in conflicts of interest. This occurs when the advice of the CPA provides a benefit to one taxpayer at the expense of another taxpayer. In such case a second CPA may required to ensure independent representation of both parties.
However, a CPA may represent both parties in an audit when there is a conflict of interest if the parties are aware of the conflict and agree to waive their concerns. This waiver should be done in writing. And, the CPA must believe that he or she can perform the service with objectivity, competence, diligence, and integrity. If both parties refuse to sign the waiver or if the CPA cannot meet the required standards of service, then the CPA will have to withdraw from the audit.
30-Day Letter and IRS Appeals
The proposed adjustments of the auditor are listed on Form 4549, also called a 30-Day Letter. The taxpayer may either agree or disagree with these adjustments.
If the taxpayer agrees with the proposed adjustment, then the additional tax must be paid, plus penalties and interest. The taxpayer has the option to enter into a payment arrangement for the amount due, such as an installment agreement or offer-in-compromise.
If the taxpayer disagrees with the adjustments, then we have 30 days to bring the case to to IRS Appeals.
While Appeals may sound scary, it is not. The staff at IRS Appeals is usually very reasonable and they are eager to resolve the matter efficiently and fairly. Appeals is an opportunity to settle the audit without the need for litigation. We often get great results at IRS Appeals, including the removal of penalties.
Notice of Deficiency (90-Day Letter) and US Tax Court
A Notice of Deficiency gives the taxpayer 90 days to file in US Tax Court. This Notice is issued for one of two reasons:
- The taxpayer does not respond to the 30-Day Letter.
- They taxpayer has less than one year remaining on the audit statute of limitations and does not agree to extend the statute of limitations.
Litigation in US Tax Court is an expensive ordeal. However, filing in US Tax Court does not necessarily require litigation because the case will first be forwarded to IRS Appeals. As stated above, IRS Appeals is an excellent venue to settle the audit in a reasonable and less-costly manner. If the case is not settled at IRS Appeals, then the case goes back to US Tax Court to be litigated.
If the taxpayer did not file in tax court and the 90-day period has passed, the IRS will use of all its powers to collect the additional tax, penalties and interest resulting from the audit. This will likely result in liens, levies and garnishments. The taxpayer can pay this amount and request a refund, if they have the funds to do so. Alternatively, there are a number of available procedures that the taxpayer can follow to resolve the debt due to the IRS. Naturally, each procedure comes with its advantages and disadvantages.
Massey and Company CPA is a boutique accounting firm with staff in Atlanta and Chicago. We provide tax and accounting services to small businesses and individuals throughout the United States and around the world.
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