For a lucky and select few, it normally begins with the ominous letter in the mail. The envelope will be marked “Department of the Treasury” and “Internal Revenue Service.” Generally, a letter from the Internal Revenue Service (“IRS|) causes a pit to immediately form in most people’s stomach. Why? A letter from the IRS is almost never a friendly, “we discovered a mistake on your return, here is a bunch of money that you paid us, but you didn’t really owe,” or “you made a mistake and overpaid us—we’ve enclosed a check.” Instead, the substance of these letters is, “we’ve think that there is something wrong with your return, and we’ve decided to initiate an examination – so you better have your documents in order.”
Now, how did you get to be one of the lucky and select few to receive such an ominous letter in the mail? While the IRS generally accepts most of tax returns as filed, the IRS will scrutinize some returns based on any number of reasons. The IRS utilizes a sophisticated computer algorithm called the Discriminant Inventory Function System (DIF) to assign a “score” to your return (See IRS Publication 556). This scoring formula identifies returns for further examination. There are many factors incorporated into your DIF score. For example, are you a high-income earner? How many itemized deductions did you take and were they aggressive, i.e. exaggerated or illusionary? Are you self-employed? These factors, as well as many others, will increase your DIF score. The higher your DIF score, the greater probability your return has for being audited. Your DIF score is calculated to identify the possibility that a return omits income or contains inaccurate information.
The IRS may also open an examination based on a past examination. In other words, the IRS may have examined a business return for your company and decided that your personal return needed to be audited based on inconsistencies with the business return.
Typically, there is a glaring reason that a tax return is pulled for audit. The IRS will cite the DIF score, however, if you give your return to a competent tax professional, they should be able to tell you right off the bat why you are being audited. For example, do your Schedule C expenses and receipts nearly-perfectly zero out? Has your business run at a loss for several years, yet your still manage to maintain a lifestyle that is irreconcilable with your income?
In other instances, sloppy preparation and poor recordkeeping are apparent from the return itself. Does the return contain math errors? Was it prepared by hand? Are all the numbers rounded (e.g., $1,200 expenses are often plugs for $100 per month expense, with no backup).
Whatever the reason for audit, and whatever documents and information the IRS is initially requesting, so long as you have the requisite support for such deductions and/or credits, then you will have nothing to worry about. Unfortunately, blaming your CPA or paid preparer for missing documents is unlikely to work on an IRS auditor. CPAs and paid preparers are not necessarily required to have supporting documents in hand when they take certain positions on a tax return. While some will require documentation that will withstand an audit inquiry (e.g., receipts, invoices, etc.), many have a lower standard for substantiation for taking a deduction or credit.
When you are one of the lucky and select few to receive an audit letter from the IRS, tax professionals provide a good opportunity to help resolve the problem. Remember, if you’ve already made one mistake in filing the return, if you aren’t careful you may make more in defending that error. A professional can walk you through the process, and make sure that you don’t say or submit something that would cause the IRS to open up additional tax return years for audit.
Audit adjustments made by the IRS are appealable. In our office, we resolve most audits either at the table with the auditor, or in appeals, without the need to go to court. Once an assessment of tax has been made (and you may get an initial sticker shock from any adjustment), the next issue is how to pay that amount due.
Read on to our next blog post, for tips and tricks to navigate the collection process! And remember, just because your auditor takes a position on your audited return, does not necessarily mean your auditor has taken the correct position.
- It’s not a party! You NEVER want to host the IRS at your home or business. IRS agents may see things or ask questions of your staff related to the audit. The best place for the audit is at your attorney or CPA’s office. If the agent wants to view a room, or measure your space, call counsel first.
- Prepare and organize your records. Many audits are won or lost on the strength of the recordkeeping. The auditors aren’t lazy, but are overworked and if the evidence to support a deduction isn’t obvious they tend to disallow the item. Use a three-ring binder, and organize your receipts by year, category and expense. It’s OK to have multiple copies of the same document in different areas, where appropriate, but be sure not to claim the expense more then once. Color code, and tabulate the binder, with a table of contents. Auditors hate “disallowances on binder audits” because they often result in calls to their managers by angry taxpayers.
- Don’t volunteer anything. Answer questions when asked, truthfully, and limit your answer to only what was asked. If you are asked a question and don’t know the answer, don’t guess, or make up information. If you are confused by the question, which frequently occurs in an audit, let the auditor know that you didn’t understand the question. Best practice—don’t talk to the auditor—let your attorney or CPA answer the questions for you.
- Don’t rush the process. The auditor will allow additional time so you can assemble and organize your documents. The auditor would prefer that you are organized so that they can spend less time on your file. But, they won’t give you endless time, so use the time to your advantage in preparing for the audit.
- Ask for the person “in charge.” Typically, this is a manager. We’ve had mixed results with auditors, many of whom were not knowledgeable, or in some instance wrong about their analysis of tax law. A manager can often help resolve the issue. Do not yell at the auditor—it doesn’t help the audit.
Jeffrey D. Katz, Esq. is the Managing Partner at JDKatz, P.C. located in Bethesda, Maryland where he bring 15 plus years of experience of advising clients on all aspects of tax compliance and business planning.
Christopher L. Young, Esq. is an Associate Attorney at JDKatz, P.C. where he focuses on issues relating to tax and business controversy as well as corporate governance and planning.