In my 28 years as a CPA, I've been asked countless times by clients "will this send up a red flag to the IRS?", "what are my chances of being audited?", "do you think I'll get caught?". Just about time that I think that I've heard it all somebody comes up with, what I call,the "I know a guy, who has a nephew that knows a guy that owns a business and he has a friend that once took an H&R Block course, and he said....." I'm sure I'll have enough to write a book by the time that I retire. There's all kinds if crazy ideas out there that have absolutely no merit at all. Here's 10 practical, common sense ways to help you avoid an audit:
- Choose your tax professional carefully - Beware of that person in your neighborhood that hammers a sign in the ground that reads "Tax Returns Prepared Here". CPAs and Enrolled Agents must possess and maintain a knowledge standard to keep their licensing. Your neighbor with his sign in the front yard is only required to sign the return as a paid-preparer. Effective May 1, 2011, these people are on their way out. IRS has revised their regulations to require that all paid preparers are CPAs, Attorneys or Enrolled Agents. The IRS also holds these professionals to a higher standard of ethical behavior.
- Report your income honestly. The IRS has stepped up their efforts with their Information Matching Program to check the income that taxpayers report. Common forms of income are reported to the IRS electronically by the payer. Wages, interest, dividends, state income tax refunds, investment sale proceeds, IRA distributions, pension distributions, Social Security and the like are all reported electronically. The IRS is able to match these records within just a few months after you file to determine if you reported all your income. That dreaded IRS letter could be in your mailbox's before the tulips pop out of the ground in the spring.
- Answer the questions. The number one reason that I see self-prepared returns come into my office is because the taxpayer did not answer all of the questions completely or check the right boxes. The conversation usually starts something like this "I was trying to save some money by doing my own return and following what the H&R Block guy did last year". I try to hold the big grin from coming across my space but, I know something that the he or she doesn't know. This person is likely to become what I call a "client-for-life". That's always good for me.
- Don't become a target. Many taxpayers believe that claiming a certain type of deduction will increase their odds for being audited. Many others believe that if you file your return early, you have a greater chance of being audited. There are all kinds of misnomers floating around about this issue. The truth is that the IRS uses a very sophisticated statistical profiling model which provides them with statistical probability of finding tax cheats. When your tax return triggers one or more of these statistical pointers, it is likely that you'll get audited. Best advice I can give is be honest. Keep good documentation about your expenses and always, always use a tax professional to be sure that you report deductions accurately. And by all means, please do not listen to your neighbor. He's an idiot.
- Don't make it up as you go along. Just because you "think" something "should be" deductible or excludable from income, don't make it necessarily so; or at least that is the way the song goes. The IRS and state revenue authorities have excellent resources available on the Internet. If you decide to go it alone, use all the resources that you have available to you. All IRS forms and instructions are downloadable in PDF format. All of these forms are searchable using the free version of Acrobat. There is no excuse for not being informed. Even if you decide to use a tax professional (which you should), I always enjoy working with an informed client.
- The devil is in the details. Trying to go cheap and quick is never good. If you try to use the old "paper and pencil" approach, there is a good chance that you will make an arithmetic error that will bring unwanted attention to your return. It also means that you return has to be processed manually by a key punch operator which means it will take longer to get your refund; hopefully you're getting at refund. Incorrect Social Security Numbers for the taxpayer, spouse or dependents are another top reason why your refund will get delayed if you choose to go the old-fashioned route. Using a tax professional that provides electronic filing will catch these errors before the return even makes it to the IRS. When using this methodology, we can warn a client about pending problems. The most common problem we see is related to divorced parents. Frequently, the divorce decree provides that the parents will divide the tax deductions for children or alternate their deduction from year to year. Inevitably, one parent, in the rush for the big refund that they so desperately need (this is a future blog topic) will file the tax return claiming the dependency deduction to which they are not entitled. This is a mess you just don't want to deal with.
- Color inside the lines. Please do not write little notes to the IRS in the margins of your return to explain some reason or logic that you are using to justify a deduction or explain some reason why you are doing what you are doing. All this does is attract unwanted attention to the return. Don't do it. It doesn't help. You don't want to get a letter in your mailbox where the return address is from the nearest IRS service center. Just don't do it no matter how strongly you feel is warranted. In the immortal words of Forrest Gump, "that's all I got to say about that".
- Update your status. The IRS has made good on their promise to audit more sole-proprietorships than they ever have. Sole proprietors reporting revenue greater than $100,000 increase their propensity to be audited more than 10 times the average. Now is the time to extol the virtues of being incorporated. Statistical probability of audit of a corporate return is substantially less than any other type of return. It may also be a good time to look at the Social Security savings from electing S-Corp status. You'll be able to offer your client a multitude of retirement investment vehicles to deposit the money they won't be sending to the Social Security Administration. It is not my intent to open up the debate as to whether or not Social Security is bankrupt (and it is bankrupt, most people just do not know it) or whether or not so Social Security will be around when we retire. That'll be a topic for another article all of its own. Be careful before you recommend this approach. Always consult a tax professional before making choices like this one.
- Beware of gossip. The IRS and state revenue authorities share information electronically. If the IRS picks you up on an error or unreported income, it won't take long before they share this information with your state revenue agency. You can usually expect a letter from the state requesting additional tax, penalties and interest within six months of the bad news from IRS. The same process works in reverse; so, do not think you can get away with it from that from that angle either. The best defense is a good offense; so it has been said. Anytime we assist a client with this type of issue, we proactively prepare an amended return for the state or federal government as the situation requires. The moral of the story is: get to them before they get to you.
- Be a Boy Scout. "Always Prepared" is their motto. Always, always keep your documentation. More importantly, always keep GOOD documentation. If you are unfortunate enough to be the lucky recipient of an audit, deductions that lack documentation or are poorly documented will be disallowed. The documentation is always your best defense in an audit. Have you ever been stopped by law enforcement officer because you were speeding? You probably didn't think you were going that fast or that driving a few miles over the posted speed limit was not enough to warrant a citation. Like me, you have probably always thought they just had to "make their quota". As much as law enforcement officials will deny that quotas exist, they do. I have it on good authority from a high-ranking official (that happens to be my client), now retired, from the State Police that officers are given a specific number of citations they are expected to write especially at certain times of the year like holidays. IRS auditors are no different. Whether they are evaluated, formally or informally, by the amount of taxes they collect is irrelevant. It's impossible for any supervisor or manager to overlook the productivity of a person in this position. So, human nature being what it is, whether you like it or not, they get evaluated by what they produce.
This information is a free service of:
J.T. Hicks & Co., PA Certified Public Accountants 470 S. Main St Brewer, ME 04412 (207) 990-3127 Notice: always consult a tax professional before implementing any tax reduction strategy.
IRS CIRCULAR 230 DISCLOSURE: Tax advice contained in this communication (including any attachments) is neither intended nor written to be used, and cannot be used, to avoid penalties under the Internal Revenue Code or to promote, market or recommend to anyone a transaction or matter addressed in this communication. © 2011 J.T. Hicks & Co., P.A.
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