IRS Audit

    When the IRS audits, adjusts or files a substitute tax return, pay close attention to deadlines

    by Michael S. Anderson, P.C. on November 30, 2011

    A great number of Americans owe the IRS at any given time.  Some estimates are as many as 10-15% of all taxpayers owe…right now.   The most common reason I see a consumer owing tax, is the most obvious one; the taxpayer just didn’t withhold enough or pay enough during the year or at the time the return was filed.  There are other reasons though that cause the tax bill to be a surprise to many like:

    • The IRS audits the return and the taxpayer ends up signing the audit report and agreeing to the amount
    • The IRS audits the return, the taxpayer appeals the audit assessment and loses the appeal but doesn’t file tax court petition.  The tax bill then becomes a final bill.
    • The IRS audits the return, the taxpayer doesn’t agree but also doesn’t appeal or file a tax court petition.
    • The IRS audits the return, the taxpayer appeals, files a tax court petition and still loses and therefore owes.
    • The taxpayer files what he believes is a correct return but the IRS later adjusts the return as a result of missing income.
    • The IRS filed a tax return for the taxpayer called a substitute return, the taxpayer doesn’t appeal timely, and sent the taxpayer the bill.

    The problem with every one of these scenarios is that at the end… the tax debt is set in stone.  I.E.  challenging the amount internally becomes very difficult if not impossible.  Also, once the debt is assessed and a notice period passes, the IRS doesn’t need court approval to take a paycheck or bank account.  It can seize assets, record a notice of tax lien that will destroy a credit rating,  and tack on penalties and interest to the debt.

    The point of this post is to show you how tax debt is created, so that you can take to heart the following advice if any of the above happens to you:

    Don’t allow deadlines to pass.  The failure to respond timely and properly can result in a debt that may not actually be correct.  I see this constantly and am dismayed about how often it could have been avoided.

     

     

     

    Important IRC Sections for those with Tax Debt, Late Tax Returns and an Audit Phobia

    by Michael S. Anderson, P.C. on September 8, 2011

    There are three sections of the Internal Revenue Code that are of special significance for taxpayers who are late in filing the tax return, late in paying the tax return or who are concerned about an audit.

    Section 6511 of the IRC

    The 3 year refund statute. This statute allows the IRS to keep your tax refund if you file a tax return more than 3 years after it’s due date. A moneymaker for them I am sure.

    Section 6502 of the IRC

    The 10 year debt collection statute. This statute says that after 10 years have passed (with some exceptions) from the date the debt was “assessed” the debt is no longer valid. i.e. gone…poof…etc. This also means that the underlying lien is gone as well.

    Section 6501 of the IRC

    This is the 3 year audit statute. The correct tax return enjoys the protection of this statute. i.e. the IRS cannot audit the return if more than 3 years have passed since filing.

    To read more about these statutes theInternal Revenue Manual 25.6.1, is a good place to start.

     

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    IRS Audit – How long do I have to worry about it?

    by Michael S. Anderson, P.C. on September 8, 2011

    As a general rule, your tax return can’t be audited after three years from it’s original filing date.   If you filed before the due date of April 15, the 3 years starts to run from April 15 of the year it was due.

    There are some exceptions of course:

    1. If you understate your income by 25% or more on the return the audit deadline is extended to 6 years.  It is not a good idea to under report income though and hang on for six years.

    2. If you file a fraudulent return, there is no time limit on the audit. Tax fraud is any conduct that was meant to deceive the IRS.  The mistake has to be purposeful. The common belief is that the IRS doesn’t audit returns after three years even if there is some fraud indication if the amount of the debt is not above certain levels.  I don’t suggest clients rely on these claims.

    3. The time limit only starts to run when the taxpayer files the tax return. Unfiled tax returns are always open to being audited. If six years have gone by and no return has been filed by you or the IRS than you may be safe because the IRS typically is not interested in personal returns unfiled for more than six years both from a civil and a criminal standpoint.

    Audit notices are typically sent out about 12 to 18 months after the filing of the tax return, and the IRM or internal revenue manual instructs that audits are to be completed within 28 months after the return has been filed. This 28 month rule of course is just an internal deadline.

    Time limits are a good thing for the taxpayer. The IRS has it’s own set of problems that cause delays and the older the return is the more anxious they are to put it away.

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    Independent Contractor designation and the problems it can cause for your small business

    by Michael S. Anderson, P.C. on September 6, 2011

    Employment tax law requires the employer to withhold the employees’ fica tax, unemployment tax and income tax from the paycheck, throw it in a pot, mix some more money into the pot equal to the employee’s fica tax and shoot the whole thing over to the IRS each quarter.

    This process requires a lot of work and a lot of money, especially when the business has a lot of employees.

    So, the employer has a natural incentive or really a “dis-incentive” to do this work and pay this tax. The investment comes with no reward, reduces profits and reduces the number of employees the business can hire and products it can sell.

    This incentive leads the small business to find ways in which it can avoid the burden by treating workers as independent contractors instead of as employees.  By doing this, the business avoids the tax reporting, the bookkeeping and the withholding tax and save’s itself a lot of money and headache.

    The problem?

    If the business treats workers as Independent Contractors when it should be treating them as employees, the headache can be much larger.

    If the IRS gets involved and determines that an independent contractor should have been treated as an employee, the business can get stuck with penalties/costs up to 35% of the payments made to the wrongly classified worker…plus interest.

    This misclassification is a priority problem in the IRS’ world. It targets businesses it suspects, like building contractors, doctors, sales organizations and beauty shops among others.  Often the IRS will make the determination without fully analyzing the status of the business’ work situation and leave it to the owner to prove that the workers deserve the independent contractor determination.

    So – how to follow the IRS’s rules and classify/treat the worker appropriately in order to avoid a mess is the question and the topic of future posts.

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    Small business and IRS audits – What they are looking for and how to prevent problems

    by Michael S. Anderson, P.C. on September 5, 2011

    Face it…The Government is at odds with small businesses in America.  Money “belongs” to the government first right?…and small businesses move around alot of it. This makes the government uncomfortable, just like you would be if you asked your small child to watch your stash of bills.

    Thus, the sour relationship.

    The IRS doesn’t really care whether our tax policy is right or wrong, it just “enforces” the policy. It has indicated that most “cheating” is done by small business and as a result it watches small business owners more closely than wage earners.

    This is partially evidenced by the number of IRS employees (more than 45,000) dedicated solely to squeezing the small businessperson where it hurts the most

    As a result, small businesses are at great risk for an audit. We know though what the IRS is typically looking for when they conduct a small business audit, and the most common items are:

    • Personal living expenses written off as business expenses
    • Auto expenses written off for travel that was not business related
    • Large business entertainment expense
    • Failure to report all business related income
    • Whether workers are being classified as independent contractors when they should be classified as employees
    • Whether the business is making all of it’s payroll tax deposits.

    I always make four suggestions to small business owners as a result:

    1. Use a reputable payroll company – this helps prevent the use of payroll withholding to keep the business afloat during down times. The most dangerous problem is when the small business owes a lot of payroll tax. It won’t go away. It will stay with the business until it dies and a large portion of it will stay with the responsible owner etc. until it’s paid.

    2. Use someone else to do the tax return – i.e. don’t do it yourself – a third party cpa or tax lawyer can look at the big picture and make sure the return makes sense, spot missed deductions, and apply tax law to the facts of your situation. This reduces the chances that income is missed and increases the odds that all legal deductions are taken. It is worth the dough in the end.

    3. Plan ahead – talk to a cpa or tax attorney about what you can do in coming year(s) to take advantage of the tax code. Talk to them especially when you plan on taking on employees and paying them as independent contractors, or leasing a private jet.

    4. Treat the business as a separate entity – set the business up properly, keep a separate set of books, use separate checking accounts, don’t use business accounts to pay for movie tickets and trips to the zoo.

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    Is the burden of proof on the taxpayer during an audit or the IRS? Hint…not the IRS….

    by Michael S. Anderson, P.C. on September 1, 2011

    When the state charges you with a crime – it has to prove the case. It gathers evidence and brings the evidence to a court of law in an effort to do so. The evidence it gathers has to meet a certain level of believability in order to convict.

    In almost every situation, the opposite is true when the state i.e. the federal government audits your tax return.  The burden of proof is on you. You have to do the work, find the evidence, pay attention to deadlines, and make sure the IRS agrees that the evidence meets certain standards.

    An IRS audit is the process by which the government determines whether you properly reported income and claimed the correct deductions, exemptions, and credits.

    If the government disagrees with your proof, it can assess additional tax, penalty and interest. Even worse, it can charge you with a crime for underreporting income or overstating deductions.

    The IRS wins the large majority of it’s audit cases usually because taxpayers can’t bear the burden. They routinely fail to provide and/or verify the information to back up the income and deductions on the tax return. The IRS wins over 80% of all audits, mostly because taxpayers can’t properly verify the information on their tax returns.

    As a result of this set up, you must remember that you are always in an adversarial/legal relationship with the IRS. Everything you do and claim should be provable. You cannot rely on the notion that the State has to prove it’s case.

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    Won’t the IRS officer be suspicious of me if I hire a lawyer?

    by Michael S. Anderson, P.C. on August 29, 2011

    Many of our clients, especially those that are facing an IRS audit, are rightly concerned that the IRS will look at them more suspiciously and/or treat them worse if representation is used.  i.e. a tax lawyer.  Specifically the fear is that the IRS will think a crime is being hidden or committed.  My response to this question is usually given in three parts:

    1. Lack of experienced representation often results in missed opportunities and mistakes.

    The IRS won’t tell you about your rights, the planning you can do, and the arguments you missed. Many taxpayers end up paying thousands of dollars more than they would have in the end, had they hired experienced counsel.

    I have represented many clients who came to me after trying to do it themselves. They realized that the IRS simply let them disclose the information and told them what to do.

    The audit was finalized with incorrect debt amounts, appeal dates were missed, offers in compromise were filed incorrectly, payment plans were too high, bankruptcies were filed without proper preparation and the tax debt remained at the end. I could go on.

    If proper representation will increase the odds that a real, long term solution is found, who cares what the IRS thinks?

    2. The IRS can’t care

    You are entitled to a defense. You are entitled to hire someone to help you deal with what can be a confusing labrynth of rules and dates. Our system of laws doesn’t assume guilt as a result of taking advantage of these rights.

    3. The IRS wants to impose the simplest solution

    The simplest solution is just to disclose what is requested and accept the IRS audit determination or calculation of your budget. Long term, this is most often a recipe for failure.

    Sometimes, IRS officers will tell a taxpayer that they don’t need representation in an effort to do the above i.e. get their way. I assume that this statement is made after the taxpayer has indicated they want to consult with a lawyer or other representative.

    If so, the officer or agent is likely breaking the law.   The IRS must stop the interview if the taxpayer indicates a desire to consult with counsel.

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    Selecting your return for IRS Audit

    by Michael S. Anderson, P.C. on August 27, 2011

    Most IRS audits originate with the IRS computer system. Your tax return is plugged into the IRS computer and reviewed by a “program” known as the “Discriminant Function”.

    The Discriminant Function program scores the tax return. How this program works and scores a return is mostly unknown however.

    A second program is used to catch unreported income. This program is called the “Unreported Income Discriminate Information Function”. In essence this program is trying to spot the return that just doesn’t make sense from an income and expense standpoint, i.e. people who live beyond their means…at least on paper.

    Imagine if your return showed $55,000.00 in income, 1 spouse, 4 children, $30,000.00 in mortgage interest/tax and $8000.00 in medical expenses. It would be difficult for the program to believe that 6 people lived on $17,000.00. (Of course the difference may have been made up with savings, but that explanation may have to be made later to the auditor assigned to the case)

    A percentage of these returns with the highest scores are reviewed by humans and a percentage of those reviewed by humans are selected for an actual audit. The “in person” audit decision, whether in person or field audit (in your office) is made by a group of managers in the IRS office.

    There are other return issues that attract attention as well – i.e. outside of the computer system. Some common items are:

    Large expense item compared to income- $10,000.00 medical expenses on a $40,000.00 income may be considered large in relation to income but it may not if the income were $100,000.00.

    Out of Character expenses- Accountant who charters a private jet may raise an eyebrow or two.

    Attempts to mislead- Not filing all attachments to the return.

    Income level- $200,000.00 or more and the risk increases substantially.

    Self employment- Some say you are 4 times more likely to be audited if you are self employed.

    Sloppiness- Don’t round numbers up or down, don’t handwrite it.

    The fact that U.S. Citizens are required to disclose their income and budget to the government in detail each year is a topic for another day. For now, it is a fact, and one that could result in an audit or worse. When doing your returns, especially if you are self employed, be aware of the fact that the truth with proof is the best way to go.

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    IRS “Audit” awaits those who don’t file tax returns

    by Michael S. Anderson, P.C. on August 26, 2011

    If you haven’t filed a tax return in a while, don’t be surprised if you are “audited”.

    The IRS tracks you, and if returns are missing it will eventually request them.

    If the requested return(s) isn’t filed, the IRS has the authority to file/audit the tax return all in your name. The IRS employee tasked with this job is directed by the Internal Revenue manual to calculate a “reasonable and substantially correct” return.

    The auditor who is creating this return can rely on the income information reported like w-2 and 1099 income, but he can also rely on other sources to estimate your income and expenses.

    This is common when the income reported doesn’t seem to match your living arrangement.

    Think…gated community and large home with only $20,000.00 of reported income.

    For businesses with unfiled returns, the auditor uses sources that provide him “industry standards”. He can actually estimate what he thinks your business may have earned and spent on overhead by comparing your business to other business’ similar in age, purpose and size.

    After the auditor is all done estimating your income and budget items, he will forward a copy to your last known address and give you the opportunity to dispute with figures of your own or provide your own correct return or he may simply issue a notice of deficiency and provide you 90 days to contest the report in Tax Court.

    Once the dates are missed and the auditor created return is “assessed”, the new “substitute” return can be used by the IRS collection department as a basis to levy a paycheck or bank account.

    This process is the most common problem my clients face; i.e. a number of years of unfiled tax returns, a few of which have been done by the IRS as substitute returns, and subsequent collection activity.

    If you have been putting off the creation of unfiled returns and you earned money during the years in question, it will be cheaper and probably much easier to beat the IRS to the punch before you are…audited.


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    Audit Reconsideration Basics

    by Michael S. Anderson, P.C. on May 15, 2011

    You can lose the audit or some portion of the audit or have the IRS prepare an incorrect tax return for you (called a substitute return), fail to timely appeal the result and still may be able to have the determination “reconsidered”.

    The most common type of Audit reconsideration is the creation and filing of a correct tax return to “challenge” an IRS created or “substitute” return. The taxpayer may also simply request an audit result to be considered as well.

    Whether the audit reconsideration request is made as a result of a failed audit or as a correct taxpayer return filing, it is NOT a matter of right i.e. you don’t have the right to file the tax return challenge or request that the audit finding be changed, if you missed your appeal deadline and are filing the reconsideration request.

    IRS auditors are trying to increase your debt, but IRS audit reconsiderations go to the IRS appeals office whose job description is to try and deal with the case as cleanly and painlessly as is possible. These appeals officers have a broadened discretion and flexibility. Therefore if issues are unclear, the result may be in your favor.

    A freedom of information act request can result in the IRS providing the auditor’s file. This can tip you off to what the auditor was thinking during the audit, and will make it easier to attack the items lost in the reconsideration process.

    A tax attorney can help to organize and clearly argue the legal issues in the reconsideration setting especially with an appeals officer and can focus on the facts that would help you to win.

    If you have a substitute return issue or have long since “lost” an audit, you may still have this option. You can call to discuss your situation with us or visit our blog to learn more.

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