The IRS is stepping up audits of taxpayers at a rapid pace.  Each of the past several years there has been a significant addition of Revenue Agents (RA) and Revenue Officers (RO); those responsible for auditing returns and collecting taxes.  In addition, the IRS has been improving its already sophisticated computer programs, resulting in much more thorough and accurate reviews of tax returns, including comparisons to documents forwarded to the IRS by third parties; W-2s, 1099MISC, 1099INT and many, many others. 

The number of audits has increased steadily each year for the past eight years in all categories, both personal and business tax returns.  Of significant concern is that the IRS recognizes that small business owners, especially those who file Schedule C are prone to making mistakes and keeping poor records.   Guess what?  This is one of the areas where they are focusing their attention.  Over recent years the IRS has received a lot of money in additional taxes, penalties and interest by auditing small Schedule C businesses. 

So, why does the IRS audit tax returns?  The IRS wants you to comply with the tax code by filing and paying on time.  The IRS wants you to be intimidated.  Our U.S. tax system is a voluntary one.  The vast majority of us play by the rules; we file and pay on time.  But, in order to get us to do that, the IRS puts the “fear of God” in us by auditing tax returns and getting maximum publicity on those high profile cases where they throw a celebrity or ordinary citizen in jail.  The result is that most of us fear the IRS more than just about anything else.  We get an IRS letter in the mail and many of us are paralyzed.  We don’t want to open it! 

The IRS has a sophisticated system of computer programs that it uses to determine who gets audited.  Obviously, they don’t have the staff to audit everyone, so they have to select the ones that they think will be the most fruitful, i.e., result in the largest amount of  taxes, penalties and interest.  All individual tax returns are computer scored by the IRS DIF system.  Discriminate Function (DIF) is a highly secretive mathematical technique used to score income tax returns as to their examination potential.  Generally, the higher the DIF score, the higher the potential for audit.  Once the IRS selects returns to be audited, it then determines what kind of audit it will do.  One thing I want you to always remember. 

The first type of audit is a CORRESPONDENCE AUDIT.  This is the simplest form of audit, but has proven to be very lucrative to the IRS in terms of return on investment.  The taxpayer receives a computer generated letter from the IRS saying the IRS is proposing to make an adjustment(s) to their tax return unless the taxpayer can substantiate (prove) the expenses he/she claimed on their tax return.  The letter gives you 30 days to do so.  As I’m sure you all know by now, when you are dealing with the IRS, in the vast majority of issues, the burden of proof is on you.  You must respond to the IRS with documents that show you actually incurred the expense.  Common issues handled by correspondence audits include mortgage interest, taxes, contributions and many more.  Correspondence audits are usually focused on a few specific items in your tax return and are limited to that. 

The next type of audit is the OFFICE AUDIT.  An office audit means that you are summoned to the office of a local IRS Revenue Agent who will look at your return in more depth.  These audits are generally focused on specific areas of your tax return but a RA can look are the entire return and even open up other tax years if he/she feels warranted.  Many times small businesses are selected for office audits.  As with the correspondence audit, the burden of proof is on the taxpayer.  These audits are generally completed in one visit, just a few hours, assuming the taxpayer is prepared when he/she comes to the office. 

The final type of audit and by far the most comprehensive is the FIELD AUDIT.  As suggested by the name, in this case the RA comes to your home or place of business.  In a field audit, expect to have a very experienced Revenue Agent and expect he/she to look at all aspects of your return, your personal financial life and, if warranted, other tax years as well. 

So, what should you do if you are notified your tax return is being audited?  First of all, if your return is selected for an audit, that in no way implies that you made a mistake on your return.  Selection simply means that the IRS has one or more questions about your return.  If it is a correspondence audit and if the audit is focused on a specific issue and you have substantiation for your deduction, go ahead and handle the audit yourself by following the instructions in the letter.  If, after you have done so, the IRS still says you owe money, I highly recommend you hire an Enrolled Agent, CPA or attorney to represent you; someone with experience in dealing with the IRS. 

If you are facing an office or field audit, I recommend you immediately hire an Enrolled Agent, CPA or attorney to help represent you.  They will generally attend the audit in your behalf, but will require you to supply the substantiation required to prove your deductions/income in question.  Someone experienced in dealing with the IRS can save you a lot of money and give you peace of mind especially in office and field audits. 

With the economy still in bad shape that means tax revenues are way down.  You would think the government would slow it’s spending.  No, just the oposite, spending is increasing at an alarming rate.  So, with spending up and tax revenues down, the Congress and the Administration have asked the IRS to work harder to find as many tax dollars as possible.

I expect the IRS to continue to look hard at mortgage interest deductions.  There are specific limits on what can and what cannot be taken as a mortgage interest deduction.  The IRS has already begun to focus on this and I expect them to do even more.  I will write a blog on mortgage interest deductions sometime in the next few weeks. 

Another area of emphasis by the IRS is to coordinate with states to look hard a small businesses to find those businesses that have misclassified workers as Independent Contractors (IC) to avoid paying employment taxes.  When they find those companies I expect the IRS to go back several years and to apply hefty penalties to those they determine are misclassifying employees as IC’s.

There will be other things the IRS will focus on as well, so taxpayer beware!  Know the rules and follow them.  This is not the time to be bending or breaking the rules.  If your not sure what the rules are, talk to a professional.  If you are operating in a gray area, clean up your act before it is too late.

Since our income tax system in the U.S. is a voluntary one, the IRS wants us to believe they are watching our every move and will come knocking on your door if you make even the smallest error on your tax return.  They want the image as the Big Bad Wolf.  Does it work?  For the most part, you betcha! 

Let’s look more closely at how the IRS operates and some of the statistics to see if you have good reason to be afraid.  The IRS sends millions of letters to taxpayers every year.  Many of the letters they send out are straight forward and are administrative in nature.  They may be correcting a math error, advising that you left something off the return and giving you a chance to fix it.  Or they may be more serious, assessing a penalty if you filed late or notifying you that your tax return is being audited.  Unfortunately, they never send you a letter saying you are doing great, keep up the good work.

So, what are your chances of being audited?  Actually they are very small.  On average, a little over1% of filed tax returns get audited each year, however that number has been going up in the past decade and as you will see a little later, the odds increase depending on the type of return you file.  Several years ago an IRS research study showed that there is an underpayment of taxes of about $300B (B as in Billion) per year, known as the “Tax Gap.”  About $250B of that comes from underreporting income and/or overstating expenses. 

Congress has asked the IRS to aggressively try to close the “Tax Gap.”  One way they are doing it is by hiring more employees and conducting more audits.  Let me analyze this a little bit further.  Financially, most taxpayers lead rather uncomplicated lives.  They work for someone else, get paid by W-2, earn interest from their bank or brokerage, buy and sell a few stocks, put some money in a 401K or similar plan, pay their mortgage or are retired drawing a pension and social security.  Virtually everything financially in their lives is reported to the individual and to the IRS on one form or another.  For this large segment of taxpayers, it is a simple matter for the IRS to know who has filed and accurately reported their income and deductions.  In many cases, if a taxpayer does not file a return, the IRS will file a substitute tax return for the taxpayer.  This will only occur only if they taxpayer owes money.  If the taxpayer is due a refund, the taxpayer will probably never hear from the IRS.  Why?  By law, after three years the IRS no longer has to refund the money. 

So, how does the IRS know who to audit?  The IRS scores every tax return filed; known as the DIF score.  Through research, the IRS knows what types and how much a taxpayer should be taking in deductions based on his/her Adjusted Gross Income.  If the computer review of the tax return finds some of the numbers outside the norm, it assigns a higher DIF score to the return.  The higher the DIF score the more likely the return will be audited. 

I’ll give you one guess where the majority of the $250B shortfall comes from.  It comes from small businesses and self employed folks; that’s you and me.  Research and IRS experience from past audits have shown that there is a significant underreporting of income as well as overstating of expenses on many business returns.  This is especially the case with sole proprietorships and single member LLC’s that report their business income on Schedule C on their 1040 return.

As a self employed taxpayer, you are about 10 times more likely to have your Schedule C audited than you would be if you filed a Form 1065 (partnership or LLC return) or 1120/1120S (corporation or subchapter S return).    Based on years of audits the IRS knows that those small businesses who file on Schedule C probably don’t keep sufficient records and frequently can’t prove the income and expenses claimed.  On the other hand, small businesses who file Form 1065, 1120 or 1120S generally keep better records and frequently use a bookkeeper or accountant and a tax professional.   As a result, the IRS knows that the “low hanging fruit”, so to speak, is in Schedule C businesses.  So take the hint.  For those of you who are filing on Schedule C, you might want to consider another type of business entity. 

The IRS uses education of the public and audits to keep people in compliance.  Lately the IRS has been putting most of its emphasis on audits and is expanding its audit force.  Audits are the subject of another article, but, briefly, there are three types of audits,   Correspondence, Office and Field, with a Field audit being the most comprehensive one.  The IRS makes sure it gets a lot of publicity on its high profile audits and criminal actions. 

So, how do you protect yourself from the Big Bad Wolf? 

• First of all, keep excellent records.  If you are not good at recordkeeping, hire a bookkeeper or accountant to help you or at least be on your team of advisors.  See:  (http://biznik.com/articles/ive-got-your-six).  Use a software program like QuickBooks to track income and expenses so you can create financial statements.  This will not only help you at tax time, it will help you immensely if you are audited.  These reports are also essential to understanding and managing your business.
• Keep your personal and business finances separate.  Always!  Have separate bank accounts and credit cards for the business and for you personally.  By the way, if you are one of those people who does not believe cash is money (in other words, not reportable to the IRS as income), the IRS has ways to determine when you are not reporting income.  In a Field audit, they always do this analysis and sometimes in an Office audit as well. 
• Have documentation to back up expenses you claim.  Cancelled checks are not considered adequate proof, although they are better than nothing; it’s always best to have a receipt for each item you claim.
• Keep good automobile records if you use your car for your business.  I know it’s a pain, but keep a log in your car and annotate every business trip you take with the miles you drive and the reason for the trip.  This only takes a minute or two and it is well worth the effort.  If you are seeing a client, note who that client is.  If you are constantly going to the same place, for example you are in construction, you can use Map Quest to determine the mileage, but you still need to keep a log of the number of trips to that location.
• File your tax return(s) on time.  On time includes an extension if you file for it.  Remember, the extension is to file your return, not to pay what you owe.  If you owe money, the IRS expects it all to be paid no later than April 15th. 
• Lastly, if you get that dreaded letter from the IRS, open it immediately!  Not dealing with it quickly will only lead to more trouble later.  IRS letters can be long and difficult to understand.  If you used a tax professional to do your tax return, contact him/her immediately for their help.   If you did not use a tax professional and the issue seems serious, contact an Enrolled Agent (http://www.professionaltaxservicesinc.net/enrolled-agent/) or CPA who has experience dealing with the IRS.  I would not recommend contacting a tax lawyer unless you suspect the IRS is after you for fraud or you are under criminal investigation.  If agents show up at your door with a badge, it’s usually very serious.  That is when a tax lawyer should be consulted. 

Should you be afraid of the Big Bad Wolf?  Absolutely not!  If you follow the simple guidelines I laid out above, you really should have nothing to worry about.  That doesn’t mean you won’t get an IRS letter or be audited, but if you are you will be prepared.  Adding a tax professional to your team of advisors will give you extra peace of mind as well.

He told me that he had been in training as a Revenue Officer in the Large & Medium Size Business unit since he joined.  However, he had already done two solo audits.  This was August, only four months after he joined the IRS. 

The IRS has seen a tremendous loss of experienced people over the last several years.  Part of that occurred in the late 1990’s when the IRS was significantly downsized and became a “friendlier” organization.  However, since early 2000 the IRS has been steadily increasing its’ hiring and is becoming the IRS of old. 

The experience level of many of the people in the IRS who conduct audits is very low.  Many of the agents have minimal training before they are told to “go get em tiger.”  This is disconcerting if you are on the receiving end of an IRS audit.

Those conducting Correspondence Audits are the least trained, often getting the bare minimum training and only in the areas they need to know to conduct the audit.  As I indicate above, this also seems to be the case for Revenue Officers conducting Office and Field Audits as well.

So what does that mean for those of us who get audited?

1. Don’t arbitrarily accept what the auditor is telling you.  Calmly and professionally fight the battle with the auditor. 
2. If you think or suspect the IRS is wrong, hire an EA or CPA to represent you; or better yet, bring one onboard before the audit begins.  At any time in an audit, you have the right to tell the auditor that you are going to get a representative.  At that point the audit will cease and resume when the representative is onboard.
3. Be prepared to challenge them with the facts and/or the IRS code.
4. Don’t hesitate to elevate the issue to the auditor’s supervisor.  Often you will get a much more seasoned and experienced person who will listen to both sides and make a decision or even negotiate with you.
5. If you believe you are right and you can’t get satisfaction from the auditor or his/her supervisor, consider taking the matter to appeals.  Going to appeals must be carefully considered and certainly cannot be done frivolously.  Often you will get a very seasoned and experienced person who is interested in resolving the case.  He/she will do an assessment as to how the IRS would do if the case goes to tax court.  In many cases, it is in the IRS’s best interest to resolve the matter in appeals.  While the Revenue Officer has little or no authority to negotiate, an appeals officer has total authority.

The IRS can be very persuasive and forceful.  I highly recommend you immediately contact an Enrolled Agent or a CPA to review the IRS correspondence and hire him/her to represent you in the case.  This will give you peace of mind of knowing you have someone in your court who will not be bullied by the IRS Revenue Officer and who knows the IRS code and can advocate in your behalf.