After 34 years as a CPA, providing tax planning advice, preparing thousands of tax returns, and representing numerous clients before the Internal Revenue Service, I’ve pretty much seen it all. Even though we have just concluded tax season for this year, audits of those returns just filed might take a year to eighteen months to come up in the IRS system for examination. So let’s talk about what might trigger an audit, and how to protect yourself going forward.
Now before we get started I want to emphasize that we are not talking about leaving legitimate deductions on the table, or not taking advantage of every possible legal tax planning strategy possible. Tax avoidance is perfectly legal and I would argue your financial obligation to yourself and your family. Tax evasion on the other hand, can get you in to some hot water. It’s important to know the difference. It was actually tax evasion that sent Al Capone to Alcatraz, not the St. Valentine’s Day Massacre.
"Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934).
There are many opinions as to what does and doesn’t trigger an audit. In its 2010 Data Book, the IRS provides some interesting statistics. About 1.1% of 142 million individual income tax returns filed were audited in 2010. Of those, almost one third were lower income returns claiming the earned income tax credit. This is because the earned income credit can actually generate a tax refund over and above the tax withholding, if any, a taxpayer might have. This is effectively being paid by the government, for having a lower income and dependent children. This is an area with great abuse as you might imagine. For returns having non-business income of $200,000 to $1 million, there was a 2.5% chance of audit, increasing to 2.9% for returns with business activities. But by far, for returns with income over $1 million, the audit rate was 8.4%.
For business tax returns, only 1.4% of small corporations with total assets of $250,000 to $1 million were audited. The rate rose to 1.7% for assets of $1 to $5 million, and to 3% for assets of $5 to $10 million. Over $10 million in assets, the audit rate jumped to 16.6%. For partnership and S corporation returns, the audit rate was 0.4%. From an audit standpoint, operating your small business as a Sub S corporation or partnership or LLC has a clear advantage over filing as a Schedule C (self-employed).
When my firm prepares a tax return for an individual or business, I always explain to my clients that I am assuming the return will be audited, even though the chance is statistically small. We prepare our work papers, supporting tax documents, reconciliations, and receipts in an organized, indexed order, electronically catalog and file these items, then begin to prepare the returns. We ask questions. Lots of questions. Probing detailed questions that may sometimes seem odd, but are designed to tease out the most intricate details that we might be able to use to take every legal tax deduction or favorable tax position possible. If there is ultimately an audit, we are already prepared to provide the IRS agent with complete support for every item on the return. More importantly, that same process guarantees that I have turned over every stone, and saved every last penny for my clients.
Even though you might have absolute support and documentation for every deduction on your return, being audited is a losing proposition. You will still have to spend a good deal of time just preparing for the examination, and the stress and aggravation associated with the process can take its toll. With the IRS, you are guilty until proven otherwise, and even a totally innocent comment can open up a can of worms. It is best to hire a tax professional to represent you, and avoid personal contact where possible. Even if you walk away with no adjustment, in the end, it is an expensive process.
Although you don’t want to be audited no matter how sure you are of your return, what can you do to help your return get through the system unscathed? As it turns out, quite a bit.
- Report Every Form 1099. Payers of interest and dividends or brokerage firms that place your stock trades, send a copy of your Form 1099 to the IRS computer. If you fail to include the exact figures on your return, the computer will flag the return and you will receive a love letter from Uncle Sam explaining the error of your ways.
- Report Mortgage Interest Per Form 1098. When you pay interest on your home mortgage, the bank also reports the interest amount to the IRS on Form 1098. These figures must agree with your deduction. If you own a second home, there are rules as to the maximum amount of mortgage interest that can be deducted.
- Report Form K-1 Income. If you are a member of a partnership or a Subchapter S corporation, or if you are a beneficiary of a trust or estate, your share of income or loss is reported to you, and to the IRS, on Form K-1. As with Forms 1099, failure to report the same income numbers will flag your return.
- Real Estate and Form K-1 Losses. If you have rental real estate and lose money, the amount of loss you can actually deduct is limited. Likewise, if you are a passive investor in a partnership or S corporation, your losses may be limited or suspended. The ability to deduct those “passive” losses is contingent on your “tax basis”, how much you have at risk, whether or not you materially participate, and other complex rules. Deducting such losses when not allowed is a sure way to earn some unwanted attention from the IRS.
- S Corporation “Reasonable Compensation”. If you own an S corporation, make sure the company pays you a fair market wage for what you do. The IRS wants to see wages, because wages are subject to FICA and Medicare taxes whereas “distributions” from an S corporation are not. If you take too much in distribution and little or no wages, then the IRS radar screen will signal trouble.
- Sole Proprietorship Business - Schedule C. Schedule C is used to report income and expenses for your unincorporated business. It is also exponentially increases the likelihood of your return being audited, because business deductions are often an area of abuse. In addition, many people will try to take a hobby or pastime, claim it is a business, only to write off the costs associated with that hobby. Bear in mind that the IRS assumes you're in business to make money. Showing a loss year after year might make the IRS question whether your business is legitimate or worse, just how you are managing to cover your living expenses.
- Business Expenses - To be considered a legitimate business expense, an expense must be both "ordinary and necessary in carrying your trade or business." Deductions that seem out of place or not ordinary for your trade or business, might call attention to your return. Travel and entertainment and car expenses are chief culprits and always heavily scrutinized by the IRS.
- Home Office Deductions - If you use part of your home for business, you may be able to take a home office deduction. However, to qualify for the home office deduction, the IRS says you must use the part of your home attributable to business "exclusively and regularly for your trade or business." That means your home office must be your actual office, not just a spot in your home where you sometimes do work, and it must be exclusively workspace and not used for other purposes. Generally, the deduction is based on the size of your home office as a percentage of the overall house, with expenses prorated accordingly.
- Charitable Donations. If you make cash contributions, make sure you have receipts to back them up. High charitable deductions in relation to a taxpayers overall income, is usually a red flag. If you make non-cash contributions, you will need to file Form 8283 with specific details of the items donated and the organizations receiving them. Large non-cash donations may require an independent appraisal attached to the return. Excessive valuations are a sure bet to generate unwanted attention from the IRS.
- Using Too Many Round Numbers – your tax return is not the place to use “estimated” numbers. In fact, too many round numbers on a tax return implies guesses or exaggerated tax deductions – all of which will simply not add up in the eyes of the IRS.
These are just a few of the more common items of course, so it is important to always consult your tax advisor on your specific circumstances, or to use good judgment if you prepare your own tax returns. Good preparation during the year will save you time and money come tax time.
Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years. Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning. Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances.