Some of you might get hit by what we in the tax law call the “AUDIT LOTTERY”. This is when you are selected for an audit. Due to extreme budget cuts by Congress for the IRS funding, the odds of being audited are as small as they have ever been. However, many folks will “win” that lottery and be audited every year.
I. Why were you selected?
There are three basic ways you are selected for an audit:
- Matching Documents. The IRS matches forms filed by various parties (employers, brokerage houses, vendor payors, etc) and the IRS matches what you have reported on you tax forms with those sent in by the payors. If they don’t match, they might audit you.
- Related party audits: If an entity is being audited by the IRS such a trust, an S Corp, C Corp or a Partnership in which you are involved, you may be audited as well.
- Statistical Formula: The most common means of being selected for an audit is based upon the statistical formula the IRS uses to see if your return should be audited. It is generally done by the computer initially and then an IRS employee verifies that it should be audited. While there are some purely randomly selected returns for audit, they are rare and not the norm. Instead, it is usually based upon the number of “red flags” in your return. This can be based on many factors. So, for example, if all your expenses on your Schedule C (proprietorship income) end in double zeros [and I’ve had clients with such returns prepared by others] then it is a clear indication that you don’t have the required accurate records. Or if you have very high Costs of Goods Sold as a percentage of Gross Receipts, then you might be selected. There are well known industry standards. By way of example, many restaurants food costs are around 35% of Gross Receipts and even lower for alcohol, a very high profit margin item. These also vary depending on the type of restaurant. Fast food costs a higher percent of the sale price (but made up by the volume) while at the other end are five star restaurants in which the percentage of food costs to sale price is often well above 35%.
II. What to do if you are selected?
If you are selected, you should carefully read the letter from the IRS. It is very clear on what you need. But if you have your own business, then you should know that the law requires you to keep adequate records. What are adequate records can vary by business or by what equipment you have in your business. So if you have a cash register and have large receipts in cash, you have far more work than if you don’t receive cash. This also varies from business to business but you must keep certain records. Banks statements, including cancelled checks, should be kept a minimum of three prior years from the return year. So, for example, if 2014 has been selected for audit, you should have a full year of bank statements for each of 2012, 2013 and 2014. On the other hand, I recommend a 7 to 10 year set of records be kept. This can be even longer if you to establish tax basis of this you bought a long time ago and have it still. Or if you have depreciable assets that still generate depreciation deductions, you need your original cost documents, even if that’s from 20 years ago!
III. How far back can you be audited?
The IRS can generally audit any year that it’s been less than 3 years since you filed. If you filed before April 15th, then use April 15th instead of the date you filed. And the date is not the date you popped the return in the mail, or even the date stamped by the IRS as having been received. The “assessment” date is the date the IRS “officially” enters your return into their “books” which is their computer and that’s often up to 6 weeks after they receive it. The only way to know that date for sure is to get a transcript from them.
If you have a large income item you failed to report, that consists of 25% or more of your Gross Income, then the three years becomes six years.
If you don’t file the return yourself, or if you file what is determined to be a fraudulent return, there is no statute of limitations on assessing you ever. This is true even if the IRS prepares a substitute return for you and then assesses you.
IV. Preparing for the Audit
When you get audited, you should be prepared to present clear and accurate records to support your income AND deductions. Audits are not just about proving expenses. In the world of the IRS, EVERY DEPOSIT INTO A BANK OR BROKERAGE ACCOUNT IS INCOME, UNLESS YOU CAN PROVE OTHERWISE. The burden is on you, not the IRS. The problem here is that there’s usually plenty of documentation support for the deductions, but most folks don’t record the deposits that are not income and years later, when they are audited, they have no clue what it was for. That proves most difficult most of the time. So for my clients, I audit them, just as the IRS will, before we go in or provide any documents. Sometimes, the client’s income and expenses are so wrong once pre-audit them that I have to give the IRS a new entire form to audit and then I have them audit just the new form and not what was originally filed.
The audit process is either at my office (a “field audit”) or at the IRS (a “desk audit”). Either way, in most cases, I go alone as clients often talk too much, explain too much or say things they believe are being helpful but indicate another problem to investigate. So I go alone and come back or provide additional information if necessary.
VI. Post Audit
If my client and the IRS do not agree on the outcome, it doesn’t end there. We can go to the Office of Appeals and get another IRS person to evaluate our position. Or, we get ask them to write it up and state that we disagree. Then the auditor will issue a Notice of Intention to Assess, a so-called “30-day letter”. That means if we don’t provide something new within 30 days, then they issue a so-called “90-day letter” which is your Notice of Deficiency. Once that letter is issued, you have EXACTLY 90 days from the date stamped within that letter to file for US Tax Court petition to determine your case. Once the case is received by the US Tax Court, nearly 100% of the cases are then assigned to an IRS Appeals Office, yes the same one as if you appeals the 30-day letter. It’s a faster process to end the entire affair if you skip the appeals after the 30-day letter before filing in Tax Court but that’s up to you as to which pathway to take. Appeals is like another audit except you only deal with those aspects in which there is disagreement.
If you cannot convince appeals to your way of thinking, then you can try to settle the case with District Counsel who may compromise the case simply to clear their desks or they don’t wish to waste time and see that a Tax Court judge might side with you. In any event, there are yet more choices before going to trial.
At trial, you testify and produce documents which support you case. It’s stricter than an audit because there are rules of evidence to meet and burdens to overcome. But by this time you’ve certainly had a lot of tries to convince the IRS you are correct.
If you are selected for an audit, don’t wait at all. Contact a tax lawyer ASAP and meet with them to prepare for the audit right away. IRS auditors are given short leashes by their supervisors to get the audit done quickly and if you delay in the beginning, you might find them writing it up against you long before you have gathered the documentation to support your return.