Why do we dread the prospect of having our tax returns audited? We have this fear of something we probably don’t understand very well – the unknown. The perception is that it will be stressful, will take a lot of time, and burden us with demands that may seem unreasonable. And no matter what, the result will be to owe more money to the government.
Statistically the chances of being audited are low. In fiscal year 2008, the IRS audited 1% of the more than 137 million returns filed the year before. That being said, nearly 1.4 million tax audits were undertaken.
Let’s take a look at the examination process, and what an audit entails. The IRS audits (examines) tax returns to verify that the tax reported is correct. And contrary to popular belief, a selected return for examination does not always suggest that the taxpayer has made an error or been dishonest. In fact, some examinations result in a refund to the taxpayer or acceptance of the return without change. The overwhelming majority of taxpayers file accurate returns and make payments on time. But, obviously, the vast majority of the tax audits undertaken by the IRS are conducted because they have detected invalid deductions or other expenses and it is confident that the audit will result in a tax bill.
The IRS selects returns for audits using a variety of methods. Some returns are selected for examination on the basis of computer scoring. Computer programs give each tax return a numeric “score”. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. The score is based on the IRS’s study of a sample set of thousands of returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.
Some returns are examined using Information Matching, which identifies payer reports (such as Forms W-2 from employers or Form 1099 interest statements from banks) that do not match the income reported on the tax return. The IRS examines many large corporate returns annually. Returns may also be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination.
Still other returns are selected based on information obtained by the IRS through efforts to identify promoters and participants of abusive tax avoidance transactions. Examples include information received from “John Doe” summonses issued to credit card companies and businesses and participant lists from promoters ordered by the courts to be turned over to the IRS.
The first step in an audit will be a computer-generated letter from the IRS, and most of these letters involve minor issues. According to the General Accounting Office, about half of the 10 million notices the IRS issues each year are because the information is “incorrect, unresponsive or incomplete.” The biggest reason people receive letters from the IRS is human error.
Each year, more than 1 million letters are sent to people because they failed to sign their returns. These types of errors rarely lead to a full audit. If the error is not easily identified, the tax audit begins. An audit is actually the process where the IRS asks you to substantiate the numbers on your tax return.
Many audits are “correspondence” audits. Nobody likes to get a letter from the IRS, but it’s probably not as bad as a visit from an IRS agent. More than 1 million of the almost 1.4 million audits last year were correspondence audits, while about 310,000 were field audits.
The audit notification letter tells which records will be needed. Taxpayers may act on their own behalf or have someone represent or accompany them. The auditor will explain the reason for any proposed changes.
An examination may be conducted by mail or through an in-person interview and review of the taxpayer’s records. The interview may be at an IRS office (office audit) or at the taxpayer’s home, place of business, or accountant’s office (field audit).
The IRS trains its employees to explain and protect taxpayers’ rights throughout their contacts with taxpayers.
These taxpayer rights include
A right to professional and courteous treatment by IRS employees.
A right to privacy and confidentiality about tax matters.
A right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided.
A right to representation, by oneself or an authorized representative.
A right to appeal disagreements, both within the IRS and before the courts.
Appeal Rights are explained by the examiner at the beginning of each audit. Taxpayers who do not agree with the proposed changes may appeal by having a supervisory conference with the examiner’s manager or appeal their case administratively within the IRS, to the U.S. Tax Court, U.S. Claims Court or the local U.S. District Court. If there is no agreement at the closing conference with the examiner or the examiner’s manager, the taxpayer has 30 days to consider the proposed adjustments and their next course of action.
If the taxpayer does not respond within 30 days, the IRS issues a statutory notice of deficiency, which gives the taxpayer 90 days to file a petition to the Tax Court. The Claims Court and District Court generally do not hear tax cases until after the tax is paid and administrative refund claims have been denied by the IRS. The tax does not have to be paid to appeal within the IRS or to the Tax Court. A case may be further appealed to the U.S. Court of Appeals or to the Supreme Court, if those courts accept the case.
1. It’s scary. They come to you: One night, there’s a knock on your door. It’s not the neighbors bringing over some freshly baked cookies. If the year was 1692, it was a mob with torches. If the year is 2010, it’s someone in a suit. Either way, it’s not a joyful occasion.
2. Claim a higher authority: The Salem Witch Trials over-extended the moral authority of respected public and religious offices. Today’s tax audits extend (and I would say they over-extend) the authority of the government.
3. Their purpose is discovery: Unlike criminal trials where all sides are considered and a judgment reached, these trials are related to discovery. Their purpose is to examine the “evidence” and draw a conclusion.
4. Guilty until proven innocent: In both cases, they didn’t come to you because you were average. The IRS came to you assuming that you’ve done something wrong and you have to prove that you didn’t do anything wrong.
5. Nothing you can do about it: Neither situation is one where you can take your time and appeal to rational thinkers during the audit. Auditors are out for blood and will leave no stone left unturned to find it.
6. Not a clear understanding of the rules being broken: In the Salem Witch Trials, those putting witches on trial weren’t exactly clear about how they defined and measured witchcraft, and what to do about it. Similarly, during an IRS audit, no auditor can be fully aware of the thousands of pages of tax code that could work for you or against you. The auditor is simply working on “best guess” and what he or she can recall or easily research.
7. (If you’ll excuse the language) “Damned if you do and damned if you don’t”: In Salem in 1692, an accusation was just the first step but it was very likely that you’d end up with a guilty verdict. Even those who were innocent of these crimes endured a lot. During a tax audit, your life is turned inside out and upside down and even if (by some stroke of luck) you have never missed a receipt or overlooked an expense, you’ll still endure the pain and frustration of an audit.
8. Scarlet letter: Audits don’t go away easily. You can be sure that the information gleaned during an audit will be used to verify information later. And if the audit reveals that you do owe taxes, the odds are high they’ll watch you closely afterward to make sure you continue to obey the tax law.
In today’s evolving business world, one of the ways that some small business owners are saving money and improving the competitiveness of their business is by hiring contractors instead of employees. Contractors take care of their own taxes and insurance, they (presumably) are good at their work, and business owners don’t have to keep them on if there isn’t work for them to do. All in all, contractors can make good business sense.
The IRS agrees… to a point. They believe that some business owners are circumventing their responsibilities by filling roles with contractors when they should be filled with employees. The result? A worker classification audit by the IRS to ensure that each business owner is correctly playing the taxes they should be paying (on employees) and not avoiding those taxes (by calling them “contractors” instead).
Moreover, the IRS may run this audit at the same time as a tax audit or it may choose to perform a tax audit afterward, if it feels that there are unpaid taxes to be found.
What is frustrating is the lack of clear rules around what the IRS considers a “legitimate” reason to have a contractor instead of an employee. The rules aren’t always clear. In fact, this Inc. Magazine article by Matt Quinn tries to outline the guidelines the IRS has in deciding whether or not the roles they are investigating should be filled by employees or contractors and it’s clear from the article that it’s not clear to the IRS! (Read the article here).
Check out Quinn’s step-by-step suggestions and make sure you’re ready because the IRS is coming. They’re randomly selecting 6,000 businesses to audit. I believe that if they find enough businesses that are breaking their poorly defined rules, we’ll see even more of these audits in the future.
This is just another way that current tax laws make life uncertain for business owners.
Hearing you have been selected for audit will concern anyone. When two Minnesota businesspeople received their audit letter, they were likely dismayed. However, like good law-abiding citizens, they met with their accountant and the IRS auditor, Roger Anthony Coombs, at their attorney’s office. You can imagine their surprise when the auditor offered to minimize their taxes owing with a $9,000 payment to himself!
That’s right! He requested a bribe in exchange for a favorable audit result. Fortunately, the quick-thinking businesspeople met again, recorded the conversation, and brought it to the attention of the authorities.
Coombs was arrested early in June and, if found guilty, could serve up to 15 years in prison. (Read the full story about the us IRS officer being bribed here).
This is a shocking news story but it prompts me to think further. Coombs only started working for the IRS in June 2009. If this was his very first foray into bribery, it took him a total of 11 months. Eleven months! Was this guy not vetted before his job? Did he have a squeaky-clean record and only turned bad in less than a year? Is this, in fact, his first attempt at stealing from taxpayers?
Another thing I’m prompted to think about is this: There are about 120,000 people working for the IRS. This is one story of one tax agent who was caught. How many more are there are operating a successful bribery scam? I’m sure it is incredibly tempting for anyone facing an income tax audit and a lot of money owing to the IRS to instead give a small amount to an agent to make the situation go away.
The last thing I’m prompted to think about: If the businesspeople in the story really do owe $60,000 in back taxes, is the IRS still going to send in an auditor to finish the job? These people did the right thing in the face of a very tempting crime. Their possible reward might be an actual audit!
In a recent blog post I highlighted the BusinessWeek article about the IRS asking for businesses to self-identify the areas where the IRS might disagree with them. If this rule change goes through, businesses will need to create a “roadmap” of the line items the IRS should consider auditing. More galling is the fact that businesses will also be required to list the full amount they would owe if the IRS decides against them.
This really frustrates me and I’ve decided to continue blogging about it today. I think this is a disaster just waiting to happen. Here’s why:
It hurts honest people more than dishonest people. This is yet another way for the IRS to go after honest people. After all, if the statistic is true which says that over 16% of Americans evade taxes, those folks are certainly not going to be the ones who will accurately report their numbers. It’s the honest ones who accurately report their numbers who will suffer while tax evaders and tax cheats continue to get away with it.
This heavy-handed “self-audit” program will increase the number of tax cheats. With a confusing and oppressive tax code, it’s not a surprise that cheating on taxes is a temptation for some. With this new rule, even fewer people will feel motivated to tell the truth. Once again, it punishes the honest, or further tempts them to be dishonest.
It’s self-incriminating. Even if someone is filing their income tax honestly, these numbers invite scrutiny which can lead to additional audits. It’s an invitation for oppressive income tax auditors to zero in on a few areas of concern.
As I’ve mentioned before, this assault is focused only on businesses – right now – but if it’s successful (“successful” in the eyes of the IRS, that is), I believe individuals will eventually be forced to perform a similar type of tax filing.
Let’s call it what it is: It’s double tax filing: One is the tax you don’t want to pay but feel is accurate. The other is the higher tax that you don’t want to pay but will have to pay if the IRS decides in their own favor.
And that leads me to another issue: The IRS gets to create these rules and gets to enforce them as well. There are no checks and balances here!
Instead, the IRS should actively pursue tax cheats and tax evaders who are getting away with billions of dollars in unpaid taxes. They should leave honest, hard-working Americans with as much of their hard-earned money as possible.
Everyone hates an audit and one of the only things that makes us feel better about being audited is knowing that the auditor has to look through tons of boring, number-filled receipts to try and squeeze more money out of us.
But now the IRS has just gotten lazier. Much, much lazier.
Thanks to new rules that are currently being explored and discussed, businesses that file taxes will need to list the areas where the IRS might disagree, and those businesses will also need to write in the amount that the IRS will need to be paid if it turns out that the IRS is correct in their assessment.
In short, if these new rules go through, the IRS will basically be asking businesses to do the work for them by requiring them to do a preliminary “self-audit” that will raise red flags for the IRS. That’s like walking up to a thug and saying: “If you hit me here and here, you’ll easily be able to take the $10 I have in my wallet.”
BusinessWeek.com brought this to our attention and they quote one tax lawyer who correctly calls this what it is: a revenue-grab for the IRS. They want to increase their auditor’s efficiencies (who currently spend 25% of their time looking through documentation) and they want to find new opportunities to make money. Instead of using auditors to do the heavy lifting, they are requiring businesses to announce what they could owe if the IRS pressed the issue.
This is terrible news for taxpayers. While it is still currently in discussion and will initially only affect businesses, I can foresee this becoming a widely used tool by the IRS to have taxpayers announce to the IRS: “This is the upper ceiling of what you can audit me for, and here are several ways that you can audit me.”
If this rule goes through, it will be a sad day for American business… And some day it will be a sad day for individual taxpayers, too.
“IRS audit”. The very words strike fear into the hearts of, well, most taxpayers. And that is exactly what one IRS employee was hoping for. But, like a boomerang, her words came back to hurt her.
Here’s what happened
Edith Squillace, of San Pablo, borrowed $3,750 from someone. (Documents don’t name who but we can safely assume it wasn’t a bank. Possibly a friend or family member). Seems like it was a regular loan for the kinds of things that we might all need loans for. Nothing out of the ordinary.
Later, Edith tried to get out of repaying the loan. That is not an unusual circumstance, either.
But here’s where it gets funny: Edith Squillace was an IRS employee. Her job was pretty mundane, actually: She answered tax questions from tax payers. However, in trying to get out of paying back the loan, she committed a felony: She threatened the lender with a tax audit if they didn’t forgive the loan.
Fortunately, the lender knew better than to take Edith’s tax audit threat seriously. Edith was indicted with a charge of attempted extortion by a federal grand jury. It turns out, you can’t use the pretense of your job to extort people (which is something I’m sure most of us knew already).
Now, I freely criticize the IRS and many of their tax enforcement policies, but I can’t hold the IRS at fault for the actions of a foolish employee.
I can only hope that Edith is no longer working for the IRS. And if she is, you can be sure that she’s going to watch what she says when her mortgage is up for renewal!
Americans face 4 very different kinds of stresses during tax season. I call them the “April 14 stress”, “April 15 stress”, “April 16 stress”, and “April 17 stress”.
April 14 tax stress
In the weeks and months leading up to the April 15 tax deadline, you (and most other Americans) will be facing the stress of tax preparation. There’s the effort of gathering paperwork, pouring through difficult-to-understand tax forms, juggling paper and a calculator, and hoping desperately that you don’t have to pay taxes this year. The stress comes from finding the time to do taxes and then from trying to figure out each separate line in your tax return.
April 15 tax stress
No sooner is that stress over then the next stressor appears: April 15 is tax deadline day. Most Americans just barely squeak their tax returns in on time and the stress of trying to get it done and rushing through those last minute calculations feels rushed. Did you get everything? What if you didn’t do something correctly? You vow to do your taxes earlier next year (but who has the time?)
April 16 tax stress
Fortunately, not everyone feels this stress, but many people do. If you owe tax and you have to pay it, guess what: your bank account may be drained on this day to cover the check you wrote for your taxes. That’s stressful as you watch your tiny nest egg now devoured. Goodbye to that new sofabed you were hoping for.
April 17 tax stress
Have you ever played roulette and hoped desperately that the ball lands on your number? April 17 tax stress is the opposite: It’s audit stress. You hope desperate that you don’t get picked for the probing and invasive procedure known as the tax audit. And realistically, this stress doesn’t go away on April 18; it hangs over us like a cloud every single day.
If you’re facing these stresses, you’ll find some good advice for handling the April 14 and April 17 tax stress in this article at CNN Money called “A guide to avoid an IRS tax audit“. And if you want to avoid the April 16 stress, give our office a call.
Comedian Jerry Seinfeld gives us a glimpse into his own IRS tax audit on this stand-up sketch, which appears at the end of a Seinfeld episode.
He’s right: tax audits are not pleasant. Watch the video for a lighthearted take on tax audits:
While you or I can do nothing to completely remove the chance we won’t someday be audited, there are some basic things we can do to make the process less painful, and less costly.
A basic tip, that many folks ignore, is to keep very good records to document any business expenses or home deductions.
What do I mean by “good” records? I mean that they should be complete and well organized. While this may sound simple, it actually takes real effort. This is a task none of us want to do, but it’s best if we do it anyway.
This is another one of the “joys” of being a taxpayer. Thanks IRS!
The use of numbers in advertising is sometimes comical. You’ve probably heard the commercials that say something along the lines of “9 out of 10 dentists will tell you to brush with XYZ-brand toothpaste”. Or, web hosts will often advertise 99.9% uptime.
These statistics tell us something. Namely, they tell us that there’s one rogue dentist out there that didn’t like his free sample of XYZ-brand toothpaste. And, they tell us that your web host service could be down a surprising 525.6 minutes each year (nearly 9 hours of down time).
Using the same statistics, you can get glass-half-full and glass-half-empty points of view. With his typical neurotic wit, Woody Allen once said, “I don’t see the glass as half empty… I see it as half full – of poison.” (From the Woody Allen/Scarlett Johannson movie Scoop).
Each year, the IRS spends several thousand of our tax dollars to compile statistics on the previous year’s tax returns and then offers them up for us to ignore. You can ignore the IRS statistics.
I’m fascinated by a few of these numbers and I’d like to highlight a couple here:
Statistic one: Helpful? Or not helpful at all?
On this page we read that there were 138 million individual tax returns filed in 2007 for the 2006 tax year (not to mention a few million more for various corporate and estate tax returns). And, on the same page, we read that there were 63 million letters, calls, or walk-ins to an IRS office to get help on tax issues. For those with an calculator handy, you’ll notice that those numbers translate into a 2:1 ratio (actually, it’s more like 2:1.2 but we’ll allow that some people might have had to call more than once). So, for every 2 tax returns, the IRS helped someone. I think they want us to believe that they’re helpful. But what it really shows is that our tax forms make no sense to 50% of the population. Can you imagine how any company would survive if 50% of its customers called in because they didn’t understand the user manual? Or can you imagine the chaos on our roads if 50% of drivers couldn’t drive without getting help?
Statistic two: The most expensive letter you’ll ever receive
On tax stats we can download a spreadsheet under the heading “Recommended and average recommended additional tax after examination, by type and size of return” and read about the 2006 fiscal year’s tax returns. According to this spreadsheet, they received 134 million individual tax returns and examined (audited) about 1% of them: 1.3 million tax returns. Of the returns that were examined by correspondence (via the mail, not in person), the average recommended additional tax per return was $8,710! That’s the most expensive letter you’ll ever write. (Still, if the IRS field agent goes into the field to examine the return, the average recommended additional tax per return was $20,419).
If the IRS shows up at your door, they are not there to help you.
