Avoiding the IRS Audit Net

The IRS has been stepping up their tax return audits after several years of heavy reliance on correspondence audits. Their mission is to help fill the tax gap. The areas of increased audits include Schedule Cs (sole proprietor businesses) where the Treasury Department estimates income is underreported by an estimated $68 billion.

An IRS tax audit can come in a number of forms. The most demanding are the face-to-face audits, which require sitting down with an auditor and reconciling income and deductions.

Others are the less demanding correspondence audits where the IRS has reason to believe that the taxpayer failed to include reported income or has overstated deductions.

Face-to-Face Audits – Self-employed, high-income taxpayers, those who have omitted substantial income, or those who repeatedly fail to show income to support their lifestyle are more likely to be subject to these types of audits. Some are simply random to provide the IRS with statistics for targeting the most fruitful audit results.

You can appear for the audit yourself, but that is probably a bad idea since you are not trained in the rules and regulations regarding audit procedures and what limits the IRS’s incursion into your private life. You can authorize your tax professional to handle it without you. Often, this is the best way to prevent the audit from escalating beyond the original areas that attracted the IRS's interest in the first place. Practitioners experienced with IRS audits are less likely to become emotional or to make statements that would lead to additional IRS questioning.

Correspondence Audits – Employers, banks, lending institutions, schools, brokerage firms, escrow companies and others all feed data to the IRS, which the IRS, in turn, matches by computer to the information reported on your tax return. If there is a significant discrepancy, the IRS will correspond with the taxpayer. Sometimes these discrepancies will result in additional tax liability, while other times a simple explanation will satisfy the IRS and make the problem go away. Here are some examples of typically-encountered discrepancies:

• Unreported Retirement Income – Whenever a taxpayer takes money out of one IRA account and rolls it over within the 60-day statutory limit into another IRA or qualified plan, the income is not taxable. The IRS will know about the withdrawal but not the subsequent rollover, and unless the rollover is reported on the tax return, the IRS will believe it to be a taxable distribution. So what would have been a simple entry on the tax return results in a correspondence audit. When moving an IRA from one institution to another, making arrangements for a direct transfer will generally avoid these types of audits.

• Gross Proceeds of Sale – Generally, when real estate, stock or marketable securities are sold, the IRS knows what you sold and for what price. Thus, you must account for the sale on the tax return and compute the gain or loss. If you omit reporting the transaction, the IRS will treat the entire sales price as profit, adjust your tax, and notify you via a correspondence audit.

• Alimony Paid or Received – A taxpayer who pays alimony is able to deduct the amount he or she paid. On the other hand, the recipient of that alimony must report that amount as taxable income. The IRS checks to make sure the amounts match. If they don’t, expect a notice in the mail.

• Home Mortgage Interest – Each of your mortgage lenders will report to the IRS the interest paid on your mortgage for the year and issue you a Form 1098 for the same amount. If these amounts don’t reconcile, expect a notice or a request for an explanation. This is frequently an issue when the loan is from a private party not reporting the interest to the IRS, or when more than one individual is on the loan but the 1099 only has space for one Social Security Number (SSN). In both cases, the IRS provides a procedure for dealing with these issues on your tax return. However, if the procedure is not followed, the IRS will be unable to verify interest paid under your SSN and will issue a notice or request an explanation.

• Tuition Paid – Because of the education tax credits that can be claimed for paying tuition to a qualified higher education institution, the IRS requires those institutions to report the tuition received to the IRS and issue Form 1098-T to the student. Thus, the IRS has the ability to verify the tuition paid during the year, and any mismatch could result in a correspondence audit.

• Interest and Dividends – The IRS allows many financial institutions to issue substitute 1099s, i.e. forms that are not in the standard 1099 format. These substitute forms—with various types of interest and dividends reported separately and spread throughout lengthy annual account statements—can often be misinterpreted by an untrained eye. To make matters worse, many brokerage firms have issued amended 1099 statements late in the tax filing season because of errors in allocating the investment income by the proper type. Incorrectly reported, erroneously reported, or omitted investment earnings can trigger correspondence from the IRS.

• Non-Taxable Interest – Interest from municipal obligations are tax-free for purposes of computing federal tax. However, tax-free municipal interest income is added to income for purposes of computing taxable social security income and determining whether a taxpayer qualifies for earned income credit (EIC). Thus, all tax-free municipal interest must be reported on the tax return or risk a subsequent inquiry from the IRS.

• Cash Contributions – Regardless of the amount of cash contributed, the contribution must be backed up with either a bank record or written communication from the donee organization showing the: (1) name of the donee organization, (2) date of the contribution, and (3) amount of the contribution. The recordkeeping requirements may not be satisfied by maintaining other written records.

What this means is that unless the charitable organization provides written communication, cash donations put into a “Christmas kettle,” church collection plate, and pass-the-hat collections at youth sporting events will not be deductible. Donations by debit or credit card can be substantiated by bank records. These new rules will give the IRS the ability to audit taxpayer’s charitable contributions via correspondence audits since all contributions must be backed by a written receipt or bank record.

Don’t assume that just because you received a notice that the IRS is correct. They are frequently wrong. Please call this office before responding to any IRS notice. Tax laws are complicated, and the notices are not always easily understood.

Caution: It is strongly recommended that you contact this office immediately upon receipt of any inquiry from the IRS or state tax agency. Don’t procrastinate, because that only leads to further action on the part of the IRS or state agency.

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