Archive for May, 2014|Monthly archive page

What are Your Chances of Being Audited? Part II – Audit Selection

Originally published in the Cedar Street Times

May 30, 2014

Two weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS.  A few of the high points from that article were: 1) on the average, audit rates for individuals are generally less than one percent each year, although audit rates jump to over three percent on people making over $200,000 a year, 2) about 75 percent of audits are actually mail correspondence audits focused on a narrow request of information for specific items on your return rather than a full-blown in-person, field audit, 3) partnership, LLC, and s-corporations have a less than half of one percent chance of being audited, while small c-corporations with less than $10 million in assets have an audit rate just under one percent, 4) larger c-corporations have increasingly higher chances of being audited with a roughly one in three chance for corporations with over $250 million in assets.  If you would like to read the full article, you can read it on my website at http://www.tlongcpa.com/blog.  The rest of this article will be devoted to audit selection and in two weeks we will discuss “red flags.”

Regarding audit selection, let me start by saying that no matter what you read or hear, nobody knows the exact methodology the IRS uses to select returns for audit as it is not public information.  All we really know is the broad overview the IRS tells us about its methodology and the limited statistical information the IRS releases about audits; the rest is conjecture based on the type of returns that we as tax practitioners see being audited.  Of course that can be warped by our own experiences.  That said, when you have been in the field long enough and have read about or talked to others about their experiences, you do get a good idea of the common issues for the types of clients with which you work.  When a client comes in and says, “I heard that if you report over ‘x amount’ of this, it is a red flag,” or “I am not going to file until ‘this date’ because you are less likely to be audited,” I know they have latched onto some misguided information.

So what does the IRS say about their audit selection tools and methods?  First, they tell us there is a computer scoring system called “Discriminant Inventory Function System” (DIF).  This system looks at your return and compares your return to similar returns to come up with a score for your return; the higher your score, the more likely an audit will yield a tax change.

Secondly, they use computers to match information reported on your return with information reported by third parties such as on Forms W-2, 1099, 1098, and the like.  Automatic notices can be generated as a result of mismatched items.

Third, they admit to using a variety of other tactics and resources such as the internet, newspapers, and other public information, or even people who may file a complaint or “squeal” on you.  They say they will investigate these sources for reliability before using it for an examination.

They also have the right to contact third parties about you, such as neighbors, co-workers, bankers, etc. Generally they have to inform you if they contact someone else unless they feel it would jeopardize their ability to collect the tax or that you might retaliate against the individual.

Although I have not seen this written as a tactic employed, I am aware of a situation where the IRS was selecting returns because they were prepared by a particular tax professional in a particular industry (and no, it wasn’t me!).

In addition there have been various programs over the years such as the Taxpayer Compliance Measurement Program and the more current National Research Program which introduces a random statistical selection methodology.  One of the uses for the information gathered in this program is to fine-tune the DIF computer scoring system.  It also means that ANYONE can be audited.

In two weeks we will discuss “red flags.”

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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What are Your Chances of Being Audited? Part I – Audit Statistics

Originally published in the Cedar Street Times

May 16, 2014

I have a diverse base of clients, but there is one thing that many of them have in common: they all know the phrase, “…but I don’t want to raise any red flags.”  The part prior to the “but” generally explains how he or she wants to push the limits and minimize the tax liability.  Then I let them in on a little secret, “Did you know the IRS is partially color blind?”

I say this because a component of audit selection is a random statistical process whereupon everyone gets a chance to spin the audit wheel.  But the majority of returns are selected for audit because of, well, “red flags.”  In this issue I will speak about some of the juicy numbers of audit likelihood, and in two weeks, we will discuss some of the methods of selection and possible red flags.

Looking back over the past 16 years of data released by the IRS, you will probably find comfort in knowing that the overall audit selection rate for individuals has generally been close to or under one percent.  In 2013 there were 1,404,931 audits on the 145,819,388 tax returns filed, or a 0.96 percent audit rate!  When most people think of an audit, however, they think of having to meet with a beady-eyed pencil pusher whose sole mission in life is to cause them stress and shake down every last dime out of their pocket.  In reality, only about 25 percent of those audited actually meet with an auditor in a “field audit.”  So now your odds are only 1 out of every 424 people!

The majority of the audits are handled by correspondence mail, and are generally very narrowly focused just asking you to send in supporting documentation on a limited scope of items.  It is less intrusive, but sometimes can actually be more challenging to handle since the auditors do not have to look you in the eye, and are generally hiding behind a cloak of anonymity.  It is also evident from my experience that a lack of training in tax law is prevalent by those reviewing the correspondence audits.

When people are selected for audit, they generally say, “why are they wasting their time on me, shouldn’t they be going after the bigger fish.”  What they are really saying is, “I really don’t care who they audit as long as it isn’t me!”  But to honor their words, you will find that the IRS does in fact follow the money for the most part.  The more money you make, the more likely you are to be audited according to the statistics the IRS releases.

The overall audit rate for individuals making less than $200,000 in 2013 was 0.88 percent.  For those making over $200,000 per year, the rate jumped to 3.26 percent.  And for those making over $1,000,000, the rate jumped to 10.85 percent.  The other big difference is that you are two-and-a-half more times likely to have a field audit than a correspondence audit when making over $200,000 or over $1,000,000.

The overall audit rate for business returns such as C-corporations, S-corporations and Partnerships in 2013 was 0.61 percent of the 9,938,483 returns filed.  Partnerships and S-corporations had the lowest percentage at 0.42 percent, generally since the income passes through and is taxed to the individual owners instead.  C-corporation audit rates, however, vary even more drastically than individual rates – small corporations with less than $10 million in assets had a 0.95 percent audit rate.  Corporations with $10 million to $50 million in assets had a 6.98 percent audit rate, $50 million to $100 million – 15.51 percent, $100 – $250 million – 19.43 percent, and one out of every three corporations with assets over $250 million were audited!  So yes, the IRS does go after the big fish!

Clients will sometimes receive threatening letters indicating that if they do not respond by a certain date, that liens could be placed or their assets could be seized.  I have always found “seizure” to be an overly aggressive choice of words at the early juncture these letters will often arrive, and it is telling that only 547 IRS seizures occurred in the entire country in 2013.

Finally, another interesting statistic for those that find it thrilling to not report income (a.k.a. tax evasion); if you ever have a Special Agent from the Treasury Department show up at your door, I suggest you take that seriously.  They are basically your beady-eyed pencil pushers…but with guns!   There were 4,364 criminal investigation prosecutions recommended in 2013…and the conviction rate was 93.1 percent.  The average sentence for tax and tax related cases was 31 months in prison.  Remember, avoiding taxes through planning, is fine, but evading taxes is a place you never want to be!

Given all these statistics, you may also find it interesting to know that the IRS budget has been cut by close to five percent for 2014, and they have the fewest number of employees in the past 16 years.  I am not sure this is really a good thing, as it will surely reduce the number of qualified individuals trying to wield an already overburdened system, but it will likely mean your risk of audit will be even lower.

In two weeks we will talk more about red flags and audit selection.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Filing an Amended Tax Return

Originally published in the Cedar Street Times

May 2, 2014

It’s May!  The sun is shining and the grass is green.  There is plenty of daylight in the evenings and summer is just around the corner.  You even have your tax returns complete.  Things are looking good!  As you mosey out to the mailbox and pull out today’s haul, you see a letter with an unusually interesting stamp, one kind of like your dad used to collect…then it hits you, “Wait a minute, did I claim the deduction for donating Dad’s stamp collection to the museum!  I even spent $300 on the appraisal, and I completely forgot about it!  And my taxes are already done!”

Fortunately for the hypothetical you as well as everyone else, there is a cure-all remedy elixir called an amendment.

The Internal Revenue Service (IRS) provides form 1040X and the California Franchise Tax Board (FTB) provides form 540X to facilitate this process for individuals.  The ‘X’ comes from the fact that you must be eXtra crazy to want to do your taxes again.  Actually, I have no idea where the ‘X’ comes from, but it is probably rooted in something – just like 401(k) plans.  Many people don’t realize 401(k) is simply the Internal Revenue Code Section that lays down the rules for that particular type of retirement plan.  Somebody was not having a creative day when they came up with that one.  But I digress…

The IRS version and the FTB version of amendments follow a similar format with a column of the original amounts reported, a column for the net change, and a revised column.  They do not cover all lines in the tax returns, however, but selected key lines as well as subtotals for other things.   Any affected schedules and statements are re-prepared in full in the corrected manner and attached to the returns.  The returns must be paper filed, and if there are changes to amounts reported for tax withholdings, the physical copies of the forms showing the withholdings must be attached.

Simple math errors are generally corrected by the taxing authority computer systems, and a change letter is sent automatically, so you generally don’t have to file an amendment if for some reason you noticed an arithmetic error on the return.  With computer tax preparation so prevalent, it is rare to see this unless the return is hand-prepared.  As a side note of interest, every client hand-prepared return I have re-prepared in the past ten years, aside from something basic like a single person with a W-2 or a pension, has had preparation errors – a tribute to the complexity of our tax code today.

If you missed something large and underreported your taxable income significantly, it is to your benefit to amend as soon as possible as interest and penalties will continue to grow.  You could also be assessed a 20 percent accuracy related penalty.

The IRS generally gives you three years to file an amendment and the FTB gives you four years.  More specifically and to illustrate, if you filed your 2013 1040 return on or before April 15, 2014, you have until April 15, 2017 to file your 1040X amended tax return.  If you filed for an automatic extension until October 15, then you have until the earlier of 1) three years from the date you actually file the return or 2) three years from October 15.  If however, you are delinquent on paying the tax you owe, and you have an outstanding balance that carries on for a period of time, that time frame could be extended as you have at least two years (one for California) after the date you actually pay the tax to file an amendment.

After filing an amendment, don’t hold your breath waiting for a response, as it typically takes two or three months to process the returns.  If you are curious, however, you can check the status of your return at http://www.irs.gov.

I have worked with quite a number of people over the years where we have gone back to file amended tax returns to claim missed deductions from the past and obtain a refund.  If the amendment can yield a greater refund than the cost of preparing the amendment, it is certainly worth considering!

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.