Archive for the ‘audit selection’ Tag

What Are Your Chances of Being Audited? Part III – Red Flags

Originally published in the Cedar Street Times

June 13, 2014

Four weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS, and two weeks ago I discussed audit selection methodology.  A few of the high points from the articles were: 1) on the average, audit rates for individuals are generally less than one percent each year, and increase as you make more money, 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) the IRS does not release its exact methods of selecting audits, and many people have incorrect notions about this process, 4) the IRS does tell us audit selection is aided by a computer scoring system to help find returns that will likely yield a change; it uses computer matching to ensure information reported on 1099s by third parties matches what you report; it uses publicly available information; and it uses statistical random sampling.  The rest of this article will be devoted to “red flags.”

So what are these “red flags” everyone talks about?  One fairly obvious assumption we can make from the audit statistics released by the IRS is that they follow the money!  You are three times more likely to be audited if you make over $200,000 a year and over eleven times more likely to be audited if you make over $1,000,000 a year.  C-corporations face a similar dynamic of increasing audit rates on larger corporations – for instance, one out of every three corporations with assets over $250 million are audited.

Not reporting all your income even when it is reported to the IRS should not be a surprising red flag, but it happens frequently.  I see this most commonly with stock sales reported on a 1099-B when people prepare their own returns – they either forget, or do not understand the form.  I also see this with contract work where a 1099-Misc is issued and the individual forgets to report it.

There are a number of issues related to small businesses that raise eyebrows.  Keep this in mind – anytime there is an easy path for someone to pass-off personal expenses as business expenses, you are going to have a higher level of scrutiny.  For instance – relatively high amounts of: business automobile mileage (or claiming 100% business use on your vehicle – very rare in reality), home office deductions, meals and entertainment, or travel expenses.  All of these can be easily abused, so they are highly scrutinized.  If you are beyond the norms, you are a clearer target.

Here is another golden nugget – if your job is one that millions of people do for fun as a hobby (although perhaps not nearly as well!), then you have a higher level of audit risk, particularly if you are losing money.  Think of the arts – photography, video, music, drawing, painting, performing, etc.  Also, think of horse racing and breeding for the wealthier set.

That brings us to another “red flag,” businesses that lose money every year.  The IRS is trying to determine which of these three describes your nonprofitable business situation: 1) Are you really trying to make this successful and genuinely feel it will be profitable overall?  2)  Are you trying to deduct your personal expenses, your hobby, or keep up appearances? or 3) Are you just plain nuts?  By allowing people to continue businesses circumscribed in two and three, the rest of the country is having to foot the bill for the lost tax revenues.  This is because the “losses” generated are offsetting the person’s other income that would otherwise be taxable.  With no realistic future expectation to recuperate the losses, the IRS is ready to pounce.

Claiming rental losses in California is fairly common due to the high cost of our real estate, but claiming a real estate professional designation in combination with these losses is an area of greater concern.  If your main occupation is in the real estate related field, and you work at least 750 hours in this trade, you are allowed to deduct all of your rental losses in the year they are incurred.  Everyone else get to deduct $25,000 at most, and are rapidly phased out to no deductions for the losses based on income levels.  The losses get suspended until the property is disposed of or until there is passive gain to offset.  There are a lot of challenges when it appears the person has substantial earned income from a trade or business unrelated to real estate or if there is very little income from real estate related trades.

Refundable tax credits such as the Earned Income Tax Credit, Child Tax Credit, American Opportunity Credit (for education), and Health Care Tax Credit can also be a point of concern, particularly when the total refund on your return is higher than the tax paid in to the system!  The IRS receives thousand of fraudulent returns each year that use refundable credits to steal money from the government.

Although harder to catch, unreported foreign income is an area worth mentioning due to the extremely high penalties by the Treasury Department for failure to report foreign accounts, and it has been a hot-button issue that has raised billions in revenues.

The above is not an exhaustive list, but it does describe many commonly seen areas of concern.

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.

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.