Archive for the ‘audit’ 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.

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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.

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.

Property Taxes on Equipment, Furniture, Tools, Etc. Due April 1

Originally published in the Cedar Street Times

March 7, 2014

Many people starting up a small business for the first time are surprised to learn that there are business personal property taxes due each year on the value of everything from the chair they sit in, to their computer, to the pads of paper in the supply closet.  Most people are familiar with property taxes assessed on their home each year, but a business is also taxed on all of its personal property.  When I say personal property, I mean anything that is tangible, but is not real property (real estate).  Intangible assets like copyrights, patents, goodwill, or even software are generally not subject to tax.

This business property tax is established in the California Constitution and the Revenue and Taxation Code.  It falls under the jurisdiction of the California Board of Equalization (the same group that handles sales tax), but it is administered by and filed with the assessor’s office of each county.  For most businesses, the form to file is BOE-571-L (BOE-571-A for agricultural businesses), and it is due on April 1st of each year.  Even though the form is due on April 1st, there is a grace period, and you technically have until May 7th to postmark the form so it will not be delinquent.  (This is much appreciated by CPAs that are working to get income tax returns completed by April 15!)  It is also important to note that the reporting covers your property that existed as of January 1st, and not as of the date you fill out the form.

Maybe you have been in a business for a few years, or maybe 20 years in unusual cases and have never seen a request for this form.  Are you in trouble?  There is an interesting rule that states if the total cost of your business personal property is under $100,000, you do not have to voluntarily start filing the form.  That would cover a lot of small businesses.  However, if you receive a request from the assessor’s office to file the form, you must file every year going forward.  As information sharing has become more mainstream among various government agencies, it is fairly common to get a request in the first year or two you operate, even as a tiny sole proprietor.

The BOE-571-L asks you to break down your property into various categories and by year of purchase.   As the property gets older, it is assessed less each year.  (Tip: retain a copy of your submitted form for reference when filing for the next year.)  Each form is processed by hand.  The assessors appreciate having attached lists that identify more specifically the property you list in the various categories and years.  As you will see on the form, it is not always clear which category to put things in.  For instance, the word equipment is used in four different categories, and you might not be sure where it should be included.  Categories are assessed and depreciated at different rates, so the assessor has a better chance of assessing you the correct tax if you provide more information.  If you have questions, you can call the Monterey County Assessor’s office at 831-755-5035 and ask for the business property tax department.  They are generally available to answer any questions you may have.

It is probably fairly obvious that computers, printers, copiers, furniture, equipment, machinery, and tools are assessed.  In addition, the supplies you have on hand for your business are assessed.  If you do not have a good idea of this value, one approach, or instance, may be to take your office supplies account in your accounting records and divide by 12 if you think you keep about a month of supplies on hand.

Leased property such as a copy machine, is an area that people sometimes overlook.  Your lease agreement will indicate whether you, or the company you lease from is responsible for the property taxes.  If you are responsible, you need to report it on your BOE-571-L.  Licensed vehicles through the Department of Motor Vehicles (DMV) do not need to be reported here whether owned or leased, as they are being taxed through the DMV.

Structural improvements, fixtures, land improvements, construction in progress, and land development are required on the form as well.  Generally, however, structural improvements, land improvements, and land development information is not assessed by the business property tax division and is passed along to the real property division for them to decide whether or not to assess it, or wait for the next time the property as a whole is assessed. Construction in progress would be assessed by the business property tax department: i.e. – you have spent $200,000 in construction on a building that is not complete at the end of the year.  Once the building was completed, the business property tax department would stop assessing it, and the real property department would start assessing it.

Fixtures such as counters, sinks, lights, bolted down equipment, etc. would generally be assessed by the business property tax department.  If you are a tenant and pay for any leasehold improvements, you should report and will be assessed on those as well.  Most leases are written that the property becomes the landlord’s after the tenant moves out of the space.

One final issue that often comes up in an audit is whether or not the business has property that was purchased and immediately expensed on its books and tax returns, and therefore do not show up on depreciation schedules, which is often the main source for reportable property.  In the code, there is no immateriality exclusion for something as small as a stapler, but in practice the auditor is not going to assess you on those items.  You should look for more significant items, however, such as the $400 in books you bought for your business library.

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.

IRS Affected by Government Shutdown

Originally published in the Cedar Street Times

October 4, 2013

Due to the inability of Congress to come to terms regarding the government shutdown (or just about anything for that matter), I have a pretty good chance that this article will still be worth reading by the time it is published in the newspaper on Friday!

Everyone is aware by now that over 800,000 federal employees are on furlough. I read that this is more than all the employees of Target, General Motors, Exxon, and Google combined.  That is a lot of people!  Included in these 800,000 are most of the Internal Revenue Service employees.

Many of you may be cheering right now, but certainly not anyone that is waiting on a refund or currently trying to work out any problems with the IRS.  Prior to the furlough, telephone wait times to speak with an IRS agent have been 15 – 45 minutes, or sometimes you would get the message that they were too busy to even put you on hold, and then hang up on you.  Right now you will have an indefinite wait since the call centers are completely closed.  All local IRS offices are also closed to the public as well.  The shutdown will of course put even more pressure on wait times when funding is restored, and there is a backlog of problems to resolve.

This is an interesting time to be shutdown considering that extended personal tax returns are due on October 15.  The IRS still expects individuals and businesses to file all tax returns on time, keep making income and payroll tax payments, etc.  Presumably, they have some essential employees still on-the-clock to let the mailman in and to make deposits!  They are encouraging electronic filing since those returns are processed automatically by computers.  Paper returns will not be processed, however any payments enclosed will still be processed!  All tax refunds are suspended until normal operations resume.

Computer generated IRS notices will continue to be mailed out, but all audits, appeals, and taxpayer advocate cases are suspended.  If you had meetings scheduled they will be rescheduled.

The IRS website will still be up and running, but certain services may be unavailable.  The IRS automated telephone system will also still be working (800) 829-1040.

I can only assume that penalties and interest will still accrue even if you are waiting on the IRS to resolve an issue.

I called the IRS employee emergency hotline for kicks.  They are informing employees that they cannot perform any work, even if they want to volunteer their time to keep certain cases moving, and they cannot use any government computers, equipment, or other resources.  If they were en route traveling when the furlough began, they were to immediately return home.

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.