Published March 20, 2013
While the Internal Revenue Service may be forthcoming with its rules and regulations, there is certain information the IRS simply won't tell you. I worked as an IRS agent in a former role; knowing the ins and outs of the IRS can help you win if you face an audit.
What triggers an audit?
While you can't fully protect your tax return from every examination, you should be mindful of some key tax issues when preparing your return.
Of course, some things are simply obvious audit triggers such as reporting more expenses than income. However, there are other areas to which taxpayers may not be privy.
Carl Johnson is a self-employed certified public accountant who has operated an accounting and tax practice in New Orleans for more than 15 years. He has seen his share of audits and has closed approximately 90% of them with the IRS favorably agreeing with his positions.
"Understanding what triggers an audit is key," he says. "Factors such as losses from year to year, unusual and large questionable deductions, and third-party referrals are some of the biggest factors considered when the IRS determines whether a tax return should be audited."
If you earn income through self-employment or rental income, a red flag may be embedded in your return. Unlike wage earners, sole proprietors or landlords can report income and expenses at their discretion, especially in cases where individuals receive cash or unreported payments from clients or customers.
The IRS also reviews these returns to make certain that deductions are in line with the income reported on the tax return.
"Taxpayers who have excessive deductions, (or) unreasonable and questionable expenses are likely to trigger an audit," says Johnson.
Before preparing your tax return, question whether your expenses are reasonable and customary for your line of work. For example, does your company really need to pay excessive amounts in meals and entertainment costs for a dog-trainer business? Maybe. Maybe not. Either way, your tax return has to first pass the "smell test" to ensure your return is not the lucky lottery winner of an audit.
Johnson also says underreporting income is an instant audit trigger. The IRS ensures taxpayers' compliance through its Automated Underreporter Program. The program matches income reported on the federal income tax return to information obtained from third parties, such as employers and financial institutions. If there is a mismatch, you will receive a notice from the IRS informing you of an additional tax assessment.
Although the IRS is forthcoming about its automated underreporting program, know that penalties assessed can be waived. If you have been assessed penalties and can show reasonable cause, those penalties could be removed, thus lowering your overall tax liability.
Know your rights
If you have been selected for an IRS examination, do not panic. You will have an opportunity to state your side of the case.
"It is essential for taxpayers to understand there are many ways to substantiate items on the tax return besides the basic canceled checks or receipts," Johnson says. "Taxpayers should also note (that) examiners allow reconstruction of financial documents. And in many cases, examiners will also accept, to a certain extent, oral testimony."
Johnson also adds that it is important to seek tax representation. In many cases, the IRS wants to deal directly with the taxpayer, because taxpayer representatives often stall the process. However, representatives can help you navigate through the process and may be more likely to obtain favorable results.
Let's make a deal
If you are undergoing a civil audit, know that the examiner's main objective is to close the report in a timely manner and have the taxpayer agree with the IRS positions, usually referred to as an agreed report. Management views examination groups favorably if examiners obtain agreed reports within a reasonable time period. For this reason, your examiner may be willing to negotiate certain disputed items in your favor for the purpose of obtaining an agreed report.
It is important for you to establish a good rapport with the agent and to be able to substantiate most disputed or questionable items. If you do so, the examiner may be willing to take oral testimony to prove other questionable areas.
Simply put, do not take "no" for an answer. As a former IRS agent, I know there is always a little wiggle room to reduce your tax liability. If you do not like your examination's outcome, request to have your case reviewed by the Appeals Division.
"Appeals are a viable option for a taxpayer to resolve difficulties within the IRS," Johnson says. "Sometimes, it has been my experience (that) the examination group may overlook some tax areas because of its haste to close the examination, but the taxpayer may be able to get a favorable decision through appeals."
No matter what, you have to be knowledgeable concerning your rights prior to any audit. Be persistent, and it will work out for you!
We would like to thank Kemberley Washington, CPA, assistant dean of student programs at Dillard University in New Orleans, for her contribution.
Copyright 2013, Bankrate Inc.