IRS auditors are trained to spot common types of deception and attempts to defraud Uncle Sam.
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IRS auditor look for these acts, called “badges of fraud”, during an audit of a taxpayer’s income tax return. The IRS expects to find a few errors on a tax return. Examiners are not surprised when they see loose or inaccurate interpretations of the tax code, after all, it’s not like the tax code is consistent or easy to understand.
A little bit of fudging here or there is not going to send a taxpayer to jail—it might not even raise an eyebrow. During the course of the audit, errors will be corrected, deductions will be disallowed, unreported income added, and a new tax liability will arise possibly including a few penalties as well as interest. No badges of fraud there, not during a run of the mill tax audit of honest taxpayers.
A new client once came to me saying she had made an error in preparing her tax return and inadvertently took a deduction to which she was not entitled. “Will I go to jail if I’m audited?” The answer of course, is no. If that were the case, you might as well surround the country in barbed wire and imprison all of us. After all, I’m sure almost everyone in this country has made an error or misunderstood a tax law and claimed a deduction they shouldn’t have or failed to report some income because the reporting document got lost in the mail or misplaced. It happens.
But some folks go too far. Their tax returns read like a fiction novel. Therefore, IRS auditors have been trained to spot the “tells” of dishonest taxpayers. Even then, I have seen cases on the verge of going to the Criminal Investigation Division (CID) but the referral was rescinded when the taxpayer came clean.
Here are the Badges of Fraud auditors look for during the course of an examination:
When it comes to income, the auditor asks for all of your bank statements from all accounts. They will match bank deposits to income declared on the tax return. If you have bank deposits from unexplained sources, eyebrows will rise.
Auditors will also look for concealment of bank accounts, brokerage accounts and other property. I recall a taxpayer who tried to hide a bank account but the auditor saw a transfer on his personal checking account statement from that account and ordered him to bring in the statements. It was in that account that he had deposited unreported income. This resulted in a hefty tax bill and a substantial negligence penalty as well as an audit of all other open tax years. If fraud exists, the IRS can go back six years rather than three to uncover fraud and assess additional taxes and penalties.
When the auditor peruses a taxpayer’s bank statements, he also checks for an excess of personal expenditures. If you are spending $100,000 per year and only making $50,000 per year, the auditor will believe you are omitting an entire income stream from your tax return.
He also becomes suspicious if you deposit income from business sales into a personal account. It’s wise to always deposit business proceeds to the business account then transfer money to your personal account.
The auditor is also trained to detect unexplained increases in net worth, especially over a period of years.
If you fudge in the area of expenses or deductions, it could be explained as simply making a best estimate rather than totaling receipts. But if there is a substantial overstatement of deductions, it will set off alarms. Some taxpayers attempt to deduct personal expenses as business expenses or claim fictitious deductions. This will only cause an auditor to dig deeper and possibly want to open other tax years for examination.
If you are self-employed, the auditor may cut the audit short if you keep a good set of books on a computerized software system or a set of books maintained by an outside bookkeeping service or accounting firm. But if you do not keep books, or the auditor discovers that you are keeping two sets of books, you will subject yourself to more scrutiny. Other badges of fraud in this area include false entries, backdated or postdated documents and false invoices. And of course if you refuse to make records available or if your books and records don’t match income and expenses reported on the tax return you will send up a red flag.
Sometimes a taxpayer will make allocations of income that are not appropriate. For example: a distribution of profits to fictitious partners or shareholders, or including your income or deductions in the return of a related taxpayer to optimize your own tax liability. Not a good thing to do.
And of course, the auditor will keep an eye on your behavior. Always tell the truth. If you get caught in a lie, well… remember the little boy who cried wolf? Once you damage your credibility, the auditor will rely more on documentation and will not want to let anything slide.
Don’t provoke the bear by attempting to hinder the examination or by refusing to answer pertinent questions. If you repeatedly cancel appointments or refuse to provide records, the auditor will become more suspicious. Bite the bullet and comply.
Another badge of fraud includes testimony of employees regarding irregular or illegal business practices of the taxpayer.
Never destroy books and records. This will not stop an audit, it will just make it that much more expensive when you must request copies of bank statements and cancelled checks and reconstruct everything in order to satisfy the auditor.
Auditors also look for the transfer of assets for purposes of concealment or diversion of funds and/or assets by officials or trustees. They can tap into public records and DMV in order to discover assets you may attempt to hide.
Other badges of fraud include the use of false Social Security numbers, and submission of false Form W-4.
Last but not least: do not attempt to bribe the auditor. This one could land you in jail!
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.