IRS Audit
INTERNAL REVENUE SERVICE AUDIT
If you are in business you will be audited by the IRS, sooner or later.
The easiest way is to cash a check [not your own] at a bank or financial institution [even a lowlife check cashing business] for ten grand or more. A SAR [Suspicious Activity Report form must be filed by the establishment to Homeland Security. Since the 1911 tragedy the government put in place many programs to find terrorists and money laundering. The result of all this is that when you cashed that check or deposited over $10,000 the report also goes to the Internal Revenue Service. Thus, when you get audited, one of the questions the auditor asks is "Did you report the ten grand check cashed on......." And then they will check the bank balances and compare them to your reported business income. A word of caution here. When you file your business tax return be sure that the amount of cash or funds that enter your bank account equal the top line of your tax return under REVENUE. Any differences have to be explained. The check which got you audited was part of a process where a DIF Differential Information Score is created when you file your taxes. All the information lines are compared to standards and the higher the numerical score, the better the odds of audit. Sort of like the reverse of the FICO score where high is better.
Unreported income from pensions cashed in, Social Security benefits not reported, interest income or security sales are great additions to the DIF score. Sometimes they just result in a SC 2000 letter which says they found a problem. Found money like the ten grand and business losses score big on the DIF scale and that sometimes rings bells for an audit.
MAIL AUDITS
Audits are now conducted remotely by mail. You receive an audit letter saying parts or all of your return are being audited and to send the following receipts and documents by mail to their office out of state someplace. You will never meet an auditor although I doubt the name is real and sometimes the voice is unreal. They will fight you if you file a power of attorney form to change the venue to a more friendly neighborhood. Overall, it is hard to conduct an audit by mail instead of face to face with a human. An SC 2000 correspondence audit can also be appealed although it will go directly to Tax Court.
ESTATE AUDITS
When I filed my first estate tax return to somewhere in Atlanta Georgia I had some anxious moments culminating when I received a letter from the dereaded IRS. They were thanking me for filing the return and passing the audit. What I found out at that time was that all estate and gift tax returns are audited on arrival. The other part of the audit process is to release the Probate in the courts.
OFFICE AUDITS
Most business audits are conducted in the nearby big-city IRS office. Uniquely, the FBI is usually nearby, hidden around the corner. The audit is generated by the high DIF score mentioned above. Most of the auditors are ordinary people with a lousy job. Many have college degrees but not Accounting degrees. If they survive for five years they can become Enrolled Agents of the Treasury, like me.
That is a long time. I took tests to shorten it. They go though a laundry check list of everything bad [tax evasive items] that you ever heard of. When you survive the list the interrogation ensues. They sometimes just audit a few major items like travel expense, or why your sales are less than the bank statements you brought [and maybe the net profit is less than the statistical score the DIF compared it to for your type of business]. Now they run it all into a computer which has your tax return in it, before in the good old days they would go to a central computer and fight it for a half hour, to get new results from the audit. You have the option of agreeing with the results or taking it home with you. Sometimes they discuss the audit differences and mail you the completed schedules with penalties and interest and more penalties. There is also an opportunity to argue mildly with the auditor while you have him in front of you and you are offered an opportunity to mail or discuss the audit after you escape to your home or business. Within a week or two after the formalities you will receive the audit and tax results. At that time you can sign it and pay, ignore it and hope the Good Fairy will make it go away, or appeal it to the Office Audit Supervisor [who has reviewed the audit anyway].
I have never had any luck with office supervision and sometimes they hide and never show up anyway. Finally, you will receive a 30 day letter which gives you a whole month to pay or appeal further to the Federal Tax Court. Always be respectful to your auditor, they have brains and a heart, just like you.
FIELD AUDITS
These auditors are paid better because they wear better suits, hold accounting degrees, and come to your place of business. They are very serious and prepared. Most times they come in pairs with one either in training or reinforcement. They conduct large audits and especially corporate audits. They now have laptop computers [same as office audit people] and your tax return now lives in there someplace. They will also visit your place of residence to see if you are living better than your tax returns show, and are highly professional. Worst of all, they are not in a hurry like their four-hour office audit counterparts. These guys can qualify for both the Enrolled Agent and CPA designations after five years because of their audit experience. Many college graduates work at this level to get the experience and move on to a less stressful job.
The routine is the same as office audits about matching documents to the returns except that the businesses are usually larger and the results take much longer. The appeal process is the same. Don’t expect their supervisor to change the audit results for you.
FRANCHISE TAX AUDITS
Like the Tooth Fairy, there are no auditors visiting from this agency.
They do most of their business by mail, however. Firsthand, every time the IRS or any other state tax agency audits and finds something worthwhile, there is a reciprocal agreement between these agencies and the IRS to share data. Thus, your Sales Tax or IRS audit, upon completion or settlement, results in a corresponding demand letter from the FTB. If you have been through an audit or paid additional taxes from an IRS SC2000 letter, it would be a good idea to amend the California 540 return for that year to avoid penalties. There will be additional interest and the taxes due but it is usually cheaper.
California, with their budget excess nightmare, is always searching for new revenue. One source is presumed income, which I call PI. If you hold a professional license such as Realtor, stockbroker, etc. and suddenly retire or have a stroke and can’t work another day, you may not file another tax return. The FTB computer tells the collection department that you have not filed and their computer sends out a bill for the tax equivalent [in thousands] of whatever average net income for people of your profession earn when they file. This tends to be about $35,000 taxable the way they do it. As a result you receive a tax bill for thousands because you didn’t file. This requires a letter on your part to advise them that there really was no income after all.
Another trick is to wait four years for a refund. As a rule, tax refunds, both state and federal, are not made after three filed tax years. That means, if you file five years back taxes, because maybe you have been out of the country with the Peace Corps, and file for your refunds, they will only pay the recent three and keep the oldest two.
Well, I have seen inquiries from California whereas they had estimates or other unclaimed tax money on file for four years past. They then ask you if it is your money, you respond “yes. Please send the check. My rent it due.” and then they re-respond, “thanks,” and keep it.
PAYROLL AUDITS
These audits are performed by various agencies. There are the Workman’s Compensation people who base their fees on the various payroll classifications and amounts paid. They also audit for non-payroll people lurking on the premises but have been omitted mysteriously from the payroll figures. Overall, without even considering medical benefits, the WC insurance plus federal payroll taxes plus Social Security taxes plus state & Federal Unemployment Taxes can easily equal an additional 1/3 times gross payroll. The easiest way to go bankrupt or out of business is to have an employee, who is not declared an employee, file a W/C or U/I claim. The numbers are big and the government agencies are looking. Also remember that California is the place where injured employees drop off at the lawyer’s office on the way to the clinic.
INTERNAL REVENUE SERVICE PAYROLL AUDITS
The IRS doesn’t really do payroll tax audits although their computers are smarter and more accurate than most returns filed by doityourselfers. They are remarkably responsive to unpaid payroll taxes. called trust fund taxes, which are the sum of the withheld wage taxes plus the other taxes. If you mail a payroll report to the IRS without prepayment or a check, a Special Agent will visit your place of business to see if you wish to continue in business without paying taxes. They also will attach and lien your bank account in a minute without notice. Their concern is real because 1099 form people and unpaid payroll taxes is a big issue in our controlled economy.
SALES TAX AUDITS
The California State Board of Equalization tries to audit most retailers for sales tax not reported on taxable sales. They will also audit general contractors and manufacturers to verify that taxes are paid on purchases as well as applicable sales.
Contractors and construction manufacturers pay taxes at source [have you ever noticed that there is no sales tax on a new or used house or building] instead of charging at retail. I was involved in a big audit of a manufacturer who had bought a corporate business which manufactured construction materials. The client had purchased the privately held stock in the manufacturing corporation, instead of purchasing the assets and folding the business structure. Thus, when the auditors found that all materials were bought for resale [no taxes paid] for many years, the new owner was stuck with a huge six figure bill. His only choice was to pay it or to fold the business. The BOE can and will lien all assets of the business in the collection process.
Other sales tax audits are based on taxable sales which somehow vanish from sales tax reports from retailers and restaurants. The BOE solution is to carefully make a shelf test of the markup on items right off the shelf or menu, and compare purchases. If the purchases, minus a small wastage or theft loss, indicates much larger sales, then the business gets the bill which includes various penalties and will cover two or three years. Then, because California is always trying to balance the budget, they notify the Franchise Tax board because unreported taxable sales are also unreported taxable income. The only defenses are to report all income or make some of the purchases go away.
A local feed store sold barn loads of hay at discounts every week. Everybody with horses to feed came there because he didn’t charge sales tax. He had been told by his bookkeeping service that hay was consumed by animals thus not subject to tax. The inevitable audit would have excluded pig food if they had eaten hay, or cattle if they didn’t have a better source which they did in pasture, but horse food didn’t pass. The owner got the huge bill and went out of business.
There are also use taxes which are items subject to sales tax. These items can be items consumed by a business [your business makes furniture and employees are given items as bonuses but no taxes are paid or patio furniture bought by employees as a payroll deduction without sales tax], or ant spray used by a retail store. With the advent of the internet many items are purchased on line and do not charge sales tax [this makes the shipping charge seem more reasonable]. The BOE would like to collect that sales tax and added a line to most individual 540 tax returns whereas you could report this item and add the tax to the other total. Now, businesses of any kind doing over $100,000 in annual sales must file an electronic sales tax return to report sales use tax on items acquired during the year for business on which sales tax was not paid. This was initiated a year ago with a requirement for three years taxes complete with penalty lines for filing late.
LABOR BOARD AUDITS
Like the IRS payroll audits, this one doesn’t happen. What does happen is that an employee or 1099 form person files with the US Dept of Labor for unpaid wages. The employer receives a copy of the complaint with a date to appear. At that time you, the employer, is expected to produce payroll records showing the employee is wrong. This is a reason to keep good records. Even in a small office where everybody is close and may even go home at the same time when the office closes. Not everybody can be trusted, so keep accurate time keeping records and have employees sign off for their hours each week or pay period. Time clocks make honest employees. If an employee quits or gets fired he or her can file a claim stating they worked every lunch hour and left an hour late at night. The burden of proof is on you and you lose if you can’t prove it.
Like all other matters of government, all agency matters can be appealed. A payroll unemployment disallowed claim was appealed and I attended the court session with the client. The judge was very fair and a good listener. She gave a favorable decision to the client who was able to receive further benefits.
NON EMPLOYEE EMPLOYEES
One object of payroll audits is to find the employees who aren’t on the wage reports. There is a laundry list from both the IRS and WC people which states that people who work with your equipment, your supervision, your tools, your place of business, [notice the word usage of YOUR here] and don’t have a profit/loss motive, are employees not neighbors. I saw a trucking company go out of business when a 1099 form person filed for unemployment and the government showed the driver was driving someone else’s equipment cross country to someone else’s clients, etc…
IRS TAXPAYER COMPLIANCE OR MEASUREMENT AUDITS
These audits gather statistical base data for comparison purposes in future audits. The taxpayers are selectively picked by industry [think optometrist] and a hundred or more of these businesses are audited to see where the hidden money and problems lie. The audits are extremely introspective into every aspect of a person’s life [let's see the birth certificates of the dependents and your marriage certificate]. For the better part of a year they will intrude into everything that could possibly touch on your tax returns. When it is over you will need the non-deductible vacation far away to recover. One of these poor souls was harassed so unreal that I had to complain to another IRS agency for relief.
MORE ABOUT IRS AUDITS
A client recently asked about a letter audit resulting in an item audit subsequent year due to tip income controversy by independent DIF score. The government has a very narrow vision on audit rears. They usually audit two calender years back and ask you to bring the prior year and later years tax returns with you. Sometimes they look at them, but if there is nothing egregious, they pass. The computer randomly picks audits depending on the DIF score, so it is possible to have two years audited separately if the same audit bell is rung. An example would be a huge number for charitable contributions or a never-ending losing business [hobby loss?]. If there is a no-change audit result they cannot audit the same item in the next year. I have had this happen where the client got another audit letter after we successfully beat back an audit. A call to the auditor called it off.]
Sometimes a taxpayer is overwhelmed by an audit and asks the auditor for assistance. The auditor provides a list of local Enrolled Agents, like myself, to contact for representation. As a result we have many clients we have met during their audit. They remain clients for many years afterward. This comes about because the Enrolled Agents are better qualified than most tax preparers and are specially licensed by the Treasury to do what we do best. There is no favoritism between auditors and Enrolled Agents. Some of my audits went on to Tax Court Appeals. It may seem that I spend all my time in audits but with my small practice I have only one or two a year. I have won the last office audit with a ‘no change result’ and also my last recent Tax Court Appeal [which was about real estate].
SUCCESSFUL CORPORATIONS AND CORPORATE AUDITS
Corporate audits are very complicated and involved. We once had a small room in our offices for the auditors so they had privacy. Corporations require a complete set of books and financial statements for the returns. We find over the years that they cycle through all kinds of audits and we have an opportunity to advise our clients on a regular basis to maintain healthy business practices and keep out of trouble.
Some of them are immensely successful but many have fallen away during the years. I have found that the most successful businesses are very conservatively managed, have good support [usually close family] and enough fear of the Government to keep honest. They treat employees as long-term partners and deal fairly with clients and other professionals.
They are also intelligent enough to bend with the times without breaking, and conservative enough to keep out of debt. Overall, they would make great Americans for a business model.