While there is no way to know the exact audit formula for the Internal Revenue Service, there are certain items that we often see the result in IRS audits and items that often become the focus of audits once an IRS agent is involved. IRS audits are costly since they always require a substantial amount of time and effort, and usually, they also require paying for representation.
Since the burden of proof is on the taxpayer, individuals who are audited are ‘guilty until proven innocent’ and can face difficulty in providing all the support on a timely basis to the IRS auditor, even when everything has been reported accurately on the tax return. Therefore, it’s important that you or your tax preparer are doing everything possible to avoid a costly audit by minimizing potential triggers or exposure that attract attention during an IRS audit.
1. Minimize Filing Amended Returns
One of the most common events that we see results in an IRS audit is filing an amended return that substantially decreases taxable income and requests a significant refund. Unlike the original filing of your tax return, an amended return is not automatically processed. Instead, it is handled by an individual person working for the IRS. This is usually the reason that the amended return processing time is much slower than the processing of an original or superseded return (an updated return timely filed after the original).
Sometimes filing an amended return is necessary. It is possible new information was discovered much later or there was an inadvertent mistake made, but if you can prevent these situations from arising, then you should. One reason we often see taxpayers filing amended returns is because they wait too long to organize their documents or they delay working with their tax preparer, which increases the likelihood that a mistake is made last minute.
Why does the IRS audit amended returns?
A potential reason we see an increased likelihood of tax audit on amended returns is because there may be an expectation that a taxpayer who made mistakes on his or her original return may have additional math errors on the amended return. In addition, often we see amended returns with minimal or unclear explanations of the changes made from original to amended. Since an individual at the IRS is looking at the return, that person may decide to forward the return for audit since the changes might look inaccurate.
So, if you are filing an amended return, make sure you have your audit file ready at the time of return preparation, showing the changes and supporting information. You want to make it easy for the IRS agent to understand the changes and close the audit.
2. Keep Information Consistent Across Tax Years
Consistent tax positions across tax years not only protect your credibility as a taxpayer if you are under an IRS audit, but it also prevents a duty of consistency argument by the IRS.
The duty of consistency is a doctrine developed by case law that is very well established and accepted by courts. As an overview, it allows the IRS to successfully argue that if you meet certain elements, even if you as the taxpayer switch from an incorrect tax position to a correct one, then you must stick with your original, incorrect tax position and accept the resulting tax consequences from it.
The duty of consistency elements are:
1. You made a representation for tax purposes in one tax year on your tax return
2. Internal Revenue Service reliance on the representation
3. You changed the representation in a future year after the statute of limitations for the first year closed, and the change was detrimental to the IRS
These elements are not too difficult to meet:
- Under Element 1, making a representation essentially means that you put a tax item on your return, such as reporting an item as income or an asset.
- Under Element 2, IRS reliance can be a passive act and often just means the IRS accepted and processed the tax return.
- Under Element 3, usually, three years have passed since the original position was made and the change would usually decrease your tax.
As an example, one taxpayer we represented reported his capital contributions to a partnership on the balance sheet as a loan. However, it was clearly not a loan – there was no loan document, no interest rate, no payments, no maturity date, and no expectation to be repaid. Upon his exit from the partnership, the contributions reported as a loan were removed from the balance sheet since the remaining owner was not expected to pay it back.
The IRS tax position was that it was a cancellation of debt income because it met the elements of the duty of consistency. The taxpayer had chosen to report the capital contributions as a loan on the balance sheet, the IRS accepted the returns, and the original return with the loan was outside the statute of limitations. Since the change from loan to capital contributions would decrease income since capital contributions do not create cancellation of debt income, the change was detrimental to the IRS. Therefore, due to lack of consistency, which was foreseeable the way that the original contribution was reported, the taxpayer was left with substantial exposure during the IRS audit.
3. Report Virtual Currency Transaction Activity
The Internal Revenue Service has shown a substantial interest in virtual currency tax reporting. The individual tax return Form 1040 now has a question about virtual currency near the top of the first page, placed just after entering your address on the return. Since Congress is in the process of passing additional cryptocurrency reporting requirements, the IRS will be utilizing the additional records and information available to review returns that they believe may not have reported virtual currency transactions.
Because virtual currency tax basis can be difficult to track, an audit regarding cryptocurrency can leave many taxpayers with a higher amount of tax assessed than required under tax law because it is a taxpayer burden to show tax basis. Usually, the IRS will assume a $0 tax basis unless you can show otherwise. The increased reporting from third parties will likely not have accurate tax basis information because it will not be information that the third party has, depending on how you have been transacting your virtual currency.
If you’re looking for more information on how to report your virtual currency, we take a deeper dive on a separate article here: Is My Cryptocurrency Taxable? 9 Tips for Smart Trading.
4. File Timely to Begin the IRS Audit Statute of Limitations
The IRS cannot audit you if your return is outside the statute of limitations, and the statute of limitations does not begin until you have filed your return. The usual statute of limitations is three years from filing. So, the sooner you file your return, the sooner the statute of limitations is closed and you’re safe from IRS audit.
5. Report All Tax Forms on Your IRS Account, Even Improperly Issued Tax Documents
The IRS has a matching system that automatically generates notices auditing and increases your taxable income if there is a mismatch. We expect this matching system to begin picking up virtual currency mismatches once Congress increases the third-party reporting requirements. It’s also very common for taxpayers to have a mismatch from a 1099-R from a 401k or IRA withdrawal that they forgot about. We saw many more IRA withdrawals during 2020, and with the Covid rules minimizing tax and penalties on IRA account payouts in 2020, it’s even more important that you report the form properly on your original return.
We also often see taxpayers receive an inaccurate tax document, like an improperly issued 1099-MISC from a disgruntled ex-business partner. However, instead of leaving it off the return and waiting for the IRS notice or audit, another option is to report it, fix the error, and disclose your tax position clearly.
We discuss more details on how to keep the IRS out of your life and avoid the notices generated from a mismatch in our article here: How to Keep the IRS Out of Your Life: The Secret is in Your IRS Transcripts.
6. Minimize Repeat Schedule C and Schedule F Losses
Based on IRS audits we will see, it appears that the IRS does a good job tracking repeat losses on Schedule C and Schedule F. This is likely because the IRS is looking out for businesses that are either truly hobbies or businesses that are underreporting income or overreporting deductions.
In fact, often Schedule C audits result in the IRS catching improperly claimed Tax Credits, discussed further under #9 of this article, because Schedule C losses will contribute to an increased Earned Income Tax Credit (EITC). This is a strategy that some bad tax return preparers, referenced in #10 of this article, use to increase their client’s refund (sometimes unknown by the client), so they can charge more for the return. As a result, IRS audit exposure can be substantially increased in these situations.
7. Keep Extensive Net Operating Loss Support in Your Workpapers
Even though the IRS audit statute of limitations discussed under #4 of this article is expired, this is not the case for net operating losses (NOLs) generating from a year outside the statute of limitations, but impacting a current tax year. For example, if you had an NOL from 10 years ago, even though the IRS cannot audit your return from 10 years ago, they can question the information on that return to argue there should not be a current-day NOL carryover onto the tax returns within the most recent three years.
This is why it is crucial to keep thorough support for net operating losses. NOLs are often the first item questioned on a tax return, especially when the number is substantial. It’s also very common for us to see the supporting information disorganized or misplaced since it is usually from older years.
8. Keep Mileage Support for 100% Business Use Vehicles
100% business use vehicles usually qualify for accelerated bonus depreciation. In recent years, the bonus depreciation allowed is substantial, making it even more necessary to keep thorough support that the vehicle is indeed fully business use.
We always recommend utilizing technology, when possible, to make business support easier. There are very helpful mileage or other vehicle or fleet tracking software that will track the information for you.
9. Verify Qualifications for Tax Credits or Exclusions
Tax credits or exclusions allowed by statute usually have very clear requirements to be able to claim them. Often, due to defaults in the tax software or lack of due diligence from a tax preparer, we’ll see taxpayers have credits on their return for which they do not qualify. Some of these tax credits are the Earned Income Tax Credit (EITC), the American Opportunity Tax Credit (AOTC), the Health Premium Tax Credit, the Child Tax Credit, or Foreign Tax Credits or Income Exclusions.
These tax credits can come with steep penalties both for the taxpayers and for the preparers when they are generating for a taxpayer who does not qualify. Since there is often abuse of tax credits, the IRS is monitoring them and imposing the allowable penalties on inappropriately claimed credits.
10. Find a Qualified and Reputable Certified Public Accountant (CPA)
Yes, the IRS tracks bad tax return preparers. We’ve represented clients who are under IRS audit solely because their tax return was prepared by a tax preparer who is being investigated civilly or criminally by the IRS. The IRS will track certain trends among preparers, such as Schedule C losses or Tax Credits. Once the IRS is reviewing a preparer for a poorly prepared or fraudulent return, like adding false or fraudulent tax deductions, even though it is often without the knowledge of the client, often the preparer’s clients then get audited by the IRS.
In addition, when you find a qualified and reputable Certified Public Accountant (CPA) who has the right practices and procedures in place, if you do get audited, you’ll find that the preparer has a proper and complete audit file ready to present to your IRS auditor.
Is IRS Auditing During Coronavirus 2021?
While early in 2020, the Internal Revenue Service shut down and its audit activity stalled, we are seeing IRS audits move forward and open in 2021. This is only expected to increase if IRS funding is increased in 2022. We have seen more of the functions of the IRS remain remote, but that has not prevented the IRS from auditing taxpayers. If anything, it may mean that as a taxpayer you have to be more proactive to communicate your information to ensure that the IRS agent does not deny proper deductions or include funds as taxable that are not income.
What Happens if I Fail an IRS Audit?
Hire representation! If your audit with an IRS agent does not go well, you have appeal rights. But you need to make sure that you do not miss the required deadlines to appeal the decision. You will want to properly utilize the time between the initial audit and the appeal to organize your information and outline the tax position that was not successful at the IRS audit level.
CONSULT WITH AN EXPERIENCED TAX PROFESSIONAL
At DiLucci, our experienced team of tax professionals is here to help you with your individual or business tax needs, including assistance with IRS audits.
Our services include:
- Audit defense
- Individual and business accounting
- Tax return preparation
- Internal Revenue Service tax resolution
- Negotiation with Tax Court Counsel
- Business bookkeeping
- Financial analysis
- Cashflow management
- Tax planning
As always, we’re here to help. Click here to schedule a consultation with our office and we’ll follow up with you promptly.