Napier & Company, LCC

On November 3, 2005 the IRS announced that the number of tax-return audits in 2005 increased by over 20% to 1.22 million, the highest number in seven years. Audits of high-income individuals, those with salaries more than $100,000, reached their highest levels in 10 years. Audits of small corporations more than doubled, and audits of corporations with assets of over $10 million increased 14%. Due to these increasing numbers, we thought it wise to share some audit tips and information to our clients and friends.

There are three categories of taxpayers most likely to be audited: people in cash businesses, certain professionals, and people taking unusually large deductions.

• Cash businesses are easy targets for the IRS. Many people in these businesses don’t declare all their income, and the IRS knows it. If, for example, your occupation is listed as a hairdresser, water or bartender, it may raise a red flag. If you regularly receive cash for your work, be sure to report all the money you earn, including tips.
• Professionals, such as doctors, lawyers, and accountants are also targeted. That’s because they generally run their business and do their own bookkeeping.
• Large, unusual deductions are easily picked up by the IRS computers. Although these deductions may be justified, they may still raise a red flag.

Other red flags include the home-office deduction, taxpayers with self-employment income, rentals, and other business losses, and large contributions to charity. The IRS has begun to implement a K-1 matching program, which compares the K-1s included with partnership and s-corporation tax returns to the income claimed on the individual’s tax return. The IRS also looks at the overall income versus expenses of the taxpayer (or taxpayers if married filing joint). If the income doesn’t look like it can support the overall expenses (business, medical, real estate taxes, mortgage, etc) then they may decide to look further into the taxpayer’s situation, causing an audit.

A way to decrease your chance of an audit includes sending attachments with your tax return to back up your claims. For example, if you donate a large fair market value object to a recognized charity, attached the receipt to the tax return. If you have large capital gains or losses on Schedule D, attached the statement from your broker backing up your numbers. For those taxpayers who electronically file, you too can send in information to back up your tax return. The IRS recommends you mail in your backup after you electronically file your tax return. Indicate on the documents that your tax return was electronically filed but the attached is the documentation for backup.

If you are notified that you will be audited, take it seriously but don’t panic. First, read the letter from the IRS carefully and figure out what you are being asked to do. There are three basic types of audits, and the letter will explain which one applies to you:

• A Correspondence Audit is for minor mistakes. A letter from the IRS will tell you what documentation to send them through the mail. Once the IRS is satisfied that it has the correct paperwork, the matter will be done.
• A Field Audit is when the auditor comes to your business or home to verify the accuracy of your return. This type of audit is usually done if the return is complicated and involves business operations.
• An Office Audit requires that you physically appear on a specific date and time at the IRS facility and bring your documentation.

You can elect to give your CPA or attorney Power of Attorney and speak to the IRS on your behalf. Instead of the taxpayer attending the meeting, the CPA or attorney can do it for you. If you do attend the meeting, follow these guidelines: don’t lie, be friendly, keep good records, bring only the documents asked for, educate yourself, don’t let the auditor keep your original documentation, appeal the audit if you don’t agree with the finding, and come clean. It pays to be organized and professional because it suggests to the auditor that you are a conscientious business person.

The IRS has up to three years to pull a tax return for audit. It’s important to keep all records that backup your tax return for at least those three years, but six years is recommended for individuals and corporations should keep permanently.

Please contact us if you have any questions about this unpleasant subject.