The just-completed tax season is plunking another 160 million tax returns on the IRS’s front doorstep. And if you reported more than $400,000 in income, the likelihood you’re going to be audited will be increasing dramatically.
If you’re in that category, you should start working on an audit letter response plan now. An individual taxpayer trying to fight the IRS alone will likely feel intimidated, outgunned and under-resourced. It won’t lead to good decisionmaking.
The originally requested 87,000 new IRS agents was reduced to 40,000 after congressional cutbacks, but all those bodies and all the technology expenditures are part of the same buildup plan. This 50 percent increase in the total number of IRS employees is for auditing more taxpayers to generate more revenue.
Audits begin with a letter to you, the taxpayer. The IRS can audit returns as far as three years back, but they will generally come in years two or three after the filing of the original return. There is no time limit if fraud is suspected or you haven’t filed for a given year.
Sometimes audits are specific and targeted to a particular item on the taxpayer’s return. Other times, taxpayers get a “compliance research examination,” which is the financial equivalent of a strip search, and every bit as pleasant as that sounds.
Generally, taxpayers have a shockingly short time to respond. One of my clients received an audit letter on April 5, with an April 10 deadline to respond.
There is always a stated reason for the audit. This can include, “You’ve been selected at random for a compliance research examination,” but in my experience, I don’t believe anything coming from the IRS is random. I have seen too many taxpayers who are vocal critics of the IRS and our tax system in their social media being “randomly” audited.
Among the stated reasons for audit letters are high income, a taxable income dramatically lower than overall income, complex financial affairs and having a characteristic in your return that the IRS has on its naughty list. For example, you might be in a targeted industry, or use a tax-minimization strategy the IRS doesn’t like.
On the business return side, the IRS regularly issues audits to look into the fundamental legitimacy of a business, out-of-average categories of expenses, and unusual deductions. It also looks at the balance sheet for aberrational or unusual items. The IRS can also demand access to conduct an inspection of the “business premises.”
The agency’s tactics, in my experience, have grown increasingly aggressive. The IRS actively tries to bully frightened taxpayers into accepting positions (including settlement offers) during the audit that are far more favorable to the government than they need to be.
In a comprehensive audit, the IRS will be looking to make you explain and document every decision and calculation made in the completion of the tax return. For taxpayers with any level of complexity in their returns, I just think it’s dangerous to do your own returns, relying on tax calculation software alone. I am biased, but you need representation.
You’ll need to be ready with bank statements, receipts, documentation and authentication. And if you don’t provide the information, the IRS may go directly to your bank to obtain it.
The only kind of audit that’s worse news than the compliance research examination is the “lifestyle audit.” That’s what happens when the IRS somehow suspects you are spending far more than you should be, given your reported income. A lifestyle audit can launch a fusillade of search warrants and perhaps criminal charges.
And remember, the IRS isn’t there to be fair. It is there to generate revenue for the government.
Don’t be surprised, either, if this stepped-up audit activity starts aiming lower — at taxpayers below the oft-cited $400,000 magic figure — if the Biden administration fails to reach its revenue goals with audits of higher-income earners.
What should you do to prepare for the possibility of an audit? First, keep every transaction record and make notes explaining anything that looks unusual. A credit card statement does not suffice — you need the actual receipt.
Second, keep all those records in a digital format that makes them as searchable and accessible as possible.
Third, don’t be greedy. If your business pays for you to travel to a vacation spot for a conference and then you spend an equal number of days skiing afterward, that’s going to get flagged in an audit. Consider taking half that cost as income. A willingness to pay what’s reasonably owed disarms a lot of suspicion.
Fourth, use your network of existing relationships to find and designate a professional (a tax accountant or attorney with a CAF number with the IRS) to be your representative to the agency. You’ll need to complete a Form 2848 Power of Attorney and Declaration of Representative to allow them to do their job for you.
A typical high income taxpayer can easily have a 100 page paper return, with 1,000 pages of supporting documents. An audit can be a lengthy and costly process, and its length and cost will increase proportionately with the level of your prior disorganization.
The IRS will seek to interview the taxpayer without representation, but I think that’s never a good idea. I’ve seen too many clients say things to IRS agents that opened the door for further examination and cost, and that’s obviously not a good outcome. “I’ll have to get an answer from my client” is something a representative can say but you can’t.
Auditors prefer to have direct access to you, so don’t give it to them. And few taxpayers have the pattern recognition database to know when to fight and when to retreat. Your representative will, but he will cost between between $300 and $800 per hour, which is deductible for a business but not for an individual. And you really want to keep your case out of tax court, where the costs can soar into the tens of thousands.
Audits are simply awful, and vastly more of them are coming for high-income taxpayers. So stay organized and build a relationship with a qualified tax accountant or attorney beforehand. It may just save you from one of the most miserable experiences of your life.
Bruce Willey is the founder of American Tax & Business Planning LLC.