Taxes

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Top reasons the IRS audits you and tips to avoid being scammed by Tax Preparers

The word “audit” strikes fear into many American’s heads around this time of the year. As an Accountant, I’m used to auditors, and have little fear of them, probably because most of them are fairly incompetent and harmless. I have to deal with our internal auditors and external auditors on a monthly basis as a part of routine business and to satisfy regulatory obligations. The only reason to truly have fear is if you’re doing something intentionally wrong, like hiding income or blatantly overstating deductions. If you’re not intentionally trying to deceive and you make a mistake, most always, the IRS will correct the error and simply set out to collect the money you owe, and or refund money you may have overpaid. Below, I will talk about how often Americans are audited and what the IRS looks for as precursors to selecting someone to investigate further and to potentially audit. In addition, I will provide some tips to help you avoid falling prey to a tax preparer that’s going to get you in trouble with the IRS so they can earn more money filing your taxes for you. Hopefully, I will help squelch your fears of being audited too.

How often are people audited? Believe it or not, the odds are very low that you will be audited. Less than %1 of people making under $100,000 per year have been audited in the past. Make over that amount, individual odds of being audited jump up to less than 2% of filers.

Here is a rather comprehensive list of reasons the IRS will audit you as well as the IRS’ past list of scams to avoid when having someone else prepare your taxes (found here ):
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1. Mathematical Corrections

The IRS uses computers to find mismatches between names and social security numbers, earned income credit qualifications, filing status issues, estimated tax and withholding tax errors, estimated tax assessments, late filing penalties and interest, or any number of other issues. Sometimes these audits require an appointment and sometimes the IRS simply recalculates your tax return with a new tax balance due, including interest and penalty assessments.

2. Income Document Matching

IRS computers match all pertinent forms, such as 1099s, W-2s, and K-1s relating to your name and social security number to what you report on your tax return. If the numbers do not match your tax return, you will be audited. The audit could begin with a phone call, an in-person meeting, or simply a bill itemizing the additional taxes, interest, and penalties.

3. DIF Scoring

The IRS scores every tax return with a discriminate function (DIF) number. It is based on secret calculations they use to identify income tax returns with the highest likelihood of tax change on audit. The DIF score increases for various items, such as Schedule C or auto expenses, and decreases for other items (such as using a paid preparer). IRS classifiers review high DIF score tax returns and select which ones and which items will be audited.

4. Additional Documentation Requests

These audits require you to mail documentation for an item or items on your tax return to the IRS auditor. This may include receipts and proof of payment for whatever items they are examining. For example, if they are auditing your charitable contributions, you will need to provide copies of the receipts from those organizations and copies of the canceled checks to verify your reported numbers. The IRS will disallow any contribution that you cannot prove and will then issue a bill for the balance due, including interest and penalties.

5. Face-to-Face

These are the audits that have received the most publicity in the last several years. Congressional pressures on the IRS and an increase in funding have dramatically increased audits. This type starts with a telephone call or letter from the IRS. The telephone call tactic is designed to get you to volunteer information long before the face-to-face meeting.

6. Randomly

The IRS randomly selects individual tax returns for audit. This strategy, called the National Research Program, replaces its Taxpayer Compliance Measurement Program (TCMP). This audit is the most intrusive by its very nature, as it thoroughly examines tax returns line by line. So, for instance, if you claimed a child as a dependent, you will need to provide the birth certificate to prove that the child is yours and proof that the child was actually living with you in the tax year being audited. It continues on from there, often through every line on your income tax return.

7. Financial Status

Your standard of living and other related factors can also trigger a tax audit. Auditors use public records and statistical data to trace spending and changes in wealth to prove that you have unreported income. Some of these records include tax returns for all open years, credit reports, property tax records, business license applications, motor vehicle records, 1099 information, currency transaction reports and SEC filings. Due to perceived abuses of these techniques, Congress limited their use in 1998, stating that the IRS cannot use financial status or economic reality techniques unless they have a reasonable indication that there is a likelihood of unreported income. The statute (law) does not define “reasonable indication.”

8. IRS Special Projects

The IRS annually identifies The Dirty Dozen – the most blatant tax scams. They use this list to identify income tax returns they will audit.

Here is the most recent list of scams (aka the dirty dozen) that you should keep in mind when someone else prepares your taxes (found here). Avoid anyone asking to do your taxes for a percent of your return. Preferably, do the taxes yourself. File for FREE with H&R Block At Home Online Free Edition.

The list of scams:

Phishing

Phishing is a tactic used by Internet-based scam artists to trick unsuspecting victims into revealing personal or financial information. The criminals use the information to steal the victim’s identity, access bank accounts, run up credit card charges or apply for loans in the victim’s name.

Phishing scams often take the form of an e-mail that appears to come from a legitimate source, including the IRS. The IRS never initiates unsolicited e-mail contact with taxpayers about their tax issues. Taxpayers who receive unsolicited e-mails that claim to be from the IRS can forward the message to phishing@irs.gov. Further instructions are available at IRS.gov. To date, taxpayers have forwarded scam e-mails reflecting thousands of confirmed IRS phishing sites. If you believe you have been the target of an identity thief, information is available at IRS.gov.

Hiding Income Offshore

The IRS aggressively pursues taxpayers and promoters involved in abusive offshore transactions. Taxpayers have tried to avoid or evade U.S. income tax by hiding income in offshore banks, brokerage accounts or through other entities. Recently, the IRS provided guidance to auditors on how to deal with those hiding income offshore in undisclosed accounts. The IRS draws a clear line between taxpayers with offshore accounts who voluntarily come forward and those who fail to come forward.

Taxpayers also evade taxes by using offshore debit cards, credit cards, wire transfers, foreign trusts, employee-leasing schemes, private annuities or life insurance plans. The IRS has also identified abusive offshore schemes including those that involve use of electronic funds transfer and payment systems, offshore business merchant accounts and private banking relationships.

Filing False or Misleading Forms

The IRS is seeing scam artists file false or misleading returns to claim refunds that they are not entitled to. Frivolous information returns, such as Form 1099-Original Issue Discount (OID), claiming false withholding credits are used to legitimize erroneous refund claims. The new scam has evolved from an earlier phony argument that a “strawman” bank account has been created for each citizen. Under this scheme, taxpayers fabricate an information return, arguing they used their “strawman” account to pay for goods and services and falsely claim the corresponding amount as withholding as a way to seek a tax refund.

Abuse of Charitable Organizations and Deductions

The IRS continues to observe the misuse of tax-exempt organizations. Abuse includes arrangements to improperly shield income or assets from taxation and attempts by donors to maintain control over donated assets or income from donated property. The IRS also continues to investigate various schemes involving the donation of non-cash assets, including easements on property, closely-held corporate stock and real property. Often, the donations are highly overvalued or the organization receiving the donation promises that the donor can purchase the items back at a later date at a price the donor sets. The Pension Protection Act of 2006 imposed increased penalties for inaccurate appraisals and new definitions of qualified appraisals and qualified appraisers for taxpayers claiming charitable contributions.

Return Preparer Fraud

Dishonest return preparers can cause many headaches for taxpayers who fall victim to their ploys. Such preparers derive financial gain by skimming a portion of their clients’ refunds and charging inflated fees for return preparation services. They attract new clients by promising large refunds. Taxpayers should choose carefully when hiring a tax preparer. As the saying goes, if it sounds too good to be true, it probably is. No matter who prepares the return, the taxpayer is ultimately responsible for its accuracy. Since 2002, the courts have issued injunctions ordering dozens of individuals to cease preparing returns, and the Department of Justice has filed complaints against dozens of others, which are pending in court.

Frivolous Arguments

Promoters of frivolous schemes encourage people to make unreasonable and unfounded claims to avoid paying the taxes they owe. The IRS has a list of frivolous legal positions that taxpayers should stay away from. Taxpayers who file a tax return or make a submission based on one of the positions on the list are subject to a $5,000 penalty. More information is available on IRS.gov.

False Claims for Refund and Requests for Abatement

This scam involves a request for abatement of previously assessed tax using Form 843, Claim for Refund and Request for Abatement. Many individuals who try this have not previously filed tax returns. The tax they are trying to have abated has been assessed by the IRS through the Substitute for Return Program. The filer uses Form 843 to list reasons for the request. Often, one of the reasons given is “Failed to properly compute and/or calculate Section 83-Property Transferred in Connection with Performance of Service.”

Abusive Retirement Plans

The IRS continues to uncover abuses in retirement plan arrangements, including Roth Individual Retirement Arrangements (IRAs). The IRS is looking for transactions that taxpayers are using to avoid the limitations on contributions to IRAs as well as transactions that are not properly reported as early distributions. Taxpayers should be wary of advisers who encourage them to shift appreciated assets into IRAs or companies owned by their IRAs at less than fair market value to circumvent annual contribution limits. Other variations have included the use of limited liability companies to engage in activity which is considered prohibited.

Disguised Corporate Ownership

Some taxpayers form corporations and other entities in certain states for the primary purpose of disguising the ownership of a business or financial activity. Such entities can be used to facilitate underreporting of income, fictitious deductions, non-filing of tax returns, participating in listed transactions, money laundering, financial crimes, and even terrorist financing. The IRS is working with state authorities to identify these entities and to bring the owners of these entities into compliance.

Zero Wages

Filing a phony wage- or income-related information return to replace a legitimate information return has been used as an illegal method to lower the amount of taxes owed. Typically, a Form 4852 (Substitute Form W-2) or a “corrected” Form 1099 is used as a way to improperly reduce taxable income to zero. The taxpayer also may submit a statement rebutting wages and taxes reported by a payer to the IRS. Sometimes fraudsters even include an explanation on their Form 4852 that cites statutory language on the definition of wages or may include some reference to a paying company that refuses to issue a corrected Form W-2 for fear of IRS retaliation. Taxpayers should resist any temptation to participate in any of the variations of this scheme.

Misuse of Trusts

For years, unscrupulous promoters have urged taxpayers to transfer assets into trusts. While there are many legitimate, valid uses of trusts in tax and estate planning, some promoted transactions promise reduction of income subject to tax, deductions for personal expenses and reduced estate or gift taxes. Such trusts rarely deliver the promised tax benefits and are being used primarily as a means to avoid income tax liability and hide assets from creditors, including the IRS.

The IRS has recently seen an increase in the improper use of private annuity trusts and foreign trusts to divert income and deduct personal expenses. As with other arrangements, taxpayers should seek the advice of a trusted professional before entering into a trust arrangement.

Fuel Tax Credit Scams

The IRS is receiving claims for the fuel tax credit that are unreasonable. Some taxpayers, such as farmers who use fuel for off-highway business purposes, may be eligible for the fuel tax credit. But some individuals are claiming the tax credit for nontaxable uses of fuel when their occupation or income level makes the claim unreasonable. Fraud involving the fuel tax credit is considered a frivolous tax claim, potentially subjecting those who improperly claim the credit to a $5,000 penalty.

How to Report Suspected Tax Fraud Activity

Suspected tax fraud can be reported to the IRS using Form 3949-A, Information Referral. Form 3949-A is available for download from the IRS Web site at IRS.gov. The completed form or a letter detailing the alleged fraudulent activity should be addressed to the Internal Revenue Service, Fresno, CA 93888. The mailing should include specific information about who is being reported, the activity being reported, how the activity became known, when the alleged violation took place, the amount of money involved and any other information that might be helpful in an investigation. The person filing the report is not required to self-identify, although it is helpful to do so. The identity of the person filing the report can be kept confidential.

Whistleblowers also may provide allegations of fraud to the IRS and may be eligible for a reward by filing Form 211, Application for Award for Original Information, and following the procedures outlined in Notice 2008-4, Claims Submitted to the IRS Whistleblower Office under Section 7623.

Faulty logic; But I can write it off on my taxes

Just because something is tax-deductible, it doesn’t mean it’s a good or smart buy, or good or smart debt. Quite often, business owners and consumers alike fall into a trap of buying things they really don’t need based upon the fact that it’s tax deductible. Moreover, some people choose to carry debt because it’s tax deductible. But is this the right thing to do?

Consumers across the world wonder; Does it make sense to pay off my mortgage early and lose the tax deduction? What about student loans? How about paying for dry cleaning for work uniforms, that’s tax deductible, so why not? The government is offering tax credits for buying new windows, appliances, or whatever else, and they’re tax deductible so it makes sense, right?

Business owners ask questions such as; Should I buy season tickets to take my clients out, it’s tax deductible right? Should I buy my staff new cell phones every year, it’s tax deductible?

Buying based upon tax savings should be avoided. Below, I hope to change your thinking by showing why that logic is flawed, and show you what you should base your decision making on, instead of making that choice to buy something or to carry debt simply because it’s tax deductible.

You should be questioning whether or not you really need the product or service in the first place. If you determine that you have a real need, then the question should be can and should you do it yourself based upon the time and cost. Leave tax deductions out of your analysis, at least to start.

So, what about the consumers whom get advice to not payoff their mortgages because they would lose the tax deductions? Should they iron their own uniforms or pay the local cleaner to do it for them? Heck, new windows would look really nice, after all it’s going to be a tax deduction right? Wrong, if you’re having to pay interest of say $10,000 per year on your mortgage to get a tax deduction of $2,500, you’re wasting $7,500, not saving $2,500. The same could be said for doing your own ironing, or deciding whether or not to buy new windows. You must look at in total, what am I spending to save? Am I really saving anything? The reason you should consider buying new windows would be because you believe there will payback on your investment, for example you will be lowering your heating and cooling bills enough to recoup the costs in 5 years, or through the sale of your home in the future. On the other hand, sometimes it does make sense to outsource portions of your life, if others can do it more cost effective than you and you don’t have the time or would be losing higher earning potential elsewhere, you might want to pay to have others do things for you, and the tax deductible nature of the expense should come into consideration at that time .

So, the small business owner wants to wine and dine their clients because the tickets are considered tax deductible (and they like going to the ball game too)… But this type of expense is only 50% deductible on the owners taxes. What else could he spend that money on though that would be 100% deductible and drive more business? It’s nice and all to have those seats to take your clients to, but do you really need to layout the expense of all those season tickets when you could easily pick and pay for the games you really must take a client to? Instead of tickets, advertising your business may pay more handsome rewards. But until you do the analysis, basing your decision to buy season tickets for the ball games because they are tax deductible is only looking at a part of the equation you need to. The same thing is true for buying cell phones or anything else, the question should be is it business critical, or are you just wasting money because a portion of the expense is tax deductible? Remember, if you have to spend money to save money – you’re not really saving any money at all.

In summary, just because something is tax deductible does not mean that it’s saving you money, quite often that’s not the case. Take the time to really decide if you must buy something, consider the payback on your investment, instead of the ability to deduct on your taxes. In the long run, you’ll be much better off.

Getting a big refund? Ask yourself why you’re lending the government interest free money.

Soon enough, Americans will be filling out their tax forms in anticipation of a large income tax refund. But should they be so excited? The fact is, if you’re receiving a large income tax refund, or any refund at all, you have lost money. How could this be? What can you do to stop this from happening again and how can you end next year with more money than you would if you continued receiving large refunds like now?

Many people treat their income taxes like a savings account, in which they pile up money they don’t touch throughout the year by having more money taken out of their pay for taxes than they are going to owe. The major problem with this method of savings is that you’re giving the government your money to hold and earn interest on. Instead, if you were to correctly estimate your withholding’s, claim the proper amount of deductions, you could earn interest yourself on that money, instead of giving the government your money to hold interest free.

Let’s show you an hypothetical example of what I’m talking about, in case you’re more of a visual person. Let’s use an example of two brothers, Fred who thinks it’s cool to get a large refund, and the other brother Mike, who wants to make every dime possible he can.

Fred has 3 kids and wife, although, on his taxes he claims only 1 person. Fred makes $50,000 per year. This results in his work taking out more taxes than he owes to the tune of $500 per month, or $6,000 per year. Fred files his taxes after the end of the year, and no surprise, he get’s back his $6,000 that he overpaid.

Mike, the self proclaimed frugal and savvy type, also has 3 kids of his own and a wife and he makes the same $50,000 per year as his brother. But instead, Mike claims 5 people on his taxes and so his payroll department takes out nothing over and above what Mike owes to the government per month. Now Mike takes the $500 and has it automatically deposited into a savings account at the end of the month, which earns %4 interest, compounded monthly. At the end of the year, Mike would have $6,132. That’s $132 more than his brother Fred for nothing. That’s $132 that the government would have, instead of Fred.

Some people will say that the main reason they do this and will continue to accumulate massive refunds in spite of knowing that they are actually losing money is because they are unable to effectively save that money, that they know if they have that extra money each month they won’t save it. With automatic withdrawals into savings accounts you can eliminate this temptation. Moreover, if you’re thinking and or fearing that you may touch those savings dollars, purchase CD’s with 6 month or annual maturities (many banks allow the ability to automatically renew too).

It’s never too late to make the change. Walk down to your payroll department now, and correct your withdrawals. The payroll department should be able to tell you what the difference is in your take home pay, and change your direct deposit to accommodate that additional portion of your pay to be deposited into a savings account. From there if you believe you may still be tempted to spend that money, talk to your bank about automating the purchases of CD’s (these often have better interest rate than your typical savings account). You have the ability to save more money now, don’t delay get started now!

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Saving money by cutting out the pros

Far too many people are overawed at the thought of dealing with their own money and therefore pay out lots of that money to professionals like CPAs, financial planners and tax advisers. But there is a great deal of money to be saved by becoming self-reliant in money management. Find yourself a good piece of free personal budgeting software and avoid paying for a financial planner. Learn to make the most of your own money and investments and do your own tax return.

If the thought of doing your own taxes leaves you cold then you’re not alone but here are five reasons to overcome your natural reticence. With a little study and some supportive software you can prepare and file your own tax return and keep more of your hard earned money in your pocket!

• You will save money! Tax advisers can be very expensive since many of them also charge by pieces of paper even if a form is left blank! Tax software packages have made the whole process easier to do, easier to understand, more transparent, far cheaper and less time consuming.

• You keep all of your personal financial information to yourself. Protect yourself in this dangerous world of open information access by dealing with all of your own tax needs.

• You learn invaluable knowledge about finance in general and your finances in particular. Each year will be easier than the last and you will learn more through the annual comparison.

• A tax advisor will only take the data that you gather and keep throughout the year and then use you to help them input it to the IRS. So you save all that consultation time when you do it yourself.

• You can do the necessary work in your own time and on your own schedule. All good tax software will save your data input progress as you go and it will be waiting for you to return and complete it.

A tip for saving money and time on your taxes is to set up labeled files that you keep up to date through the year. For example car expenses with gas, maintenance bills etc. all added up as you go. Do this now for next year’s tax deadline and there will be no big surprises. File any receipt and tax related documents in the appropriate file as soon as you receive them. Fifteen minutes each week will save the time and costs of errors that inevitably arise when you do the ‘last minute rush’. You will also avoid the cost of applying for a deadline extension as well.

Doing E-taxes also helps save some trees! It speeds up the whole process and you get your correct refund more quickly and directly deposited to your account. Don’t give your interest to Uncle Sam. Empower and educate yourself in financial planning and the tax laws as they apply to you and make money by not spending it on professionals.