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.
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.
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.
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 email@example.com. 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.
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.
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.