How IRS generates Audits

AuditRikAss PicAn IRS audit is generated in a number of ways. In certain cases, returns are selected based upon a statistical formula. The IRS will compare your return against “norms” which are developed from a statistically valid random sample of returns.  Audits are also generated when there are issues and transactions involving other taxpayers. In some cases examination can be triggered by a disgruntled employee, ex-spouse or whistleblower who decides to contact the IRS.  Court documents, such as a bankruptcy petition or financial affidavit in a divorce can also trigger an IRS examination as can the failure to pay the business payroll taxes.

Concerns related to the accurate reporting of income and expenses have been the subject of various studies conducted by the IRS. It is estimated that the “tax gap” is in the hundreds of billions of dollars. The IRS is interested in identifying business owners and other self-employed taxpayers who consistently report business losses or low profit percentages on their Federal Income Tax Returns that are insufficient to support a business.  Equally important, the IRS is interested in a business owner’s lifestyle and whether it can by supported by the income reported. They are also interested in whether the individual has accumulated assets, while at the same time reporting either a small profit or a loss for the business.

If you own a business, are otherwise self-employed or if you conduct your business in cash, getting an IRS Audit Risk Assessment (“IARA”) may reduce or mitigate the likelihood of an IRS adjustment of your Federal Income Tax Liability. The IARA will also serve as a blueprint for the steps a business needs to take going forward in preparation for an audit. The IARA is intended to address the following issues:

(1) The likelihood of your Federal Income Tax returns being selected for examination by the IRS.

(2) Whether the examination will be expanded to include multiple tax years or limited in scope to one year.

(3) Whether you are likely to be subject to penalties in the event of an upward adjustment to your federal income tax liability.

(4) Whether “badges of fraud” are present.

The IARA is a confidential report that includes a comprehensive analysis of your Federal Income Tax Returns for the past three years. It may also include an analysis of your business returns. The IARA will serve to identify the strengths and weaknesses of your business in the context of the income and expenses reported on your Federal Income Tax Returns. The process of assessment is based upon methodologies and audit techniques used by the IRS during an examination and includes an in person interview, an audit examination, proposed adjustments to your income and expenses, and remedial steps to be taken.

The Process of preparing for IRS Audit Risk Assessment

To begin the process, we secure your income tax transcripts from the IRS as well as your Individual and business Federal Income Tax Returns. We then examine the your business books and records used in the preparation of your Federal Income Tax Returns, your business and personal bank statements and any other source documents we deem relevant. The IARA also includes an examination and documentation of your personal lifestyle and actual monthly living expenses to determine whether the income reported on your Federal Income Tax Returns is sufficient to sustain your lifestyle.

No investigation is complete without a thorough public records search that includes, among other things, court records to determine whether you have made any affirmations under penalty of perjury related to the overall financial condition of your business and/or you, individually. Courts records, unless sealed by the court, are considered public records and readily accessible to the IRS. A public records search will also reveal the existence of any federal or state tax liens, judgments, mortgages, or other encumbrances as well as litigation to which you are a party. During an examination IRS will examine all public records to see if there are any inconsistencies between the income contained in the court records and your Federal Income Tax Returns.

The IARA also includes the review of any application for credit you may have recently submitted including any application for financing in connection with the purchase or refinance of any real estate property, purchase of an automobile or any large luxury items, as well as any application for credit. While these documents are not considered public records, the IRS can easily obtain them by subpoena. As part of our due diligence, it will also be necessary to obtain credit reports from the three major credit bureaus.

The most important phase of the IARA is the examination of the business. Here, we look at the structure of the business (i.e. single member LLC, C Corp. S. Corp), and in this regard, examine all organizational documents for the business. We also look at the type of business, industry and accounting methods used in the industry.

The gross profit percentage for your business reported for income tax purposes is compared to the industry standards. In addition, an examination of net income/loss, interest expense and related party transactions is undertaken. The IRS is aware that it is not uncommon for a closely held business to pay for personal expenses on behalf of its owners and deducting those expenses on the business return, nor is it uncommon for the business to purchase large ticket items for personal use by its business owners and thereafter expensing or capitalizing those expenditures. In this regard, it is necessary to evaluate the impact of  any large purchases by the business, such as an automobile, boat, RV, vacation home, etc. as wells personal expenses paid by the business on behalf of its owner that are claimed as business expenses.

Loans to and from shareholders, partners, etc. in a business is an area targeted by the IRS and often results in the IRS reclassification of a loan to a dividend and the disallowance of the expenditures as a business expense. The IARA includes an evaluation of all shareholder loans to and from the business to determine whether such loans: (1) are memorialized in writing; (2) reflect a market interest rate; and (3) are actually being paid and reported on your Federal Income Tax Returns.

If you are a business owner or otherwise self-employed, you are much more likely to be audited by the IRS.  Having an IRS Audit Risk Assessment prepared by our office can mean the difference between successfully surviving an IRS examination and economic devastation. Contact us for further details.