Newsletter 2015
Newsletter 2015
Limiting Risk
Limiting Risk
Print Full ArticleLast Reviewed: Jan 2016
Last Modified: Jan 2016
In recent years, the "leading attack" of a typical audit has shifted from deductions to income. While deductions are still reviewed at a later stage, auditors have generally found it more productive to verify the amount of income reported. Unfortunately, at least in our experience defending such audits, this is because it is extremely difficult and time-consuming for the taxpayer to respond to the methods IRS uses to re-compute income. Here is how it works: First, the auditor requests copies of all monthly bank statements (bear in mind that audits usually span the previous three years of tax returns) for all bank accounts controlled by either spouse. They add up all the deposits to all the accounts for the entire year and this is their starting point. Next they prepare a large spreadsheet that totals all "explained" deposits: paychecks, transfers, gifts from parents, loan proceeds, etc. and compare the total of these deposits to their initial total of all deposits. If total deposits are higher than explained deposits, the difference is assumed to be unreported income and is added to the tax return. While this in itself is bad, it is only half the danger. On the "back end" of the audit, deductions reported on the return are also compared against the bank deposits; any excess is assumed to have been paid with funds received and never deposited. In other words, unreported income. As you can see, this "prove-it-didn't-happen" audit format is extremely difficult to defend.
Proper documentation and certain protocols will be your best defense to any issue that comes up in an audit. To prove your income from a business you should retain copies of all the 1099s you receive from your clients and customers. For retailers point of sale software is essential to track sales income as well as returns and credits. If you maintain inventory you will need to be able to document all your purchases and all returns. You will also need to document your annual beginning and ending inventory as these amounts are used to compute your costs of goods sold.
If you have a small operation, do not be tempted to deposit business income into your personal account. You should be able to easily trace income deposits to your business account and draws of profits you have taken out and deposited into your personal account. If you add personal money to the business account for any reason you should be able to document the source of this money to prove it is not income. On the flip side, you should never use the business account to pay personal expenses. Take a draw first and pay personal bills from your personal account.
For both personal and business deductions, you should have a receipt or access to a receipt for every expenditure. Although credit card or bank statements can work to prove expenses in an audit, the auditor technically can deny any deduction without a matching receipt or invoice from the vendor.
Proving your deduction for business use of your vehicle may be the biggest challenge you will have in an audit. IRS rules require every business trip be documented in some way at the time it is made. A mileage log kept in your glove compartment is a good system to use for tracking your mileage. There are also apps available for your smart phone you can use. Unfortunately, the bottom line on business use of a vehicle is that if you estimate your mileage you will most likely lose this deduction in an audit.
A fundamental issue for any audit is maintaining credibility with the auditor. Your record keeping does not have to be spotless or perfect, but if you can show the auditor that you tried to maintain good records and that the missteps were few and inadvertent then you are well on your way to a decent outcome. The first question an auditor will ask is whether you know about any problems with the return. Your instinct will be to try to hide all your mistakes. However, one of the best things you can do to build credibility with an auditor is to voluntarily reveal the errors you know about. They will probably find out about them anyway, so you might as well get it out in the open at the beginning. You would be surprised how often the response is to thank you for your honesty and to not make an adjustment (or at least mitigate the impact) for the error you fess up to!
Even if your records are spotless, don't be surprised if there are unresolved disagreements toward the end of the audit. It is not uncommon for taxpayers to eventually reach a point they'd rather just pay the remaining tax adjustment and be done than continue to fight. It can be an emotional, and sometimes even degrading, experience. Proper perspective is critical; remember that the audit process will eventually end.
With few exceptions, our experience has been that auditors are at least trying to be fair and that the overall audit process has safeguards (like the appeals division and the Taxpayer Advocate Service) to override an overzealous auditor. We know it is hard not to panic when you receive an audit notice or other correspondence from IRS, but hopefully this information will help you understand a little about the process and what to expect and provide some comfort that there are safeguards in place to make the process fair.
