Written by guest writer, Gilberto Neira of Neira Tax
Greetings! Have you ever wondered how the Internal Revenue Service (IRS) could select you for an audit?Do you know what procedures you will have to go through if you are audited? Do you know your rights you have as a taxpayer?
I’m Gilberto Neira, a former IRS Revenue Agent, who now represents taxpayers, like you. My time with the IRS involved conducting audits, of a wide variety of taxpayers. Most of my audits were of high-income individuals and businesses with large gross receipts. In this report I share the knowledge I gained from my years working directly of the IRS.
After reading this special report, you will learn the how the IRS can select you for audit. I will also provide you with my simple process for preparing you to face the IRS if you are audited. You will learn your rights as a taxpayer.
How You Can Be Selected For Audit
There are several ways a tax return gets selected for audit. Once the tax return gets assigned to an IRS Agent it becomes an open case. I often refer to a tax return as a case, since that is the terminology used internally at the IRS. Your tax return can get selected for audit for several reasons but there are three that you should be most focused on.
1. Discriminate Function (DIF) Score
2. National Research Program (NRP)
3. Whistleblower program
Discriminate Function Score (DIF) Score
The IRS will most likely use this factor to select you for Audit. The higher your DIF Score the stronger the likelihood you will be selected for audit by the IRS. DIF is a mathematical technique used to classify income tax returns in relation to the audit success potential. Formulas are developed based on available data and are programmed into the computer to classify returns by assigning weights to basic return characteristics. These are then added up to give a DIF score, and remember the larger this number the higher the likelihood of an Audit. Although tax returns are selected randomly, they are based on the DIF score, based pm the data obtained from audits of other taxpayers as entered into the computer system. Based on these statistics the tax returns get selected for IRS audit. Once a tax return is selected, the case is sent out for classification. From there, an IRS Agent looks for Large, Unusual, and Questionable (LUQs) items within the tax return. As an IRS Agent, I would disallow the following LUQ expenses: Car and Truck , Travel, Meals and Entertainment. If there are other expenses that could be categorized as being LUQs, they would more likely to be selected for audit as well.
Example: Taxpayer A is a Realtor, receives a 1099-Misc for Non-Employee compensation, and reports the income on Schedule C, Form 1040. Taxpayer A, has compensation of $20,000, meals and entertainment deduction of $10,000. The Meals and Entertainment expense is considered large since the amount deducted is half of income reported. This is considered a Red Flag for the IRS.
National Research Program (NRP)
These are random audits, but very painful for a taxpayer since all the items on the tax return are examined by an IRS Agent. For example, if you have a Schedule C Business, the examination will consist of all the items deducted for the business. Moreover, the examination is not just on the Schedule C, but also includes an examination of income and any other deductions in the tax return.
The reasoning behind an NRP audit is for research purposes, in a greater effort to identify possible compliance issues for examination. Based on the results of the examination, computer controls are adjusted to better select future audits.
Example: Husband and Wife file a Joint Tax Return, Husband owns a Restaurant, and has a rental property. Wife works as an employee for XYC Corporation. Their tax return will include wages, a schedule C business and Schedule E for the rental property.
They get selected for a NRP audit. The audit will cover each line item reported in the tax return. Husband and wife will need to provide all records for the items reported in the tax return. Including Wages, Income and expenses for the Restaurant business, income and expenses for the Rental Property. Keep your receipts for at least three years after filing your tax return.
The IRS will pay an award of at least 15%, but not more than 30%, of the proceeds collected attributable to the information submitted by a prospective whistleblower. Yes, there are audits because a Whistleblower submitted information that would lead to additional tax assessment. There are more cases coming out of this program. This could come from a disgruntled employee, a competitor, or other rival.
Example: Taxpayer X, is always boasting around his employees, how he hasn’t filed tax returns for years and has evaded taxes by not filing. One day Taxpayer X (the boss) is having a rough day, employee Y keeps complaining about how his work is not fairly compensated for the amount of work he performs, and keeps aggravating the situation. Boss is not having it and decides to fire Employee Y. Employee Y, hears about the IRS whistleblower program; learns how the IRS will pay an award from the proceeds of amounts the Government collects, as a result of the information provided by the whistleblower. Employee Y submits form 211 application for award for original information to IRS. In the Form 211, Employee Y enters all the information the he knows about the non-compliance of taxpayer X, in this case, how many years he hasn’t file a tax return, his business practices, and any other information that will help the IRS assess and collect a tax.
There are other programs on how the IRS selects a tax return for Audit; however, based on my experience most of the cases have derived out of these aforementioned programs.
You Get the Letter
So, you receive a letter from the IRS letting you know you were selected for examination. What should you do next? I will go into more detail on actual Field Audits shorty, since that is was what I did as an IRS Agent.
Publication 1 A brief summary of Publication 1: As a taxpayer you have the rights, specifically:
The right to be informed,
The right to quality service,
The right to challenge the position of the IRS, The right to appeal a decision, and THE RIGHT TO RETAIN REPRESENTATION.
What all this means is you have the right to know what is going on in the audit process, the right to clear explanations for any adjustments, and should you disagree with any of the adjustments, you have the right to challenge the IRS Agent’s position and appeal his/her decision. All of your information is confidential and private, as the IRS Agent cannot disclose return information to anyone that is unauthorized.
The Right To Retain Representation
The right to retain representation: As a taxpayer you have the right to retain an authorized representative of your choice. For your information, I am an Enrolled Agent, and a Former IRS Agent. I can deal with the IRS on your behalf. I know the processes and will help you achieve the best possible outcome.
What to do First
Before you make initial contact with the IRS, be sure to review your tax return to determine the presence of any discrepancies. Timing its crucial and talking to an IRS Agent before retaining representation can have its consequences. Penalties are assessed based on the facts, evidence, and a taxpayer’s testimony; therefore, you should exercise caution when speaking to an IRS Agent. What you say can and will be used against you, even if they don’t tell you. Penalties can range from 20%, on additional taxes assessed, to 75%, if the IRS Agent can prove the adjustments were due to fraud.
What goes on behind the scenes
Throughout the audit, the IRS Agent conducts their pre-audit analysis, which includes the minimum income probes. One of the first steps is to review internal data – the IRS Agent does an analysis of information returns (1099, W-2, etc.) and compares them the tax return. If there is income missing on the tax return, there is a 99% chance the adjustment will be made. The minimum income probes are conducted because the IRS has the burden of proof for income. It is up to the taxpayer to substantiate any expenses selected for examination. An income tax deduction is a matter of legislative grace and the burden of clearly showing the right to the claimed deduction is on the taxpayer. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84, 117 L. Ed. 2d 226, 112 S. Ct. 1039 (1992); Interstate
Transit Lines v. Commissioner, 319 U.S. 590, 593, 87 L. Ed. 1607, 63 S. Ct. 1279 (1943); Deputy v. Du Pont, 308 U.S. 488, 493, 84 L. Ed. 416, 60 S. Ct. 363 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 78 L. Ed. 1348, 54 S. Ct. 788 (1934); If you are a business owner, be prepared to provide bank statements, invoices, and a calculation explaining how the amount of income reported on the tax return was determined.
§ 61. Gross income defined (a) General definition. Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; and (2) Gross income derived from business. For deductions, be ready to provide receipts, invoices, or bills to substantiate those expenses. The majority of business expenses fall under Section § 162 – Trade or business expenses (a) in general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
Example: Taxpayer Z receives a 1099-Misc for contract work in the amount of $44,000. Taxpayer Z does not like the outcome of his tax return since he will have to pay self-employment tax and regular tax on the income. Taxpayer Z decides to report only $4,000 out of the $44,000 received. During the audit the income difference was noticed and taxpayer was questioned. Taxpayer decided to submit a “corrected” 1099-Misc in the amount of $4,000, caution: IRS can contact third parties to verify the correctness of the information, in this case a third party was contacted. The issuer of the 1099-Misc, was contacted, and confirmed the taxpayer did received the amount of $44,000 and no corrected 1099 was issued. Also, a bank deposit analysis revealed the taxpayer received full amount reported in the 1099. Based on the actions of the taxpayer he can potentially be charged with the Fraud penalty of 75% for providing false documents and for trying to mislead the Agent during the Audit.
There are expenses that require additional substantiation. Those expenses are Meals and Entertainment, Travel, Gifts, and Listed Property (passenger automobiles). These expenses fall under section § 274 (d) Substantiation required. No deduction or credit shall be allowed (1) under section 162 for any traveling expense (including meals and lodging while away from home), (2) for any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity, (3) for any expense for gifts, or (4) with respect to any listed property [as defined in section 280F(d)(4)], unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.
Example: Same Taxpayer as above, Taxpayer Z, decides to deduct $20,000 in meals and entertainment, does not keep any receipts, and cannot substantiate the business purpose of the meals. In order for meals to be deducted, you must be either away from home, that means 40 miles or more, and stay overnight. If you are not away from home, you will need to substantiate the expense by providing adequate records, keep your receipts, describe the business purpose of the meal and describe the business relation to the person entertained. Note: Under the Tax Cuts and Job Creation Act, Entertainment is no longer deductible.
You could be selected for an audit, now you know how your name could get on the Audit list. You also know the importance of having good records and having representation before the IRS. If you find yourself with an audit letter, I can help, but you must act quickly. If you want to be sure you are prepared no matter what storm the IRS brings you, I can help with that too.
Contact Gilberto Neira for more info on how he can help:
Neira Tax Consulting LLC
2 Lindenwood Dr. Ste. F
Laredo TX 78045 956-740-0541