The IRS has a complex formula in determining who to audit so secret even the government doesn’t know what it is. This secret is the subject of much debate and some even claim to know the formula. (They also have the secret formula to Coca Cola.)
In my neighborhood if you have an S corporation and get audited, I apologize. The lady who handles S corporation audits at the IRS around here was once an employee of mine. I take full responsibility for my limited role in training her. I am ashamed of my behavior.
But an IRS audit is not really an issue for most people. IRS audits are at all-time lows and do not look to be expanded much in the future. Most audits are not the dreaded visit to the IRS office or the auditor showing up at your place. Most audits are of the correspondence type, where they send you a letter. Correspondence audits are generally narrow in focus and are the result of a misplaced number or a mismatch on the tax return with information the IRS has.
Since so few people get audited nowadays, there should be no worry among taxpayers of a visit from your friendly government revenue agent. Still, I audit proof every tax return I prepare and train my employees to do the same. This isn’t cheating either. I am talking about preparing a tax return in a manner that doesn’t encourage scrutiny.
Who I Would Audit
The IRS seems to take an erratic course when choosing who to audit. Areas I would consider fertile ground for audit are ignored and areas where the ground has more stones is gleaned for any additional revenue. It seems counterproductive to take such an approach.
Since so much income is now reported to the IRS, most returns are easy to eliminate from audit consideration, or so you would think. Business owners and landlords are prime audit candidates since they receive income not always reported to the IRS. But there are millions of small businesses and landlords. You can’t audit them all.
The IRS selects tax returns for audit using their DIF System (Discriminant Inventory Function System). Other methods are used to uncover unreported income (UI DIF: Unreported Income Discriminant Index Formula). Only a government could come up with such names and acronyms.
The higher your DIF score the greater the chance of audit. The system works pretty well and is constantly tweaked and updated to improve efficiency. It also misses by a mile more often than not.
When you have 30 plus years in the tax industry you start to get a feel for who is pulling a fast one on their tax return. I am wrong periodically, but usually I can sniff out malfeasance.
There are two types of tax returns I would focus on auditing if I were an IRS auditor. The first is S corporations showing a loss and the other is people deep in debt and still spending.
The S corporation seems a strange choice. It isn’t. Since debt by an S corporation does not increase basis unless the debt is from the shareholder, all kinds of nasty surprises show up if the corporation shows a loss above basis. This is a complex area of tax law we will not delve into today. All I will say is please, if you have an S corporation, never have the company borrow from anyone but you, the owner. Guaranteeing a loan doesn’t help. Talk to a tax professional if you have this issue.
What I do want to focus on today is the type of person incentivized to cheat on their taxes: those deep in debt and spenders. A better way to look at who I would audit is to look at who I would not audit.
Who I Would Not Audit
If I worked for the IRS there is a group of people I would avoid auditing except for the most extreme cases. People reading this blog are awful candidates for audit! Why? Because savers don’t have a reason to cheat on their taxes. The people reading this blog are more interested in investing every penny they can. Instead of cheating on their taxes so they can spend more or to fund a heavy burden of debt, they cut spending on stupid stuff to free capital for investments in index funds and real estate.
People with a lot of toys are perfect candidates for audit. Decades in the business has proven my theory correct. When I see a client with a lot of big-boy toys they always perform poorly in audit. It is so bad I am nervous just preparing their returns. You know they have some serious preparer penalties out there. Never paid one; don’t want to start now.
A couple of things always concern me. When a client drives up in Hummer I am certain they don’t want to pay my fee (or they can’t). In the interview process I may learn of a lifestyle filled with lots of stuff coupled with debt. The risks these clients present my firm and me is higher. If I know of income and/or expenses, they must go on the return. It’s the stuff I don’t know about that keeps me thinking. The IRS may not believe I didn’t know. And then those preparer penalties show up again.
Avoiding Audit and Winning if You Are Audited
There is no fool-proof, 100% guaranteed way to prevent an audit. There are things you can do to significantly reduce your chances of getting that letter from your uncle in Washington.
- Report all income as it appears on tax documents.
- Make adjustments on the tax return for incorrect tax documents.
- Disclose positions you are taking on the tax return if you are adjusting for a tax document and for issues that make the return look like it has an issue (large charitable contributions, large business expenses, et cetera).
Where tax documents do not report the transaction to the IRS you need to consider how the return looks. Cost of goods sold higher than normal or other business or rental expenses should be covered in a disclosure included with the return. Better yet, change the mechanics of the tax return without changing the final result.
To prevent the IRS computer from throwing a fit, I will change how I handle certain numbers. This usually applies to small business owners, side gigs, hobbies, and landlords. For example, let’s say you have a really large advertising expense for a program in your business that failed to generate expected revenue. First, I would add a disclosure to the return. I would also break it up if possible. I might list the Yellow Pages ad separately to bring down the out of place advertising number.
Before you ever file your tax return you should review the return with the eyes of an auditor. What would you question if you worked for the IRS? Be brutally honest. Many returns selected for audit never get called because the auditor reviews the return and knows there is not much to gain if they open the file. As long as her supervisor doesn’t demand the audit take place, the thing will eventually run out of stat. The best audit is the one you never have to fight. Even if you win on all counts in an audit you still have time and money invested defending yourself.
When you review your tax return for things that look off, consider changing how you report the item. Again, I am not talking cheating. What I suggest is breaking big number up so they don’t look so out of place. When in doubt, disclose. Too many tax professionals are afraid to disclose a position they are taking with the IRS. They think it alerts the IRS to something they should audit. I disagree.
When the IRS sees a disclosure attached to a tax return it means you took the time to research the issue. You already self-audited. The IRS might disagree, but collecting more tax revenue is more difficult when the taxpayer already went out of her way to prepare an accurate return. My experience shows the same. I have never had a client audited when there was a disclosure attached to the return. Ever! That doesn’t mean I will not have one waiting for me when I get to the office. Even if there is one waiting for me, the number of audits of returns with a disclosure is very small.
The IRS is Reading this Blog
IRS auditors probably read this blog. It doesn’t bother me. They want to know how I conduct business, fine. One of the local auditors worked for me for a short time and knows how I conduct business. Like any tax professional, I sometimes get things wrong. Shit happens. What I don’t allow is willful errors. Judgment calls are part of the trade. Some returns we are happier with than others.
Since this is a public blog written by the owner of an accounting firm and we can assume the IRS is watching, let me share a few additional tips. I cannot remember the last time I saw a tax return audited from someone who maxes out their retirement account. I can’t remember ever seeing one. I think the IRS knows what I know; savers rarely cheat on their taxes. What would their incentive be? These people think along the lines of spending less. Their attitude is: my taxes are what they are. I’ve done everything I can to reduce them.
And reduce them they have. How much cheating do you have to do to get the same benefit as filling every retirement account you can? If you sock away $20,000 into your 401(k) and IRAs, the IRS can easily see what you did. Drop an extra 20k into the contributions to charity line on Schedule A and the revenuers might just want to verify that.
So how do you reduce your risk of audit to near zero? Simple! Spend less, pay off debt and save/invest more. The IRS is defenseless against such intelligent financial planning. It’s all legal. Pay off a credit card and you now have tax-free income! All that interest was not deductible and is now free for you to use elsewhere. In effect, tax-free income.
You can double down on the benefits by pushing the interest saved on consumer debt into a retirement account to get additional tax advantages. And the IRS has nothing to talk to you about. Your life is simpler. The government has less interest in your money. And you can finally start living the life you dreamed.
That is something everyone should be happy doing. Even an IRS auditor.