One of the most common questions I answer is how the IRS chooses its audit targets. Once understood, avoiding questioning by the Service is a simple task.
Business Audits
The IRS compares similar businesses in the same geographic area to each other to see which numbers red flag in the algorithm. This makes perfect sense. Why would they compare a clothing retailer in Chicago to a CPA in Arkansas? Nothing would match.
They do this through your zip code and your business industry classification, which is a Dewey Decimal classification type system that assigns numeric codes to your business. All business returns, regardless of entity type, must include both of these numbers.
To explain how this works, let’s use an example. Let’s say your business and mine both have a business industry classification code of 12345 and reside in 60601. The IRS then compares the numbers we report on our income tax returns.
Let’s also say that you’re a good taxpaying American, and that I’m a complete thief. You take a deduction equal to one percent of your income for meals and I take a ten percent deduction for the same line item.
Naturally, my ten percent deduction raises a red flag because everyone else who is a 12345 close to 60601 only takes a one percent deduction.
It’s important for you to understand that this is an electronic process. They compare our numbers, flag what is statistically significant, and mark the numbers deemed too large inside the computer file.
Once the computer system does its work, the return is then sent to an IRS Officer who must make a decision. Their decision choices are as follows…
1 – Let It Pass
Maybe the income on my return is so low that the 10% deduction isn’t unreasonable? As such, there would be no reason to expend resources looking at it.
2 – Do A Correspondence Audit
This is when the IRS sends letter asking me to prove the deductibility of a particular line item on the return. To prove that the deduction is valid, I would need to send in all proof, including canceled checks, credit card statements, etc., to substantiate the deduction.
3 – Audit The Entire Return
This is where they do a full audit, we answer their questions, and provide proof on their areas of concern.
This is just the most common way the Service can choose a business return for audit.
Let me leave you with this..
Given this example, there are two ways to avoid an audit.
1 – Get The Bookkeeping Right
Please understand that if you get the bookkeeping right, it’s easy to get the income tax return right. But if you get the bookkeeping wrong, you’ll never get the income tax return right.
Period. End of story. Fahgetabadit.
Clients who do their own bookkeeping and then take that work to an Accountant who basically cuts and pastes their numbers onto a return run a huge risk. Those clients don’t begin to know the tax laws and have no idea what is or isn’t deductible in the first place.
And even if they knew the laws, no client should ever be expected to police themselves. This is why I won’t sign an income tax return until I’ve either done the bookkeeping work myself, or spent the time to go through it with a fine tooth comb making sure that it complies with IRS Laws and Guidelines.
Getting it right means that your numbers won’t raise a red flag in the algorithm.
2 – Don’t Electronically File
Knowing what you now know about how the IRS chooses its audit targets, why would you ever want to electronically file a return unless it’s absolutely necessary? Take a moment and think through the system.
Please remember that choosing audit targets is an electronic process. The only reason they began electronic filing so many years ago, was to avoid paying individuals to put your information into the machine so that it could be checked.
When you electronically file they don’t have to do that. They just run their diagnostics, see what red flags, and send out the auditors.
Understand that the easiest way to avoid an audit in this country is to invest in a $0.76 stamp.
I’m sure that there’s a portion of my readers that are now saying something like, “But they do put that information into the system anyway.” Mailing in a return doesn’t make a difference.
Au contraire my friend.
With the budget cuts that the Service has gone through in the past couple of decades, many times they don’t have the manpower necessary to complete this task. The IRS sent out a communication several months ago admitting to destroying 20M information returns that they just couldn’t get into their system so that returns could be checked.
I’m also sure there’s another portion of my readership that is now saying that electronic filing is mandated, which it is. If you’re a paid preparer that completes more than 10 returns annually, you’re required to electronically file.
But if you know anything about tax law, you know that for every tax rule there are exceptions.
If any of my clients sign a letter instructing me not to electronically file because paper is their preference, for whatever reason, then I’m off the hook and the return can be mailed. The majority of my clients sign the letter.
As such, I haven’t had one of my returns audited at the Federal Level in the past twelve years. That’s quite a feat. Please realize that most of my clients are perfect upper income individual audit targets.
Most accountants don’t agree with me because they want their clients to be audited. They’ll take your numbers, slap them on a return, and electronically file it. Why?
Because they can then charge those clients $10K to $20K apiece to get them through an examination. For those accountants, it’s just good business.
But I’ve always taken my oath of office more seriously than most. I’m in business to help my clients, not myself.
And who in their right mind wants to spend their summers arguing with the svelte beauties on the 16th Floor of the Kluczynski Federal Building? I’d rather be on my boat, knowing that I’ve done everything possible to protect my clients
.
Think about it.
This is my first column in a series devoted to how not to get audited.
If you find yourself in a position where your worried about getting audited, I’m waiting for your call…
We’re all going to get through this. Let’s get through it together.
Accounting Solutions Ltd. stands ready to complete our mission and purpose of protecting you, your family, and your business. Whether you need Payroll Services, or Accounting and Tax Work, you have but to ask. I’m here and I remain,
Sincerely yours,
Chris Amundson
President
Accounting Solutions Ltd.
773-267-7500
888-310-0300
www.AccountingSolutionsLtd.com
Disclaimer: The content on our website or newsletter is provided solely for general informational purposes and should not be construed as tax, accounting, legal, investment, or professional advice of any kind. Accessing this information does not create, and is not intended to create, an accountant-client relationship. This information may not reflect the most current tax laws, accounting standards, or regulatory developments and may not apply to your specific jurisdiction or circumstances. It is not a substitute for consulting qualified professionals. Before making any decisions or taking any actions, you should seek advice from a professional who is fully informed of all relevant facts pertaining to your situation.
Tax-related content on this site is not intended, nor may it be used by any taxpayer, to avoid penalties that may be imposed under applicable tax laws. To comply with IRS requirements, we inform you that any U.S. federal tax advice contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties or promoting, marketing, or recommending any transaction or matter addressed herein.
All information is provided “as is,” without any guarantee of completeness, accuracy, or timeliness, and without any warranty, express or implied, including but not limited to warranties of performance, merchantability, or fitness for a particular purpose. We disclaim all liability for any loss or damage arising from reliance on this information.
Links to third-party websites are provided for convenience only; we do not endorse or assume responsibility for their content. All materials are the property of our firm and may not be reproduced with
out prior written consent.