One of the most common questions I answer is how the IRS chooses its audit targets. Once understood, not ending up being questioned by the Service is a simple task.
Business Audits
What the IRS does is take similar businesses in a similar geographic area and do a comparison. 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 System that classifies your business into particular numeric codes. All business returns, regardless of entity type, are required to include both of these numbers.
To explain how this works, let’s use an example. Let’s say that your business and mine have a business industry classification code of 12345 and that our businesses both reside in 60601. As such, the IRS takes the numbers we report on our income tax returns and compares them.
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 red flags because everyone else who is a 12345 close to 60601 only takes one percent deduction.
It’s important for you to understand that this is an electronic process. They compare our numbers in an algorithm, see what jumps out as being statistically significant, and put a red flag on the computer file next to the numbers that the system deems as being too large.
Once the computer system does its work, the return is then sent to an IRS Officer who has a decision to make. 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 my return.
2 – Do A Correspondence Audit
This is when the IRS sends out a 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 of the proof including canceled checks, credit card statements, etc., to substantiate the claim.
3 – Audit The Entire Return
This is where they go through the entire return, we answer their questions, and provide proof on their areas of concern.
This is just one of the ways that the Service can choose a business return for audit.
Let me leave you with this..
Given this example, there are two ways to not end up in 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 will never get the income tax return right.
Period. End of story. Fahgetabadit.
Clients who do their own bookkeeping and walk into an Accountant who basically cuts and pastes their number 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 did know 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 is within IRS Laws and Guidelines.
Getting it right means that your numbers won’t 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 never want to electronically file a return unless its 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 that they didn’t want to be forced to pay individuals to put your information into the machine so that it could be checked in the first place.
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 not get audited in this country is to invest in a $.69 cent 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 that there’s another portion of my readership 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 to not 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. 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 our friends down at 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.
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
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