Tax Audits on the Rise!

Tax Audits On The Rise

This is a long post but it is a very important topic, so please read the whole thing. And do feel free to pass it along to anyone you think may be interested.

Do you know how many tax return audits are based on “random selection”? The answer is about 50%. Like the spin of the wheel regardless of what may be on your return, a taxpayer may be audited.

That leaves the other 50% of returns audited being chosen based on IRS so-called “test scores.” The IRS has what is called a “discriminant function system” (DIF) which computers score the return for the potential for change in tax. It also uses a related “unreported income DIF” which scores the potential for collecting tax on unreported income.

That is, the higher the score the more likely the return is to be audited. There additional ways to be audited like computer matching of forms like W-2s, 1099’s, 1098’s, related return programs, and tax shelter watches.

Due to budget constraints, failed computer systems, lack of training, and other things, IRS audits have been very low for many, many years. This has given taxpayers and even many tax preparers the warm fuzzy feeling that they just ain’t looking at returns. The IRS has picked up on this.

Well, read the papers, listen to the news. Our federal and state governments are in bad financial shape, and they’re all looking for ways to collect additional revenue, and they are making it a top priority to after every dollar of potential tax. The main way to do this is with encouraging compliance in complying with the tax laws. One big way to do this is putting teeth in auditing tax returns, and they are doing this.

Not only with more audits, but also training auditors to be much more diligent in requiring documents, logs, and proof of everything on the returns.

I’m not telling you all this to scare you. No, this is just a gentle reminder to keep great records. And this article will give you some tips to keep these records. This accomplishes a number of things.

Audit Survival Tactics
One, if you are audited you have everything you need to prove that your return is correct. Two, by keeping great records you can be sure you pay the least tax possible. Also, the time and money saved during the audit process is greatly reduced if you prepare for the audit beeore filing your tax return.

How do you do this? Save your receipts for all items you are putting on your tax return. This includes medical, dental, eyeglasses, property tax, DMV, mortgage and other deductible interest, charitable contributions, employee business expenses. If you are in business for yourself, save everything.

If addition to your receipts, the IRS wants you to prove that you actually paid the receipt. This is done with cancelled checks, bank statements, and credit card statements. Save all these. No if’s, and’s, or butt’s.

Charitable Contributions
For most taxpayers filing Schedule A (the long form) a big area to shore up is with charitable contributions. Do not donate cash if you want to deduct the expense. Write a check or pay with a credit card, and get receipts from the organization. Actually, when you donate $250 or more in any one day you are required to have written substantiation from the organization. This means that even if you have proof of payment, they can disallow the deduction if you don’t get this written substantiation.

Non-Cash Charities
For non-cash charitable donations like clothes, furniture, household goods to organizations like Goodwill, Salvation Army, churches, etc you must adhere to special rules.

With a few exceptions we get to deduct the fair market value of items we donate to qualified charitable organizations. What is fair market value? Depending on the item the valuation could be, thrift shop value, comparable sales, Kelly Blue Book for vehicles, stock quotes, appraisals or any reasonable method to determine value. Written appraisals are required for property exceeding $5,000.

Now, with these non-cash items and the values claimed, step into the IRS shoes and think what proof they’d want to see. Take pictures, make lists with values and the method used to determine value and anything else you can get as proof. Oh yeah, and don’t forget the written receipt.

A free service by Turbotax can be found at www.itsdeductible.com that tracks and itemizes items donated and has suggested values. These values are not bulletproof in an audit so use judgement when using this service.

Employee Business Expenses
If you are required by your job as an employee to spend money in order to you your job (vehicle expenses, meals and entertainment, travel, supplies, telephone, etc) you really need to keep excellent records as this is a very targeted area.

Tip: The best way to handle this is really to have your employer set up an accountable plan. You keep documents, logs, etc as required by the employer and turn these in to the employer monthly and the employer reimburses you dollar for dollar. This way the reimbursement does not go on your W-2 and you don’t have to deal with deducting them on your tax return, lowering audit risk and you’re fully reimbursed.

Caution: A flat reimbursement amount, say $500 per month is not a substantiated accountable plan! In this situation, the $500 checks are thrown and taxed on your W-2 and you must try to deduct the expenses on your tax return.

No matter which method you use you still need to keep great records. Same as above; receipts, cancelled checks, credit card statements and…

Mileage Logs. You absolutely must keep mileage logs. I know, I know, I hate it too but, the IRS auditors are really grilled on reviewing taxpayers mileage logs, and they are assessing whether the logs were kept as you traveled, not put together for just for the audit. If you deduct vehicle expenses and are selected for audit, they will audit your mileage.

A good way is to keep an appointment book showing who you saw, where you went, when you went, why you went. You can make the mileage entries in your appointment book/daily planner. Do this as you go along daily. It takes a lot of time trying to reconstruct the log two years later. Not keeping these logs are now considered the “mortal sin” in an audit. They can disallow all of your mileage without the log!

The principles here apply to self-employed taxpayers, corporate shareholders, partners in partnerships as well. Remember corporate shareholders are considered employees of their corporation, so see the accountable plan described above and implement the plan. I can help set these up if you need help.

Travel, Meals, & Entertainment. This is another area where you can be sure that, if you are selected for audit, the auditor will check your records on travel, meals, and entertainment.

They even have more and stricter rules for substantiation. You must be able to prove what is called the who, what, when, where, why and how for each expen- diture. It’s not enough just to produce a restaurant receipt and the credit card statement. You must show that it is indeed an allowable deduction per the tax code.

Show why and the days you were out of town on business, who you took out to breakfast, lunch or dinner, why you took them out, what was discussed, the result of the meeting, the where and when are usually on the receipts you keep.

If you are in business and are not out of town on business you cannot deduct meals and entertainment while working unless you meet with a customer, client, vendor, or someone with a related business purpose.

This substantiation can also be put into your appointment book/daily planner along with the mileage log. Set up a good filing system to organize receipts, cancelled checks and credit card statements.

In conclusion, ignoring your tax records is a major mistake. Reconstruction the records after the fact takes a tremendous amount of time. And the fact of doing this one or two years later makes it even more difficult trying to jog the memory.

If we don’t have the 10 minutes to do this daily, where are we going to find the three weeks trying to put it all together in the event of an audit.

There are no short cuts. The IRS will not accept just cancelled checks, or just credit card statements as bulletproof documentation. If there’s one or two missing and everything else is documented, it’s probably no problem. Also, if we have great documentation and show this, the auditor will most likely lose interest in pursuing a fruitless search for errors which will certainly shorten the audit.

Thank you for reading this and feel free to call me with any questions you may have.

Bob
(805) 264-3305

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