AUDIT SECRETS: HOW TO KEEP FROM BEING AUDITED AND WHAT TO DO IF YOU ARE
By: P. Thomas Austin
WHAT THE IRS COMPUTERS LOOK FOR ON YOUR RETURN
Tax returns are selected for examination by a combination of computer and human factors. It is possible to improve the odds slightly against having your tax return selected by doing what the tax pros do for their own clients. Be aware, though, that there is nobody around (at least nobody who is talking) who knows the IRS computer program used to determine whose tax return is a candidate for audit.
What is public knowledge about the computer side of the selection process is that the computer determines the likelihood of a particular tax return generating additional tax dollars, if it is examined, by using a scoring system known as the Discriminant Income Function (DIF). Each tax return processed by the computer is assigned a DIF score. The higher the score, the more likely the return will be audited. The formula used to arrive at the DIF score is updated on a regular basis with information gathered by IRS examiners. Data is compiled from the thousands of tax returns actually audited, and the highly guarded and secret DIF formula is then modified. No public information is available on the factors that go into the DIF scoring.
Another scoring factor used by the IRS computers is known as Total Positive Income (TPI). TPI is the sum of all positive income values appearing on a return, with losses treated as zero. The purpose of this system is to eliminate or minimize the use of adjusted gross income as a factor in deciding the potential for additional tax dollars if a return is audited.
The IRS found that it was not getting a true reading of tax returns when it relied on adjusted gross income. An adjusted gross income of, say, $15,000 can represent either a salary of $15,000 or a salary of $150,000 with tax shelters that bring the adjusted gross income down to $15,000. High income taxpayers are less likely to escape audit now that the IRS computers have a second method to check for high audit potential.
The human process of tax return selection is much less scientific but just as important. After a tax return has been identified by the computer as having audit potential, it is shipped to the District Office and manually screened by the Classification Division. An IRS examiner assigned to the Classification Division gives most tax returns a quick “once over” to determine if the computer has made an obvious error in selecting it or if there is a special item to be brought to the attention of the examining agent ultimately assigned to the return.
If at this initial human level of contact there is adequate explanation or proof of a particular deduction attached to your return, the Classifier may decide that an audit is not in order. For example, receipts attached to your tax return that prove property was donated to a charity may satisfy the Classifier and eliminate the need for an audit to document the claims.
If your return reaches the Classifier at the end of the day, he or she may be bleary-eyed and less concerned about what you reported, and the special attention that might have been given to a particular issue will not be given. When your return actually reaches the Classifier is, of course, out of your control.
HOW TO REDUCE YOUR CHANCE OF BEING AUDITED
You may have the impression at this point in the discussion that the IRS computers are quite sophisticated and that it is virtually impossible to do anything legally to divert their eagle eye from your tax return. By and large this is true, but there are at least two things that may help minimize the effect of the IRS’s high-tech capabilities.
First, how income is reported on the return may make a difference. Suppose you have freelance income. If it is merely reported as “Other Income” with an appropriate description as to its source, chances of having the return selected for audit may be smaller than if the same income is reported as business income on Schedule C (Income from a Sole Proprietorship).
Second, you can minimize your chances of being audited by filing as late as legally permissible. A tax return filed around April 15 generally has a greater chance of being audited than one filed on October 15 (the latest possible date). This is because the IRS schedules audits more than a year in advance. As returns are filed and scored by the computer, local IRS districts submit their forecasted requirements for returns with audit potential. The fulfillment is made from returns already on hand. If your return is filed on October 15, there is a smaller chance that it will be
among the returns shipped out to the District Office in the first batch. As a result of scheduling and budget problems that are likely to develop in the two years after your return has been filed, it may never find its way into the second batch slated for examination.
Although the IRS is wise to this ploy and has taken steps to make sure that the selection process is as fair as possible, inequities invariably result. Why not try to be part of the group that has the smallest chance of being audited?
The best way to reduce your chances of being audited is to avoid certain items universally thought to trigger special IRS scrutiny. There are also some common-sense considerations that should be thought about before you mail in your return. They are often overlooked by the very people who can least afford to be the subject of an audit. Here are a few examples:
Some people who are in cash businesses are not content with merely skimming some of their income. They also want to get every possible tax deduction-which is where the potential for audit comes in. When a business owner reports only a modest income, the IRS naturally becomes suspicious if that person also claims many business expenses and has high interest expense deductions. Two immediate questions are raised in the mind of the IRS examiner: Where does this person get money for personal living expenses and how is he or she able to make the principal repayments to justify the interest expense? When you are preparing your return, step back and think like an IRS auditor. If you can spot questions, so can the IRS.
What else can be done to minimize the chances of being audited? The following items should be reviewed carefully:
*Choose your return preparer carefully. When the IRS suspects return preparers of incompetence or misconduct, it can force them to produce a list of all their clients – all of whom may face further IRS examination, regardless of their personal honesty.
*Avoid problem tax shelters. Many tax shelters are perfectly legitimate, but many have been identified by the IRS as abuses. If you really want to avoid any chance of an audit, steer clear of all but the most conservative tax-shelter investments.
*Avoid formal membership in barter clubs. Members of these clubs trade goods and services on a cashless basis. The club keeps track of all transactions between members. Although no cash changes hands, these trades are taxable like any other profitable deal. Very often, however, they are not reported to the IRS. The IRS can force such clubs to produce membership lists, so that the returns of all club members can be examined.
*Answer all questions on the return. IRS computers generally flag returns with unanswered questions. For example, there is a question asking if you maintain funds in a foreign bank account. Even if you do not, you should answer no to the question.
Income tax returns with unanswered questions are considered no returns. That means the statute of limitations never expires and you can be audited no matter how many years have passed. Unanswered questions can also delay refunds, result in interest charges, and call attention to your return by IRS agents (since the computer automatically spits out the return). If a
question doesn’t seem to apply to you-do you have any foreign bank accounts? Do you claim a deduction for an office in your home – just answer no-but answer.
*Fill in the return carefully. A sloppy return may indicate a careless taxpayer. The IRS may examine the return to be sure the carelessness did not lead to any mistakes.
*Categorize each deduction. Don’t place deductions under headings such as miscellaneous or sundry. If you can’t categorize a deduction, the IRS may decide you can’t prove it.
*Avoid round numbers. A deduction that’s rounded off to the nearest hundred or thousand dollars will raise IRS suspicions. It makes it look as though the taxpayer is guessing at the deduction’s size, rather than determining it from accurate records.
*Limit deductions for unreimbursed business expenses and casualty losses. These deductions typically trigger audits. Try to have as many business expenses as possible reimbursed by your employer rather than taking them as tax deductions. It’s cheaper for you and will not make your tax return stand out. Make sure that casualty losses can be properly documented and be
aware that the IRS may be able to make a case that you actually realized a gain from the receipt of insurance proceeds, even though you think you had a loss. Insist that your tax adviser check this out carefully before taking a deduction.
Source: How to Beat the IRS by Ms. X. Esq., a former IRS agent, Boardroom Books, Springfield, NJ 07081.
DO YOU THINK YOU WILL BE AUDITED?
The IRS audits far fewer returns than most people suspect. The percentage of audited business returns has decreased more dramatically. Audit facts and figures:
*Business returns. For business owners, incorporation helps. Small and medium-sized businesses that are run as corporations are audited less frequently than similar-sized businesses that are operated as proprietorships or partnerships. Comparisons:
Noncorporate business % audited income – Schedule C 1988 1989
Under $25,000 1.45% 1.31%
$25,000 to $100,000 2.12 1.92
Over $100,000 4.20 3.79
Source: Irving L. Blackman is a partner with Blackman, Kallick, Bartlestein, CPAs, Chicago IL 60606.
HOW RISK OF AUDIT VARIES GEOGRAPHICALLY
The IRS district you live in may affect the odds of being audited. In the Manhattan district, for example, 1.98% of all individual income tax returns filed are audited, whereas in Dallas, the rate is only 1.2%. The following table shows the percentage of returns audited in various IRS districts. It will give you an idea of which areas are the most audit prone in the country.
IRS District Percent of Returns Audited
Albany .88
Anchorage 2.48
Atlanta 1.21
Baltimore .99
Boston .69
Chicago .98
Cincinnati .75
Dallas 1.20
Denver 1.37
Detroit .90
Jacksonville 1.36
Los Angeles 1.88
Manhattan 1.98
Nashville 1.14
Newark 1.34
New Orleans 1.30
Philadelphia .82
Phoenix 1.44
Salt Lake City 1.97
San Francisco 2.17
Source: IRS Commissioner’s Annual Report.
THE IRS’ HIT LIST
Doctors and dentists are high-priority targets for tax audit. Items IRS agents look for: Dubious promotional expenses. If the same four people take turns having lunch together once a week and take turns picking up the tab, a close examination of diaries and logbooks will show this. Agents also take a close look at limited partnership investments, seeking signs of abusive tax shelters. And they take a dim view of fellowship exclusions claimed by medical residents. Other target occupations:
*Salespeople: Outside and auto salespeople are particular favorites. Agents look for, and often find, poorly documented travel expenses and padded promotional figures.
*Airline pilots: High incomes, a propensity to invest in questionable tax shelters and commuting expenses claimed as business travel, make them inviting prospects.
*Flight attendants: Travel expenses are usually a high percentage of their total income and often aren’t well documented. Some persist in trying to deduct pantyhose, permanents, cosmetics and similar items that the courts have repeatedly ruled are personal rather than business expenses.
*Executives: As a group they are not usually singled out. But if the return includes a Form 2106, showing a sizable sum for unreimbursed employee business expenses, an audit is more likely. Of course, anyone whose income is over $50,000 a year is a high-priority target just because of the sums involved.
Teachers and college professors: Agents pounce on returns claiming office-at-home deductions. They are also wary of educational expense deductions because they may turn out to be vacations in disguise.
*Clergymen: Bona fide priests, ministers and rabbis aren’t considered a problem group. But if W-2s show income from nonchurch employers, the IRS will be on the alert for mail-order ministry scams.
*Waitresses, cabdrivers, etc.: Anyone in an occupation where tips are a significant factor is likely to get a closer look from the IRS nowadays.
Many people, aware their profession subjects them to IRS scrutiny, use nebulous terms to describe what they do. Professionals in private practice may list themselves as simply “self-employed.” Waitresses become “culinary employees,” pilots list themselves as “transportation executives.” But there’s a fine line here. Truly deceptive descriptions could trigger penalties. And, if the return is chosen for audit, an unorthodox job title for a mundane profession could convince the agent you have something to hide. Then he’ll dig all the deeper.
Source: Ralph J. Pribble, a former IRA field agent, president of Tax Corporation of California, 5420 Geary Blvd., San Francisco 94121.
HOW TO HANDLE AN IRS AUDITOR
Prepare meticulously for the audit. Gather all your receipts for the deductions the IRS has questioned. List each, in detail, on a sheet of paper. Also, meticulously reconstruct cash expenditures for which you don’t have receipts. Explain exactly how and when you made those expenditures.
By presenting your case in factual detail, you establish your credibility. And credibility is everything at an audit. It will be easier for the auditor to allow nondocumented items if you can show him that you kept some receipts, that you made an effort to comply with IRS rules and regulations, and that you’ve reconstructed, as best you could, your cash outlays.
T & E Audits
Travel and entertainment is the most commonly audited deduction: Your goal: To limit the items the agent examines by persuading him to do a test check of your expenses. Let the auditor choose a three month period for detailed examination. Or talk him into limiting the audit to items over, say, $100. Make sure you can document all items in the test-check period or in the amount. Double benefit: A test check cuts down your work in assembling backup data, and it prevents the agent from rummaging through all your travel and entertainment expenses.
Keep Talking
Don’t expect to walk out of an audit not owing a dime. Your objective is to strike the best possible deal. To get an auditor to see things your way: Keep harping on the items he says must be adjusted. Keep talking. Don’t give up until he reduces the adjustment. Even the most hard-nosed agent will ultimately concede some proposed adjustments if you’re stubborn enough. But you must be prepared to give a little, too-to concede items you’re weak on, to bargain. Keep in mind that the agent’s goal is to close the case and move on to his next audit.
Special Problems
Business audits: If your business is being audited, have it done at your accountant’s office, not at your home or your place of business. You don’t want the auditor to see your standard of living nor run the risk that an employee will say something to the auditor that could hurt you.
Unreported income. Generally required to be asked at IRS audits is: Have you reported all your income? Never answer this or other potentially embarrassing questions with a lie. Deliberately failing to report all your income is a crime. So is lying to an IRS employee. To avoid incriminating yourself, deflect the question with Why do you want to know that? or I’ll get back to you on that later. The question may not come up again. Another way to avoid answering this question is to not show up for the audit. Then the deductions you’ve been asked to prove will be automatically disallowed. But you can appeal the agent’s disallowance at the appeals level of the IRS. At the appeals level, you’re generally not asked whether you’ve reported all your income.
Special agents. Their job is to develop evidence for criminal tax cases. If they show up at your door, don’t answer any of their questions, even seemingly innocuous ones. Tell them to talk with your lawyer. Then retain a lawyer who is knowledgeable in criminal tax matters. Best: A former assistant US attorney.
Source: Randy Bruce Blaustein, Esq., M.R, Weiser & Co., 310 Madison Ave., New York 10017. Mr. Blaustein is author of How to Do Business with the IRS, Prentice-Hall, Englewood Cliffs, NJ 07632.
HANDLING TRICKY IRS AUDITORS
Some IRS auditors take it upon themselves to adopt strained interpretations of the Tax Code. For instance, some say that depreciation can’t be taken on a building that’s appreciating in value. That just isn’t so. Taxpayers and their representatives must be cautious. Not everything that comes from the mouth of an auditor is authoritative. When in doubt, tell the auditor that his interpretation of the law seems unusual. Ask him for IRS regulations, revenue rulings or court decisions. Don’t agree to adjustments to your tax bill until you’ve had a chance to review the authority the agent cites.
SURVIVING AN IRS AUDIT
Very few things in this world have the effect of bringing the most hardened people to their knees the way notification of an IRS audit can. The letter from the IRS notifying a taxpayer that he or she has been selected for an audit contains language that is far from threatening, yet it strikes terror in the heart of most recipients. Various survival tactics can be used in preparing to do battle at the IRS audit. All of them are legal, but some aren’t very nice.
Types of Audits
*Correspondence Audit: Some IRS audits are more thorough than others. The least thorough is a correspondence audit. Here, the IRS seeks to test compliance with perhaps one item on either a regional or national basis. For example, the IRS may send out hundreds of letters asking for verification of energy credit expenditures. On receipt of this notice, all you have to do is mail in the appropriate documentation to support your deduction.
Technically, this inquiry constitutes an audit. Once it takes place, there is very little chance that the rest of your return for that particular tax year will ever be audited. If the IRS should decide it wants to audit your return at a later date, it must go through a formal “reopening procedure” -which is rarely done. The obvious advantage of the correspondence audit is that if the IRS does not select an area in which you may be vulnerable, it will never know that it could have made other adjustments to your return that might have resulted in more tax.
*Office Audit: The next level of audit is the Office Audit. This examination is handled at a local IRS office, Typically, one or two deductions on your return will be questioned. Absent special circumstances, such as suspicion of fraud or gross errors in other areas of the return, the audit will not be extended to other issues. The primary advantage of the Office Audit is that it is generally conducted by individuals who lack the sophistication in tax matters needed to recognize more significant issues. The training and method of operation at the Office Audit level consists of telling the examiner (called a Tax Auditor) exactly what to look for in a given issue. The audit will be conducted mechanically and “by the book.”
*Field Audits: These are conducted by the best educated employees at the IRS, known as Revenue Agents. They are usually assigned the tax returns of businesses and wealthy individuals. An audit conducted by a Revenue Agent is usually quite complete, and although it will not examine every item in depth, it will attempt to cover many areas. One of the jobs of the Revenue Agent is to identify promptly areas with the potential for extra tax dollars and then to spend time developing the tax issues.
The chances of having the IRS uncover unreported income or disallowing deductions that are either personal or otherwise not deductible are more likely at the Field Audit than at any other type of IRS examination. It is unwise to try to handle a Field Audit yourself because the potential adverse ramifications can be severe – even if you think you did everything right! A sharp Revenue Agent can be quite creative when it comes to interpreting the Internal Revenue Code in the government’s favor. Your ability to survive such creativity is enhanced by having an experienced practitioner representing your interests.
*TCMP Audit: The most encompassing type of IRS audit is the TCMP Audit. TCMP stands for Taxpayer Compliance Measurement Program. TCMP audits are conducted to gain a statistical sample of the kinds of adjustments that are being uncovered. (For example, are adjustments of medical deductions on returns with an adjusted gross income of $25,000 or less more likely than on returns with an adjusted gross income of $100,000 or more?) The results of these audits are used to reprogram the IRS computers so that in the future they can select those returns most likely to result in additional tax dollars.
TCMP audits are usually conducted by Revenue Agents. The biggest problem with these examinations is that the Agent is required to comment on every item appearing on the tax return, starting with the spelling of your name. This does not mean that every line is audited, but the audit is lengthy and there is greater risk that adjustments will be found that will cost you a lot of money. One of the required audit techniques is the analysis of all a taxpayer’s bank accounts for possible monies that were deposited but not reported.
*Criminal Investigations: These investigations, conducted by IRS employees known as Special Agents, are the most threatening to your personal liberty. The job of the Special Agent is to gather evidence of the commission of a tax crime. The least serious penalty that may result from a criminal investigation is the payment of some extra tax. The most serious penalty is indictment, conviction and a jail sentence.
The anxiety created by a criminal investigation can be overwhelming. In most cases the subject of the investigation is not a “crook” or “Mafia” character. It is likely to be a professional or successful small businessperson who got carried away rationalizing that some of the money received during the year wasn’t really income or, if it was income, that nobody would ever find out if it wasn’t reported. The IRS gains tremendous publicity when a local person is convicted of tax evasion. As a result of an indictment or a conviction, the IRS assures itself; that the level of voluntary compliance increases.
Audit Survival Tactics
Knowing how the system at the IRS works gives an experienced practitioner an advantage when it comes to representing a client at an audit. Here are some of the truly “inside” things that go on.
*Postponing Appointments: It is possible, though not likely, that the IRS will actually change its mind about auditing you if you have postponed the appointment enough times. The IRS is constantly under pressure to start and finish tax examinations. If the return selected for an audit becomes “old” (i.e., more than two years have passed since the return was filed), the IRS
may not want to start the audit. This situation may develop if you are notified of an audit about 15 to 16 months after filing. By the time you have cancelled one or two appointments, the 24-month cut-off period may have been reached.
When is the best time to cancel? The day before the appointment. By that time, the next available appointment will probably not be for 6 to 8 weeks.
*Best Time to Schedule an Audit: To someone uninitiated, it may seem ridiculous that one time of the day or month is better than another to have your tax return audited. However, a real advantage can be gained by following some simple tips. Try to schedule an audit before a three-day weekend. The auditor may be less interested in the audit and more interested in the holiday. Another excellent time to schedule an appointment is at the end of the month. If an auditor has not “closed” enough cases that month, he or she may be inclined to go easy on you to gain a quick agreement and another closed case. As for the best time of the day, most pros like to start an audit at about 10 o’clock in the morning. By the time it comes to discussing adjustments with the auditor, it will be close to lunch time. If you are persistent, the auditor may be willing to make concessions just to get rid of you so as not to interfere with lunch plans.
Source: How to Beat the IRS by Ms. X, Esq., a former IRS agent, Boardroom Books, Springfield, NJ 07081.
AUDITS THE IRS FORGETS TO DO
Asking the IRS to transfer your case to another district may be the key to avoiding an audit. Don’t expect the IRS to admit it, but transferred cases often fall between the cracks and never get worked on even though the taxpayer has been notified of the examination. Delays caused in processing the case file between districts, combined with the fact that the case is likely to go to the bottom of the pile when it is assigned to a new agent, may bring help from the statute of limitations. Rather than asking the taxpayer to extend the statute of limitations, as is the usual practice,
many agents are inclined to take the easy way out and close transferred cases without auditing them.
WHEN IT’S SMART TO ASK FOR A TAX AUDIT
*When a business is closed down, the records and key personnel who can provide tax explanations may disappear. A subsequent IRS examination could prove very costly to the business’s former owners.
*When someone dies, the heirs can count only on sharing in the after-tax size of the estate. So the sooner the IRS examines matters to settle things, the better.
When a taxpayer requests a prompt assessment of taxes due, the IRS must act within 18 months. Otherwise, the IRS has three years to conduct an examination. Use Form 4810 to ask for the prompt assessment. You don’t have to use this form, but, if you don’t use it, eliminate any uncertainty on the part of the IRS by having your letter mention that the request is being made under Code Section 6501(d).
MORE ON AUDITS… When Your Corporation Gets Audited
When the IRS decides to audit a company, the Revenue Agent assigned to the case generally asks for copies of the officer-shareholders’ tax returns. If the company happens to be a restaurant, or is in an industry in which tipping is a common practice, a test-check of employees’ tax returns may also be requested to see if tips are being properly reported as income. Recommended audit strategy for employers: Have the company’s accountant represent the selected employees at the audit, free of charge to the employees. You want to keep the employees away from the Revenue Agent so as to avoid the risk that they might volunteer additional information that could be damaging to both themselves and the company.
Should You Fear an Inventory Audit of Your Company?
Inventory audits. It is taken for granted that a vast amount of the country’s wealth is tucked away in the inventory reserves of small businesses. Inventory reserves do not accurately appear on the books because company owners would have extra income tax to pay if their inventories were properly reflected. (If reported properly, end-of-the-year inventory would be higher, cost of goods sold would be lower and gross profit would be higher, causing more income to be taxed.) Although the IRS makes a lot of noise about making sure that inventories are accounted for, they do very little to enforce the rules. Auditing inventory records is a time-consuming and technically difficult task that most Revenue Agents, including the few who understand the rules, avoid whenever they can.
Odds of an Audit When You’re in Your Grave…
Latest IRS statistics reveal that the chances of being audited are significantly better after you die than when you are alive… if you have an estate of $5 million or more. Virtually every estate tax return with a gross estate of $5 million or more is examined. But only about 5.5% of individual tax returns showing gross receipts from self-employment of $100,000 or more are audited. And high-income taxpayers with more than $50,000 of nonself-employment income have only a 3.53% chance of being audited.
MORE THAN THE FACTS
A winning presentation goes a long way toward convincing an IRS agent that your position has merit even though the facts are weak. Example: You took a deduction for home entertainment, but you don’t have any receipts to prove it. Your presentation at the audit might include the following: A guest list showing the business relationship of each guest. Affidavits from guests stating what you served at the party and how many people were present. A caterer’s written estimate of the cost of serving that number of people. Photographs taken of the affair.
NEGLIGENCE OR TAX FRAUD?
Failure to report income deposited in a bank could be considered careless. Carelessness is punishable, generally, by a 5% negligence penalty. But when the omitted income represented deposits made in a bank in a different state, one court regarded the omission as a fraudulent, willful attempt to conceal income.
Source: Candella et al, v. United States, USDC, E. Dist. WI.
IRS ENVELOPE LABELS-WHAT THE NUMBERS REALLY MEAN
Here’s the scoop on the numbers and symbols on the peel-off label the IRS sends with your tax package.
_______________________________________________
| A) B) C) |
| BN 000-00-0000 CAR-RT-SORT **CR01 |
| I |
| JOHN Q. PUBLIC E) S89 20 D) R |
| 310 OAK DR. S |
| HOMETOWN, STATE 0011 G) |
| 94105 F) H) |
|_______________________________________________|
A) Two-letter “alpha code” that is computer shorthand for your name.
B) Your Social Security number. By entering the two-letter code and your Social Security number, the IRS can identify the correct account. The data-entry clerk doesn’t have to type your full name and address into the computer.
C) Postal Service home delivery route.
D) Type of package mailed to the taxpayer- 1040, 1040A, etc.
E) IRS service center where you filed your return last year – in this case, Fresno, CA (S29 is the Ogden service center, Kansas City, and so on.)
F) Your postal ZIP code.
G) The IRS’s presort mail for the US Postal Service.
H) Certain labels, to help with mail distribution, have either PP, SS, or PL directly under the “S” in IRS. These letters indicate:
*PP – Package (first label in a package).
*SS – Sack (first label in a sack).
*PL – Pallet (first label in a pallet).
Source: George S. Alberts, former director of the Albany and Brooklyn IRS district offices.
HOW THE IRS BUILDS A CRIMINAL CASE
Criminal tax investigations are the ultimate weapon in the IRS enforcement arsenal. They are conducted by IRS Special Agents. They generally show up at a taxpayer’s home or business without an appointment or any advance notice. And they work in pairs so that they can corroborate each other’s testimony about taxpayers’ statements. They may not seem like policemen, but they are.
Special Agents will usually give a Miranda warning, letting the taxpayer know that what he says may be used against him in court, and that he does not have to answer questions without an attorney present. The trouble is that many taxpayers are afraid of appearing guilty by refusing to cooperate. And the agents will press for answers. Typical questions:
*Did you report all of your income?
*Where do you keep your savings and checking accounts?
*What kind of car do you own?
*What is the procedure for reporting sales in your business?
*Do you gamble?
*Did you have a lot of cash on hand at the beginning of last year?
Caution: A false or misleading answer may, itself, be a crime.
The interview is usually low-key, seeming to imply that if the taxpayer cooperates, the agents will close their file. But that rarely happens.
Agent’s Target
What the agents are trying to establish: That a taxpayer failed to report or misreported his income and that the error or omission was willful. To do this, they can, and will, subpoena copies of checking account statements, cancelled checks, savings accounts, deposit and withdrawal tickets and signature cards.
They may also talk to neighbors and business associates. And they will look at public records to find out whether the taxpayer owns any real estate, cars, boats, etc. Insurance records may indicate ownership of furs, jewels and other expensive possessions. Passport records give a clue to expensive overseas vacations a taxpayer may have taken.
Mail surveillance helps them determine who a businessman’s customers and suppliers are. Although the IRS will not open a taxpayer’s mail, they can tell a lot just by looking at the outsides of envelopes.
Establishing Income
To establish unreported income, the IRS relies most often on bank deposits. Basically, they add up all the taxpayer’s bank deposits for the year. Then they subtract deposits that clearly come from nontaxable sources (loans, gifts, inheritances, transfers between accounts). The rest is assumed to be income for the year.
Another method that may be used is the net worth analysis. Procedure: The value of all the taxpayer’s property at the beginning of the year is added up. Then his end-of-year assets are totaled up. The difference between these two figures (with adjustments for appreciation, nontaxable income and other factors) represents the increase in the taxpayer’s net worth for the year. And it is assumed he had at least enough income to generate that large an increase in net worth.
Sometimes, during an initial interview, a taxpayer is asked how much cash and property he had at the beginning of a year. A taxpayer who does not want to appear too prosperous may say he only had a few hundred dollars and no other property to speak of. This opens the door for the IRS to claim that everything he owned at the end of the year was acquired during the year and should have been reported as income.
Of course, a taxpayer who declines to answer the Special Agents’ questions makes it hard to establish his opening net worth. In fact, the IRS does not have all that much information on most individuals. It must get information from the taxpayer himself and from third parties. Legal defense strategies tend to focus on keeping information out of IRS hands.
Key to Enforcement Strategy
Criminal prosecutions are aimed at keeping taxpayers nervous and honest. That means the IRS is quite willing to spend $25,000 to prove a $2,500 omission. They are interested in punishment, not rehabilitation. They usually will not plea bargain. They will ask for jail time rather than probation. And they are not impressed by a taxpayer’s exemplary record. In fact, a pillar of the community is a desirable defendant from the IRS’s point of view.
But they will be conciliatory if they do not have enough evidence to build a solid case. In 1980, for example, there were only 80 acquittals out of 1,874 cases disposed of at trial. The IRS is anxious to protect that winning image. So the one thing a taxpayer should say when IRS Special Agents come to call is, “I prefer not to make any statements at this time, please contact my attorney.”
(The above material was published by Boardroom Reports, 1991.)
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