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IRS Audit Penalties: Avoid And Reduce Your Tax Liability

 

Why are IRS audit penalties imposed? There are probably some good public policy reasons, such as the penalties encourage taxpayers to properly report and pay their taxes promptly. A better answer is that the penalties help the government recover the expenses of conducting an audit. We believe that penalties are another revenue source for the government. Hence the new focus on offshore account holders.

 

What kinds of penalties does the IRS impose for non-international audits?

We have listed the penalties below:


 

Would the IRS really go after me for civil or criminal fraud?

Absolutely. However, the auditor does not do so arbitrarily. She looks for “badges of fraud” for criminal fraud which include:

  1. Understating income whether by omission of specific items or other sources of income, or failing to report substantial amounts of income received
  2. Claiming fictitious or improper deductions (e.g. overstatement of deductions or personal items deducted as business expenses)
  3. Accounting irregularities (e.g. using two sets of books, or making false statements on documents)
  4. Acts evidencing an intention to evade tax (e.g. making false statements, destroying records or transferring assets)
  5. A consistent pattern over several years of underreporting taxable income
  6. Implausible or inconsistent explanations of behavior
  7. Failing to cooperate with the examining agent
  8. Concealing assets
  9. Engaging in illegal activities (e.g. drug dealing) or attempting to conceal illegal activities
  10. Maintaining inadequate records
  11. Dealing in cash

 

Pay close attention to items 7, 10 and 11. Item 7 results from not understanding the role of you and the examiner. The burden of proof is on you. She does not have to prove that a deduction is unreasonable or fraudulent. The burden is on you to prove that it is fair and accurate. We sometimes get clients who have tried representing themselves before an auditor. They come to us very angry and upset because the “auditor is stupid, does not know what she is doing, and is vengeful and mean.” The problem with that statement is that often we have worked with the same auditor on other cases and found she is more than fair and reasonable. Auditors do not get bonuses for unfairly collecting money, they get paid to close cases.

 

Items 10 and 11 are not illegal in themselves. They are, however, intertwined. There is nothing wrong in conducting business in cash as long as you document the receipt of cash and the spending of cash for expenses. Where the taxpayer works under the table things can go wrong in a hurry. For example, the carpenter who does substantial work under the table and thus reports a much lower income than he actually earns may think that he is fooling the IRS. He may not realize that the auditor may question how he has $35,000 in Schedule A deductions on an income of $50,000 per year. She may start drawing some unfavorable conclusions when she analyzes his bank statement and finds $80,000 in deposits. If the taxpayer took out a liar’s loan mortgage and shows income of $125,000 then it is game over. Public policy does not allow telling the Department of Housing and Urban Development that one makes $125,000 and the IRS that he makes $50,000.

 

But what about civil fraud?

Here, the IRS must prove an attempt to evade payment of tax that the taxpayer believed to be owing as distinguished from a mistake, reliance on incorrect technical advice, honest difference of opinion, negligence or carelessness.

According to the Internal Revenue Manual civil fraud generally involves one or more of the following:

  1. Deception
  2. Misrepresentation of material facts
  3. False or altered documents
  4. Evasion
  5. Conspiracy

 

There are three differences between Civil and Criminal Fraud

  1. Civil fraud requires clear and convincing proof
  2. Criminal fraud requires proof beyond a reasonable doubt.
  3. With criminal fraud you can go to jail; with civil fraud you just pay the taxes, penalties, and interest due. You will not have a criminal record.

Here is where attitude, cooperation, and honesty become crucial. We need to make it as easy as possible for the auditor to choose civil fraud as opposed to making a criminal referral.

 

This is frightening. Can we get back to the non-fraud penalties?

Yes, but here we focus on avoiding paying them. The statutes governing accuracy penalties, Section 6664(c) IRC and Section 1.666-4(b)(1) 26 C. F. R., provide as follows:

 

“No penalty shall be imposed under section 6662 … with respect to any portion or an underpayment if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” Sec 6664(c).”
“The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Generally, the most important factor is the extent of the taxpayer’s efforts to assess the taxpayers’ proper tax. Circumstances that may indicate reasonable cause and good faith include a misunderstanding of the fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer. An isolated computational error or transcriptional error generally is not inconsistent with reasonable cause and good faith… Reliance upon an information return, professional advice or other facts, however, constitutes reasonable cause and good faith if, under all circumstances such reliance was reasonable and the taxpayer acted in good faith…” 

 

The plain language translation is that you attempted to keep your records accurately but due to some circumstances of which you were not aware, you nonetheless made a substantial error.

 

So, how do you do that?

Sometimes a taxpayer attempts to save money by using a tax preparation program purchased at a stationery supply store. The programs can be helpful, but, in the hands of an ill-informed taxpayer, can be dangerous. For example, the program allows the taking of both mileage and car and truck expenses. It does so because one might operate a business where it would be appropriate to take mileage on a car used to make sales and to take car and truck expenses on the 15-ton dump truck that is used to do the work. The problem is that the taxpayer takes both for the car. Another area is meals. You can deduct the cost of the meal that you take while engaged in out of state travel for a business purpose. You cannot take a deduction for a meal that you take within the state during your lunch hour. Entertainment meals pose a problem in that they can be legitimately taken but also have stringent documentation requirements.

 

Rental property is another area. Often the taxpayer claims the cost of extensive renovations, which must be capitalized and recovered through depreciation, as a repair. Repairs are a current operating expense which reduces the yearly income. Claiming the renovation as a repair improperly reduces your income and is not allowed by the IRS. So doing also causes a large misstatement of income and hence the penalty. Incidentally, if your eyes started to glaze over during our discussion of depreciation, repairs, and renovations, you will serve yourself better by hiring a tax professional.

 

Note the part of the statue that says “Reliance…on professional advice…” This means that you relied upon a tax preparer or CPA to prepare your return. However, for some reason or another, he made an error.

 

Does that happen often?

It happens enough to provide us with audit work. But note that many taxpayers bring in their records at the last minute during a hectic tax preparation season. Inevitably someone can make a mistake.

 

How can I avoid substantial tax audit penalties?

There is a 6 step program that we recommend:

  1. Look around, talk to people and do whatever it takes to find a competent CPA enrolled agent or tax professional who will help you set up and operate your business books.
  2. Once you are set up, operate your business honestly. Deposit all your receipts into your business account. Pay for everything either by credit card or check. When you make a substantial purchase and pay with cash the auditor’s first question will where did you get the money?
  3. Keep receipts for everything that you purchase and issue an invoice or receipt for each sale.
  4. Read the financial reports that your CPA prepares for you. If you have a question, ask it then. Make sure that you understand what is contained in your balance sheet and your income statement. Remember that your CPA performs accounting work in order to help you manage your business better. He can’t accomplish his goal if you fail to pay attention.
  5. Keep supplementary documentation for expenses that cannot be determined from your checkbook. Good examples are Entertainment and Mileage expenses.
  6. Finally, look at each transaction and ask yourself how you would explain it to an auditor. If you can’t do so quickly and confidently, then change it.

 

 Always remember that you are responsible for the accuracy of any return that you file.

We cannot guarantee that if you follow these steps that you will never be audited and that the auditor will never find an error. However, by so doing you certainly increase the chances that you will prevail in an audit and will not have the penalties imposed upon you. Remember, once you sign your tax return, even if it was prepared by someone else, you are responsible for all of the information provided on that return. If you are being audited, or if you need assistance getting the books for your business in order, contact us. We can help.