Every once in awhile, a client receives a love letter from the IRS. The vast majority of these are computer generated where an amount reported by a third party does not match the amount reported on the tax return in question. A few weeks ago this happened to a client of mine involving an IRA withdrawal. As it turned out, the bank reporting the 1099-R made an error, agreed to correct their mistake, and everyone went on their way.
A week later, a client received another type of letter informing him that he had been selected for a Compliance Research Examination. This type of audit is utilized by the IRS to judge how taxpayers actually comply with IRS regulations, and according to the IRS letter, improve the fairness of the tax system. I won't comment on that, but will tell you these audits can be very lengthy, take much preparation work, can be fairly costly, and always result in loads of time that usually is better spent (by the taxpayer) elsewhere.
In light of this, I thought it a good idea to discuss what steps you should take if you should be selected for this type of audit. This IRS web site has an excellent video of the Audit Process which may answer many of your questions. The very first thing I should say, however, is if you've been a good record keeper and have complied with the IRS record keeping requirements, you have nothing to worry about. The IRS needs to find out where taxpayers are not in compliance, possibly hiding income, and other pertinent information. Remember, our tax system in the US is voluntary. Unfortunately, this can also mean you're guilty of non-compliance until proven otherwise.
First, every item on your tax return for the year selected, needs to be verified. Married filing jointly? Better have a copy of your marriage certificate handy. Yes, it is that intrusive, and you will be asked questions which are very personal and may not seem to pertain to the tax at hand. Don't get mad at the auditor though, he or she is just doing their job. I have actually been asked if the auditor came into my office with a chip on their shoulder ready to hang my client out to dry. Nothing could be further from the truth. In this case, the gentleman who showed up at my door, was courteous, considerate, and went out of his way to explain any concerns.
Prior to the audit, you will be sent Form 4564 Information Document Request which will detail every document needed to justify the income and or expense claimed on the return being reviewed. In this case, it was 7 pages long, which seems like a lot, but most pages covered two Schedules on the return. This letter will inform you of the documents you need to provide. You will be given ample time to provide the documents and you will know exactly the items which the IRS intends to review.
Next you will go line by line down each form of the return to verify both the reported income, and resulting expenditures, if any. In my case, it was simple as all the income was from a W-2 form, and pass-through entities, such as an S-Corporation and LLCs. Since I also prepared these business returns, it was easy to answer questions.
You will need to provide receipts and cancelled checks or other proof of payment for the expense items claimed. As an example, if you claim a deduction for real property taxes on Schedule A you will need to meet the two IRS requirements: (1) That you own the property, and (2) you have a legal requirement to pay them. Here you would provide a copy of the grant deed with your name on the property, and copies of the tax bill and either a cancelled check or online receipt of payment. The same requirements are true for home mortgage interest, so you will need to provide proof of indebtedness, so on and so forth.
It is helpful to remember the IRS computers and auditors are concerned with swings in both income and expenses. Why high in one year, lower in another? In this case, one of the taxpayer's LLCs consisted of rental income from commercial buildings which had been under construction over a couple of years. This resulted in little income in early years and higher income in later years. Knowing my client kept records and spread sheets of monies invested, copies of these spread sheets and cancelled checks were provided along with copies of the Certificate of Completion from the County office. Together with copies of the depreciation schedules showing that no depreciation was claimed prior to completion of the buildings, the swings in income were clearly explained. Don't be afraid to go back a couple of years and even forward 1 year to show the progression of a large asset when questioned. Even though it may not be requested, sometimes a little extra effort to explain a situation goes a long way.
To prepare for the audit, I put on my IRS auditor hat and tried to think of things that I would need if I were the auditor. Knowing that time is money, copies of every document needed, together with a header page were provided, resulting in 14 piles of documents. The auditor could go through it in the same order it was listed on Form 4564. If the auditor needed, for example, a K1 form in more than one stack, he or she could find one included in each stack. This reduced the need to shuffle paper back and forth. Once each and every item was checked off, I was ready for the auditor. I also used a highlighting pen to highlight the item of income or expense which flowed to the individual tax return.
It took almost 19 hours to prepare all, and the effort paid off. What was to be a 6 to 8 hour review, resulted in a 4 and 1/2 hour visit. The auditor was happy that he could leave early, and he was free to take all the stacks with him to review at his leisure. Remember, you only need copies, not originals.
If the thought of going through this by yourself seems daunting, you should consider giving your preparer a power of attorney to handle the audit on your behalf. This is exactly what my client did. My client didn't need to show up and give up a day of time, and I had all the information at hand to take care of it. When the interview portion was over, there were only two questions which I couldn't answer. The auditor simply made note of it, and I was able to contact my client, get the answers, and then follow up with the auditor. By letting a third party handle your audit, it will save you time, frustration, and you won't run the risk of insulting or berating the auditor, who is only doing their job. I can assure you, you won't be doing yourself a favor.
So what items can be problematic? Although there were no issues on the return in question, I can see where some taxpayers may not keep some documents long enough. The statute of limitations expires 3 years after the latter of the due date or filing date of the year in question; but if you have any type of capital assets, especially a business asset which you are depreciating, you need to keep proof of the purchase price of the assets along with the amount of depreciation claimed each year. This is no different than keeping the escrow settlement statement on a purchase of a personal residence, along with proof of all capital improvements to justify the tax basis when you sell the house. The very same principal applies to all capital assets, including sales of stock.
In review, the audit was time consuming yes. But my client had the substantiation required, there were only a couple of minor mistakes which may or may not result in additional taxes owed, since they may offset each other. Although the result won't be final until later this month, I was very pleased by the way it went. The auditor was great! (Maybe when this is over he will let me take him to lunch.) The key to a stress-free audit is preparedness. Perhaps the system I use for my business may work for many of you. I have adapted a 3 ring binder system. Rather than keep everything in filing cabinets, each year I start a new 3 ring binder with monthly dividers. When making a deposit, I photocopy each and every check, and attach the ATM machine receipt to the page with the photocopies. Then for each bill paid, (I pay them all online) simply put the bill into the binder for the corresponding month, then write the confirmation number for each payment on the bill. Oftentimes bills are paid on credit cards. Use the same approach. Take the original receipt and staple it to the credit card bill. Your credit card statement will show proof of payment. If you should use the credit card for both personal and business use, be certain to pay the credit card using two different accounts! In is best to have a separate credit card for business, but experience shows this isn't always practical. As soon as the bank statement is ready, reconcile the bank balance and put everything into the binder. This way, if you should ever be selected for a Compliance Research Examination, all you will need to do is hand the auditor the binder for the year. No worries, no searching, no copying and no printing, it's all there in black and white. Give it a little thought, and you should be able to design a simple system that makes your life IRS worry free as well!
Coming soon: Answers to your questions. This audit consumed my time.Thanks for your patience and bring on more questions!