Chances for Being Audited

During Fiscal Year (FY) 2010, the IRS processed 230 million Federal tax returns and supplemental documents and collected $2.3 trillion in gross taxes. After accounting for 122.2 million refunds, totaling $467.3 billion, collections (net of refunds) totaled $1.8 trillion.

During FY 2010, there were more than 141.1 million individual income tax returns filed, accounting for 61.3 percent of all returns filed. Individual income tax withheld and tax payments, combined, totaled almost $1.2 trillion before refunds. Individual taxpayers received $358 billion in refunds.

The IRS also processed almost 2.4 million returns and collected almost $278 billion in taxes, before refunds, from corporations in FY 2010. Partnerships and S-Corporations filed an additional 8 million returns.

More than 116 million returns, including almost 70 percent of individual income tax returns, were filed electronically in FY 2010. More than 64 million returns were submitted to the IRS through paid preparers, while 2.9 million taxpayers whose adjusted gross income was $58,000 or less filed using the IRS Free File program. The following table shows the percentage of returns By AGI and the audit percentage for that income category. Certain income levels are audited more frequently than others.

AGI % Of all returns filed   % Audited  
All Returns 100.00 1.11
No adjusted gross income 2.11 3.19
$1 under $25,000   39.62 1.18
$25,000 under $50,000 23.96 0.73
$50,000 under $75,000 13.41 0.78
$75,000 under $100,000 8.21 0.64
$100,000 under $200,000 9.64 0.71
$200,000 under $500,000 2.41 1.92
$500,000 under $1,000,000 0.41 3.37
$1,000,000 under $5,000,000 0.20 6.67
$5,000,000 under $10,000,000 0.01 11.56
$10,000,000 or more 0.01 18.38

When to Throw Out Tax Records

Are you doing your spring cleaning and wondering if you can throw out some of those old tax records? If you are like most taxpayers, you have records from years ago that you are afraid to throw away. It would be helpful to understand why you keep the records in the first place.

Generally, we keep “tax” records for two basic reasons: (1) we need to keep the records in case the IRS or a state agency decides to question the information reported on our tax returns, and (2) we need to keep track of the tax basis of our capital assets so when we actually dispose of them we can minimize the tax liability.

With certain exceptions, the statute for assessing additional tax is three years from the return due date or the date the return was filed, whichever is later. However, the statute of limitations for many states is one year longer than the federal. In addition to lengthened state statutes clouding the recordkeeping issue, the federal three-year assessment period is extended to six years if a taxpayer omits from gross income an amount that is more than 25 percent of the income reported on a tax return. And of course, the statutes don't begin running until a return has been filed. There is no limit where a taxpayer files a false or fraudulent return in order to evade tax.

If an exception does not apply to you, for federal purposes, you can probably discard most of your tax records that are more than three years old; add a year or so to that if you live in a state with a longer statute.

Examples - Sue filed her  2010 tax return before the due date of April 15,  2011. She will be able to dispose of most of her records safely after April 15,  2014. On the other hand, Don filed his  2010 return on June 2,  2011. He needs to keep his records at least until June 2, 2014. In both cases, the taxpayers may opt to keep their records a year or two longer if their states have a statute of limitations longer than three years. Note: If a due date falls on a Saturday, Sunday or holiday, the due date becomes the next business day.

The big problem! The problem with the carte blanche discarding of records for a particular year because the statute of limitations has expired is that many taxpayers combine their normal tax records and the records needed to substantiate the basis of capital assets. They need to be separated and the basis records should not be discarded before the statute expires for the year in which the asset is disposed. Thus, it makes more sense to keep those records separated by asset. The following are examples of records that fall into that category:

  • Stock acquisition data - If you own stock in a corporation, keep the purchase records for at least four years after the year the stock is sold. This data will be needed in order to prove the amount of profit (or loss) you had on the sale.
  • Stock and mutual fund statements – Where you reinvest dividends. Many taxpayers use the dividends they receive from a stock or mutual fund to buy more shares of the same stock or fund. The reinvested amounts add to the basis in the property and reduce gain when it is finally sold. Keep statements at least four years after final sale.
  • Tangible property purchase and improvement records - Keep records of home, investment, rental property, or business property acquisitions AND related capital improvements for at least four years after the underlying property is sold.

Avoiding Tax Audits

An IRS tax audit can come in a number of forms. The most demanding are the face-to-face audits, which require sitting down with an auditor and reconciling income and deductions. Others are the less demanding correspondence audits where the IRS has reason to believe that the taxpayer failed to include reported income or has overstated deductions.

Correspondence Audits– Employers, banks, lending institutions, schools, brokerage firms, escrow companies and others all feed data to the IRS, which the IRS, in turn, matches by computer the information reported on your tax return. If there is a significant discrepancy, the IRS will correspond with the taxpayer. Sometimes these discrepancies will result in additional tax liability, while other times a simple explanation will satisfy the IRS and make the problem go away. Here are some examples of typically-encountered discrepancies:
  • Unreported Pension Income – Whenever a taxpayer takes money out of one IRA account and rolls it over within the 60-day statutory limit into another IRA or qualified plan, the income is not taxable. However, the financial institution from which the funds were withdrawn will issue a 1099-R and report to the IRS that you made a withdrawal. To show the rollover, a taxpayer must report on their tax return that the distribution was in fact rolled over. All too frequently, taxpayers will fail to bring the distribution to their return preparer's attention thinking that they have met the 60-day rollover requirement. Because the rollover is unreported, it will result in a correspondence audit. Generally, when moving an IRA from one institution to another, making arrangements for a direct transfer will avoid these types of audits. However, that is not universally true, because some institutions will still issue a 1099-R, which must be reported on the tax return.

  • Gross Proceeds of Sale – When real estate, stock or other securities is sold, the IRS computer knows what it sold for since the gross proceeds of sale for real estate, securities stock are included on the form 1099-B that is filed with the IRS.  Even if there is no gain or loss, it still needs to be reported on the tax return. Otherwise, the IRS will assume the entire sales price (gross proceeds of sale) is taxable profit. By reporting the sale on the return, the taxpayer is able to show what he or she paid for the sold investment, thus minimizing or even reporting a deductible loss.

  • Security Basis - Beginning in 2011, the 1099-B was revised to include the basis and profit or loss information required by the new broker reporting rules. The official format is shown below. Substitutes from brokers that incorporate the same information as required on the official form are permitted. Unfortunately, based on the variety of layouts brokers used for 2011 reporting, it seems no two were alike, making interpreting the information and entering it correctly into software a challenge to the return preparer. Broker statements that weren't categorized in such a fashion that permitted copies of the statements to be submitted, and allowed the practitioner to say “see attached” on the Form 8949, meant that each transaction had to be separately listed – This creates a real nightmare for clients who have a significant number of transactions for the year. IRS instructions clearly state that it is not permissible to enter summary totals on the tax return in lieu of reporting the details for each transaction.

  • Alimony Paid or Received – A taxpayer who pays alimony is able to deduct the amount he or she paid. On the other hand, the recipient of that alimony must report that amount as taxable income. The IRS computer checks to make sure the amounts match; otherwise, a correspondence audit will be initiated by the IRS. This is an area of frequent mismatch because there is a lot of confusion with what constitutes alimony, child support and property settlements.

  • Home Mortgage Interest – Each of your mortgage lenders will report to the IRS the interest paid on your mortgage for the year and issue you a 1098 for the same amount. If these amounts don't reconcile, expect a correspondence audit. Where this frequently becomes an issue is when the loan is from a private party and the paying taxpayer must report on his or her tax return the name and social security number of the individual to which the interest was paid, thus allowing the IRS to make sure the private lender is reporting the income. Another frequently encountered area of mismatch is when two or more individuals are on the same loan, but lenders report the interest paid only under one of the borrower's social security numbers. Here again, a notation must be made on the return showing the individual who actually received the income, so the IRS can make sure they are not claiming 100% of that interest and that the total reported paid by all parties does not exceed the total reported paid on the loan.

  • Tuition Paid – Because of the American Opportunity, Hope and Lifetime education tax credits that can be claimed for paying tuition to a qualified education institution, the IRS requires those institutions to report the tuition received to the IRS and issue the 1098-T to the taxpayers. Thus, the IRS has the ability to verify the tuition paid during the year, and any mismatch could result in a correspondence audit.

  • Interest and Dividends – The IRS allows many financial institutions to issue substitute 1099s, i.e. forms that are not in the traditional standard 1099 format. These substitute forms can often be misinterpreted by an untrained eye with various types of interest and dividends reported separately and spread throughout lengthy annual account statements. To make matters worse, many brokerage firms have been issuing amended 1099 statements late in the tax filing season due to their errors in determining the allocation of a taxpayer's earnings between dividends, qualified dividends, capital gains dividends, and original issue discount interest. Thus, if the taxpayer has already filed, the changes are significant, and if the taxpayer does file an amended return, they will probably receive a correspondence audit.

  • Non-Taxable Interest – Interest from municipal obligations are tax-free for purposes of computing federal tax. However, tax-free municipal interest income is added to income for purposes of computing taxable social security income. It is also counts as income for purposes of determining whether a taxpayer qualifies for earned income credit (EIC). Thus, payers of tax-free municipal interest must report the interest paid to the IRS and issue a 1099 to the taxpayer so that the IRS can match the tax-free income to the computation of taxable social security and EIC disallowance. Taxpayers should pay particular attention to this new matching program.

  • Cash Contributions – Regardless of the amount of cash contributed, the contribution must be backed up with either a bank record or written communication from the donee organization showing the: (1) name of the donee organization, (2) date of the contribution, and (3) amount of the contribution. The recordkeeping requirements may not be satisfied by maintaining other written records.

    What this means is that unless the charitable organization provides a written communication, cash donations put into a “Christmas kettle,” church collection plate, and pass-the-hat collections at youth sporting events will not be deductible. Donations by debit or credit card can be substantiated by bank records. These new rules will give the IRS the ability to audit taxpayer's charitable contributions via correspondence audits since all contributions must be backed by written receipt or bank record.

    Don't assume that just because you received a notice that the IRS is correct. They are frequently wrong. Please call this office before responding to any IRS notice. Tax laws are complicated, and the notices are not always easily understood.

Face-to-Face Audits – The more demanding face-to-face audit is rarely encountered by wage-earning taxpayers who report all their income and have deductions that are within the general norms. Self-employed, high-income taxpayers, those who have omitted substantial income, or those who repeatedly fail to show income to support their lifestyle are more likely to be subject to these types of audits.

You can appear for the audit yourself, but that is probably a bad idea since you are not trained in the rules and regulations regarding audit procedures and what limits the IRS's incursion into your private life. You can authorize your tax professional to handle it without you. Often, this is the best way to prevent the audit from escalating beyond the original areas that attracted the IRS's interest in the first place. Practitioners experienced with IRS audits are less likely to become emotional or to make statements that would lead to additional IRS questioning.

Caution: It is strongly recommended that you contact this office immediately upon receipt of any inquiry from the IRS. Don't procrastinate, because that only leads to further action on the part of the IRS.

IRS Has Your Numbers!

Correspondence from the IRS has a tendency to escalate a taxpayer's pulse rate. However, most of the communication received is not the feared “come on down” letter that requests an appearance for a face-to-face audit, but instead may only require a written explanation.

Generally, all types of income (wages, interest, dividends, etc.) are reported by the payer to the IRS, who in turn, matches the reported income to the recipient's tax return based on Social Security number (SSN). Over the past few years, the IRS has become very proficient in using their computer matching programs to pick up unreported income and other discrepancies on tax returns. Discrepancies will generate an IRS inquiry, so take note of the following items which are frequently monitored by the computer matching programs:

  • Dependent SSN – The IRS allows only one taxpayer to claim the exemption for a dependent. Frequently, a dependent will claim the exemption themselves, or in other cases, separated or divorced individuals will both attempt to claim the dependent. Expect correspondence when the exemption for any SSN has been claimed twice.

  • Gross Proceeds of Sale – All brokerage firms are required to report security sales to the IRS as “gross proceeds of sale” on Form 1099-B. The 1099-B copy provided to the account owner is generally combined with interest and dividend reporting requirements and included in a consolidated 1099 statement. These statements can be confusing, and the “gross proceeds of sale” is frequently buried in the multi-page statements. If a taxpayer fails to report these security sales, the IRS will treat the gross proceeds as all profit, recompute the tax owed and send a bill. In addition, the IRS is now requiring brokers to match up and report the cost of securities giving the IRS the ability to compute the gain or loss from individual security sales.

  • Pension and IRA Rollovers – Unless it is direct (trustee-to-trustee) rollover, the plan administrator is required to issue a Form 1099-R whenever a taxpayer withdraws funds from an IRA or other type of qualified plan. If the 1099-R income is not properly accounted for on the tax return, the IRS may treat it as unreported pension income and issue a revised tax bill. Even if it is directly rolled over, ALWAYS bring rollovers to our attention.

  • Alimony – The person paying alimony must include the recipient's name, address and SSN with the deduction claimed for alimony payments. The IRS will match the payments to income reported by the recipient. If the two amounts are not the same, the IRS will initiate correspondence to both parties.

  • Home Sales – Technically, escrow companies are not required to issue 1099-S forms to taxpayers who sell their primary residence for less than the home sale gain exclusion amount and certify that they meet the exclusion qualifications ($250,000 for a single taxpayer and $500,000 for married taxpayers). Despite this, many escrow companies choose to issue them, making it necessary to report the home sale and avoid IRS correspondence.

  • Home Mortgage Interest – Since all lenders who are in the business of lending money are required to report home mortgage interest, the IRS can verify the amount claimed as deductible mortgage interest on the Schedule A of a tax return, and any significant discrepancy can lead to IRS correspondence. If a private party holds the loan (not the course of business), Form 1098 is not required to be filed, but the taxpayer claiming the mortgage interest as a deduction is required to include that party's name, contact information and SSN on Schedule A. The IRS can then match the claimed interest deduction to the amount reported by the private party as interest income.

  • Education Benefits – Schools are now required to report the tuition payments qualifying for the Hope or Lifetime Learning tax credit or the tuition and fees deduction that were made during the year on Form 1098-T. Educational lenders report the amount of student loan interest paid on Form 1098-E. Both are used to match against claimed deductions and credits on the tax return.

Should you receive a notice, it is generally best to contact this office. Don't just pay the revised tax the IRS proposes. Frequently, the IRS notice is in error and attempting to respond to the notice without professional advice may create additional problems.

Innocent Spouse Relief

When married taxpayers file jointly, they become “jointly and individually” responsible (often referred to as “jointly and severally liable”) for the tax and interest or penalty due on their returns. This is true even if they later separate or divorce.

Joint filers remain “jointly and severally liable” even if a divorce decree states that a former spouse is responsible for any amounts due on previously filed joint returns. The IRS will use all means to collect the tax from either or both of the spouses. One spouse may be held responsible for all the tax due, even if all the income was earned by the other spouse. However, a spouse may in certain cases be relieved of responsibility for tax, interest, and penalties on a joint return under special relief rules. There are three types of relief available:

1. Innocent spouse relief
2. Separation of liability
3. Equitable relief

INNOCENT SPOUSE RELIEF - To qualify for innocent spouse relief, a taxpayer:

1. Must have filed a joint return with an “understatement of tax” (i.e., the difference between the amount of tax that should have been shown on a return vs. the tax actually shown) that was due to “erroneous items” of his/her spouse;

2. Must establish that at the time he/she signed the joint return, he/she didn't know (and had no reason to know) that there was an understatement; and

3. Accounting for all the facts and circumstances, it would be unfair (i.e., inequitable) to hold the taxpayer liable for the understatement of tax.

Erroneous Items are either:

  • Unreported income that was received by the non-innocent spouse and isn't reported on the return, or
  • Incorrect deductions, credits, or basis claimed by the non-innocent spouse which are improper or for which there is no basis in fact or law.

Indicators of Unfairness are determined based on the facts and circumstances of each individual case. To decide unfairness, the IRS will check several factors, which include:

  • Whether the “innocent spouse” received significant direct or indirect benefit from the understatement of tax. A significant benefit is one which is excessive in terms of normal support. Example: In March 2012, Jenna received $20,000 from Terence, her spouse of 10 years. The funds were traced to Terence's lottery winnings in 2010. No winnings were reported on the couple's joint federal return in 2010. The couple's normal monthly household operating budget was around $4,000. More than likely, the IRS would rule that Jenna had received a significant benefit due to the $20,000 gift, even though it was received in a year other than the one in which the unreported income occurred.
  • Desertion of the innocent spouse by the non-innocent spouse.
  • Divorce or separation of the spouses.
  • Innocent spouse received a benefit on the return from the understatement.

RELIEF BY SEPARATION OF LIABILITY - To file a claim for this type of relief, the understatement of a joint tax liability (including interest and penalty) must be allocated (separated) between spouses (or former spouses). Since this form of relief is for unpaid liabilities resulting from understatements of tax, the relief doesn't generate refunds.

To request relief by separation, a taxpayer must have filed a joint return and meet either of the following when the application is filed:

  • Be divorced or legally separated from the spouse with whom the joint return was filed (widowed counts the same as divorced or legally separated), OR
  • Not be a member of the same household as the spouse with whom the joint return was filed during the 12-month period ending on the date Form 8857 is filed. Note: The reason for living apart must be due to estrangement, not temporary absence.

    Limitations - Innocent spouse relief by separation won't be granted in these situations:

    1. IRS proves that the spouses transferred assets to each other fraudulently.

    2. IRS shows that the “innocent spouse” had actual knowledge of erroneous items at the time of signing the joint return. NOTE: A victim of domestic abuse who had actual knowledge of errors may still qualify for relief if the abuse happened before signing the joint return and fear prevented the abused spouse from challenging treatment of return items.

    3. The “non-innocent” spouse transfers property to the “innocent” spouse to avoid taxes. A transfer to avoid tax is presumed if made within one year before the date on which the IRS sent its first letter of proposed deficiency. However, this presumption doesn't apply if the transfer is made under a divorce decree or separate maintenance agreement, nor does it apply where a taxpayer can establish that the main purpose of the transfer was not tax avoidance.

EQUITABLE RELIEF - If a taxpayer doesn't qualify for the two other forms of innocent spouse relief, the IRS will automatically consider whether equitable relief is suitable to the situation. A taxpayer may qualify for equitable relief if all of the following are met:

1. The taxpayer doesn't qualify under one of the other forms of relief (e.g., separation of liability);

2. The spouses didn't transfer assets to each other fraudulently or for the purpose of avoiding tax payment;

3. The taxpayers' return wasn't fraudulently filed;

4. The taxpayer did not pay the tax owed (although a refund may be available for certain installment payments made after Form 8857 is filed);

5. The taxpayer can establish that it would be unfair (inequitable) to hold him/her responsible for the tax liability;

6. The income tax from which the taxpayer seeks relief is attributable to the “non-innocent” spouse, unless one of the following exceptions apply:

a. The item is partly or totally attributable to the taxpayer under community law.
b. An item titled in the taxpayer's name is attributable to the taxpayer unless rebutted by facts and circumstances.
c. The taxpayer had no knowledge, or reason to know, that the “non-innocent” spouse misappropriated the funds that were intended to pay the tax.
d. The taxpayer establishes being an abuse victim before signing the return, and because of prior abuse, didn't challenge the treatment of items on the return for fear of retaliation by the spouse.

INDICATORS OF UNFAIRNESS - The IRS considers all facts and circumstances to determine if it is unfair to hold the innocent spouse responsible for an underpayment or understatement of tax. The following factors are examples of items weighed by the Service in equitable relief cases:

Favorable Factors:

  • Separation or divorce of the involved spouses
  • Economic hardship
  • Abuse
  • Lack of knowledge of the innocent spouse
  • Non-innocent spouse's obligation under a divorce decree to pay the tax
  • The tax owed is attributed to the non-innocent spouse.

Unfavorable Factors:

  • No economic hardship if relief is not granted.
  • Innocent spouse had knowledge of the understated items.
  • Innocent spouse received significant benefit from the unpaid tax.
  • Lack of good faith effort to comply with the tax law by the innocent spouse.
  • Innocent spouse has an obligation to pay the tax under a divorce decree.
  • Tax for which relief request is made is attributable to the innocent spouse.

Spousal Notification – Be aware that the law requires the IRS to inform your spouse or former spouse of the request for relief from liability. The IRS is also required to allow your spouse or former spouse to provide information that may assist in determining the amount of relief from liability. The IRS will not provide information to your spouse or former spouse that could infringe on your privacy. The IRS will not provide your current name, address, information about your employer, phone number or any other information that does not relate to making a determination about your request for relief from liability.

If you believe you qualify for relief under innocent spouse, separation of liability or equitable relief, you will need to complete IRS Form 8857 and include a written statement explaining why you would qualify for relief. You should also complete and attach IRS Form 12510 (Questionnaire for Requesting Spouse), which may help speeding up the processing. Generally, you can expect the IRS to request additional information before making their final determination.

Installment Agreement

So what happens if you can't pay your tax liability?   For taxpayers who cannot pay all their taxes at once, there is the installment agreement option. IRS Form 9465 is used to request a monthly installment plan. Generally, you can have up to 72 months to pay off the liability. Depending upon how much you owe, the IRS may investigate your ability to pay before granting an installment agreement.

To be eligible for an installment agreement, you must first file all returns that are required and be current with estimated tax payments.

If you owe $50,000 or less in combined tax, penalties and interest, you can request an installment agreement using the web-based application called Online Payment Agreement found at IRS.gov.

You can also complete and mail an IRS Form 9465, Installment Agreement Request, along with your bill in the envelope that you have received from the IRS.  The IRS will inform you usually within 30 days whether your request is approved, denied, or if additional information is needed.  If the amount you owe is $50,000 or less, provide the monthly amount you wish to pay with your request.  At a minimum, the monthly amount you will be allowed to pay without completing a Collection Information Statement, Form 433, is an amount that will full pay the total balance owed within 72 months.

You may still qualify for an installment agreement if you owe more than $50,000, but a Form 433F, Collection Information Statement, is required to be completed before an installment agreement can be considered. If your balance is over $50,000, consider your financial situation and propose the highest amount possible, as that is how the IRS will arrive at your payment amount based upon your financial information.

If an agreement is approved, a one-time user fee will be charged.  The user fee for a new agreement is $120 or $52 for agreements where payments are deducted directly from your bank account.  For eligible individuals with incomes at or below certain levels, a reduced fee of $43 will be charged, and is automatically figured based on your income.  Caution: The IRS is proposing to raise the $120 fee to $225.

But before requesting an installment agreement, you should consider other less costly alternatives, such as a bank loan, home equity loan or other sources of funds. The IRS will charge a $43 fee and you will continue to pay interest on the balance, which is generally higher than bank rates.

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