IRS Audits: Top Six Field Audit Issues
Some field audits last a couple of hours and are wrapped up that day. In extreme cases, a revenue agent may spend hundreds of hours over a year or two conducting a field audit.
The typical field audit, however, involves an interview with the revenue agent that lasts an hour or two, followed by the revenue agent spending ten to 15 hours reviewing your records.
The vast majority of people who are subjected to a field audit are small business owners whom the IRS historically suspects of having not reported all of their self-employment income and having claimed personal expenses as business deductions.
For this reason, field audits focus almost exclusively on unreported business income, verification of business expenses, sales of assets, living beyond one’s means, rental of real estate, and classification of workers as employees or independent contractors.
Unreported Business Income
This is the revenue agent’s number one concern, particularly if your business has many cash transactions. The revenue agent suspects owners of businesses that deal in cash of skimming cash off the gross receipts rather than reporting 100% of the income. This is why owners of restaurants, bars, liquor stores, pizza parlors, video arcades, laundromats, vending machine companies, and grocery stores are perennially audited.
Unless the IRS has direct evidence of you cheating—such as your confession—the revenue agent will use one or more of four common methods to detect income. Your best preparation for the audit is to know how to counter these methods.
Net Worth Method
Using the net worth method, the IRS attributes any increase in your net worth—assets minus liabilities—during the year in question to taxable income. The revenue agent hunts for any financial statements prepared for your business or as part of a mortgage or other loan application. The agent will ask related questions of you in an interview and look back at your bank records. He or she will use that information to establish your net worth at the beginning of the audit year and then again at the end.
The agent will value assets at their original cost without considering any appreciation. If your net worth has risen but your reported income has not, the IRS will assume you’re not reporting everything. It’s up to you to refute it.
There are two ways to defend against the net worth method:
Show the revenue agent that his or her valuations or calculations are wrong, or show that your net worth increased due to nontaxable factors. Maybe you inherited a substantial sum of money—inheritances and gifts are not taxable.
Or, it’s possible that you worked, paid taxes on the money you earned, and accumulated a huge amount of cash that you kept hidden in your home. If you deposited the money during the year under audit, it will look like unreported income for that year. Once you offer a reasonable explanation of where you obtained nontaxable income, the legal burden shifts to the IRS to negate your explanation.
Using the expenditure method, the revenue agent estimates all of your spending for the year and compares that amount to your reported income. If you spent more than you earned, the IRS attributes the difference to unreported income.
As with the net worth method, first show that the revenue agent didn’t add or subtract correctly. More likely, you can demonstrate that the revenue agent overestimated your spending. Again, perhaps the money you spent came from nontaxable sources—loans, gifts, inheritances, or prior accumulations.
Bank Deposit Method
The bank deposit method is the IRS’s favorite way of establishing unreported income because it is the easiest. The revenue agent simply totals up 12 months of bank account deposits and compares the total with the amount of income you reported. If you deposited more than you reported, the IRS assumes that the difference is unreported income.
Keep in mind that your financial and property records are easily obtained by the IRS from banks, stockbrokers, and county recorders.
As with the net worth and expenditure methods, your first possible defense is to show that the revenue agent made math mistakes.
Or, if you have several accounts, there is a very good chance that some of the deposits are actually transfers of money among accounts and the revenue agent is counting that income twice. Prepare to counter this double-counting by listing all of your bank deposits before the audit begins.
Note the source of money for each deposit, whether taxable receipts or nontaxable sources, such as a transfer. Other nontaxable sources include proceeds of a loan, redeposits of bad checks, inheritances and gifts received, sales of assets, holding money in accounts for relatives or friends, and depositing cash earned in other years.
Using the markup method, the revenue agent looks at reported sales, cost of goods sold, and net profit for a business that sells goods. If these numbers are much lower than the figures for similar businesses, the revenue agent may assume that you have not reported all income.
Garth’s roofing materials business sold $1,000,000 of supplies, which Garth purchased wholesale for $600,000. He had $375,000 in overhead expenses, netting him only $25,000 for the year.
The IRS has data showing that the average markup on roofing materials for similar operations is 100%, meaning that Garth actually sold the $600,000 of materials for $1,200,000, not $1,000,000. The IRS assumes that Garth underreported the sales—and his income—by $200,000.
First, examine the source of data the revenue agent is using for the markup analysis. He may be comparing your business to one of a completely different type—for example, you wholesale computer parts and the agent has figures from home electronics retailing. If the IRS is comparing apples to apples, then provide an explanation of why your operation underperformed similar businesses.
- Is your business newly established?
- Were you closed several months because of your ill health?
- Did you lose a major customer or key employee?
- Is your operation sensitive to extreme weather conditions?
- Did a competitor undercut your pricing to try to put you out of business?
- Were you victimized by an embezzling bookkeeper?
Verification of Business Expenses
Revenue agents always ask for verification of major business expenses. For sole proprietors, this means the deductions shown on Schedule C.
The agent is on the lookout for phony deductions (adding an extra “0” to a deduction—$200 instead of $20) and for business owners claiming personal expenses as business expenses (running personal errands using your business vehicle or installing the “office” stereo system in your living room).
The agent is particularly interested in auto, travel, and entertainment deductions.
The tax law mandates that you must keep accurate written records for these three categories. A business diary, calendar, or log will be expected of you. If you lost or didn’t keep one, create it for the audit—but tell the auditor it is a reconstruction.
Auditors have a keen sense of freshly minted records. Honesty here builds your credibility.
Sales of Assets
If you sold any asset, the IRS may ask for substantiation of the “tax basis” you claimed on your tax return of the asset if it was used in your business or held for investment. The tax basis is the figure from which the IRS calculates the profit or loss you made on the sale or verifies your annual depreciation deduction.
Essentially, the tax basis starts with the amount you paid. To this figure, you add the cost of improvements and subtract expenses such as depreciation. If you received property as a gift or inheritance, your tax basis is the asset’s tax basis at the date of the transfer, not the date of the original purchase.
Proving the tax basis can be a problem if you bought an asset many years back. Do the best you can to dig up the original purchase papers. If they are lost, you will have to recreate them. Also, you’ll need receipts for real estate improvements done during your ownership. And with stock sales, you’ll need to show any reinvested dividends on which you previously paid taxes.
Living Beyond One’s Means
If the revenue agent has a strong suspicion that you have not reported all of your taxable income, he or she may use something called a financial status analysis to detect unreported income.
The IRS will ask one essential question:
Does the income on your tax return support your financial condition and business transactions?
Be ready to show how you acquired a Lamborghini while clerking at Futon World. While financial status inquiries were discouraged by 1998 tax code changes, they were not banned altogether.
Standard of Living Issues
The IRS training materials given to auditors direct them to consider the following questions:
- The standard of living of a taxpayer:
- What do the taxpayer and the taxpayer’s dependents spend?
- How much does it cost to maintain this level of consumption?
- Is the reported net income sufficient to support this?
- The accumulated wealth of a taxpayer:
- How much capital/assets has the taxpayer accumulated?
- When and how was this wealth accumulated?
- Has the reported income been sufficient to pay for these items?
- If not, how did the taxpayer obtain and repay credit?
- The economic history of a taxpayer:
- What is the long-term pattern of profits and returns on investment in the reported activity?
- Is the business expanding or contracting?
- Does the reported business history match with changes in the taxpayer’s standard of living and wealth accumulation?
- The business environment:
- What is the typical profitability and return on investment for the taxpayer’s industry and locality?
- What are the typical patterns of noncompliance in the taxpayer’s industry?
- What are the competitive pressures and economic health of the industry within which the taxpayer operates?
- Other nontaxable sources of funds:
- Do claims of nontaxable sources of support make economic sense?
- How creditworthy is the taxpayer—how many claimed loans?
- How did the sources of claimed funds’ transfers obtain those funds?
- Do the taxpayer’s books and records reflect the economic reality of his or her personal and business activities, or has the taxpayer omitted income in order to minimize tax liability?
Rental Real Estate
If you claimed rental property income and expenses on Schedule E of your tax return, you will have to verify them to the revenue agent.
As a property owner, you should keep records. If you don’t, you must reconstruct records from canceled checks, deposits, receipts, and notes.
Classification of Workers as Employees or Independent Contractors
The revenue agent will be keenly interested in whether you properly classified people working for your business as independent contractors or employees.
For all employees, you are required to withhold and pay over taxes to the IRS and probably your state taxing authority.
By contrast, you have no tax withholding responsibilities or FICA taxes for independent contractors. But you must meet strict standards to classify a worker as an independent contractor, and the IRS has a strong bias toward finding that workers are employees. If the IRS finds that you have misclassified workers, the tax bill could be enormous.