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Avoid the Stress: The Best Protection Against Trouble With the IRS is to Play By the Rules

Richard J. Nelson, CPA
Richard J. Nelson, CPA Director, Tax Strategies

This article originally appeared in the September 2015 issue of Smart Business Philadelphia.

Richard J. Nelson, CPA

The number of IRS audits will be reduced to 1 million in 2015, down from 1.3 million audits in 2014, according to IRS Commissioner John Koskinen. This is a direct result of budget cuts that have left the agency at a level which is 17 percent lower than where it was five years ago.

So what are your chances of being audited?

Of the 189 million returns filed in 2014, 1.3 million or approximately 0.7 percent were audited. However, don’t be fooled by the 0.7 percent overall rate. Your chances of being audited increase as your income goes up. For taxpayers with over $200,000 in income, the audit rate was 2.2 percent and for incomes over $1 million, the audit rate was 7.5 percent.

Smart Business spoke with Richard J. Nelson, CPA, Director, Tax Strategies at Kreischer Miller, about what you should know about the IRS auditing process.

What should you do if you are audited?

First of all, don’t panic. If it is a correspondence audit, respond timely and mail in your supporting documentation. If it is a field audit, cooperate with the agent and meet your agreed upon deadlines.

Most agents and taxpayers want the same thing, for the audit to progress quickly and to end as soon as possible. If you and the agent cannot agree on an issue, there is an appeals process. If you are uncomfortable handling your own audit, retain a tax professional to handle it for you. All that is required is a power of attorney signed by both you and the tax professional.

How are returns picked for audit?

There are many reasons a return might be selected for audit. However, many of the returns are selected through the Discriminate Function or DIF system. The DIF system is a mathematical technique used to score income tax returns according to their examination potential.

The mathematical formulas used in the DIF system are a closely guarded secret. The higher the DIF score, the greater the audit potential.

Your return may also be selected if it contains items that generally result in audit adjustments and additional tax.

What are some of these items that might get your return selected?

If you are an individual, it’s things like taking a home office deduction; having unusually high charitable contributions; deducting business meals, and travel and entertainment expenses; and taking higher-than average deductions.

You will also increase your chances of an audit if you file a Schedule C, Profit or Loss from a Business which shows a large loss, especially if you have W-2 wages.

If you are a business, filing for a change in method of accounting; research credit claims; cost segregation studies; taking the domestic production deduction; issuing gift cards; a high volume of business meals, travel and entertainment expenses; and owning airplanes, yachts and hunting lodges can lead to an audit.

How can you protect yourself from an audit?

You can’t really protect yourself from getting audited. You can be selected for audit even though you did everything right. The best thing you can do is to be prepared. Make sure you have the documentation to support all the items of income and deduction you have reported on your return.

One area agents spend a lot of time reviewing is business meals, travel and entertainment. Besides looking for nondeductible personal expenses, they are looking to see if you have the proper documentation.

For example, to support a business dinner expense, you should be able to produce a receipt with the name of the restaurant and documentation of the names of the individuals and their companies who were there, and a description of the business discussion that occurred at dinner. Without this documentation you run the risk of losing the deduction.

It cannot be stressed enough the need to keep good records. Even though the number of audits is low, it is not a good idea to take positions or deductions that cannot be supported. If audited, the penalties and interest can be steep. You don’t have to worry about the IRS if you have the proper documentation and support for the items reported on your tax return. ●

Richard J. Nelson can be reached at Email or 215.441.4600.

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Richard J. Nelson, CPA

Richard J. Nelson, CPA

Director, Tax Strategies

Business Tax Specialist, Individual Tax Specialist, Estates, Trusts, & Gifts Specialist, International Tax Specialist

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