Thursday, January 26, 2012

IRS Audits: Why You Should Not Represent Yourself

An audit is a review by the IRS of your financial records and information to make sure that the information that you reported to the IRS on your tax returns are correct and accurate. The audit may be completed by mail or through an in-person interview – but your records are always reviewed.

The following nightmare occurred with one of my clients:
“Tom” is a small business owner who runs a successful small manufacturing business. Although he was great at his work and his clients loved him, he wasn’t as good maintaining his business records. One day, he received a notice from the IRS that he was being audited. During the audit process, the IRS requested that Tom provide copies of his bank statements.
Tragically, Tom believed that some relatively large deposits from his clients would draw the attention of the auditor, so he altered a few of the paper statements before handing them over to the IRS. When the IRS compared them to the records that they had received from the bank (the IRS can obtain these records by a “summons”), they discovered what Tom had done.

Eventually, Tom’s case was referred to Criminal Investigations and he was criminally charged for this act and is awaiting sentencing to Federal prison.

The tragedy of this story is that Tom never consulted with a professional during the audit process. Instead, he acted out of fear and ignorance – to devastating consequences.

What makes an IRS audit so daunting is that the burden of proof is on YOU to show that you have included all of your taxable income and provided receipts for all of your tax deductions. It is not enough that your return is accurate. You must be able to prove its accuracy. However, the process of proof is both time-consuming and difficult; the process sometimes leads people to make grave mistakes.

If your audit is not handled properly, the following might occur:
  • An accuracy related penalty will be assessed (20% of the underpayment); 
  • A substantial understatement penalty will be assessed (20% of the underpayment); 
  • A civil fraud penalty will be assessed (75% of the underpayment); 
  • A referral to the Criminal Investigation Division of the IRS will be made; 
  • The IRS will expand its audit to other tax years; 
  • The IRS will expand its audit to related taxpayers; 
  • The IRS will contact third parties about your tax return. 
My general rule of thumb: in any instance where you are providing financial information to the IRS, you should allow a professional to assist you because you may inadvertently supply information which is unnecessary and may harm you. 

Or you may even be tempted to make up information (as Tom did above).

Hiring a tax professional will save you time and money – and likely bring you a better result. According to IRS reports, “taxpayers represented by counsel fared noticeably better than their pro se counterparts” in audit and tax court matters. Taxpayers with representation received full or partial relief in 58 percent of litigated cases vs. just 34 percent for pro se taxpayers. This is not a time to pinch pennies.

Naturally, the best way to avoid an audit is never to end up there in the first place. But if you’re audited, (when the IRS is knocking on your door) get your tax professional involved early in the process as positioning is everything. Second, listen closely and understand fully the IRS’ concerns. Third, provide the IRS documentation and legal support justifying your positions and addressing the IRS issues. Fourth, exercise your rights for review at IRS appeals and mediation. The IRS has recently been much more open to alternative dispute resolution – something that can save you time and money.

Finally, I am a big believer that you need to be on offense when dealing with an IRS audit. The taxpayer should review the open year under exam closely and determine whether there are any additional tax savings available. This has meant that in some cases we’ve had clients who actually are OWED money by the IRS from an audit.

I have found working with many businesses and individuals that vigorous representation during exam and appeals right from the beginning will carry you a very long ways towards success.

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