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Tax Filing Season Audit Thoughts

The due date of April 15 for your federal and state taxes is fast approaching. However, don’t fret, you are getting a reprieve this year. The actual due date for your return is Tuesday, April 18, 2017 due to the 15th being a Saturday, and the following Monday being Washington D.C. Emancipation Date holiday. I am sure many procrastinators will be spending that final weekend wrapping up their returns or completing their extensions.

Heading into tax filing season, there are always concerns as to what triggers an audit. Other than the individuals who came up with the IRS Discriminate Function system (DIF), nobody really knows for sure. The DIF score is generated by the computer using statistical profiles by comparing the tax figures on returns with figures generated from national statistics for taxpayers in similar tax brackets. The higher the DIF score, the more likely an audit. The formula for how this is determined is not disclosed by the IRS.

Other than the DIF, there are various theories on what triggers audits. From my perspective, a lot of the triggers make sense. Others shouldn’t necessarily trigger an audit except that many taxpayers compute the amounts incorrectly and thus it is ripe grounds for an audit. Below are various categories or issues that have a higher probability of triggering an audit.

– Mistakes. This makes sense. For example, you receive a 1099 for the withdrawal of the money from your 529 plan to pay your kids’ college tuition but fail to report that withdrawal. That will trigger an audit. Whether or not the IRS limits your audit to that one issue depends on what else is of interest on your return.

– Losses on Schedule C, or excessive deductions. Often times I will meet with a taxpayer undergoing an audit and will review their return prior to the start of the audit. They will be reporting low amounts of income or even losses on their Schedule C or F, excessive itemized deductions and little to no taxable income. The question always then becomes how did you afford to live? Most times the answer is deductions are overstated or income omitted. Sometimes, the answer is they borrowed a lot of money or used credit cards, but from a tax administration perspective, such returns often attract scrutiny.

– High income. The trend used to be that taxpayers that reported net income of less than $100,000 on Schedule C were a higher target for audit than taxpayers reporting more than said amount. Now, the trend is taxpayers that report more than $200,000 of income are audited more frequently. The rationale on the lower scale used to be that such individuals likely overstated deductions and/or understated income. Now, the rationale is that high income earners have more opportunities to make errors. I guess the zone you want to be in now is between $100,000 and $200,000.

– Home office. The home office rules are complicated. Make sure you consult a professional regarding them as taxpayers customarily compute the deduction incorrectly.

– Real estate losses. Rental real estate losses are per se passive activities such that such losses can only be deducted against passive income. Many taxpayers will try and claim that they are real estate professionals in order to make those losses deductible. The rules to qualify as a real estate professional are complicated and require a lot of substantiation and documentation. Accordingly, before you deduct real estate losses confer with your tax professional to make sure you are handling the issue correctly.

– Excessive deductions part II. The IRS asks what you do and your occupation code to compare what you report against others in the same industry. For example, if your auto or meals and entertainment are substantially higher than customary in your industry, you will likely be audited. Additionally, auto and meals and entertainment are customarily not substantiated properly and are an area of frequent adjustment.

– Casualty losses. Like the home office, people customarily report a casualty loss incorrectly and don’t have the proper substantiation. Before claiming a casualty loss, talk to your tax professional and be prepared to report it correctly and maintain the substantiation.

– Gambling losses. People have a misconception about reporting gambling winnings. They often report their losses against the gross winnings and only report the net as the gambling income. However, all the gambling income is reported on the first page of your Form 1040 and the losses are itemized losses on Schedule A to the extent of your reported winnings. Accordingly, where your losses may be limited as a result of limitations on itemized deductions, not only did you lose at the tables, you lose on your tax return.

– Unreimbursed employee business expenses. Large amounts of reported unreimbursed employee business expenses are a target because frequently they were reimbursed.

– Timely filed or extension? Answers vary on this question. Some believe you are more likely to be audited by filing on extension, some believe filing timely generates more risk, some think it does not matter. I am a proponent of filing timely to get the statute of limitations running sooner and expiring sooner. Further, a lot of the audits I handle are for people that filed on extension. Is it because they filed on extension or were just not as careful as they needed to be? Who knows.

When a taxpayer is audited, the first thing the IRS typically asks for is all of your bank statements and investment account statements. They add up the total deposits and if those deposits do not match the reported gross amounts on your tax return, you are deemed to have unreported income to the extent of the difference. The burden then is on you to prove certain deposits are non-taxable. Accordingly, review your bank statements to make sure you have reported everything deposited to your bank account. This does not mean you do not have to report cash items not deposited, it is just a way to test to make sure you have not missed something.

Audits are not a fun experience and for the most part come down to substantiation. No matter what you report on your return, make sure you have the substantiation for it. If you do not know what you might need, talk to your tax professional.

– Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP who concentrates his practice in all manners of Taxation, Real Estate Transactions, Corporate, Partnership and Limited Liability Company law matters. He is a certified specialist in Taxation. Mr. Harrel may be reached at 209-952-4545 or

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