Who's afraid of the Big Bad Wolf?

I just attended an intensive training program on dealing with the IRS.  One of the instructors, at prominent tax lawyer, said that, based on his experience, about 15% of the U.S. population becomes functionally illiterate when they receive an IRS letter.  Another 5 – 10% breaks out in a cold sweat and many are afraid to open the letter.  What causes all this fear?  Should you be afraid?

Since our income tax system in the U.S. is a voluntary one, the IRS wants us to believe they are watching our every move and will come knocking on your door if you make even the smallest error on your tax return.  They want the image as the Big Bad Wolf.  Does it work?  For the most part, you betcha! 

Let’s look more closely at how the IRS operates and some of the statistics to see if you have good reason to be afraid.  The IRS sends millions of letters to taxpayers every year.  Many of the letters they send out are straight forward and are administrative in nature.  They may be correcting a math error, advising that you left something off the return and giving you a chance to fix it.  Or they may be more serious, assessing a penalty if you filed late or notifying you that your tax return is being audited.  Unfortunately, they never send you a letter saying you are doing great, keep up the good work.

So, what are your chances of being audited?  Actually they are very small.  On average, a little over1% of filed tax returns get audited each year, however that number has been going up in the past decade and as you will see a little later, the odds increase depending on the type of return you file.  Several years ago an IRS research study showed that there is an underpayment of taxes of about $300B (B as in Billion) per year, known as the “Tax Gap.”  About $250B of that comes from underreporting income and/or overstating expenses. 

Congress has asked the IRS to aggressively try to close the “Tax Gap.”  One way they are doing it is by hiring more employees and conducting more audits.  Let me analyze this a little bit further.  Financially, most taxpayers lead rather uncomplicated lives.  They work for someone else, get paid by W-2, earn interest from their bank or brokerage, buy and sell a few stocks, put some money in a 401K or similar plan, pay their mortgage or are retired drawing a pension and social security.  Virtually everything financially in their lives is reported to the individual and to the IRS on one form or another.  For this large segment of taxpayers, it is a simple matter for the IRS to know who has filed and accurately reported their income and deductions.  In many cases, if a taxpayer does not file a return, the IRS will file a substitute tax return for the taxpayer.  This will only occur only if they taxpayer owes money.  If the taxpayer is due a refund, the taxpayer will probably never hear from the IRS.  Why?  By law, after three years the IRS no longer has to refund the money. 

So, how does the IRS know who to audit?  The IRS scores every tax return filed; known as the DIF score.  Through research, the IRS knows what types and how much a taxpayer should be taking in deductions based on his/her Adjusted Gross Income.  If the computer review of the tax return finds some of the numbers outside the norm, it assigns a higher DIF score to the return.  The higher the DIF score the more likely the return will be audited. 

I’ll give you one guess where the majority of the $250B shortfall comes from.  It comes from small businesses and self employed folks; that’s you and me.  Research and IRS experience from past audits have shown that there is a significant underreporting of income as well as overstating of expenses on many business returns.  This is especially the case with sole proprietorships and single member LLC’s that report their business income on Schedule C on their 1040 return.

As a self employed taxpayer, you are about 10 times more likely to have your Schedule C audited than you would be if you filed a Form 1065 (partnership or LLC return) or 1120/1120S (corporation or subchapter S return).    Based on years of audits the IRS knows that those small businesses who file on Schedule C probably don’t keep sufficient records and frequently can’t prove the income and expenses claimed.  On the other hand, small businesses who file Form 1065, 1120 or 1120S generally keep better records and frequently use a bookkeeper or accountant and a tax professional.   As a result, the IRS knows that the “low hanging fruit”, so to speak, is in Schedule C businesses.  So take the hint.  For those of you who are filing on Schedule C, you might want to consider another type of business entity. 

The IRS uses education of the public and audits to keep people in compliance.  Lately the IRS has been putting most of its emphasis on audits and is expanding its audit force.  Audits are the subject of another article, but, briefly, there are three types of audits,   Correspondence, Office and Field, with a Field audit being the most comprehensive one.  The IRS makes sure it gets a lot of publicity on its high profile audits and criminal actions. 

So, how do you protect yourself from the Big Bad Wolf? 

• First of all, keep excellent records.  If you are not good at recordkeeping, hire a bookkeeper or accountant to help you or at least be on your team of advisors.  See:  (http://biznik.com/articles/ive-got-your-six).  Use a software program like QuickBooks to track income and expenses so you can create financial statements.  This will not only help you at tax time, it will help you immensely if you are audited.  These reports are also essential to understanding and managing your business.
• Keep your personal and business finances separate.  Always!  Have separate bank accounts and credit cards for the business and for you personally.  By the way, if you are one of those people who does not believe cash is money (in other words, not reportable to the IRS as income), the IRS has ways to determine when you are not reporting income.  In a Field audit, they always do this analysis and sometimes in an Office audit as well. 
• Have documentation to back up expenses you claim.  Cancelled checks are not considered adequate proof, although they are better than nothing; it’s always best to have a receipt for each item you claim.
• Keep good automobile records if you use your car for your business.  I know it’s a pain, but keep a log in your car and annotate every business trip you take with the miles you drive and the reason for the trip.  This only takes a minute or two and it is well worth the effort.  If you are seeing a client, note who that client is.  If you are constantly going to the same place, for example you are in construction, you can use Map Quest to determine the mileage, but you still need to keep a log of the number of trips to that location.
• File your tax return(s) on time.  On time includes an extension if you file for it.  Remember, the extension is to file your return, not to pay what you owe.  If you owe money, the IRS expects it all to be paid no later than April 15th. 
• Lastly, if you get that dreaded letter from the IRS, open it immediately!  Not dealing with it quickly will only lead to more trouble later.  IRS letters can be long and difficult to understand.  If you used a tax professional to do your tax return, contact him/her immediately for their help.   If you did not use a tax professional and the issue seems serious, contact an Enrolled Agent (http://www.professionaltaxservicesinc.net/enrolled-agent/) or CPA who has experience dealing with the IRS.  I would not recommend contacting a tax lawyer unless you suspect the IRS is after you for fraud or you are under criminal investigation.  If agents show up at your door with a badge, it’s usually very serious.  That is when a tax lawyer should be consulted. 

Should you be afraid of the Big Bad Wolf?  Absolutely not!  If you follow the simple guidelines I laid out above, you really should have nothing to worry about.  That doesn’t mean you won’t get an IRS letter or be audited, but if you are you will be prepared.  Adding a tax professional to your team of advisors will give you extra peace of mind as well.