Like most tax professionals, I am relieved that April 15th has now come and gone.  As a member of the tax department here at Bond Beebe, tax compliance has been the center of my universe for the past three and a half months.  With many returns completed and the rest safely extended, my thoughts now turn to other areas of tax practice, including representing various clients in audits before the IRS and other state and local taxing authorities.  This is a part of my practice that I have, unfortunately, seen expand considerably over my 15 years as a tax professional.

Noncompliance: Where the Money is and is NOT Coming From

In an environment of growing demands on limited government resources, every dollar counts.  According to the 2008 IRS data book, net tax revenue has decreased by approximately 3.3 %while government spending has continued to increase.  It is further estimated that close to 16% of taxpayers are either underreporting income, overstating deductions or otherwise not in full compliance.  This percentage of the taxpaying population is estimated to represent a tax gap of well over $300 billion per year.  In light of the difficulties presented to many by the current downturn in the economy, the IRS is rightly concerned that this gap may continue to grow.

Given that the largest component of the tax gap is the result of underreporting noncompliance among individual taxpayers, the natural response of taxing authorities is to crank up enforcement activity and specifically to direct that enforcement activity to the returns of business owners and other high net-worth taxpayers.  The current budget outlined by the Obama administration calls for an increase to the budget of the IRS of approximately 4%, most of which will be directed for greater funding of enforcement activities including audits, criminal investigations, collection activities and greater policing of offshore tax evasion.

The Income/Audit Correlation

As you would expect, the greater the income reported on a return, the greater the likelihood of audit.  According to the 2008 IRS Data Book, approximately 2% of individual income tax returns with adjusted gross income between $200,000 and $500,000 filed in calendar year 2007 were pulled for examination in fiscal year 2008.  The rate of audit increases dramatically as the reported AGI increases.  Nearly 7% of returns with income between $500,000 and $5 million and over 16% of returns with income in excess of $5 million were selected for examination.  The level of scrutiny on these high income returns is especially apparent when you consider that these returns represent only .66% and .03%, respectively, of all returns filed.

How Can an Honest Taxpayer Prepare for an Audit?

The method used by the IRS for selecting returns to audit involves a number of scientific and statistical models designed to help identify noncompliant taxpayers.  However, for every noncompliant taxpayer who is caught, there are likely dozens of law-abiding citizens who have to endure the cost and aggravation of an IRS audit.  My advice to clients is to approach every tax return like you are going to have to undergo an audit.  Effective preparation and recordkeeping can significantly lessen the sting of an audit.  The following are my top pieces of advice on how to be “audit ready.”

1. Be selective about who prepares your tax return.  The laws and regulations governing income taxation are voluminous, incredibly complex, and constantly changing.  A qualified tax professional invests hours and hours every year in education and training to provide his or her clients with quality service.  When selecting an accountant or tax preparer, you want to determine if they are competent and up-to-date with tax law.  If possible, reach out to trusted friends or business advisors for recommendations or referrals.  Don’t be afraid to ask questions about the quality control process and other safeguards your potential tax preparer employs to insure that your return is complete and correct.

2. Communicate with your tax preparer.  Like most business services, the outcome of the tax return preparation process is largely a function of the quality and quantity of information provided to a qualified professional.  Make sure that you take time to discuss your financial transactions thoroughly with your tax preparer and provide complete documents to insure that they can make informed decisions when preparing your return.

3. Keep complete and thorough records.  It is said that Andrew Carnegie kept meticulous and detailed records of every nickel he ever spent.  While this level of detail is not necessarily required, well-organized records and contemporaneous documentation regarding business and other deductible expenditures can go a long way in establishing the validity and completeness of your tax returns in an audit environment.  Make an effort to separately track your business and personal expenditures through the use of separate bank accounts and credit cards.  Using computer software to organize and track your business and personal transactions is also extremely helpful.  You should always obtain and keep necessary documentation to substantiate the deductibility of expenses, especially those related to the use of an automobile, travel, meals and entertainment and charitable contributions.

4. Review your tax return completely before you sign it, and ask questions.  While your tax preparer should make every effort to correctly and properly reflect your financial transactions on your income tax return, people are fallible and mistakes can happen.  Likewise, miscommunication and misunderstandings may lead to errors.  It is always important to remember that ultimately, your tax return is your responsibility, and in spite of how much you trust your tax professional, you should understand what you are signing.  If necessary, ask your tax preparer to review your return with you and to explain elements you do not understand.  In my experience, a client who is informed and interested in the work I am doing is ultimately a better client.

As they say, nothing is inevitable but death and taxes.  It follows that where you have taxes, the tax man is usually not too far behind.  Hopefully, if you have an “inevitable encounter” with an IRS audit, you and your tax professional can meet the challenge efficiently and as painlessly as possible by being informed and prepared.