IRS Examinations, 0313 SCBJ, SC Lawyer, March 2013, #2

Author:John A. Ecton.

IRS Examinations

2013 #2

South Carolina Bar Journal

March, 2013

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Tax Audits of Attorneys

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0 John A. Ecton.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0As a lawyer in Small Town South Carolina, Owen Truepay operated his practice as a professional Subchapter-S Corporation. He and his wife consider themselves an average American family. They have two kids, Axel and Elvis, and a moderately priced home. Bob has been practicing law for 20 years and is proud of the firm he founded eight years ago. While trying to find a good niche practice to support the operations of the firm, he has dabbled in several practice areas, including personal injury, workers' compensation, criminal defense, collections and even some insurance defense. Owen's wife, Louise, operates a HomeCare Distributorship, a part-time home-based side business selling vitamins and other nutritional supplements via network marketing. Life has its ups and downs, but for the most part all is good. That is, until Owen and Louise receive a letter from the Internal Revenue Service. Late that night, Owen sits down to open the letter. It's one of his biggest fears—"Your federal income tax return for the year shown above has been selected for examination." We call them "audits, " but whatever the term, it describes one of life's most dreaded experiences. The words "IRS audit" strike fear in the hearts of many taxpayers. We have all heard the horror stories. This article will explain the focus of IRS examinations and specifically what attorneys may need to know before they get selected for audit.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Overview of the audit process

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0An IRS examination or audit is the process by which the IRS determines whether you properly reported all income and took the correct deductions, exemptions and credits on your tax return. If the IRS determines there was an error on your return, you will most g likely be assessed additional taxes, § interest and usually penalties. This i assessment will be a formal entry g of a tax liability in your master file S at the IRS Service Center. The IRS ™ will examine approximately 1.5 5 million tax returns every year, S about one percent of all individual tax returns. And as your income increases, so does the likelihood of an IRS audit. Taxpayers earning over $100, 000 per year doubles the likelihood of an audit, as do self-employed individuals.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0With the initial notice of IRS audit, you will be given a checklist of items that the auditor, called an IRS Revenue Agent, will be investigating. Contrary to popular belief, the burden of proving that you correctly reported your income and claimed the proper deductions, exemptions and credits is on you, the taxpayer, not the IRS. You will be required to prove the information is correct. Yes, you are guilty until proven innocent in this situation, and attorneys know it is not always as easy to prove your innocence as it may seem. Many individuals have problems verifying what is on their tax returns. In fact, many Revenue Agents will admit it usually is not dishonesty by the taxpayer, but a lack of documentation and poor record keeping. Unfortunately, most audits will cost the taxpayer money, as more than 80 percent of people who are audited are found to owe additional taxes.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0One of the main questions taxpayers ask once they receive the audit notice is "why was I picked for an audit?" The IRS uses sophisticated computer algorithms in the selection of which returns to audit. There are three different computer software systems the IRS uses on each tax return to see if the information is accurate. The first software program is called the Discriminant Inventory Function System, which is a secret formula used by the IRS to rank returns on potential for error. The second computer system is the Unreported Income Discriminant Function System, which ranks the return for the potential of having unreported income. The third computer system is the Information Returns Processing System, which will compare the information the taxpayer reported to the information provided by third parties to see if everything matches up. These software systems have closely guarded formulas that statistically analyze tax returns for oddities and discrepancies and assign a score that determines whether you are selected for audit.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Reasons for selection—red flags

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Assuming you are reading this article and have not been selected yet for audit, then a better question right now would be "what can I do to reduce the chances of being selected for an audit?" Many times audits can be avoided if you are aware of how the IRS audit process works and the common audit red flags. These 10 tips may help taxpayers avoid a tax audit:

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA01. Be truthful/report all income: The easiest way to avoid an audit is to be 100 percent truthful in what you file. The IRS gets copies of all 1099s and W-2s, so it is important to make sure to report all required income on the return. The IRS computers are pretty good at matching the numbers and will likely catch on if you fail to report income. Any mismatch sends up a red flag and causes a separate inquiry or even an additional assessment based on the numbers. The

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0IRS has many checks and will likely find out if you are not truthful.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA02. Avoid using Schedule C: Large Schedule C losses tend to invite audits. In fact, individuals who file a Schedule C are much more likely to be audited than people that don't. This is because many individuals abuse the deductions they can take with a Schedule C. Agents are specially trained to sniff out those who improperly deduct hobby losses. While you can deduct expenses from a hobby up to the limit of income from the hobby you cannot write...

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