RED FLAGS?

Peter Pappas has written a post at THE TAX LAWYER'S BLOG identifying what he considers to be "5 Slam Dunk IRS Audit Red Flags". The 5 items he says IRS examiners are trained to look for as they "indicate a high probability of error or fraud" are -

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* Home Office

* Employee Business Expenses

* Rental Losses

* Schedule C Losses

* Charitable Contributions

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I think Pete is somewhat misleading in his post. When he refers to these items as "red flags" I do not think that it is true that anyone who claims one of these items on their Form 1040 will automatically be audited - or even that their existence on a tax return will substantially increase the chance of an audit (with a possible exception discussed below).

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The mere fact that you claim a deduction for employee business expenses will not increase your chance of being audited.

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Pete correctly describes the method used by the IRS to select returns for audit - "The IRS assigns a numeric value to each tax return known as a DIF score. Returns with a DIF score higher than a pre-specified number are flagged and sent to the IRS regional examiners for further review and analysis."

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Information from your tax return is entered into a computer. The "DIF score" is based on IRS internal parameters for individual items of income and expense build into the analysis software.

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While excessive deductions claimed in any of Pete's 5 alleged red flags may increase your DIF score such that it is passed along for further review, the mere existence of these items on a return does not, I believe, increase the score (with, again, a possible exception discussed below).

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I, and I am sure Pete also, certainly would not want to scare you from claiming any legitimate deduction because it may cause your return to be audited. If you spent the money for a genuine business purpose, or made the contribution to a qualified charity (and have the required documentation), you should by all means claim a deduction.

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I do believe that these five areas are indeed "tax return items that indicate a high probability of error or fraud" and have been so identified by the IRS. And I do believe that if a return is "kicked out" by the DIF scoring process and any of these individual items show a substantial variance from IRS-considered "norms" they are looked at ore closely.

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I also agree with Pete's "common threads running through the five items" -

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"First, each of these items requires a subjective judgement to determine whether and to what extent a deduction is permitted. The more subjectivity involved, the greater the likelihood of mistake or outright abuse.

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Second, at least with respect with the first 4 items, these deductions tempt taxpayers and unscrupulous tax preparers to try to convert personal, non-deductible living expenses into deductible expenses."

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And, if I may add a third based on my own personal experience and that of other ethical tax pros, with all items these are the deductions that unscrupulous tax preparers have in the past often "inflated" or just plain "made up" to reduce a balance due or increase a refund.

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As I pointed out in my appropriately-titled post "Audits" -

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"In my 35+ years in 'the business' I expect I have prepared at least 10,000 sets of tax returns. During these 35+ years I can count on the fingers of my two hands the number of traditional IRS office audits I have had to deal with - none of which have been in the past 10 or so years."

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Over the years returns that I thought would be audited because of excessive deductions, attested to be legitimate by my clients, were never chosen for review. I have never had an audit of a return claiming rental losses, a home office, or a Schedule C loss, although employee business expenses and charitable contributions have been questioned.

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After Congress came out with its strict new documentation rules for claiming a deduction for charitable contributions tax pros, myself included, anticipated a substantial increase in the number of audits of this deduction, and expected that many clients, chosen at random, would receive "correspondence audit" notices from "Sam" requesting documentation of contributions deducted on Schedule A. This did not happen.

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However, if a return is selected for audit and the return claims more than nominal charitable contributions I would expect that documentation would be requested.

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One area where I do believe that the existence of the item may be, or possibly will be, a true "red flag" is Schedule C losses.

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As far back as December of 2006 then IRS Commissioner Mark Everson said that the IRS plans to conduct more audits on individuals with sole proprietorships. The IRS strongly believes, and frankly so do I, that a sizable portion of the "Tax Gap" (the difference between the taxes the government actually collects and what it thinks it should collect) is attributable to unreported income by self-employed persons.

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When Everson introduced his plans Schedule C returns were already being audited more frequently than "non-Schedule C" returns. As budget deficits continue to soar Congress and the IRS will be taking more action to reduce the Tax Gap and generate more federal income - and Schedule C returns with consistent losses is one area where the IRS will be concentrating its efforts.

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The post correctly observes that - "The mere reporting of business operations on Schedule C rather than a separate corporate tax return increases a taxpayer's chances of being audited 50 fold." Regardless of Tax Gap considerations, one of the reasons has always been to do with level of income. The greater one's "gross income", from whatever source, the greater the choice of an audit. A gross income, before expenses, of $250,000 reported on Schedule C is high when compared to the total 1040 "population", but minuscule when compared to the 1120 (corporate income tax return) population.

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Pete says, "Because there is so much abuse in the Schedule C loss area, we have adamantly recommended that taxpayers who are conducting a legitimate, for-profit business incorporate that business or form an LLC."

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While incorporating will certainly reduce one's 1040 audit risk, it is more often than not not the best idea for the average sold proprietorship. Incorporation can generate much more paperwork, recordkeeping, federal and state tax filings, costs, and general all-round "agita" than it is worth.

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Like a marriage - it may be relatively cheap to "get into" a corporation, but it can be highly expensive to "get out". A Schedule C filer who is considering incorporation should review very carefully all the consequences of such an action and do a detailed cost benefit analysis.

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I also recommend that all Schedule C businesses become an "LLC" - but it has nothing to do with taxes. Doing so adds an extra degree of liability protection.

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If you have a legitimate ongoing Schedule C business you probably should consult an accountant (not necessarily a CPA) instead of just a basic tax return preparer on a year-round basis. Some tax professionals are also available to provide excellent accounting services for small businesses throughout the year, while others, as I currently do, limit their practice to 1040 preparation. You can use the accountant for year-round accounting, bookkeeping, and payroll services and still have a separate tax pro prepare your 1040. The accountant can provide a "profit and loss" statement for use by the tax pro in completing the Schedule C.

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Pete provides the following "final thoughts" for those with potential "red flags" -

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"If you do decide to take one or more of the above deductions, there are several things you can do to dilute their red flag status.

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1. Timely file our return;

2. Use a recognized software program to prepare and print your return;

3. File the return electronically;

4. Have a respected CPA, tax lawyer or IRS Enrolled Agent sign your return as tax preparer; and

5. Attach explanatory statements to your return where necessary."

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I do not agree with most of these thoughts.

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1. The only one with which I concur. You should always, whenever possible, timely file your return. It is an "urban tax myth" that extending your return will reduce your chances of audit.

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2. You should never use a "box" to prepare your return unless you know what you are doing. It is more cost effective in the long run to use a competent tax professional.

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3. I do not think this makes any difference.

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4. In my 37 years in "the business" I have never come across anything that would lead me to believe that the "designation" of a tax preparer is a factor in audit selection. Returns prepared by CPAs, lawyers, and EAs are audited just as often as those of "unenrolled" preparers. And the IRS knows full well that there are incompetent and unethical CPAs, lawyers, and EAs, just as there are incompetent and unethical "unenrolled" preparers. The IRS does not say, "If the return was prepared by a CPA it must be accurate". That is utterly ridiculous. The IRS does have a list of "red-flagged" preparers, of all "designations", who are suspected of unethical practices, and the returns of these preparers are reviewed more closely than those of the average preparer.

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5. There are two schools of thought on this issue. Some tax pros feel that the more explanatory documentation you attach to a return the less likely the chance of any questions. Others feel that "less is more" - only attach to the tax return items that are absolutely necessary and do not clutter the form with unrequested or unnecessary schedules and attachments. I tend to lean more in the "less is more" direction, although I do believe that you should attach explanatory statements when appropriate. For example, in most cases if I claim more than $5,000 for cash contributions I will attach a statement listing the various charities by amounts (i.e. St. Mary's Church $2,500, Columbia University $1,000, Hurricane Victims Fund $1,000, United Way $650, Other Church and Charity $150). I do not, however, attach copies of receipts, acknowledgements, or documentation for the actual contributions.

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My bottom line - if you have a genuine home office that meets all the requirements in the Tax Code, or have legitimately incurred out of pocket "ordinary and necessary" expenses in connection with your job or profession, or have made contributions to church and charity, etc. do not hesitate to claim these deductions on your Form 1040. Do not omit them because you think they will cause your return to be audited. However, as with any business or personal deduction, make sure you have adequate documentation to substantiate the deduction.

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TTFN