What happens in a tax audit is a topic discussed throughout tax season. Let me start with who is responsible. Too often taxpayers think the accountant is responsible.
Example: The accountant has a question as part of the due diligence responsibility. The relationships between the numbers look unreasonable. Upon making adjustments for error, the return has a balance due. The accountant discovers the error occurred in the prior year and amends it. Client is not happy and refuses to pay the bill. Comment goes something like “if those returns are wrong it is your fault”, then further in the discussion “aren’t you suppose to take my numbers and not question them?”. Yes, there are clients that think accountants must take the numbers without question and then be responsible for those numbers when they are wrong. We are only responsible for applying the law correctly and pointing out issues that come to our attention. The taxpayer is responsible for the final results.
So, how does an audit happen? Some are based on statistical analysis by IRS computers, some based on a specific project, one audit can bringing attention to a second audit and some by random sample.
Do you wonder what the NAICS Code is used for? These codes identify the type of business, for example Trucking, Farming, Restaurants and so forth. This tells the IRS computer systems which statistical ratio to use when comparing your return to the norm. Fuel usually is a percentage of gross income for a trucker, input cost (Fertilizer/Chemical/Seed) as a percent of grain sales and food cost a percentage of sales for a restaurant. We believe when the return hits the system, it is scored based on a top secret scoring system (confirmed by a former IRS employee many years ago). Fall outside a certain score and the return gets looked at by a human. What happens next is a matter of human decisions.
In my more than 30 years in the business, computers have become a HUGE part of the industry. When the PDF file format was created in 1993 we began seeing more changes. Today, it is very common for an audit to be performed without ever meeting the auditor. Many set in offices and expect documents be delivered to them using technology. This was not the case when I started. We developed an understanding and professional relationship with the auditors from the local offices. They got to know our work and we got familiar with their methods. This connection is being lost.
It is typical for a taxpayer to ask, “How are they going to find it?” when discussing the possibility of leaving something off a return. This is a conversation that should never take place with your accountant. We are not afforded “attorney client privilege”. If you wish to engage in criminal activity, keep it to yourself or hire an attorney. If we are summoned to testify, we must testify or risk jail. While we may really like you, we are not going to jail for you.
So, “How are they going to find it”? Understand the code begins with “All Income is Taxable” and “All Expenses are Not Deductible”. They are going to have an Initial Interview designed to set the stage for what’s about to follow. Then they are going to assess your life style, drive past your home, search Google, Facebook and probably run a Credit Report. They might even visit the court house for property records and other legal filings. Certainly they will look for FINCEN (foreign bank account), Crypto Currency Transaction and Large Cash reports filed by the bank. They will determine, based on statistical averages, what it cost to house, feed, clothe, entertain, transport and educate a family your size. This gets compared to the return and then they have a variance, usually called the Pre T-Account Understatement (or Overstatement) of income.
Now the fun begins. They will ask for bank statements (including deposit slips and cancelled checks), brokerage statements, loan activity, purchase agreements (especially large purchases), rental agreements and other proof of living cost such as utilities, clothing, vacation and insurance receipts (to name a few). From this they adjust the Pre T Analysis to come up with a Post T Analysis (Pre and Post refer to Pre Audit and Post Audit, the T references T- accounts used in accounting). At this point they will generally have an idea of the accuracy of the income tax return that you filed “under penalties of perjury”.
During the process there will be questions regarding large cash purchases, proof of gifts (often requiring a statement from the donor), proof of inheritance, proof of basis in sold assets. They are trying to count all income taxable and disallow all expenses. Remember how the code begins? All income is presumed taxable and all expenses are presumed not deductible. This should be committed to memory by every taxpayer. This does not begin in your favor!
The explanation above is basic, there is far more to it. The bottom line, you might be able to get away with an immaterial amount missed on the return, but if you are trying to hide large amounts of income, it can be found. Big Crime Syndicates’ understand this, which is why they “lauder money”, a process that exposes the illegal income to TAXES thus making it legit. Probably the opposite of what the average taxpayer believes.
Usually only 3 years are available for audit. That goes to 6 years in the case of “a gross understatement” and all years are open if the IRS can prove "fraud". What a taxpayer says and does during an audit could be evidence of “fraud”. Agents take their job seriously. Joking comments about “bribes or cash” are not laughing matters, even if they are jokes. This is one reason we do not recommend a client represent themselves in an audit. It’s also the reason we do not want to know anymore than we need to know.
While your risk of audit is approximately 1% each year, that equates to once in a 100 years. You could say 1 out of 2 people during a 50 year period will be audited. Putting it this way, this is a 50/50 chance over your 50 year working life you will be audited. Don’t look so good now, does it.