An IRS tax audit can come in a number of forms. The most demanding are the face-to-face audits, which require sitting down with an auditor and reconciling income and deductions. Others are the less demanding correspondence audits where the IRS has reason to believe that the taxpayer failed to include reported income or has overstated deductions.
Correspondence Audits– Employers, banks, lending institutions, schools, brokerage firms, escrow companies and others all feed data to the IRS, which the IRS, in turn, matches by computer the information reported on your tax return. If there is a significant discrepancy, the IRS will correspond with the taxpayer. Sometimes these discrepancies will result in additional tax liability, while other times a simple explanation will satisfy the IRS and make the problem go away. Here are some examples of typically-encountered discrepancies:
- Unreported Pension Income – Whenever a taxpayer takes money out of one IRA account and rolls it over within the 60-day statutory limit into another IRA or qualified plan, the income is not taxable. However, the financial institution from which the funds were withdrawn will issue a 1099-R and report to the IRS that you made a withdrawal. To show the rollover, a taxpayer must report on their tax return that the distribution was in fact rolled over. All too frequently, taxpayers will fail to bring the distribution to their return preparer’s attention thinking that they have met the 60-day rollover requirement. Because the rollover is unreported, it will result in a correspondence audit. Generally, when moving an IRA from one institution to another, making arrangements for a direct transfer will avoid these types of audits. However, that is not universally true, because some institutions will still issue a 1099-R, which must be reported on the tax return.
- Gross Proceeds of Sale – When real estate, stock or other securities is sold, the IRS computer knows what it sold for since the gross proceeds of sale for real estate, securities stock are included on the form 1099-B that is filed with the IRS. Even if there is no gain or loss, it still needs to be reported on the tax return. Otherwise, the IRS will assume the entire sales price (gross proceeds of sale) is taxable profit. By reporting the sale on the return, the taxpayer is able to show what he or she paid for the sold investment, thus minimizing or even reporting a deductible loss.
- Security Basis – Beginning in 2011, the 1099-B was revised to include the basis and profit or loss information required by the new broker reporting rules. The official format is shown below. Substitutes from brokers that incorporate the same information as required on the official form are permitted. Unfortunately, based on the variety of layouts brokers used for 2011 reporting, it seems no two were alike, making interpreting the information and entering it correctly into software a challenge to the return preparer. Broker statements that weren’t categorized in such a fashion that permitted copies of the statements to be submitted, and allowed the practitioner to say “see attached” on the Form 8949, meant that each transaction had to be separately listed – This creates a real nightmare for clients who have a significant number of transactions for the year. IRS instructions clearly state that it is not permissible to enter summary totals on the tax return in lieu of reporting the details for each transaction.
- Alimony Paid or Received – A taxpayer who pays alimony is able to deduct the amount he or she paid. On the other hand, the recipient of that alimony must report that amount as taxable income. The IRS computer checks to make sure the amounts match; otherwise, a correspondence audit will be initiated by the IRS. This is an area of frequent mismatch because there is a lot of confusion with what constitutes alimony, child support and property settlements.
- Home Mortgage Interest – Each of your mortgage lenders will report to the IRS the interest paid on your mortgage for the year and issue you a 1098 for the same amount. If these amounts don’t reconcile, expect a correspondence audit. Where this frequently becomes an issue is when the loan is from a private party and the paying taxpayer must report on his or her tax return the name and social security number of the individual to which the interest was paid, thus allowing the IRS to make sure the private lender is reporting the income. Another frequently encountered area of mismatch is when two or more individuals are on the same loan, but lenders report the interest paid only under one of the borrower’s social security numbers. Here again, a notation must be made on the return showing the individual who actually received the income, so the IRS can make sure they are not claiming 100% of that interest and that the total reported paid by all parties does not exceed the total reported paid on the loan.
- Tuition Paid – Because of the American Opportunity, Hope and Lifetime education tax credits that can be claimed for paying tuition to a qualified education institution, the IRS requires those institutions to report the tuition received to the IRS and issue the 1098-T to the taxpayers. Thus, the IRS has the ability to verify the tuition paid during the year, and any mismatch could result in a correspondence audit.
- Interest and Dividends – The IRS allows many financial institutions to issue substitute 1099s, i.e. forms that are not in the traditional standard 1099 format. These substitute forms can often be misinterpreted by an untrained eye with various types of interest and dividends reported separately and spread throughout lengthy annual account statements. To make matters worse, many brokerage firms have been issuing amended 1099 statements late in the tax filing season due to their errors in determining the allocation of a taxpayer’s earnings between dividends, qualified dividends, capital gains dividends, and original issue discount interest. Thus, if the taxpayer has already filed, the changes are significant, and if the taxpayer does file an amended return, they will probably receive a correspondence audit.
- Non-Taxable Interest – Interest from municipal obligations are tax-free for purposes of computing federal tax. However, tax-free municipal interest income is added to income for purposes of computing taxable social security income. It is also counts as income for purposes of determining whether a taxpayer qualifies for earned income credit (EIC). Thus, payers of tax-free municipal interest must report the interest paid to the IRS and issue a 1099 to the taxpayer so that the IRS can match the tax-free income to the computation of taxable social security and EIC disallowance. Taxpayers should pay particular attention to this new matching program.
- Cash Contributions – Regardless of the amount of cash contributed, the contribution must be backed up with either a bank record or written communication from the donee organization showing the: (1) name of the donee organization, (2) date of the contribution, and (3) amount of the contribution. The recordkeeping requirements may not be satisfied by maintaining other written records.
What this means is that unless the charitable organization provides a written communication, cash donations put into a “Christmas kettle,” church collection plate, and pass-the-hat collections at youth sporting events will not be deductible. Donations by debit or credit card can be substantiated by bank records. These new rules will give the IRS the ability to audit taxpayer’s charitable contributions via correspondence audits since all contributions must be backed by written receipt or bank record.
Don’t assume that just because you received a notice that the IRS is correct. They are frequently wrong. Please call this office before responding to any IRS notice. Tax laws are complicated, and the notices are not always easily understood.
Face-to-Face Audits – The more demanding face-to-face audit is rarely encountered by wage-earning taxpayers who report all their income and have deductions that are within the general norms. Self-employed, high-income taxpayers, those who have omitted substantial income, or those who repeatedly fail to show income to support their lifestyle are more likely to be subject to these types of audits.
You can appear for the audit yourself, but that is probably a bad idea since you are not trained in the rules and regulations regarding audit procedures and what limits the IRS’s incursion into your private life. You can authorize your tax professional to handle it without you. Often, this is the best way to prevent the audit from escalating beyond the original areas that attracted the IRS’s interest in the first place. Practitioners experienced with IRS audits are less likely to become emotional or to make statements that would lead to additional IRS questioning.
Caution: It is strongly recommended that you contact this office immediately upon receipt of any inquiry from the IRS. Don’t procrastinate, because that only leads to further action on the part of the IRS.