IRS Red Flags and Avoiding an Audit

Speaker - Paul Hodge CPA

I.      Introduction: My name is Paul Hodge

A.   Qualifications: I am a Certified Public Account with degrees in Accounting and Finance from the University of Texas A&M.  I am also getting accredited to teach continuing education for real estate agents.

B.   Experience: I have worked as a Controller and CFO for over twelve years at a variety of companies.  I started my CPA practice five years ago focusing on real estate and I have grown it into a successful business operating in both Houston and Dallas.  I am member of the Better Business Bureau. I am a RICH Club Gold Business Member and a real estate investor with twelve single family properties.

C.   Subject Matter – How to avoid IRS red flags and reduce your risk of an audit.

II.   Main Topic – IRS Red Flags

A.   IRS Red Flag:  Anything thing that will draw attention to your return.

1.      Math Errors – one of the quickest ways to trigger an audit is with a math error.

2.      Always put down exact numbers from the following forms, even if they are wrong (these are checked by a computer).  If wrong contact the issuer and request a corrected version immediately.

a)    W-2

b)    1098

c)     All 1099s (1099-INT, 1099-DIV, 1099-MISC,   1099-R

d)    5498

e)     K-1, K-1S

3.      Try to avoid round numbers in entries ($5,000 could be changed to 5,002 or 4,997)

4.      Do not take too many exemptions.  This applies mainly to divorced parents that have not worked out who is taking the kids as dependents or which ones.

5.      High meals and entertainment expenses. Especially in a business that is not known for entertaining clients.

6.      This is mainly due to poor or improper record keeping.

7.      Home office deduction - Even if you really use a room in your home as a home office do not take the deduction.

a)    The calculation is long

b)    The record keeping is great (Insurance bills, electricity, HOA dues, water, sewer, trash, gas, repairs)

c)     The amount you end up with as a deduction is little and not worth your time.

d)    Besides I guarantee I could disqualify your office and so could an IRS agent.

8.      Never include other forms that are not required with your tax return – Do not volunteer additional information

9.      Do not file electronically.  You give the IRS too much information with an electronic return.

10. Always file regardless if you owe or not.  Nonfilers are targets for the IRS

B.   Things to do right and timely

1.      File on time – use an extension only if absolutely necessary.  Remember we are dealing with computers now and they work 24/7 365.

a)    Some tax professionals say that the workloads are set and returns are selected for audit by the end of August, so if you file in September or October, your return will not be selected for audit.  THIS IS NOT TRUE.

b)    A return can be selected at any time.  If your return contains some unusually large deductions, the chances of it being selected for audit will not diminish simply because you wait until October to file.

2.      Be thorough in checking your return for errors, misspellings, social security numbers, addresses and duplications.

3.      Make sure the returns are neat and orderly.  If you can use a computer to do the return and do not hand write.

4.      Consistency is very important with the IRS. Do not change accounting methods or designations without good reason.

5.      Sign your return and make sure your tax preparer signs the return.

6.      Gray area information should be used as full deductions.  Many times there are multiple places to put information, always put it in the place that gives you the most deduction.

a)    Advertising – If you can put it on schedule C and not schedule E

b)    Car and Truck Expense – Schedule C is best, followed by Schedule E and last is Schedule A

c)     Legal and Professional Services - Schedule C is best, followed by Schedule E and last is Schedule A

d)    Telephone Expense -  Schedule C is best, followed by Schedule E and last is Schedule A

e)     Travel Expense – Same

7.      A practical rule in deciding whether or not to take a tax deduction is the LAUGH TEST. The rules is this; if you can claim an expense for business without LAUGHING about putting one over on the IRS then you are probably OK.

C.   Strategies to avoid an audit.

1.      Do not be a corporation.  C-Corporations have the highest rate of audit because they are more complicated and their larger numbers makes an audit more justifiable.  They are better targets.

2.      Do not be a Sole Proprietor (Self-employed) schedule C-Filer.  The IRS already assumes you are cheating them.  The IRS has maintained its audit focus on “C-Filers” since 1999, especially those reporting under $25K.

a)    Poor record keeping.

b)    Not keeping separate bank accounts

c)     Running personal expenses as business expenses

d)    Unrecorded income is suspected to be higher

e)     Cash transactions more prevalent with this type of business structure.

f)      Independent contractors are sometimes misclassified and should be employees of a business

g)    The sole proprietor is assumed to less sophisticated and less likely to take advice from professionals like CPAs.

3.      How to help the Sole Proprietor - You need to remove as much information from your 1040 to another place where the chances of audit are greatly diminished.  What does that mean? CREATE A CORPORATE ENTITY

4.      Setup an S-Corporation

a)    Who should do this?

(1)  A profitable business that is subject to self-employment tax.

(2)  An individual that wants to be more aggressive about deductions

(3)  Someone interested in reducing the risk of Audit

b)    Why does this help?

(1)  The IRS assumes first that a business expense here is a business expense.  This is not a person running a business, but a business entity.

(2)  Range of deductions are much larger with S-corps

(3)  IRS assumes they are dealing with a more sophisticated business owner

(4)  Usually better record keeping

(5)  All information reported in the 1120S is then reported on one line of the 1040

c)     Other benefits

(1)  Reduce FICA

(2)  Corporate protection

(3)  Spouses are now business partners

5.      Setup an LLC or LTD

a)    Who should do this?

(1)  Real estate investors expecting losses the first couple of years

(2)  An individual that wants to be more aggressive about deductions

(3)  Someone interested in reducing the risk of Audit

b)    Why does this help?

(1)  The IRS assumes first that a business expense here is a business expense.  This is not a person running a business, but a business entity.

(2)  Range of deductions are much larger with LLCs

(3)  IRS assumes they are dealing with a more sophisticated business owner

(4)  Usually better record keeping

(5)  All information reported in the 1065 is then reported on one line of the 1040

c)     Other benefits

(1)  Reduce FICA

(2)  Corporate protection

(3)  Allow spouses to be partners

III.            Good news about audits

A.   There continues to be a decline in the audit rate for both individual and all returns.  The audit rate for individuals is down 45% over the last ten years.  This is due to several reasons.

1.       IRS staff has declined creating more filers to examiners.

2.      IRS staff has shifted from examination and collection to customer service.

3.      Audit selection is based on 12 year old databases.

B.    The IRS is a kinder and gentler IRS.  They are not bad to work with and 70% of their audits are handled through correspondence.  47% of all audits result in additional refund back to the taxpayer.

C.   Always consult a Tax Professional(CPA) for advise about your own tax or IRS situation.  Everyone’s tax and audit circumstances are different and a good CPA will pay for themselves in saving you time and money.  Plan for your taxes and reduce your risk of audits. Keep more of what you make, because it’s not what you make, but what you keep that matters.

 

 

 

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