8 things that will get you audited by the IRS or other agencies!
In my career I have defended countless taxpayers who have been audited by the IRS, Board of Equalization, and Franchise Tax Board. This includes thousands of hours spent preparing for income and sales tax audits. My goal as a tax attorney is always the same: protect my clients so they pay only what they owe and not a cent more. I tell all prospective clients that audit results all fall within a spectrum. In the worst-case scenario, all of your deductions are denied. In best case scenario, the agency accepts all of your tax positions, which no additional tax owed. I’ve even had several cases where clients have been issued refunds because some expenses were not claimed or income had been overstated. Over time I’ve noticed many common themes during audits that I would like to share with you now. If any of the following apply to you or your business, get ready for a potential audit.
1. Your gross income is less than your 1099s (1099-M or 1099-K) or K1s.
I just can’t seem to understand why your 1099s don’t match your gross receipts at least. 1099-Ms are issued to you for work you have done for someone and 1099-Ks are issued for credit card payments to you. In this simple example you will see this huge red flag. You are issued a 1099 or K1 for a certain amount let's say $100k, but you put that you only received $60k for whatever reason. That is the easiest way to get audited. The company that issues you the 1099s or K1s have filed reports with the government of a certain amount and you have underreported that amount. When the numbers don’t match up the auditing agency will pick that up and just like that, you are under audit. They have tools to pick up these inconsistencies.
2. Your gross income matches your 1099-K exactly or close to it.
You are probably annoyed with me now. You are saying to yourself, you just said above that I should not underreport, so now that I report exactly, why would I be audited. This is called the cash to credit card ratio. These audits are so common between IRS and Sales Tax agencies I can’t tell you enough about this. So how does this happen. Let’s say you have a burger shop and you get a 1099-K from your credit card processor for $500k. You report the $500k plus another $5k cash. Now, you have reported a total of $505k in sales. Do you see where I am going with this? In this example you are reporting that you get 99% credit card sales and 1% cash sales. This would all be fine and dandy except that when the auditing agencies do a market analysis they will see that every other burger business within a certain mile radius reports an average of 50%-80% ratio. That means you are off by a huge amount. In the example your cash should have been at least $100k, so you are off by a minimum of $95k. What is worst, if they come to your burger shop and watch people pay and do a daily average and your amount is closer to 50%, then you would be off by $500k (50% credit card and 50% cash). That is a big deal and you don’t want to get caught up in this, especially if it's a 3-year deal, meaning it could be $1.5 million in the example above. Just be honest and report everything. I can say, during an audit like the one above, we did really well. But why did we do really well? Because the business they were auditing was an online clothing store with a warehouse address? How much cash does an online business take? $0 The IRS in this case was trying to add a minimum of $300k on $800k in gross receipts, meaning the IRS thought the client had $1.1 million in gross receipts, based on the added cash sales. We were able to prove that you can’t make online payments via cash, but we still have to prove that. At the end we were victorious and there was a $3k discrepancy. This was a huge relief to the us, but not so much to the IRS.
3. Your IRS tax returns don’t match your sales tax returns.
So what does this mean? Let’s say you are in the business of selling sunglasses or tacos, but we will say sunglasses for now. You are in your first quarter and you have sold $30k of sunglasses. However, your finances are low and you report to the sales tax agency that you only sold $5k in order to only pay the tax, let’s say it’s 10% here so you only need to pay $500. So you think I will amend next quarter to fix the error. As time goes on you never correct the error and file incorrect sales tax returns for 4 quarters. At the end you have earned $120k in gross sales and reported only $20k of sales to the sales tax agency. Now you know if you correct the error to the correct amount it would add $100k of taxable sales tax which lets say its 10% in your region, and that would add $10k that you just don’t have to pay. (Trust me it never gets easier to make up as you go). You file your IRS tax returns correctly, but leave the sales tax agency returns alone. Eventually, the sales tax agency will get a hold of the numbers from the IRS and you will be audited because your sales tax returns don’t match your IRS gross receipts. My thinking ...it’s better to be honest and owe, than to lie and get caught later.
I just can’t explain this one. I have been to a few audits where the IRS already knew the amount of the bank deposits was off on what was reported as gross income. It can always be possible you got a loan or added a capital contribution yourself, but what I don’t know is how the IRS finds out about that. Yes I do understand that certain large deposits are reported, but they have some interesting information. My point is report all your income and make sure you have documentation of loans or capital contributions, so that you do not get taxed on deposits that are NOT INCOME.
5. Unreimbursed employee expenses. (For employees)
What is an unreimbursed employee expense? Well, think of it as an expense your employer does not reimburse you for. For example, let’s say you work for a hospital and you are a quality assurance professional. You earn a decent salary, but the employer (the hospital) does not reimburse you for quality assurance conferences, even though attending these conference are part of your job. You will be allowed to deduct the expense associated with attending these conferences under Form 2106. However, we see a lot of audits where taxpayers either put false or overly inflated expenses. The IRS is very good at picking these discrepancies up. Think of it like this. You are a doctor at a hospital and you make a nice salary. Your tax guy says, you should write off your trip to Cancun, your Mercedes, dry cleaning, and mileage. Well the IRS uses their tools that show that most doctors don’t have these expenses and furthermore, they know the hospital the doctor works at has a great reimbursement policy. So think of it like this, there are 8000 doctors that work for this one big hospital network and only 80 of them take these unreimbursed employee expense deduction. Guess who is getting audited? I always advise people to just be honest, life is better that way.
6. Overstating your business expenses.
Congress has created a lot of benefits for small business and large business to operate, but those benefits are to promote real spending and create jobs. When you report expenses you don’t have the IRS will find out and audit you. I can create a 20 page book on each line item that I have seen, however I won’t bore you with the many example. The last example I will use is the common mileage example. If you are a traveling salesman or a facility manager that travels to different facilities or like me, a tax attorney, that travels all across California to represent clients in audits then all of the above would have a mileage deduction. Even if we don’t keep logs, we would be able to recreate a log of where we have been simply by using our appointment books, etc. However, if you are in the business of an IT individual that works from home or a travel agent that works from home or website developer that works from home, then you probably would have little to zero mileage. Driving to and from work does not qualify as mileage. If you never meet with clients and conduct all your work online, then you most likely don’t have mileage and the government will find out through the audit procedures that you work from home and should not have taken the mileage deduction. Point being, be cautious.
Here is one issue that I see time and time again. This goes for Schedule C, Partnerships, Corporations, etc. The government agencies have sophisticated tools to catch people that overstate their business expenses. Yes meal and entertainment are a big problem and the most talked about, but there are also many more that catches the IRS’s eye. Overstating the cost of goods sold or in the alternative, having cost of goods sold when you are a service company. When I see something like this, I can tell that someone is working with a creative preparer (more to come below on those people) because service companies like lawyers, doctors, gardeners, fitness instructors usually have zero to very little cost of goods sold. Another common thing I see here is the fact that a company or individual has no receipts at all. So it’s not even about overstating expenses here, it’s about stating expenses you really have. My advice is just don’t do that, be honest and just report what is real.
7. You have a shady tax preparer.
I can tell you that I have seen this on more than one occasion. Essentially, there is a tax preparer who is extremely creative. So creative that he is committing tax fraud. So what happens? What is the best way for the IRS to get to the bottom of it? Audit all of the tax preparer’s clients. I have seen the tax preparer that doesn't sign the returns (that’s a no-no), the tax preparer that creates fake business to take losses, the tax preparer that adds education credits even though the client did not attend a qualifying university, the tax preparer that uses his cousins dependents on your tax return to split the money with you, the tax preparer that inflates all your expenses for a bigger refund, and so on. Once the IRS catches wind of these guys, it’s like a domino effect and the friend that recommended you to this “good tax guy/lady” will have an audit hearing date just like you. If it’s too good to be true, it probably is. I have been in the situation where people will ask me “what should I put as an expense?” I sometimes am rather surprised by the question. The answer? You put whatever is honest, you can’t arbitrarily pick numbers to help you out, if you have big expenses put them there, if you had none then don’t put them. Its really simple. Beware of your tax preparer, do some research on them.
8. If there is anything weird, make sure you explain it.
If it feels weird, just make sure you can back it up. For example, let’s say you buy a 3-D printing machine for $200k (I don’t know how much they cost, just as example) and you are going to charge people for printing items. You spend $200k on the machine, and $10k in supplies and $15k on support staff, but you only made $25k. You have a pretty big loss when adding the machine (lets just say 50% depreciation first year) $100k ($200k machine 50% depreciation) - $10k (supplies) - $15k (support staff) = $125k expenses and $25k profit giving you have a $100k loss. That looks weird because no one goes into business to NOT make money. However, your plan is to expand revenue and at some point turn a profit. So even though it looks weird, you can still back it up with your receipts and that is ok. It is ok to have a loss, but be mindful. What you don’t want is to have a random $120k expense in order to have a loss, so that your taxable income is lowered. Keep track of everything you do.
If you or someone you know is correctly under audit, please feel free to contact Bismark Tax, Inc. for representation 855-829-6055.
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