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The Nightmare
Audit ...
and How To Avoid It
by
Eva Rosenberg, MBA, EA
Don't you hate picking up your mail
and finding the IRS logo on an envelope? Regardless of the contents, you
cringe. The notice inside says "Your return has been selected for
an audit." Your terror is justified. Or is it? This year, I've dealt
with several audits. Some easy - no change or sizable refunds. Others were
(or still are) a nightmare. Why?
The NIGHTMARE AUDIT
CZ was audited for 1989. His tax professional had handled the
audit. He didn't take care of the fundamental preparation needed
for an audit. Result: IRS assessed CZ $174,000 in taxes, interest and penalties.
They got an audit reconsideration. They went in with little additional
information. Result: a reduction to about $138,000.
CZ came to me. He told me "It's not right. I didn't make this much money.
Help me." His is a common problem in audits, so I'll describe the problem.
TOO MUCH CASH
The IRS assessed CZ because deposits into his main account were
over $600,000. Although most of that money came from loans or transfers
from other accounts, his tax professional didn't prove this to the IRS.
RIOTS, FIRE, FLOODS AND THE BANK-CLOSURE PLAGUE
By 1995, some of CZ's records (and one of his bank's) had been
destroyed in the Los Angeles riots. Another bank had changed hands
so many times since 1989 that their records were lost. CZ made a good-faith
effort to reconstruct the information. He had a correspondence trail a
foot high. But no proof of his innocence.
What was the crime?
BEING A TAX OUTLAW
Tax Outlaws fudge their tax returns. Tax Outlaws hide out and
don't file tax returns. But, the easiest Tax Outlaw to find is the
one who lies blatantly on tax returns. From the looks of the deposits,
the IRS thought he might be such an Outlaw.
PENNY WISE, CASH FOOLISH
Presently, competent tax professionals take two things for granted
about audits:
1) The IRS will do a proof
of cash.
2) The IRS will look at lifestyle costs.
It's no longer enough to substantiate
the expenses to the penny.
Proof of cash: The auditor will total up all your deposits to all bank
and brokerage accounts. If you cannot identify the transfers, the cash
advances from credit cards, gifts of money, inheritances, the loans from
banks, mortgage companies, family and friends, the IRS will assume it is
income. It's up to you to prove otherwise.
Lifestyle: Look at where you live, what you drive, where your children
go to school, what you wear, where you worship. The IRS knows all this
about you, too.
Aside from the information on your tax return, they might research your
credit, contact the motor vehicle department, the county recorder and all
other public sources of data. In fact. many auditors are requesting completion
of a form which spells out all your living expenses.
The goal is determine whether or not you can live on the income you reported
on your tax return. If you can't, you had better be able to prove cash
advances, loans, gifts, etc. that you used to pay all those expenses. If
you cannot prove where the funds came to support your lifestyle, you might
find yourself being assessed for unreported income - along with fraud,
negligence and late payment penalties plus interest.
Solutions for a better future:
- It is wise to photocopy all deposits, especially those that are NOT income.
- Get written documentation of all loans from ALL sources, even personal.
- File gift tax returns, where applicable. Otherwise, get written proof of the gifts.
- Funds received from insurance settlements - get a written description of the cause of the judgment. Some or all that money may be taxable.
- If roommates shared your expenses or you had other non-cash subsidies, get objective verification and put it in the file.
- Keep your business accounts totally separate from personal funds.
WAKING
UP FROM THE NIGHTMARE
What happened to CZ? We got the assessment reduced to $2,981.
And we finally got the levy released too!
How did I do it? Sorry, we've run out of room! :)
__________________________________
Copyright © 1998-2001, Eva Rosenberg
Initially Published May 11, 1998
Reprinted and Revised 3/24/01
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