Taxable Talk

Two tax bloggers who I respect, Robert Flach (The Wandering Tax Pro) and Peter Pappas (The Tax Lawyer’s Blog) have been debating Peter’s 5 Slam Dunk IRS Audit Red Flags. Robert responded, Peter replied, and Robert made his rebuttal. All of these posts are worth reading.

I have some thoughts about audit red flags. It’s a subject I hear about annually at the CSEA SuperSeminar; each year I take a class taught by Robert McKenzie and this issue always comes up.

Here is Peter’s list of red flags:

* Home Office Deduction
* Job Expenses
* Rental Losses
* Schedule C Expenses
* Charitable Contributions

My feelings about deductions are simple: If you are entitled to a deduction, you should take the deduction. Notice that I said entitled. I think that Peter and Robert would agree that there’s been plenty of abuse of certain deductions. All of these deductions (along with education deductions/credits) are popular among unscrupulous preparers.

That said, only one of these to me is directly a large red flag: Schedule C. The statistics I saw at the CSEA SuperSeminar show that returns with Schedule C’s are far more likely to be audited than returns without one. Of course, as Robert noted there’s an obvious corollary: Returns with Schedule C’s have far more income (generally) than returns without them. The IRS is a collection agency. Assume Joe Salaryman has income of $30,000 and cheats on his taxes by 10% while Sam Businessman has income of $300,000 and also cheats on his taxes by 10%. Clearly, the IRS would get more bang from the buck by auditing Sam than Joe. Not surprisingly, taxpayers with Schedule C’s and income in the mid-six figure range have a higher likelihood than others of being audited.

Peter also lists five things you can do to alleviate “red flag status:”

1. Timely file your return;
2. Use a recognized software program to prepare and print your return;
3. File the return electronically;
4. Have a respectable CPA, tax lawyer or IRS Enrolled Agent sign your return as tax preparer; and
5. Attach explanatory statements to your return where necessary.

I absolutely agree with Peter’s items 1 and 5. If you untimely file your return it will be subject to scrutiny, and that can (but does not always) lead to an audit. Item 5 is obvious. Unfortunately, explanations are not always visible to the IRS until after a return is selected for audit. Still, in a correspondence audit if you can tell the IRS, “Look at this explanatory statement that was included with the return,” it’s probable that the audit can be a short-lived one.

Items 2 and 3 are related. I have been told that the process for a printed return (this would include those that are manually done) is that they are transcribed by clerk-typists and then follow exactly the same path as electronically filed returns. I agree with Peter that a messy, hand-written return is more likely to be audited. But I think that’s more because the numbers might not be clear to the typist. That’s also one of the reasons I like electronic filing; I trust my ability more than a clerk-typist’s. I think that there’s a slight advantage for electronic filing versus paper filing for audits, but that’s mainly because of the possibility of transcription errors by the clerk-typist.

I somewhat agree with Peter’s item #4. But I think a better way of stating it would be, Don’t have your return signed by an unscrupulous CPA, EA, tax attorney, or other tax preparer. The IRS conducts audits of returns prepared by individuals they think are unscrupulous. For example, in the Western Tax Service case, the IRS audited one return prepared by Western, found what looked like gross preparer fraud, selected several others and found that it was indeed systemic tax fraud by a preparer.

There’s one last point I’d like to make on this debate. Peter suggests that individuals either incorporate or form an LLC. If a sole proprietor forms an LLC, that LLC is generally a disregarded entity for tax purposes and files a Schedule C unless they choose to be taxed as a C Corporation or an S Corporation. Be advised also that the ability to form an LLC varies by state, and some states are restrictive of what businesses can form LLCs.

I’ve enjoyed reading both sides of this debate. I think that everyone who does so, no matter which side you take, will come out a winner.