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Dealing with an IRS Audit

Houston Tax Attorney

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Getting Audited by the IRS

If you’re visiting this page, perhaps it’s because you’re being audited by IRS; or maybe you’re wondering what the IRS audit triggers are; or perhaps you’re just interested in learning about the IRS audit process. Regardless of why you’re here, it’s important to understand how to protect your rights during an audit.

Types of IRS Audits

Most individuals will likely deal with an IRS audit at some point in their lives. It may be a simple correspondence audit, or it may be a field visit to your business.

Correspondence Audit Program

A correspondence audit is conducted through (you guessed it), correspondence. Such audits are for issues that involve records that can easily be submitted by mail. Examples of issues that are covered by a correspondence audit include:

• Dependent Exemptions
• Earned income tax credits (EITC)
• Child Care Credits
• Adoption Credits
• Educational Credits
• Certain itemized deductions and Schedule C expenses

While correspondence audits are less intimidating since they do not involve a face-to-face audit, they can be extremely frustrating. First, there is no one assigned to your case. These cases are worked by Tax Examiners, which is an entry-level position requiring no college education. The case will be handled by a different person each time you call the IRS or submit documents. Because it’s an entry-level position, Tax Examiners are given very little ability to make judgments in gray areas of the law. You may have to go back and forth over the course of several months to get an issue resolved at the correspondence audit level. If you’ve been unable to resolve your issues in a correspondence audit, hiring a tax professional may help.

Automated Underreporter Program (AUR)

The IRS uses computer-matching and error-checking programs to verify the accuracy of tax returns. The most common notice generated by the AUR is a Notice CP2000. A CP2000 informs the taxpayer that there is a discrepancy between income shown on the tax return and income that was reported by others. For example, if you had cancellation of debt (which is considered income), the creditor will issue a 1099-C to you and file it with the IRS. If your tax return does not include that income, the AUR will generate a Notice CP2000 informing you of the mismatch.

Office Audits

An office audit is a face-to-face examination with a Tax Compliance Officer (TCO). The majority of cases worked by a TCO involve Schedule C issues. The TCO will audit up to 4 vital issues and possibly additional issues on the return with managerial approval. If you are chosen for an office audit, you will receive an examination letter, requesting you to call and set up a day and time to have your return and supporting documents examined. The TCO will also send you an Information Document Request (IDR) which contains a list of documents that the TCO wants to review.

TCOs are trained to not only verify questionable expenses and credits on the tax return, but to also look for unreported income. Such examinations can be highly invasive and difficult for clients. However, you should know that TCOs are not allowed to automatically request bank statements without meeting specific criteria in the Internal Revenue Manual.

If you’ve received a letter requesting an office examination, you need to hire a tax professional. There’s too much at stake to attempt this yourself. One thing that taxpayers and even tax professionals don’t know is that the TCO will have completed a background search on you prior to the appointment. They also have the authority to make 3rd party contacts to verify documents that you provide. A false statement or document from you could result in the audit turning into a fraud case. I’ve seen it happen, and in fact, I’ve personally had to turn an audit case to fraud on a few occasions while working at the IRS.

Field Audits

Field audits are conducted through on-site visits by a Revenue Agent (RA). Unlike TCOs who examine individual, self-employed, and disregarded entity returns, RAs examine only business returns. In addition, there are RAs in the Small Business/Self-Employed (SB/SE) department and RAs that are assigned to Large Business and International (LB&I). SB/SE revenue agents will audit business returns with assets under $10 million.

The first contact with an RA is through a letter providing a time, date, and place of examination of the taxpayer’s books and records, along with an Information Document Request (IDR). If you have a representative, the examination can be conducted at the practitioner’s office.

A field audits will always include a reconciliation of income from books, records, and bank statements to the tax return. The revenue agent will already have picked some issues to review prior to the examination but will examine additional issues as warranted.

IRS Audit Triggers (“Red Flags”)

If your tax return doesn’t match information returns (e.g., 1099s, 1098s, W-2s etc) filed by 3rd parties, that’s obviously an automatic trigger for an adjustment letter from the IRS.

All tax returns are scored through a computer program called Discriminant Inventory Function (DIF). Certain tax filers, such as those with Schedule C or EITC, seem to have higher DIF scores and therefore a higher chance of getting audited. Additionally, any tax returns that appear to have “large, unusual, or questionable” (LUQ) deductions or expenses may cause the return to be flagged for an audit. For example, if you’re claiming $30,000 charitable contributions but earning only $70,000 of income, this is LUQ based on your income level. However, for an individual earning $500,000, a $30,000 contribution might not be considered LUQ.

For Schedule C and business filers there are various factors that can cause the DIF score to increase. For instance, your business expenses will be compared with similar businesses nationally and locally as identified through the business’ NAICS code. If your business expenses appear out of line compared to other similar businesses, that may increase your DIF score.

How to Prepare for an Audit

If there’s ever a reason to hire an attorney, an IRS audit should be at the very top. Unless your records are in perfect order and you have records to substantiate every deduction taken on the return, do not attempt to handle this on your own. The benefits of having a tax attorney on your side, especially one with prior IRS experience, will more than offset the costs of representation.

After you’ve hired a tax attorney, you and the attorney should have an honest discussion about your tax returns and identify any weak links, such as expenses that you may have accidentally overstated or are unable to provide documents. Your attorney can help limit the damage.

FAQ

IRS Audits

How Far Back can the IRS Audit you?

The Internal Revenue Code (IRC) contains time periods within which the IRS must assess and collect tax. These limitations are known as “statute of limitations.” Section 6501(a) of the IRC states that an assessment of any income tax must be made “within 3 years after the return is filed.” This applies even if a return is filed late.

However, there are exceptions to the 3 year statute of limitations:

  1. False, fraudulent, and unfiled tax returns. There is no statute of limitations where a taxpayer files a false return, engages in a willful attempt to evade tax, or does not file a tax return.
  2. A return is filed with a substantial omission of income. The IRS may assess taxes within 6 years of a tax return filing where the taxpayer omitted more than 25% of the reported income for the year under examination.

Example 1: Bob files his 2014 tax return on 4/15/2015. The IRS has until 4/15/2018 to audit and assess any additional taxes on the return, absent fraud or more than a 25% omission of income.

Example 2: Bob files his 2011 tax return on 4/15/2012. Bob’s 2014 tax return is audited by the IRS and after reviewing his bank statements, the IRS discovers that he underreported his income by more than 25% in 2014. The IRS now has until 4/15/2018 to audit his 2011 tax return.

Sources:

26 U.S. Code § 6501 – Limitations on assessment and collection

 

US Citizens Owing Back Taxes Now Getting Passports Revoked

Houston Tax Attorney

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US Citizens Owing Back Taxes Now Getting Passports Revoked

More travel complications are in store and it’s not just for foreigners. Under new rules to be implemented soon, American citizens can be banned from travelling by having their passports revoked for unpaid tax debt.

Certification of Individuals with Seriously Delinquent Tax Debt

A new law passed by Congress in 2015 authorizes the IRS to certify to the State Department if a taxpayer has seriously delinquent tax debt. IRC § 7345. According to the IRS website, the IRS has not yet started certifying tax debt to the State Department but it is expected to begin in early 2017.

What is Seriously Delinquent Tax Debt?

Under the new law, seriously delinquent tax debt is an individual tax debt totaling more than $50,000 (including penalties and interest) for which a (1) Notice of Federal Tax Lien has been filed or (2) Levy has been issued.

However, taxes that are being paid under an installment agreement or other alternative form of relief are not considered to be seriously delinquent tax debt under this provision.

Revoking of Passport

Upon receiving certification, the State Department may revoke your passport. There is no grace period prior to the revocation.

If you’re currently applying for a passport, the State Department will hold your application for 90 days to allow you to enter into a payment agreement or apply for one or more forms of tax debt relief.

If Your Passport is Revoked or Denied

You can file suit in the US Tax Court or a US District court to have the court determine whether the certification is erroneous.

If the certification is valid, you should immediately pay the debt, enter into a payment arrangement, or make an alternative arrangement such as an offer in compromise to keep your passport. The IRS will reverse the certification within 30 days of resolution of the issue.

If you are Planning on Leaving the Country and Owe Significant Tax Debt

If you are a US citizen, you are free to travel until the State Department has received a certification from the IRS. If the certification is received while you are abroad, the Secretary of State may limit your passport to allow you to return to the US.

If you are not a US citizen, do not travel abroad if you owe significant tax debt! You should inform your immigration attorney of your travel plans and retain a tax attorney to resolve the back tax issues prior to your travel.

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Source: IRS

Discharging Tax Debt Under Chapter 7

Houston Tax Attorney

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Discharging Tax Debt Under Chapter 7

A common misconception is that federal taxes cannot be discharged through bankruptcy. This is false, and unfortunately even many bankruptcy attorneys do not understand tax issues in bankruptcy cases. A Chapter 7 filing can be a very powerful tool in obtaining relief for past due taxes.

What is Chapter 7 Bankruptcy?

A petition filed under Chapter 7 of the Bankruptcy Code is used to discharge debt through liquidation of assets. However, exempt and excluded assets are retained by the debtor. Examples of exempt assets include your homestead up to 1 acre, personal property ($30-60K), life insurance, pensions for state and local employees, tools of trade, earned but unpaid wages, and unpaid commissions up to 75%.

What does Filing a Chapter 7 do to Taxes?

Filing a bankruptcy petition gives rise to an automatic stay which immediately halts IRS collections. The IRS cannot file additional liens, send notices requesting payments, issue a summons, or levy your assets for any tax debt that arose prior to the bankruptcy petition. The automatic stay continues through the remainder of the bankruptcy process.

However, filing bankruptcy freezes the collections statute. If any of the tax debt is nearing statute expiration, you would not want to do anything that could freeze the collections statute. All tax returns must be filed prior to filing a bankruptcy petition. Additionally, failure to file tax returns or obtain an extension for returns that are due after the bankruptcy petition will result in the dismissal of your case.

Will my Tax Debt be Discharged Through a Chapter 7?

It depends on what types of tax claims are present. Tax claims will fall under one or more of the following categories, listed from highest to lowest priority:

  1. Secured tax claims
  2. Unsecured tax claims
    1. Administrative taxes that accrue while the bankruptcy case is proceeding
    2. Gap taxes
    3. Unsecured tax claims that meet the criteria to be priority claims
    4. General unsecured (i.e., nonpriority) taxes

Secured Tax Claims

If the IRS has recorded a Notice of Federal Tax Lien, those taxes are considered secured tax claims. The underlying debt against the individual may be discharged, but the tax lien will stay on the property until it is sold, at which point the debt will be paid through the sales proceeds.

Priority Claims

Taxes that are priority claims are not dischargeable in a Chapter 7 to the extent not paid out of the assets. Such claims include:

  1. Trust fund recovery penalties
  2. “Three-year Rule” taxes: Income taxes for which the due date of the return, including extensions, is within three years before the date of bankruptcy filing
  3. “240-day Rule” taxes: Income taxes assessed within 240 days of the date of bankruptcy filing
  4. “Two-year Rule” taxes: Income taxes related to a late return filed within 2 years of bankruptcy

General Unsecured Taxes

Unsecured taxes will be fully discharged.

Example

Bob owes taxes for 2010, 2011, and 2012, owing $25,00 for each year. All returns were timely filed prior to their October 15 extensions. Bob owns a home worth $500,000 with an equity of $300,000. IRS has filed a tax lien for 2010, but not the other years. If Bob files a Chapter 7 bankruptcy, the 2011 and 2012 taxes would be completely discharged since they meet the 3-240-2 rules and are nonrpriority tax claims. The 2012 is discharged against Bob personally, but a lien will remain on the property for $25,000 because it is a secured tax claim. The IRS legally could choose to enforce the lien by foreclosing on your home after the bankruptcy. However, this is not something that is commonly done, and almost never where the equity is less than $100,000.

Should I File a Chapter 7?

If you’re considering filing a Chapter 7 to discharge federal tax debt, you need to speak to a tax attorney first to determine whether that is an option for discharging the debt. Some of the factors that need to be considered include:

  • Whether you primarily owe tax debt, or if you also have significant consumer debt. If you have consumer debt, you may be subject to the means test.
  • The dates the returns were filed and taxes were assessed
  • Whether any tax liens have been filed
  • What types of assets and amount of equity in assets you currently own
  • Whether there are any trust fund recovery penalties assessed

This is yet another reason why hiring a tax attorney versus a CPA or enrolled agent for tax disputes is important. A CPA or enrolled agent cannot provide tax court or bankruptcy court representation, and may not even suggest to you all the options available in resolving your tax matter.

Won’t a Chapter 7 Hurt my Credit Score?

Bankruptcy should always be a last resort and it will significantly lower your credit score for 10 years. However, the effect on your credit score should not dissuade you from considering a Chapter 7. Most clients with tax debt already have low credit scores caused by IRS liens. Liens remain on your credit report for 7 years, or until the tax has been fully paid and the lien is withdrawn. You will have a difficult time buying a house or qualifying for a loan anyway with a tax lien on your credit report.