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Immigration and Taxes

Kunal Patel

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Immigration and Taxes

Immigration and taxes might not seem like two areas that have much in common, unless you’re in the immigration process. With the current political climate, it’s important that anyone going through the immigration process understands the importance of being in compliance with your taxes and what it means for your application.

Why Taxes are Important in Immigration

Anyone that is applying for green card, naturalization, or a favorable exercise of discretion (e.g., cancellation, asylum) must demonstrate good moral character (GMC). As part of establishing good moral character, USCIS will request your tax returns for the 3-5 most recent tax years. The government can go further back to 10 years in some cases, such as for cancellation of removal.

An applicant who fails to file tax returns or pay his or her taxes may be precluded from establishing GMC.

What Types of Tax Issues will Affect my Immigration Application?

Obviously, the failure to file your tax returns or failure to pay the taxes you owe will be major issues for your application.

Additionally, what’s on your tax return may have an impact on the success of your application. If the USCIS officer uncovers inconsistencies in facts submitted on the application, the applicant may be precluded from establishing GMC due to an attempt to defraud the ​Internal Revenue Service (​IRS​)​ by avoiding taxes. The following are types of issues that have precluded applicants from establishing GMC:

  • Failing to file tax returns or filing under false SSNs. The later is a felony in Texas and can be considered a crime involving moral turpitude (CIMT). A CIMT causes a person to be inadmissible to the United States.
  • Unreported cash income. If a large portion of your income comes from cash income that hasn’t been reported on your tax return, the USCIS may question how the income you reported on the return is sufficient to support yourself and your household. Matter of Locicero, 11 I&N Dec. 805 (BIA 1966); Sumbundo v. Holder, 602 F.3d 47 (2d 2010)
  • Single or head of household filing status by a married petitioner.
  • Claiming earned income tax credits (EITC) while not a lawful resident.
  • Falsely claiming dependents on your tax return.
  • Claiming false deductions on the tax return. Meyersiek v. USCIS, 445 F.Supp.2d 202 (D.R.I. 2006)

Can I Apply for Citizenship if I owe Taxes?

This is a question that is asked frequently. The answer is ‘yes’, but only if you have made arrangements for payment. The USCIS office will request a letter from the taxing authority indicating that (1) the applicant has filed the appropriate forms and returns; and (2) has paid the required taxes, or has made arrangements for payment.

What Should I do if I Believe my Taxes Were not Filed Correctly?

You should amend your tax returns for at least a period of 5 years, or 10 years if you’re seeking cancellation of removal. If you have other issues with your application that may put into question good moral character, then you may want to amend tax returns up to 10 years. If you owe additional taxes after filing the amended returns, you should hire a tax professional to assist you in making arrangements with the IRS to resolve tax debt.

How to Settle IRS Debt

Kunal Patel

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How to Settle IRS Debt

If you’re struggling with tax debt, you’re probably looking to learn how to settle IRS debt. This is a process known as an Offer in Compromise – Doubt as to Collectibility (OIC). While many taxpayers might think this requires “negotiating” or “playing tough” with the IRS, it’s actually all about the numbers. There’s almost nothing you or your tax practicioner can say or do that will affect the outcome of an offer, unless it’s in the Internal Revenue Manual (IRM). Here’s how to settle your IRS debt through an OIC.

Step 1: Determine if you are Current on your Tax Obligations

You must be currently be in full compliance (1), which means:

  • You’ve filed all your tax returns that you are legally required to file
  • You’re having the correct amount of taxes withheld based on your Form W-4 or paying your estimated tax payments for the current year if you’re self-employed
  • Businesses must be making their current quarter’s payroll tax deposits
  • Continue to remain compliant through the rest of the process

Step 2: Calculate your Discretionary Monthly Income

Next, you should calculate your discretionary or remaining monthly income, which is basically your monthly income minus necessary living expenses. See IRS Form 656B for a worksheet. For a lump sum offer, your remaining monthly income over the course of 12 months would have to be more than what the IRS could collect before the expiration of the statute on an installment agreement (more in step 3). If your remaining monthly income over the course of 12 months exceeds your tax debt, then obviously there’s no point in submitting an offer in compromise, unless you’d like to pay the IRS more than you have to.

Step 3: Obtain a copy of your Tax Account Transcripts

Before you can resolve any problem, you need to understand the problem. Simple right? Get a copy of your account transcripts from the IRS for the tax year(s) for which you currently owe taxes. Determine the amount that you owe, including penalties and interest. Then determine the collections statute of limitations (CSED). If your CSED is about to expire, you might want to hold off on submitting an OIC as this will “freeze” the statute.

Step 4: Complete a Financial Analysis

Complete a financial analysis by calculating your reasonable collections potential (RCP). This is a very critical calculation as it determines whether your offer will be ultimately accepted or rejected. The RCP is basically a calculation of your ability to pay which is a combination of your future monthly discretionary income (over a course of 12 or 24) months and what the IRS could potentially collect from seizure of your assets. (2) The IRS will calculate an 80% quick sale value on the fair market value of your assets for purposes of calculating the RCP, minus the loan balance, if any. (3) Your Offer must equal or exceed the RCP to be accepted. (4)

RCP as expressed in a formula:

RCP = (DMI x #MO) + (FMV x 80% – LB)

DMI = Discretionary Monthly Income (Gross monthly income – IRS allowed personal living expenses)

MO = 12 or 24 months (depends on whether you’re applying for a lump sum or periodic payment offer).

FMV x 80% – LB = total equity in assets, or total fair market value x 80% – loan balance

When the calculations show that you are eligible for an Offer in Compromise based on Doubt as to Collectibility, in addition to the financial analysis you should carefully consider the impact of the CSED (Collection Statute Expiration Date). In accordance with IRM 5.8.4.3 Offers should not be accepted where the tax can be paid in full as a lump sum or can be paid under current installment agreement (IA) guidelines, unless special circumstances are identified that warrant consideration of a lesser amount. The offer should be recommended for rejection based on the taxpayer’s ability to full pay under current IA guidelines. In other words if taxpayer has a remaining monthly income and can pay the entire amount of liability before the CSED expires or under a PPIA (Partial Pay Installment Agreement) the IRS could potentially receive a substantially higher amount than the proposed offer, the offer will most likely be rejected as “not in the government’s interest”, provided that no special circumstances exist.

Step 5: Submit your Paperwork and First Payment

If you’ve determined that you have an offer that is acceptable (and also taking into consideration the CSED), then you’ll submit the following to the IRS:

  • Completed and signed Form 656
  • Completed and signed Form 433-A (individuals) or 433-B (businesses)
  • Photocopies of all required supporting documentation
  • A check or money order payable to the “United States Treasury” for the initial payment
    • If making a lump sum offer, you must make a payment of at least 20% of the total offer amount, and the remaining balance to be paid in 5 months. (5) *
    • If making a periodic payment, the first payment must be paid with the offer and the rest within 6 to 24 months per the terms of the offer.*
  • A separate check or money order payable to the “United States Treasury” for the $186 application fee.*

*There are exceptions for taxpayers that qualify as low income.

Mail the above documents to the appropriate IRS processing office in your state.

Step 6: Continue to Make Payments and Remain in Compliance

While your offer is being reviewed (anywhere between 6-12 months or longer), you must continue making payments per the offer terms as if the offer has been accepted. Additionally, you must remain in full compliance with the tax code for 5 years after the acceptance of the Offer. If a tax return is late or a new tax debt is incurred during this 5 year period, your offer is revoked and the complete amount of the existing debt with interest becomes collectible. (6)

The Risks of Submitting an Offer that is Rejected

  1. Applying for an offer in compromise requires you to send complete financial information to the IRS that they would not have had otherwise, including your bank account information, assets, and household expenses. If your OIC is rejected, you’ve just given the IRS all the tools they need to accelerate collections against you.
  2. If the IRS rejects the offer, it will NOT return the application fee or any other payments made with the offer. (7) 
  3. Filling a Offer in Compromise freezes the statute of limitations. If you or your practicioner didn’t consider an imminent collections statute expiration, you’ve probably cost yourself a lot of money that could have been wiped out by the statute expiration. In fact you’ve given the IRS more time to collect since the statute will be “frozen” during the 6-12 month or longer process.

Do I Need to Hire Someone to do this?

As you can see the OIC process is time-consuming and exhausting. Which makes sense – this is tax that you owe and you’re asking the IRS to write it off. This type of relief is not given out easily. If you’re a do-it-yourself type, carefully understand the risks of a rejected offer. You may not need to hire a tax attorney if you are willing to take the time to fully understand the IRS collections process. I honestly don’t know of many people that have the time or patience required to do so.

The only thing worse than making a half-measured attempt yourself is hiring a tax resolution firm. You can expect to pay $5,000 and more in fees in addition to your offer amount. You can identify these firms through their generic sounding business names and dozens of 5 star reviews, often posted by the company. These resolution firms will sometimes refund part of your fees if you don’t qualify, but you’ll still incur a loss for the amount you paid to the IRS, not to mention the valuable financial road-map you’ve now provided to IRS. I would also not hire any tax “professional” that blatantly advertises how much they’ve saved their clients. These are not typical cases, and there’s no government agency verifying these claims (or for you to verify the claims).

The truth is very few taxpayers will have a shot at an offer in compromise. The key for any practitioner is to review the client’s transcripts and financial information. I do not suggest an OIC for clients that do not have a high chance of succeeding, both in the offer itself as well as after the offer is accepted.


References

1 IRM § 5.8.4.6

IRM § 5.8.5.25

IRM § 5.8.5.4.1

IRM § 5.8.5.28

IRM § 5.8.5.28

IRM § 5.8.9

IRS Topic 204

The Five Biggest Mistakes Tax Practitioners Make When Filing an Offer-in-Compromise!

Kunal Patel

0

The Five Biggest Mistakes Tax Practitioners Make When Filing an Offer-in-Compromise!

The Internal Revenue Service’s (“IRS”) Offer-in-Compromise program continues to be one of the most popular programs with both practitioners and taxpayers when they are considering a way to resolve their back tax issue.  Yet, only 42% of Offers filed by taxpayers are ultimately accepted.  Why are less than half of the Offers filed being accepted? Read more about common offer in compromise mistakes.

Mistake #1: Not Checking the Statute of Limitations

There is a ten-year collection statute.  What this means is the IRS has ten years from the date it assesses the tax liability to collect that tax.  Easy enough.  However, taxpayers often do things that may toll or freeze the statute, preventing it from running.  These actions include anything that prevents the IRS from taking collection action, including:

  • Filing an Offer-in-Compromise
  • Filing bankruptcy
  • Filing a request for an installment agreement (payment plan)

Practitioners who are considering an Offer-in-Compromise for a client should first obtain power-of-attorney and pull updated transcripts for taxpayers, because it is critical to understand what has occurred and how much time remains on the statute.  The reason is that if the ten-year statute is about to run out, then the last thing practitioners should do is file an Offer-in-Compromise.  Instead Practitioners should consider filing a Collection Information Statement (Form 433-A) and arguing for a taxpayer to be deemed uncollectable, which does not stop the collection statute from running.  Why have the taxpayer incur the expense and stress of fighting for an Offer if we can allow time to take care of the liability?  By filing an Offer without considering the statute of limitations, practitioners may be doing extreme harm to their clients, and arguably are committing malpractice.

Mistake #2: Not Dealing With The Taxpayer’s Current Compliance

In order to make a deal with the IRS – any deal – the taxpayer must be in “tax compliance.” “Tax Compliance” means that they have filed all the tax returns required and are making their current tax payments.  For businesses, this means they are making their current quarter’s payroll tax deposits.  For individual taxpayers, it means they are having either the proper taxes withheld from their pay (wage earners) or have made the current year’s estimated tax payments (if self-employed).

Taxpayers who are not in compliance are not eligible for an Offer-in-Compromise, and any Offer filed will be returned and the filing fee and deposit paid with it kept by the IRS.

Mistake #3: Not Properly Calculating Future Income

So many taxpayers and practitioners list taxpayer’s income and then deduct what the taxpayers are actually spending, the result being the taxpayers show no future income!  It’s terrific: the taxpayers have zero future income in their Offer calculation and can offer almost nothing, just like those late night commercials.

Unfortunately, this is not how the Offer process works.  The IRS uses a taxpayer’s gross monthly income and then reduces the income for “allowable expenses”, which are frequently less than those actually being paid by the taxpayer.  The IRS allowable expense tables are based on the Department of Labor statistics and often represent county or state averages.  It is therefore not uncommon for a taxpayer to have negative cash flow when actual expenses are used, but to be positive once the IRS standards are applied.  The change can drastically change the results of the Offer calculation and can mean the difference between an Offer that is accepted and another that is ultimately rejected.

Mistake #4: Not Looking at What the Taxpayers are NOT Spending!

As an extension of Mistake #3 above, when a practitioner calculates the taxpayers’ future income based upon IRS allowable expense standards, taxpayers often ends up with a positive cash flow on paper, which can increase the Offer calculation above the point where taxpayers can afford to settle the back tax debt.

By understanding the allowable expense standards the practitioner can help taxpayers.  A Practitioner should consider what expenses the IRS allows that the taxpayers are currently not spending already and have them adjust their financial picture accordingly.  These “allowable” expenses that taxpayers often do not have include insurance, as many taxpayers in financial trouble drop health their health insurance, life insurance and disability insurance, yet these expenses are not only allowed but are necessary to protect the taxpayer’s health, family and income sources.

It’s important to know that the IRS will only allow those expenses that the taxpayers have a history of paying, meaning for at least three months as reflected by the bank statements or cancelled checks.

Mistake #5: Not Properly Calculating Reasonable Collection Potential

What is “Reasonable Collection Potential,” or “RCP”?

RCP is the amount the IRS calculates it could collect from the taxpayer if it obtained the net equity in the taxpayer’s assets and from twelve months of future income (or 24 months if applying for a differed offer).  We discussed the future income calculation in Mistakes #3 and #4.  What about the net equity in assets?

The IRS Offer forms contained in the Offer Booklet walk taxpayers through the net equity in assets calculation.  The issue arises when taxpayers assume that, because they cannot access the equity in the asset the IRS will not include it in its available equity calculation.  This is Mistake #5.

IRC § 7122 authorizes the IRS to agree to a compromise of a taxpayer’s debt, but it does not make the acceptance of a taxpayer’s Offer mandatory.  The decision to accept or reject a taxpayer’s Offer rests with the IRS.  In fact, the IRS will reject an Offer if the agency feels it is “not in the best interest of the government” to do so.

Practitioners need to remember that, unlike a payment plan or a request to be deemed uncollectable, the Offer-in-Compromise is asking the IRS to write off a debt it is otherwise entitled to, and a debt that most other taxpayers pay every year voluntarily.  This is not something the IRS does lightly, and the fact that taxpayers have assets that they cannot access does not change the fact that the taxpayer has assets.

Payroll Taxes – When the IRS Doesn’t Mess Around!

Kunal Patel

1

Trust Fund Recovery Penalty

The IRS may be kinder and gentler after the 1998 IRS Restructuring and Reform Act, but that certainly doesn’t seem to be the case with payroll taxes. When a business is doing poorly, a small business needs to make a decision – to reduce staff or not pay the bills. Oftentimes, a struggling business owner, for emotional or other reasons, may not want to lay off employees. At the same time business expenses need to be paid to keep the business running. A tempting solution can be to dip into their employees’ payroll tax funds to pay off business expenses. This ends up being a recipe for disaster. The struggling business gets behind on payroll taxes, continues to incur new payroll taxes and business expenses, and is unable to catch up. Eventually when the business shuts down, the owner will be personally liable for some of the payroll taxes. The IRS will prioritize collection of these taxes from the owner and other responsible parties. I’ve seen clients with excess of $300,000 in income tax debt who were not contacted by a revenue officer for years. In most of my payroll tax cases, however, the case was picked up by a revenue officer for enforced collection action within a year of the assessment.

Payroll Taxes vs. Trust Fund Taxes

Employers must withhold federal income taxes, social security, and Medicare tax from their employees’ pay. All of the federal income tax and ½ of the social security and Medicare taxes are paid by the employee, while the employer pays the other ½. The employees’ portion is referred to as trust fund taxes. Payroll tax is comprised of trust fund and non-trust fund taxes.

Failure to Pay Trust Fund Taxes

The IRS considers it a theft of government money when employers dip into the trust fund portion and fail to pay these taxes to the government. And it’s easy to see why – the employees are still able to deduct their payroll taxes on their tax returns, while the government is left holding an empty bag.

When an employer fails to pay the trust fund portion, the IRS has the authority to assert a trust fund recovery penalty (TFRP). A TFRP may be asserted against those determined to have been responsible and willful in failing to pay over the tax. The persons responsible could include:

  • an officer or an employee of a corporation,
  • a member or employee of a partnership,
  • a corporate director or shareholder,
  • a member of a board of trustees of a nonprofit organization,
  • another person with authority and control over funds to direct their disbursement,
  • another corporation or third-party payor,
  • payroll service providers (PSP) or responsible parties within a PSP,
  • professional employer organizations (PEO) or responsible parties within a PEO, or
  • responsible parties within the common law employer (client of PSP/PEO).

Whereas when an employer fails to pay the non-trust portion (i.e., the employer’s share of payroll tax), the IRS may only hold the company responsible, and the liability generally does not extend to the owners or partners.

Trust Fund Recovery Penalty Process

TFRP cases begin when the employer files a Form 941 with a balance due or an IRS FTD (Federal Tax Deposit) alert is created. FTD alerts identify employers that have not made current deposits or made them in substantially reduced amounts.

The alerts are then routed to a Revenue Officer (RO) and a pre-contact analysis is performed. If the analysis shows that the funds have been paid after the alert was created, the RO will close the case. Otherwise, the revenue officer is required to make initial contact with the taxpayer within 15 calendar days. During the initial contact, the RO is required to explain the TFRP and provide a copy of the TFRP calculation. The IRS will then conduct an interview and record their notes on Form 4180. This is the RO’s time to begin asking questions and gathering documents for purposes of asserting the penalty.

Taxpayers are encouraged to retain a representative to complete the interview on their behalf. The IRS cannot force a taxpayer to attend absent the issuance of a summons.

The RO will then assemble the core evidence necessary to assess a TFRP, such as the interview notes on Form 4180, business operating agreement and certificate of formation, bank signature authority cards, and a sampling of cancelled checks showing payments to other creditors instead of the government.

After all responsible persons are interviewed and documents are reviewed, the RO will submit a recommendation of assertion or non-assertion of TFRP on Form 4183. If the RO group manager confirms, a Letter 1153 and Form 2751 will be issued, notifying each responsible person of the proposed assessment.

If you are the recipient of a Letter 1153 and Form 2751, you should not sign the form without talking to an attorney! Form 2751 waives the restriction on notice and demand. You waive your right to a 60-day notice and give the IRS the authority to assess the TFRP immediately and initiate collections action.

Relief from Trust Fund Recovery Penalties

A Trust Fund Recovery Penalty asserted against you can be overwhelming. While there may be multiple responsible parties, the IRS has the authority to collect all the tax from any responsible individual (joint and several liability). That individual would then have a right to bring suit against the other responsible parties to pay their portion in civil court.

Statutory prerequisites. The first step if you’ve been asserted a TFRP is to determine whether you meet the statutory prerequisites – responsibility and willfulness. There are a multitude of TFRP cases where the tax court has found that the IRS overreached in asserting these penalties against parties who were not responsible.

Statute of limitations. Absent fraud, or failure to file, the TFRP must be assessed within 3 years of the date the Form 941s were filed.

Payment strategies. Often a company will owe both trust fund penalties as well as income taxes (non-payroll). Since TFRPs are asserted on the individual members and pursued aggressively, it would be advantageous to pay the trust fund portion first before paying the income tax.

Criminal Liability

While criminal prosecution by the IRS is rare, criminal cases involving TFRP are on the uptick. This is especially the case where the taxpayer has a history of unpaid payroll tax. Recently a trucking firm owner was sentenced to 18 months in prison for failing to pay $300,000 of payroll taxes between 2007 and 2012. See IRS Press Release 3/4/16.

A Simple Solution for Reducing your Chances of an Audit

Kunal Patel

0

The IRS Tells You how to Reduce your Chances of an Audit

If you’re an independent contractor (aka self-employed or sole proprietor), or in a general partnership, here’s another reason why you should form a separate legal entity.

In its annual Data Book, the IRS has released the percentages of tax returns that were audited in 2015. One of the most heavily audited returns were Schedule C business returns, which are filed by unincorporated businesses (i.e., those that have not formed a business entity). The stats reveal that your chances of audit are at least 4 times higher if your business is not incorporated.

And if you’re not already aware, incorporating your business also offers limited liability protection and lowers taxes by eliminating your self-employment tax.

Read more about the different options for incorporating your small business or sole proprietorship

IRS collections – Federal Tax Liens

Kunal Patel

0

IRS collections – Federal Tax Liens

Anyone who has been in trouble with IRS tax debt probably has some experience with a federal tax lien. Learn about what an IRS tax lien is, how it’s filed, and what you can do to get it released.

How a Federal Tax Lien is Created

After the IRS makes a tax assessment (when you file your return, through an audit adjustment, or an amended return filing), the IRS is required to give notice and demand for payment within 60 days. If the taxpayer fails to pay, a tax lien arises and attaches to all property owned on or after the date of the tax assessment. A lien continues until the underlying tax liability is satisfied. If it is not, then the lien will exist for the entire 10-year collections statute of limitations period.

A lien is only an encumbrance – it does not result in an actual transfer of property. For an actual transfer of property, the IRS must levy upon the property. Levies can either be directed to the taxpayer to seize tangible real and personal property belonging to the taxpayer, or it can be served on third parties such as banks and employers to levy bank deposits and wages. In FY2015, IRS levies on third parties totaled 1,464,026.

What Property is Subject to an IRS Tax Lien?

The general rule is that a federal tax lien attaches to all property and rights to property, both real and personal that belong to the taxpayer under IRC § 6321.

  • Real Property. This includes primary residences, secondary residences, land, and rental properties. The homestead exemption does not apply to a federal tax lien.
  • Personal Property. Personal property can include money, goods, tangibles (e.g. jewelry, cars, tools), and intangible property. Additional personal property subject to a federal tax lien includes bank accounts, insurance proceeds, retirement plans, pension plans, trusts, licenses, and franchises.

Note: For married couples in Texas, a community property state, there are a number of factors that may determine which property is subject to a tax lien, such as 1.) whether the debt was incurred prior to or after marriage, 2.) whether the couple have separate property, and 3.) whether the filing status is married filing jointly or separately.

Filing of a Federal Tax Lien

While is not necessary for a federal tax lien to be filed or recorded to be valid against the taxpayer, the IRS often does file a Notice of Federal Tax Lien with the County Clerk in order to have priority over other creditors.

Procedures for filing: For real property, the lien is filed in the county where the property is located. And for personal property, the lien would be filed in the county where the taxpayer resides.

Procedures for notifying taxpayers: IRC § 6320 requires the IRS to notify taxpayers in writing at their last known address within 5 business days of the filing of a Notice of Federal Tax Lien. While it is required to be sent via certified mail, there is no requirement that the taxpayer must sign or physically accept the delivery to be valid notice.

Relief from a Federal Tax Lien

Every lien that is filed will eventually be released, either after payment, by entering into a payment plan, or expiration of the 10-year collections statute of limitations. For those concerned about their credit scores, a lien release is not enough. A released lien will remain on the taxpayer’s credit history for 7 years after it is released. Combined with the 10 year statute of limitations, that’s 17 years that a lien can affect your credit history!

Fortunately, pursuant to IRC § 6323(j)(1)(D) and clarified in an IRS Office of Chief Counsel memorandum (PTMA 2009-158), the IRS may withdraw a federal tax lien after it has been released. This is not automatic – the IRS must be petitioned to withdraw the lien by the taxpayer. If the IRS accepts, then credit reporting agencies will receive a notice of withdrawal of a Notice of Federal Tax Lien, thereby which they are required to delete any references to the tax lien in the taxpayer’s credit history. It’s essentially as if the lien never existed. Additionally, IRC  § 6323(j)(1)(B) allows the IRS to withdraw a lien when the taxpayer enters into an installment agreement and meets certain requirements.

Conclusion

Often taxpayers with outstanding tax debt are not even aware that the IRS has filed a lien against their property. If you’ve moved or used a PO Box address on your tax return, you may have never received the notice. Regardless of whether you’re aware of the lien filing or not, a federal tax lien can lower your credit score by an average of 100 points and make it impossible to buy or sell a home, get a loan, or finance a car. Additionally, you may face scrutiny during a job application process when the employer conducts a background check and discovers the lien. It can be embarrassing to have a federal tax lien in public records for anyone to access and view.

If you’re dealing with an IRS tax lien, you should know that you do have rights and ways to get relief.

Guide to IRS Penalties

Kunal Patel

0

Guide to IRS Penalties

There are many different types of penalties that the IRS can impose on individual and business taxpayers. Here are some of the more common IRS penalties.

Failure to File and Failure to Pay Penalty

Legal Authority

Legal authority for the IRS to assess penalties for failure to file and/or pay are provided by:

  1. IRC 6651 – provides for additions to tax for failure to file returns required to be filed to report tax, and for failure to pay tax required to be reported on those returns
  2. IRC 6698 provides for a penalty for failure to file a complete partnership return as required under IRC 6031.
  3. IRC 6699 provides for a penalty for failure to file a S-corporation return as required by IRC 6037.
  4. The penalty for failure to make required payments under IRC 7519(f)(4)(A),

Postmarked Date Rule

Under IRC 7502, any return or payment received after its due date is treated as filed or paid on the postmark date. IRC 7502 also applies to electronic postmarks for e-filed returns. When the due date for filing or paying falls on a weekend or legal holiday, the return or payment is considered to have been filed or made on the dude date if it is mailed in the next succeeding date that is not a weekend or legal holiday.

When the IRS Service Center receives a return, the tax technician should date stamp the return and check the postmark date of the return before applying the stamp. If the postmark date is after the return filing date, then the envelope will be retained as evidence of late filing. If the postmark date is before the filing date, then the tax return due date will be stamped on the return.

I have personally seen mistakes occur. For example, a client had submitted a claim for refund that was postmarked a day or two prior to the date of the refund statute of limitations. The IRS received it a few days after this date and accidentally used the receipt date instead of the postmark date and denied the claim for refund. This is another reason to always send any documents to the IRS via certified mail return receipt, or through a carrier that offers tracking.

Also, the tax return must be signed! If the IRS receives an unsigned return, they will not use the postmark date of that return and will not consider it as filed. I’ve seen a case where the client (prior to coming to us) mailed his return on time but forgot to sign the tax return and wasn’t notified by the IRS until months later. Meanwhile, his account accrued significant failure to file penalties. “IRC 6061 through IRC 6065 require that any return made under the provisions of the internal revenue laws must be signed by the taxpayer (or other such authorized individual) under penalties of perjury. A return that is not signed by the taxpayer (or an authorized individual) fails to meet the requirement to file that return, and may subject the taxpayer to penalties for failure to file.” IRM 20.1.2.1.1.1 (04-10-2011)

Extensions

The IRS provides many types of extensions for individual and business taxpayers; in addition, there are specific extensions for taxpayers that are in combat zone duty, those located in a federal disaster area, and taxpayers suffering undue hardship. IRC § 7508, 7805A, 6061(a). However, an extension to file a tax return does not extend the time to pay (except if you file for an extension due to undue hardship, or taxpayers abroad who are allowed until 6/15 to pay). You should make a tax payment along with your filing extension. You should have your accountant calculate the estimated taxes that you will owe.

Penalty Amount

If you file your federal tax return late and owe tax with the return, two penalties may apply. The first is a failure-to-file penalty for late filing. The second is a failure-to-pay penalty for paying late. The failure-to-file penalty is normally 5 percent of the unpaid taxes for each month or part of a month that a tax return is late. It will not exceed 25 percent of your unpaid taxes. The failure-to-pay penalty is generally 0.5 percent per month of your unpaid taxes. It applies for each month or part of a month your taxes remain unpaid and starts accruing the day after taxes are due. It will not exceed 25 percent of your unpaid taxes.

Estimated Tax Penalties

Taxpayers are required to pay income tax as income is earned, through either withholding or estimated tax payments. Taxpayers who do not have sufficient amounts withheld are fail to make estimated tax payments may be assessed a penalty for underpayment of estimated tax. IRC 6654 (individuals) IRC 6655 (corporate).

Penalty Amount

The penalty is computed by applying the underpayment rate established under IRC 6621 to the amount of the underpayment for the period of the underpayment. In effect, the penalty is the sum of the penalties for each day during which an underpayment exists. The penalty for each day is computed by multiplying the daily rate by the underpayment amount. The daily rate is the rate determined under IRC 6621 divided by the number of days in the calendar year.

Taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and estimated tax payments, or if they paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller.

Failure to Deposit Penalty

This is also known as a payroll tax penalty. Employers have an obligation to submit payroll taxes on time and the IRS is very stringent about this requirement. Payments must be both made on time and in full. Failure to do so can be severe, especially if the IRS finds the employer intentionally failed to make the deposits.

Deposit Due date

The deposit due date will depend on the tax form involved and the amount of tax. Taxpayers must make their deposit anytime between the date the payroll liability is incurred and the date the deposit is due. Deposits are due only on business days. A business day is every calendar day that is not a Saturday, Sunday, or legal holiday under IRC 7503.

Penalty Amount

The amount of the penalty depends on how late the payment is and the amount that is past due. For liability amounts not properly or timely deposited, the penalty rates are as follows:

  1. 2 percent for deposits 1—5 days late,
  2. 5 percent for deposits 6—15 days late,
  3. 10 percent for deposits made more than 15 days late. This also applies to amounts paid within 10 days of the date of the first notice requesting payment for the tax due.
  4. 10 percent for required deposits not paid by EFT.
  5. 15 percent ( a 5 percent addition to the 10 percent for late payment in (c) above) for all amounts still unpaid more than 10 days after the date of the first notice requesting payment of the tax due or the day on which the taxpayer received notice and demand for immediate payment, whichever is earlier

Return Related Penalties

There are several types of penalties that can be assessed for filing inaccurate returns:

  1. IRC 6662, Imposition of Accuracy-Related Penalty on Underpayments,
  2. IRC 6663, Imposition of Fraud Penalty,
  3. IRC 6662A, Imposition of Accuracy-Related Penalty on Understatements with Respect to Reportable Transactions,
  4. IRC 6707A, Penalty for Failure to include Reportable Transaction Information with Return, and
  5. IRC 6676, Erroneous Claim for Refund or Credit penalty.

Legal Authority

The above IRC sections provide legal authority to the IRS to assess these types of penalties. Unlike some of the prior penalties discussed, return related penalties are not automatically assessed. Rather, they are assessed by an IRS examiner usually during the course of an audit.

Penalty Amount

  1. The amount of the IRC 6662 penalty is 20 percent of the portion of the underpayment resulting from the misconduct. The penalty rate increases to 40 percent in certain circumstances involving gross valuation misstatements, nondisclosed noneconomic substance transactions, and undisclosed foreign financial asset understatements.
  2. The amount of the IRC 6663 penalty is 75 percent of the underpayment due to fraud. See IRM 20.1.5.14.
  3. The amount of the IRC 6662A penalty is 20 percent of the reportable transaction understatement. The penalty rate increases to 30 percent of the reportable transaction understatement where the transaction was not properly disclosed. See IRM 20.1.5.15.4.
  4. The amount of the IRC 6676 penalty is 20 percent of the “excessive amount.” See IRM 20.1.5.16.
  5. Stacking of IRC 6662, IRC 6663, IRC 6662A, and IRC 6676 penalties is not permitted. The maximum amount of the IRC 6662 penalty imposed on a portion of an underpayment of tax is 20 percent (or 40 percent in certain circumstances) of that portion of the underpayment, even if that portion of the underpayment is attributable to more than one type of misconduct under IRC 6662.

Information Return Penalties

Some taxpayers are required to file information returns to the IRS such as Forms W-2, 1098, 1099, and 1042-S. If you are an employer or hired an independent contractor, and fail to file a W-2 or 1099 for your employee or contractor, you could be subject to penalties under this section.

Legal Authority

IRC 6721 and 6722 provide authority to the IRS to assess penalties for failing to file or incorrectly filing information returns with the IRS and/or for failing to provide a correct information return to a payee.

Penalty Amount

Recently Congress passed the Trade Preferences Extension Act of 2015 which has increased the penalty from $100 to $250 for each form that is not filed or furnished, up to a maximum of $3 million. The penalty for intentionally failing to file has increased from $250 to $500. The law became effective Jan 1, 2016.

Reduced penalties are charged if failures are corrected quickly, but the Act increases the reduced penalties also. For failures that are corrected within 30 days, the reduced penalty is $50 per return (currently $30) and the maximum penalty is $500,000 per calendar year (currently $250,000). For failures corrected after 30 days but before Aug. 1, the reduced penalty is $100 per return (currently $60) and the reduced maximum penalty is $1 million per calendar year (currently $500,000).

Payors rely on payees to provide accurate information to make the filings, such as social security numbers, correct names, addresses, etc. In come cases when payees do not provide accurate information or refuse to provide the information, payors are obligated to initial back-up withholding and deposit the amount with the IRS.

Penalty Abatement

Nearly all penalties can be abated. Taxpayers are usually unsuccessful in trying to abate penalties on their own because they do not understand how to qualify or apply for penalty abatement. Penalty abatement is discretionary and it helps to have a tax attorney present a well-reasoned and thought out request for penalty abatement that is supported by facts and law.

If you have been assessed substantial amounts of penalties by the IRS, contact us. The first step will be to request and review your account transcripts to determine what types of penalties have been assessed and the amount. We will then discuss which ones might qualify for penalty abatement and have the best likelihood of succeeding.

– Law Office of Kunal Patel LLC

IRS “Dirty Dozen” Tax Scams for 2016

Kunal Patel

1

IRS “Dirty Dozen” Tax Scams

I was inspired to create this post by a few clients that contacted us recently. Read on to learn how to protect yourself from IRS scams. The names below are fictitious to preserve client confidentiality.

Client #1 “Bob”: Bob went to a tax return preparer named “Jimmy” to have his 2015 tax return filed. Bob heard from a friend that Jimmy was a tax pro and would get him the biggest refund. As agreed to, Jimmy prepared the tax return and went over it with him. The preparer then had Bob sign a “refund anticipation loan” so that the refund would be directly sent to the preparer. In exchange, Bob would get his refund immediately from the preparer (minus a small fee) rather than having to wait for the IRS to process the return. A few months later, Bob needed to request a return transcript from the IRS as required for a loan. When he received the transcript he noticed that the refund amount on the transcript was larger than the refund that was on his copy of the return. After a consultation, Bob learned that he was a victim of tax preparer fraud. Jimmy prepared two tax returns for Bob – a fake return and the one he actually filed with the IRS. The fake return had a significantly smaller refund amount than the actual return. And the actual return had overstated deductions that Bob did not qualify for. The preparer pocketed the difference of the refund amounts.

How do you protect yourself from this type of fraud? First, be sure you pick the right tax professional. Second, do not rely solely on word of mouth. Many tax return preparers are popular with their clients because they maximize clients’ refunds by claiming erroneous deductions and credits. Second, steer clear of refund anticipation loans (RAL). Be especially wary of return preparers that are pushy with RALs. Third, review the documents that you are signing and ask questions if you’re not sure.

Client #2 “Jane”: Jane received a phone call from someone claiming to be from the IRS fraud department. The caller told Jane that she was past due on her IRS debt and that if she did not pay immediately, she would be arrested in 45 minutes.

How do you protect yourself from this type of fraud? First, do not give out any personal information to anyone claiming they represent the IRS. The IRS generally does not initiate phone calls to taxpayers, and they certainly will not call threatening to arrest you. IRS communicates through mail, unless you are in the IRS collections process. Even then, this wouldn’t be the first time the IRS has reached out to you regarding past due taxes. You would have received numerous letters from the IRS before IRS collections calls you. Additionally, the IRS would not ask you to wire money or demand payment over the phone. If in doubt, hang up and call the IRS 1-800 number on the latest IRS correspondence you received.

You should report telephone scams to the Treasury Inspector General for Tax Administration. Use TIGTA’s IRS Impersonation Scam Reporting web page to report the incident. You should also report it to the Federal Trade Commission using the FTC Complaint Assistant. Please add “IRS Telephone Scam” to the comments of your report.

The IRS “Dirty Dozen” List

The IRS released their yearly Dirty Dozen tax scams for 2016. The above cases are just a few of the many different types of scams out there. Here’s the rest of them.

Identity Theft: Taxpayers need to watch out for identity theft especially around tax time. The IRS continues to aggressively pursue the criminals that file fraudulent returns using someone else’s Social Security number. Though the agency is making progress on this front, taxpayers still need to be extremely careful and do everything they can to avoid being victimized. (IR-2016-12)

Phone Scams: Phone calls from criminals impersonating IRS agents remain an ongoing threat to taxpayers. The IRS has seen a surge of these phone scams in recent years as scam artists threaten taxpayers with police arrest, deportation and license revocation, among other things. (IR-2016-14)

Phishing: Taxpayers need to be on guard against fake emails or websites looking to steal personal information. The IRS will never send taxpayers an email about a bill or refund out of the blue. Don’t click on one claiming to be from the IRS. Be wary of strange emails and websites that may be nothing more than scams to steal personal information. (IR-2016-15)

Return Preparer Fraud: Be on the lookout for unscrupulous return preparers. The vast majority of tax professionals provide honest high-quality service. But there are some dishonest preparers who set up shop each filing season to perpetrate refund fraud, identity theft and other scams that hurt taxpayers. Legitimate tax professionals are a vital part of the U.S. tax system. (IR-2016-16)

Offshore Tax Avoidance: The recent string of successful enforcement actions against offshore tax cheats and the financial organizations that help them shows that it’s a bad bet to hide money and income offshore. Taxpayers are best served by coming in voluntarily and getting caught up on their tax-filing responsibilities. The IRS offers the Offshore Voluntary Disclosure Program (OVDP) to enable people catch up on their filing and tax obligations. (IR-2016-17)

Inflated Refund Claims: Taxpayers need to be on the lookout for anyone promising inflated refunds. Be wary of anyone who asks taxpayers to sign a blank return, promises a big refund before looking at their records, or charges fees based on a percentage of the refund. Scam artists use flyers, advertisements, phony store fronts and word of mouth via community groups where trust is high to find victims. (IR-2016-18)

Fake Charities: Be on guard against groups masquerading as charitable organizations to attract donations from unsuspecting contributors. Be wary of charities with names similar to familiar or nationally-known organizations. Contributors should take a few extra minutes to ensure their hard-earned money goes to legitimate and currently eligible charities. IRS.gov has the tools taxpayers need to check out the status of charitable organizations. (IR-2016-20)

Falsely Padding Deductions on Returns: Taxpayers should avoid the temptation of falsely inflating deductions or expenses on their returns to under pay what they owe or  possibly receive larger refunds. Think twice before overstating deductions such as charitable contributions and business expenses or improperly claiming such credits as the Earned Income Tax Credit or Child Tax Credit. (IR-2016-21)

Excessive Claims for Business Credits: Avoid improperly claiming the fuel tax credit, a tax benefit generally not available to most taxpayers. The credit is generally limited to off-highway business use, including use in farming. Taxpayers should also avoid misuse of the research credit. Improper claims generally involve failures to participate in or substantiate qualified research activities and/or satisfy the requirements related to qualified research expenses. (IR-2016-22)

Falsifying Income to Claim Credits: Don’t  invent income to erroneously qualify for tax credits, such as the Earned Income Tax Credit. Taxpayers are sometimes talked into doing this by scam artists. Taxpayers are best served by filing the most-accurate return possible because they are legally responsible for what is on their return. This scam can lead to taxpayers facing big bills to pay back taxes, interest and penalties. In some cases, they may even face criminal prosecution. (IR-2016-23)

Abusive Tax Shelters: Don’t use abusive tax structures to avoid paying taxes. The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them. The vast majority of taxpayers pay their fair share, and everyone should be on the lookout for people peddling tax shelters that sound too good to be true. When in doubt, taxpayers should seek an independent opinion regarding complex products they are offered. (IR-2016-25)

Frivolous Tax Arguments: Don’t use frivolous tax arguments in an effort to avoid paying tax. Promoters of frivolous schemes encourage taxpayers to make unreasonable and outlandish claims Even though they are wrong and have been repeatedly thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law or disregard their responsibility to pay taxes. The penalty for filing a frivolous tax return is $5,000. (IR-2016-27)

Unreported Income

Kunal Patel

1

IRS Income Examination Process

How does Uncle Sam know that you haven’t reported income if you don’t receive W-2s or 1099s? And you’re also clever enough not to deposit your unreported income in your bank account, so there is no “paper trail.” What then? The IRS uses what are called “indirect methods” of uncovering this income during IRS income examinations. Don’t worry, the IRS won’t come after you for the $100 winnings you didn’t report from your office fantasy football league challenge. The materiality threshhold is generally $10,000 for most taxpayers.

Direct vs. Indirect Methods

A direct method for the IRS to look for potentially unreported income would involve looking for direct evidence of omitted income such as cancelled customer checks, public records, deeds, etc. An indirect method would involve the IRS reconstructing your financial records. Indirect methods are used when there is no “paper trail.”

Why Would the IRS Use an Indirect Method?

When you are audited by the IRS, it almost always includes a “minimum income probe”, which is required under Internal Revenue Manual (IRM) 4.10.4.3.2. This applies to both business and non-business returns. Non-business includes individuals, self-employed/sole proprietors, and disregarded LLCs. A large majority of taxpayers fall into this section. When the IRS suspects a large amount of unreported income during the minimum income probe, then the scope of the income probe is expanded.

A minimum income probe of an individual return consists of:

  • Matching income reporting documents (W-2s, 1099s, etc) with the tax return
  • Asking a standard list of income questions during your initial interview. The examiner will note your responses on the “initial interview questionnaire.” You will be asked about sources of income and your record-keeping practices. A taxpayer who intentionally lies on the questionnaire would be a prime candidate for a civil fraud penalty.
  • Financial status analysis: This is a spreadsheet in which the examiner enters sources of funds on the left side of the T-Account and expenditures of funds on the right side. Total sources are compared with total expenditures. It’s common practice before an audit for the IRS to complete a public records check to determine what assets you own and when they were purchased. If you purchased 3 brand new BMWs in 2014 and you’re being audited for that year, the purchase price of those vehicles (or a close approximation) would be entered into the expenditure side.

If the T-Account does not show a material imbalance, then the examiner should stop here. And if he doesn’t, get a tax attorney! The examiner is not allowed to continue examining your income under the minimum income probe section of the IRM.

If the T-Account shows a material imbalance, additional questions will be asked of you to reconcile the difference. For example, you received a $100,000 nontaxable inheritance from your “nana”, which would explain the 3 BMWs you purchased. The examiner will likely ask you for proof such as probate records. A lie here also makes you a candidate for the civil fraud penalty.

If the T-Account is not reconciled during the audit of a non-business return, the examiner will request bank statements for all your accounts and conduct a bank deposit analysis. Here, the examiner is looking for unexplained cash deposits. If additional income is found here that resolves the T-Account, then your financial status audit should end. However, if the income still is not reconciled, then the IRS will use an indirect method. See further below, “Results of Minimum Income Probes.”

A minimum income probe of an individual “business” return includes the following:

  • Financial Status Analysis – Prepare a financial status analysis to estimate whether reported income is sufficient to support the taxpayer’s financial activities. See IRM 4.10.4.3.3.1.
  • Interview – Conduct an interview with the taxpayer (or representative) to gain an understanding of the taxpayer’s financial history, identify sources of nontaxable funds, and establish the amount of currency the taxpayer has on hand. Consider possible bartering income as part of the minimum income probes. See IRM 4.10.4.3.3.2.
  • Tour of Business – Tour the business site and review of the Internet website to gain familiarity with the taxpayer’s operations and internal controls, and identify potential sources of unreported income. However, a tour of the physical business site is not required for office audit cases but may be conducted if appropriate and with manager approval. See IRM 4.10.4.3.3.3.
  • Internal Control – Evaluate internal controls to determine the reliability of the books and records (including electronic books and records), identify high risk issues, and determine the depth of the examination of income. See IRM 4.10.4.3.3.4.
  • Reconciliation of Income – Reconcile the income reported on the tax return to the taxpayer’s books and records. An analysis of the IRP information in the file should also be completed to ensure all business and/or investment activities reflected on the IRP document are properly accounted for on the tax return. See IRM 4.10.4.3.3.5.
  • Testing Gross Receipts – Test the gross receipts by tying the original source documents to the books. See IRM 4.10.4.3.3.6.
  • Bank Analysis – Prepare an analysis of the taxpayer’s personal and business bank and financial accounts (including investment accounts) to evaluate the accuracy of gross receipts reported on the tax return. See IRM 4.10.4.3.3.7.
  • Business Ratios – Prepare an analysis of business ratios to evaluate the reasonableness of the taxpayer’s business operations and identify issues needing a more thorough examination. See IRM 4.10.4.3.3.8.
  • E-Commerce and/or Internet Use – Determine if there is Internet use and e-commerce income activity. See IRM 4.10.4.3.7.1.

Results of the minimum income probes

After completion of the minimum income probes for both business and non-business returns, the examiner must evaluate the information collected to this point and determine the scope of the examination of income, using the following criteria:

IF THEN
The results show that the taxpayer reported all taxable income from known sources, the books and records can be reconciled to the tax return, all financial activities are in balance, and the bank deposits do not exceed reported income. The examination of income may be limited to the Minimum Income Probes. The results and conclusions reached should be documented in the examination workpapers.
The results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, the books and records cannot be reconciled to the tax return, a material imbalance in the financial status analysis that cannot be reconciled, excess unexplained bank deposits, or inadequate internal control. A more in-depth examination of income is warranted. See IRM 4.10.4.5 for suggested guidelines for an in-depth examination of income.

A “more in-depth examination of income” would depend on the taxpayer and the type of business being conducted. A preliminary step might be to contact 3rd parties (for example, business associates) to obtain information or evidence to reconcile income issues. It may also involve reviewing your books and records.

A formal indirect method to make the actual determination of tax liability may be pursued when the taxpayer’s books and records are missing, incomplete, or irregularities are identified; or the financial status analysis indicates a material imbalance after consideration of specific adjustments identified during the examination.

Results of the in-depth examination of income

After completion of the in-depth examination of income, the examiner will decide the next step using the following decision criteria:

IF THEN
The taxpayer or third parties have successfully explained the reason for the understatement. Document the results in the workpapers and conclude the examination of income without adjustment.
The adjustments to income and understatement meet the criteria for referral to Criminal Investigation. A referral should be made to Criminal Investigation.
The taxpayer agrees to the proposed adjustments to income. There is no indication of additional unreported income. Document the results in the workpapers and make the adjustment, resolve other issues, and close the case agreed.
The taxpayer does not agree to the proposed adjustments to income and the adjustments are not based on estimated personal living expenses derived from BLS data or comparable statistics. Document the results in the workpapers and close the case unagreed.
The taxpayer does not agree to the proposed adjustments to income and the adjustments are based on estimatedpersonal living expenses derived from BLS data or comparable statistics. Consider using one of the formal indirect methods to determine the actual amount of unreported income. NOTE: A case should not be closed unagreed if adjustments to income are based on estimated Personal Living Expenses.

Formal Indirect Methods of Determining Income

Authority to use formal indirect methods come from two sources
  • Internal Revenue Code. IRC 446(b) provides that if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
  • Case law. If the examiner has a reasonable indication that unreported income exists, the Service has been granted the authority, through the development of case law, to use a formal indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The “formal” indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954).

When the IRS will use an indirect method?

The use of a formal indirect method to make the actual determination of tax liability should be considered when the factual development of the case leads the examiner to the conclusion that the taxpayer’s tax return and supporting books and records do not accurately reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.

The following list, which is not intended to be all inclusive, identifies circumstances that, individually or in combination, would support the use of a formal indirect method.

  • MOST COMMON for non-business taxpayers. A financial status analysis that cannot be balanced; i.e., the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference. This was discussed above under “minimum income probes.”
  • Irregularities in the taxpayer’s books and weak internal controls.
  • Gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry.
  • The taxpayer’s bank accounts have unexplained items of deposit.
  • The taxpayer does not make regular deposits of income, but uses cash instead.
  • A review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income.
  • There are no books and records. Examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when.
  • No method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income. See IRC 446(b).

There are 5 types of indirect methods

  • Source and Application of Funds Method: The Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the adjustment to income.
  • MOST COMMON for non-business taxpayers. Bank Deposits and Cash Expenditures Method: Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately.
  • Markup Method: The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability. It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s gross receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit, or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. If known, use of the taxpayer’s actual markup is required.
  • Unit and Volume Method: In many instances gross receipts may be determined or verified by applying the sales price to the volume of business done by the taxpayer. The number of units or volume of business done by the taxpayer might be determined from the taxpayer’s books as the records under examination may be adequate as to cost of goods sold or expenses. In other cases, the determination of units or volume handled may come from third party sources.
  • Net Worth Method: The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.

Summary

The IRS is thorough when it comes to examinations of income, and examiners are expected to document their findings in detail. The reason is that the IRS has the burden of proof when it comes to income (as apposed to deductions, for which taxpayers carry the burden of proof). This is why it is important to be represented by a tax professional for an IRS audit. For complex income issues, it’s even more important to hire a tax attorney who understands the IRS process. Even after the audit has ended and adjustments have been made, it’s not too late to hire an attorney. There’s a good chance the examiner did not properly document the income examination, made procedural errors, or made substantive errors. The first thing a knowledgeable attorney should do after a contested audit is request a copy of the examiner’s workpapers under the Freedom of Information Act (aka FOIA request).

Choosing a Tax Professional

Kunal Patel

1

Choosing a Tax Professional

Who should you hire when you have a tax problem?

Enrolled Agent (EA)

An enrolled agent is authorized by the IRS to represent taxpayers before the IRS for audits and collections. EAs can advise and prepare tax returns. While there is no educational requirement to become an EA, there is a short exam administered by the IRS that a person must pass in order to become an EA.

Certified Public Accountant (CPA)

The educational and licensing requirements for obtaining a CPA are:

  • 5 years of education (bachelors and usually a masters)
  • A passing score on the CPA exam

CPAs do not all specialize in tax. The accounting profession is broken down into internal audit, tax, and consulting. Even within tax, CPAs can specialize in individual, corporate, state and local, and international tax. CPAs prepare returns, ensure you are in compliance with tax code, and maintain business and financial records. A CPA is a great choice if you are current on your taxes and do not have outstanding tax issues.

Tax Attorney (JD)

The requirements for a licensed attorney are as follows:

  • 7 years of education (bachelors and juris doctorate, JD)
  • Passing score on the bar exam

Attorneys can specialize in estate planning, personal injury, criminal law, bankruptcy, immigration, and more. Some may decide to specialize in two or three areas. There is no formal requirement for an attorney to call themselves a “tax attorney” or “immigration attorney.” As with CPAs, you want to ensure that the attorney has experience in the specific area of tax for which you are seeking help. Tax is probably the most specialized of the different practices. Some lawyers will take an additional 1 year of law school to earn a tax LLM in order to learn this specific body of law. However, for attorneys that have tax experience, an LLM is unnecessary.

Attorneys are trained to advocate for your legal rights and will fight to ensure that your rights before the Internal Revenue Service are protected. A good tax attorney should have a solid understanding of IRS procedures for tax controversy cases.

Situations Where you may Need a Tax Attorney

  1. Audit representation – An EA, CPA, or attorney can represent you in an audit, but only an attorney can litigate your case in tax court if needed. There are some exceptions whereby an EA or CPA can take an exam administrated by the US tax court, but only a 100 have passed nationwide in the past 16 years combinedSource. Cases are very rarely litigated and are usually settled prior to trial by IRS Appeals; however, the IRS knows that if you’re represented by an attorney that the case has the potential to go to litigation. The IRS is required to consider the hazards of litigation in determining an appropriate settlement. You have much more leverage with attorney representation.
  2. Potential fraud – If you need attorney-client privilege to discuss a potential tax fraud issue. Attorneys can maintain attorney-client privilege and cannot be forced by a third-party, including government entities, to provide confidential information. Under federal law, CPA/accountant-client privilege is not recognized. Enrolled agents may have limited privilege in connection with a tax audit or collections, but it does not extend to tax return work-papers or to criminal proceedings. In order to resolve your issues it is important that you are able to discuss freely with a tax professional without worrying whether the information you provide may be used against you by the IRS, whether in a civil or criminal investigation.
  3. Tax debt – If you owe back taxes, only attorneys can represent you in bankruptcy proceedings. Many non-attorneys in this field are not even aware that federal taxes can be discharged in a Chapter 7 bankruptcy discharge. However, for small tax due balances (under $50K) or where a Chapter 7 is definitely not a option for you, a CPA specializing in tax debt cases should suffice.
  4. Tax return delinquency – If you have not filed your tax returns for many years, you could be subject to fraudulent failure to file penalties and even criminal prosecution in extreme cases.

  5. Unreported foreign accounts – The IRS aggressively pursues individuals who have unreported foreign income and assets, assessing civil and criminal penalties in some cases. There are offshore compliance options for such individuals that a tax attorney can guide you through to minimize your risks.

“Tax Professionals” You Should Always Stay Away From

There is an abundance of individuals that call themselves “tax professionals” that you should never hire. The IRS will almost always hold you responsible for additional taxes, penalties, and interest, regardless of the person who prepared the returns.

Tax resolution firms. “Tax resolution” firms advertise heavily on television, online, and on the radio, promising relief which they can not deliver. They have generic-sounding business names and don’t use any of the owners’ names in the business name. As a result, if the company goes under or enough complaints are filed, they can just shut down the business and open up another with no personal accountability. These firms use high-pressure sales techniques to extract substantial retainers. Unlike lawyers or CPAs, these firms are not subject to any professional regulations. They are allowed to charge whatever fees they are able to extort from their clients. Some common characteristics of these firms are to use BBB accreditation and hundreds of fake online reviews to convince clients of their legitimacy.

Here’s an example of a marketing video for a tax resolution firm that went out of business. They marketed to those with tax debt of greater than $20,000 and suggested they could reduce their debt to $1,500 or less. After being sued by the FTC and thousands of clients they ripped off, the owners probably still walked away with a substantial amount of money. If you’re in Houston, you may also have heard of Tax Masters. They went out of business and the owner spent jail time for tax fraud, and the clients who went to them were left on the hook. Here are some more examples of resolution firms that have been sued and gone out of business:

– American Tax Relief
– Roni Deutch “the tax lady”
– JK Harris

We get a lot of fallout clients from companies such as these, but unfortunately for many clients, by the time they come to us they’ve already spent thousands of dollars without any results.

Unregistered tax preparers. Unregistered tax preparers have no professional certifications and have not been able to demonstrate any sort of tax competence. These tax preparers will seek to maximize your refunds without adequate support in order to get your repeat business. Many will outright steal part or all of your tax refund. While the IRS has been vigilantly trying to shut down these businesses, it’s hard to catch “phantom” unregistered tax preparers who prepare returns but do not sign as the tax return preparer on the tax returns. This makes these individuals hard to detect. You could end up owing a substantial amount of money to the IRS if false deductions and credits were taken. Within the group of unregistered tax preparers, there are businesses called “notario publicos” or commonly just “notarios“. Notarios prey especially on the Hispanic population and take advantage of immigrants’ poor understanding of U.S. law. They mislead and steal from customers. They will often tell their clients that they are attorneys or CPAs. If you’re unsure of a person’s credentials, you can look up their information as follows:

EA verification  |  CPA verification (TX)   |  Attorney verification (TX)

When you are ready to work with an experienced attorney to put your tax problems behind you, give us a call (281) 746-6066.