Income Tax Audit Exposure and Deterrence Measures for 2011 tax returns

INFORMATION ABOUT INCOME TAX AUDIT EXPOSURE AND AUDIT DETERRENCE MEASURES FOR 2011 TAX RETURNS

Number of Tax Audits Continues to Increase

Taxing agencies continue to increase the number of tax audits to provide a way to fund the financially strapped federal and state treasuries.  Special targets are taxpayers with moderate to high income, high mortgage interest deductions or several other high exposure issues.  The list is practically endless.

The California Franchise Tax Board continues to be vigilant about under-reporting of "use" tax not paid at the time of purchase for internet, swap meet and out-of-state goods.  The personal use of business cell phones has become less of an issue, but we continue to stay vigilant and report personal use when the requested information is made available by clients. 

The IRS announced in 2009 that it is pursuing unreported income on foreign bank accounts.   Moreover, last year, the IRS instituted the "Compliance Research Examination" (the "audit from hell"), where absolutely every item on the return is verified.

Audit Deterrence Measures Offered as an Optional Service

No one has a strategy to absolutely prevent tax audits.  Regardless of whether your paperwork is in order, audits are disruptive, upsetting, expensive, and lucrative, to both the taxing agency and to the tax preparer who represents the taxpayer in the audit.  Some tax preparers dismiss the validity of active audit deterrence measures.  They claim that narrative information or numeric detail draws undue attention to the tax return.

We believe this passive approach is outdated, counter-productive and self-serving.  Passivity may backfire, causing or encouraging audits by intentionally ignoring obvious errors, unsustainable positions or other "red flags," all unbeknownst to the client,   In some cases, we have seen reckless positions taken, which, if detected, would seem to invite an audit.

Audit issues are quite obvious to the well-trained and experienced tax audit reviewer (the "Classifier").  Frequently, the limitations of numeric information on the tax forms alone can raise further questions, create mysteries, mislead the reviewer, leave matters unresolved or incomplete, or omit important information completely. 

For example, President Obama's tax accountant included a supplemental note on their tax returns to inform the IRS Classifier about the direct transfer of his Nobel Prize proceeds to several charities, and included the relevant citation of the Internal Revenue Code.

Our deterrent strategy proactively addresses possible issues directly with the Classifier by including in your tax returns supplemental narrative information and more detailed numeric breakdowns based on the information you provide.  These deterrent measures are intended to add context, dismiss unwarranted presumptions, dispel suspicions or clarify ambiguities which might otherwise require an audit to resolve.

We believe this proactive approach constitutes a useful deterrent and a modern alternative to passive avoidance.  However, each client is the final judge, as the adoption of these measures is strictly optional.