IRS Audit: Correspondence Audit vs. Office Audit

IRS audits are the concern of everyone. People wonder why their tax returns are selected for an IRS audit. There are many reasons as to why the IRS selects a return for an audit. Briefly, the IRS has a scoring system for each return. They call it Discriminant Function (DIF). It is basically a computer program that is able to identify which returns have the potential to be audited. They score these returns, the higher the DIF the more the potential for a tax audit. No one precisely knows what the ingredients in this program or the formula are? It may contain relationship between the numbers on your tax return such as travel expenses to your gross income on schedule C. It may assign certain skewed weight to certain items on schedule C such as office at home and so on. 

Your chances of an IRS audit are usually higher as your reported income gets higher. Also, if your deductions do not conform to certain ratios for your size of income. Some items may be especially looked at such as employee business expenses, travel and meal, repairs and maintenance and office at home on schedule C. Amended returns may increase your chance of audit especially if you are requesting a large refund. Also errors mathematical or otherwise may cause the return to be audited.

What type of IRS audit will you be subjected to?

The IRS may send you a notice to send proof of items such as interest and tax on your home. You just send the evidence to them. Being Mr. Anxious you send the required documents quickly. You agree in the end with the IRS. You may pay a few dollars more. Case is closed. You have just gone through an IRS correspondence audit. It is an audit that the IRS thinks that it can usually be resolved through correspondence, no need for your presence. This type of audit is usually performed through the Service Center not the Area Office. It is usually used for an audit of individual returns and the amounts looked at are smaller.  Perhaps the IRS employee performing that audit is less experienced than the other types of audit.

The second type of IRS audits is Office Audit. In this type of audit you take your files and your shoe boxes and go to the nearest IRS Area Office. You present your case and you argue your evidence (we usually don’t even attend the IRS Office Audit.  We send our document to the IRS as if it is a correspondence audit.) As in correspondence audit you may have to present original documents such as cancelled checks and invoices. The items chosen for an office audit may require some explanation as to why an item by way of example was expensed instead of being capitalized or the calculation of an asset basis or whether income should be treated as capital gain or ordinary income. 

So the difference between these audits may be looked at through the nature of the items examined and the dollar amounts that may be subject to the audit. We will discuss Field Audit in later blogs. 

As always we welcome any comments or experiences anyone has had.

IRS Help for Gulf Oil Spill Victims

The IRS is preparing to provide help to people with tax problems related to the oil spill in the Gulf of Mexico. BP is beginning to issue payments as compensation for lost wages or income, property damage, or physical injury. People receiving these payments may have questions as to whether these payments are subject to taxes or not. If you are benefiting from any of these payments, it might be a good time to foresee any future tax issues. The IRS has announced a Special Assistance Day on Saturday, July 17^th from 9 a.m. to 2 p.m. local time at the following Centers in seven different cities:

1110 Montlimar Drive, Mobile, Alabama

651-F West 14^th St., Panama City, Florida

7180 9^th Ave. North, Pensacola, Florida

2600 Citiplace Centre, Baton Rouge, La.

423 Lafayette St., Houma, La.

1555 Poydras St., New Orleans, La.

11309 Old Highway 49, Gulfport, Miss.

It is good to know that the IRS is willing to provide help to those who are already experiencing a very difficult situation. At the Centers you will have the opportunity to work with IRS employees to provide tax help and resolve any tax issues you may have related to the oil spill. You will be able to ask questions about your specific tax situation and possibly have faster tax resolution to your tax problem. The IRS has also opened a toll-free line for people with tax problems due to the situation in the Gulf: 866-562-5227. You can call this number on weekdays from 7 a.m. to 10 p.m. and also on Saturday, July 17^th from 9 to 2 CT.

If you have or anticipate a difficult tax problem related to the Gulf disaster and you need tax help, don’t hesitate to take advantage of these opportunities to resolve or foresee any tax issues. It is better to take care of things before they become more complicated.

Basically, it is anticipated the tax problems will evolve around three issues:

1. Property damage tax issues

2. Payments in lieu of lost wages

3. Payments for sufferings

First if you get compensated for the property damage you incurred the tax problem that you may be facing is the following question: do I recognize gain or loss on payments of damage? The answer depends on what is called the tax basis in the property. For starters think of tax basis as the cost of the property. If you are compensated more than your cost then you have a taxable income. 

Now let us instead of saying cost we use the term “basis” The term tax basis means simply modified cost. If you benefited from having the property and depreciated the property then the IRS will not use the cost but the cost minus the depreciation that you took in prior years and that is what they call basis.

The second issue that inevitably will come about as a result to the spill in the Gulf is compensation for lost income. This compensation is taxable because it is considered as wages that would have been taxable in way had it been earned without the Gulf spill.

Third type of compensation which we may encounter and you may need tax help on is the compensation damage as a result to some physical damage or mental anguish. This type is not taxable compensation.

Tax Help: Ordinary Income vs. Capital Gains - Tax Planning is Key

If your company offered you a stock bonus for free, would you take it? Would you rather pay something for it?  Intuitively, the answer is why pay money if they're for free.  The correct answer is, however, you may be better off paying for it.

To make my point, here is an extreme case, and why extreme?  To drive the point I want to shock you as to the consequences of the wrong decision.

John is an executive in his company.  He is offered 100,000 stocks for free.  Each stock is traded on the exchange for $100.  So how much is he getting free?  $10 million.  Let us say that after one year the company is kicking butts and he sells the stock for $200.  So now he collects $20 million.  Uncle Sam comes in and wants his cut.  Assuming 40% tax rate, John must write a check for $8 million.

Now let John be a little stupid and decide to pay for the stock that was originally available for free. Say John offers to pay one penny per stock.  John writes a check for 100,000 pennies.  Yes, we pay a $1,000 dollars for those stocks. John sells the stock just as explained above for $20 million.  What is his tax?  It's not $8 million anymore, but it is only $4 million.  The tax is now $4 million (assuming 20% rate)

What happened?  We simply played a little trick.  We converted the amount paid to John from being considered as a compensation (salary) subject to ordinary income rate (in this case we assumed 40%) to a capital gain when we created a basis for the stock (basis here means we created a cost) How much did the trick save? $4 million dollars.  Does it happen?  You bet you.

NFA Tax Help can help provide tax planning, advice, and tax resolution to any tax problem.