IRS Audit: A Shoe Box of Receipts vs. Detailed Analysis

You get a notice of an IRS Audit.  Your first instinct (hopefully) is to prove your case. Proving your case entails looking for receipts, checks, tapes, invoices, contracts, statements and schedules that you may prepare to present your case. This evidence will be submitted to an IRS agent either by you or your tax representative; a CPA, a tax attorney or an enrolled agent who is trying to offer you the best tax help.

Our question here is how should you present your evidence to the IRS agent? 

There are two ways to do this: the first is to shove everything, chaotic as it may be, in envelopes or shoe boxes to the IRS and let them have at it. The second approach is to make sense of the documents first and do some fancy work, a rather professional approach before you present it to the IRS.

Shoe Box of Receipts

Advocating the shoe box approach may be easier but it it is not the best. For one, when you throw everything in a shoe box without going methodically over every receipt it may not give you the best tax relief and could undermine your audit should you present a document that should not be there. That may destroy your chance of winning the audit and possibly compound your tax problem.

Secondly, if you follow this approach, you may not be able to determine your own weaknesses and strengths. You may not have the knowledge of the dollar amount that you have evidence for versus the amount that you may concede.

Finally those advocating this approach are hoping to distract the auditor by adding additional burden to his already crowded desk.  Each agent has his share of IRS audit workload. They have pressure from their managers and maybe the CPA or tax attorney is adding more pressure to make the IRS agent compromise. This really does nothing but antagonize the IRS agent who has your tax audit and the auditor may not be as amenable as they would have been if you were cooperating and hoping to reach a quicker IRS settlement.

Detailed Analysis

The other approach is to go to another extreme and do all the work for the auditor. If you do that your tax audit may go a lot faster but you may run the risk of giving the auditor extra time that he would not have otherwise had to munch and ponder on the issues that may not have been available to him due to time constraints. 

The reasonable thing to do is to organize the work papers in a logical sequence, identify each expense and summarize the evidence and the dollar amount for each expense. We even like to do a table of contents to present to the auditor so they may cross reference our work paper and make it easier on the auditor to follow the evidence trail. In many of the tax audits that we have, we get compliments on the way we send the work paper. 

That will start us on a good faith beginning. This is a good approach to tax resolution you may do on your own. Remember, there will be a penalty abatement issue coming as soon as the auditor finalizes his report. There may be other items that can be waived at the discretion of the auditor as well.

There are things that you may not want to get out of your way to accommodate so much, such as the case of sending bank statements. Should you summarize the deposits by revenue versus non revenue deposits to the auditor when it is an intimate analysis schedule they have to perform? The answer will depend on my benefit as a taxpayer. We will summarize those deposits if it is important to direct the IRS auditor to specific issues in the deposits. Only then we will do that.

Generally speaking if we have to choose sides, we will always opt for a professional and organized package that is easy to read and less time consuming to the auditor on your case. This may go a long way for a favorable audit tax settlement.

IRS Audit: Tax Audit Selection

In our minds tax audits mean tax problems. Many ask why my return? How did I fall prey to a dreaded tax audit? There are several reasons that cause one's tax returns to be selected for an IRS audit. Let us just say that if we have done everything by the book and we have mitigated all the reasons for the tax audit that we will talk about, our return still may be selected through random selection.

Now let us talk about tax audit reasons other than random selection. Let us start by saying that the amount of income and tax liability may be a reason for an IRS audit. The larger the amounts on the tax return the better the chance for a tax audit.  Why? It makes sense from the IRS point of view. The reasons go as follows: we will invest time and money for the IRS agent and we would like to recover our money. The higher the amounts reported (or not report or underreport) on your tax return the more handsome the chance they will recover money from you for their investment.

Let us speak about tax audit reasons that we would like to put them under the banner of self induced tax problems. It is a tax problem that you could have avoided but you either asked for it or mistakenly caused. Arithmetical mistakes on the tax return can cause your return to be selected for a tax audit. So check your math as they always say. Among other reasons are tax exemptions. Many taxpayers claim the wrong exemptions especially divorced taxpayers. Both parents sometimes claim same exemptions or more exemptions than they should.

For self employed people, the favorite items for an IRS audit are excessive car expenses relative to the income; meals and entertainment and the ever favorite office at home raises tax audit flags as well. Schedule C is one of the prominent schedules we see that cause tax problems to taxpayers. 

The return can be selected for an IRS audit because you report high income on the schedule C. We recommend to our clients that if their income goes over $100,000 on schedule C, to consider incorporating. The opposite is true about income on schedule C.  If you reported too little an amount and claim a lot of expenses, that may be a sure tax audit trigger. Some even deduct substantial expenses with $0 income on Schedule C. That may invoke the issue of hobby losses.

IRS audit can also be caused by taking deductions for expenses that do not suit the activities such as say liquor and beer purchase for an office supply store or say large office supplies expense by a truck driver.

One of the reasons that may cause you a problem and a tax audit is an amended return. This is true especially if you are claiming a large refund. They want to look at this return before they send you say $10,000 that you did not ask for to begin with. So be careful but always remember there is tax resolution to any problem. Next blog we will talk about the IRS audit and Taxpayer Rights

Payroll Taxes and Tax Settlement

Payroll taxes is the worst tax debt you can owe to the IRS. Your tax problem is magnified by the fact that payroll taxes are not personal taxes or even corporate taxes that you or the corporation pay out of pocket to finance public policies. They are taxes taken from others and given to you to deliver to the IRS. I guess that is why they call them “trust fund.” For some reason those payroll taxes were not delivered. At the end of the year, your employees will file their personal income tax and send the W-2’s along with them and they will request the refund. The IRS will have to pay them their refund even if they never received the money from you. You get the picture. That will make them mad, of course.  Did you intend to willfully choose to ignore the tax law and to incur tax debts to IRS? Most likely not. You just got caught in a cash flow problem threat which became an IRS tax problem. Does the IRS care that you did not mean to use the trust fund? Probably not.

The IRS will deal, most likely, harshly with you if that tax debt ever became excessive. They will hold you personally liable for the tax debt. Your company tax problem is not only a proprietorship or a corporate tax problem but also became an individual tax problem. The tax problem has mushroomed into tax problems.

The IRS will issue a bank levy your account as they will the corporate account. They will garnish your wages if you become an employee of someone else and still owe those back taxes. The bank levy and the wage garnishment are not the only manifestation of IRS anger. They may attach among other tax penalties hefty civil penalties. Is their a tax resolution to this tax problem?  The answer is like anything in life, there is always a solution hanging out there; tax problem or no tax problem.

The proposed IRS settlement will be one of the traditional tax resolutions we have enumerated previously such as Installment agreement (IA), Offer in Compromise (OIC) or to be declared Currently Not collectible (CNC) by the IRS.  After you obtain tax representation the question will be: which flavor would a CPA, a tax attorney or an enrolled agent propose as a tax relief? The tax relief will depend on your financial situation. The worse it is the better the tax resolution to your tax problem it will be.

The best tax settlement to your IRS debt probably will be a minimum amount of an Offer in Compromise, if you qualify.  This will be an ideal tax help or tax relief for your IRS debt. The worst tax resolution is payment of the full amount of IRS debt which will include the penalty and interest. This solution is an Installment Agreement. Obviously, your CPA or your tax attorney will prefer to provide a better tax relief but they may have no choice because of your financial situation. You may have to accept this tax solution as the best tax help available at that time. Certainly such an IRS settlement can be renegotiated if your situation changes in the future.

Tax Problems: The Anatomy of Tax Resolution

Many taxpayers seek tax resolution services only after things go so bad. The IRS threatens you with wage garnishment or a bank levy or may have filed a tax lien against you. Now what will you do? An immediate call to your CPA or your tax lawyer to handle your tax problems to get IRS representation? Most likely this will be your first call to action.

Your CPA, IRS lawyer or enrolled agent will collect financial data from you. The priority is to remove the bank levy or the wage garnishment. Sometimes they cannot begin to negotiate any tax debt relief unless you are in compliance. Compliance for IRS tax settlement purposes means filing all your back taxes.

Assuming you have filed all your previous tax returns and now we know all your back taxes which with interest and penalties make up your tax debt. It is now time to search for a negotiated IRS tax settlement to get rid of this nagging IRS problem. We spoke in previous blogs about how to remove bank levies and wage garnishment through either an installment agreement or an offer in compromise which may provide your tax help that you are looking for when seeking IRS representation.  

We want this time to talk about currently not collectible status as a way of settling IRS debt. For starters we want to state that both currently not collectible status and offer in compromise are available to people who owe back taxes to the IRS; qualifying for one most likely allows you to qualify for the other. 

If you qualify for one as a tax resolution, you probably qualify for the other except when you have net assets. If you have no income to pay your tax debts and you do have assets the best alternative to settle your IRS problem is currently not collectible and not offer in compromise. Please consult your CPA, tax attorney or other tax professionals to discuss in further detail.

Which Tax Resolution Will Be Your Best Tax Relief?

We discussed in the last blog of 3 possible tax settlement options available to settle IRS debt to prevent or remove wage garnishment, or bank levy. Tax lien will be a subject of its own in subsequent blogs. We mentioned three alternatives, installment agreement, offer in compromise and being declared currently-not collectible by the IRS.

We saw that installment agreement meant that we will pay all IRS taxes including interest and penalty but instead of a lump sum settlement, we will do it over certain period. We also said that we the tax relief that we will get for our back taxes will be shaped by our financial situation; assets and liabilities on one hand and income and expenses on the other. 

Your CPA or tax lawyer has to calculate both the amount of income in excess of your expenses and the net worth to decide the best tax help for your tax problem he or she should recommend. Generally, if you have assets to pay in full your total tax debt or if your monthly income is more than your monthly expenses in such a way that it is enough to pay your tax debt over the statute of limitation, you are not eligible for an offer in compromise but you may be eligible for an installment agreement and possibly the currently not collectible status. 

In the last blog we gave an example of how would an installment agreement be the only option to pay your back taxes and solve your tax problem. Now it is time to talk about offer in compromise as an IRS tax relief solution to your tax debt. Let us assume that your tax debt is $10,000 and you have no assets whatsoever. Let us assume that your monthly income is $1,000 and your monthly expenses are $1,100. In this case you have no assets and no residual income to payoff your tax debt. You are a perfect candidate for offer in compromise or currently not collectible.

The question then, should we try to declare you as currently not collectible or seek tax relief in an offer in compromise? We will discuss the difference between both alternatives as a way to resolve your IRS problems.

Offer in Compromise, Installment Agreement or Not Collectible?

If you have a tax problem or tax problems such as a bank levy, or wage garnishment and you are seeking tax relief for your tax debt, the tax help a CPA, an IRS Tax Attorney or an enrolled agent will offer you has to be one of three:

a. Installment Agreement

b. Offer In Compromise

c. Currently not Collectible

IRS Installment Agreement:

Basically, an installment agreement means that your tax debt settlement offered you no reprieve on the amount you owe.  You will pay the full amount of the IRS debt. The only tax debt relief you have is making periodic payments of the full tax debt amount. The tax resolution for this tax debt will not stop the accrual of interest and penalty.

The question is, why would a rational human being choose an Installment Agreement over, say an Offer in Compromise or Currently-Not-Collectible status? The short answer is: typically your financial situation dictates the agreement that will ultimately shape the tax resolution of your case.

Generally speaking, if you have a lot of net assets and your income is much more than your expenses, your chance of reducing IRS debt is lower. Net assets are defined as your assets minus your liabilities.  If you own a house that is worth $120,000 and your loan is $80,000, your net asset in this case is $40,000. Any IRS tax resolution must account for this fact. For example, if your tax debt is $10,000, the IRS will insist that you pay the full tax debt because they can collect that much from you. The only tax relief in this case is to schedule the payments over several years and you must understand that in your search for professional tax help.

The other factor when you seek tax debt settlement is the income and expenses as we said above. Let us say that you have no home and you own nothing in this life and your tax debt is $10,000 as in the case above. Let us assume further that your monthly income is $5,000 and your expenses according to IRS national and local standards are $4,500. If this is the case, the IRS will not reduce your tax debt and the only tax resolution for your tax problem is an Installment Agreement. 

If you have a wage garnishment or bank levy, the IRS will not embark on levy release or removals of your wage garnishment unless you strike some sort of a tax debt settlement be it an Installment Agreement, Offer In Compromise or be declared as Currently Not Collectible. As a side note you must bear in mind that your CPA or your tax attorney must prepare all your unfiled taxes.

Discussion of the rest of tax resolution options will be continued on the next blog.

Back Taxes: The Case Against Not Filing

The simplest argument for filing taxes in time is that it is the law. You must comply with the law. If you are not a tax protestor, and we hope that you are not (tax protestors usually end up on the wrong side of the bed) then you have no qualms with the legality of filing.

There are many benefits of filing in time besides being in compliance with the law. The most obvious benefit is getting your refund. If you are entitled to a refund and you don’t file, you may lose your refund because you are barred by the statute of limitations when you eventually file. We have seen people losing $7,000 or more of money in some cases that were coming to them and when they filed late they got nothing. Never mind that the IRS will ask you to pay the tax debt even if you don’t file. You guessed it. They file for you and now you owe back taxes (more on that later.)

One of the benefits of filing is that you may be able to wait out the IRS on you tax debt. The law states that the collection statute of limitation is 10 years.  If for example you owe taxes and disappeared from the radar of the IRS for ten years, the IRS may have lost the amount of tax you owed forever. In this case you have got yourself a nice tax settlement.

One of the disadvantage of not filing your taxes is that the IRS will file on your behalf. IRS calls that SFR or substitute for return.  Needless to say, in preparing your unfiled taxes, the IRS will not look after your best interests. The IRS will assume the worst against you. They will do a return for you as married filing separate even if you are single because filing separately causes you a tax liability higher than the latter.  In an SFR, you will not get any deductions for your expenses. 

For example, if you sell a house, the tile company will give you a 1099 for the proceeds and sends the IRS a copy of this 1099. The IRS records the total sale price as your income even if you were upside down on the house and they will not record the cost of the house. That is why we have many clients who come to us for $70,000 or even $100,000 of tax liability because of the sale of their residence when in fact they lost money. Unless you file, the tax liability remains on the book. The IRS had one of our clients owing over $250,000 in 2003 because of this exact issue. Guess how much he would have owed? Zero.

Because the amount of taxes owed is usually high you may even have a revenue officer appointed. When you have a revenue officer, that spells bad news. And to make things worse, we do charge more for revenue officers. So, that is another reason that you should file your taxes earlier.

Audits is another reason.  If you don’t file, the IRS can select any return regardless how old it is for an audit. On the other hand if file in time and you happen to have a year in the past that you made a lot of income and you think if you get audited on that year you will pay a lot of money, this year cannot be audited after three years. So, here you may have gotten away with murder.

We have seen other benefits to filing your taxes in time that particularly come in handy when you have a bank levy or wage garnishment or even when you want to do an installment agreement or an offer in compromise.  If you have unfiled returns, there will been no tax settlement for your tax debt unless you are in compliance. Tax compliance in this instance means filing all your back taxes. If have not filed, that may delay the process of IRS negotiation when you need it most.

Finally the IRS may even look sympethatic on your case if you have been filing on time.

IRS Tax Liens and Tax Levies....Challenges or Business as Usual?

Taxpayer Advocate continues to report IRS problems and IRS collection practices.  National Taxpayer Advocate Nina E. Olson released a few days ago (we appreciate her work on behalf of taxpayers who have IRS tax problems) a report to congress.  It addresses three main concerns:

1. Taxpayer Services: To show how the service is degrading the IRS after answering 87% of taxpayer's calls to IRS in 2004 now it is down to 57%. The IRS is taking on more of the social program such as Economic Stimulus payments, First Time Homebuyer Credit, Making Work Pay Credit and now the anticipated Health Care program. The IRS plans to increase funding for Collections activites by about 17% from 2004 while dereased spending on taxpayer service by 7%. Does that explain why almost half the calls to the IRS are not answered?

2. Reporting 1099 Requirement: This is a huge, huge problem and we would speculate that it may be practically unenforceable.  This 1099 provision applies to businesses, non profit organizations and even government entites. Basically they are trying to tell us if you do business with anyone and you pay them over $600 a year, then you must report them to the IRS. This requires that as a small business owner, you must keep track of everyone you do business with during the year, tally up how much you pay them, and then report them by giving them 1099 at the end of the year. 

Taxpayer’s Advocate estimates that about 40 million busineses are affected by this. Assuming that every business deals with 25 people a year, the IRS must receive 1 billion extra pieces of paper to deal with in addition to the burden they have. Common sense says that you should answer first the calls that you get before adding 1 billion 1099's to add to your fights. In addition, imagine the burden placed on each small business owner. If they don’t comply, they incur another penalty, another IRS notice, another collection action and another Revenue Officer that knocks on your door because now you owe tax debt to the IRS just because you did not participate in the massive paper Leviathan.

The third emphasized by Taxpayer advocate is the IRS Collection Practice which we will address in the next blog....

Offer in Compromise or Uncollectible

Offer in Compromise (OIC) is the best thing since sliced bread. You owe $100,000 in tax debt to IRS. You make an offer for the debt settlement of $1,000 or even less and they accept it. How good is that?

Does it happen all the time? Not by far. Most offer in compromise applications are rejected. Who wins and who loses is what we want to talk about?

In any IRS negotiations, the outcome must be one of three, either an installment agreement, uncollectible status, currently not collectible (CNC) as the IRS calls it or an offer in compromise. In my opinion offer in compromise is superior to all when a taxpayer has the ability to choose either the OIC or the CNC.

Although, unlike the offer in compromise, uncollectible status requires you to pay zero, I still contend that the offer in compromise is superior to the non collectible status.

We frequently choose to seek an offer in compromise for our clients rather than the non collectible status, even when both are available to the client. Why would any one in his right mind choose to pay money for an offer in compromise when he or she could get away with zero? 

There are two main important reasons for that. The first is the penalty and interest. The second is that the uncollectible status can be an apparition which may be resurrected to torment you in the future. The key thing to understand about the currently not collectible is the word currently. It means although we, the IRS, cannot collect form you now, we have not forgot that you owe us money. 

The minute the IRS sees that you have a raise or some money is coming your way, they will summon the spooky ghost to knock on your door and demand everything; all prior taxes that you owed and then some. And then some? Yes and then some.  The IRS wants you to pay the tax debt, all the tax debt and the interest and the penalty thereon. My friends, the IRS computer has been ticking all along when they declared you CNC. They did not attack you but their computer is preparing for a day of reckoning.

Now, let me ask you a simple question: you have a tax problem of $100,000 and you have the option of paying $1,000 in an offer in compromise that will put the tax debt to rest once and for all. $1,000 will erase your name from among those who have an IRS problem for eternity. On the other hand, you can pay zero now as uncollectible but have Big Brother watching you for years to come, waiting to take your wallet. Big Brother smells the scent of money and he's coming your way, again. Need I tell how to cast your vote? Ok, take the offer in compromise, my friends and then dissolve your tax problems in the ether.

Offer in Compromise - 80% Rejected by IRS

Let us start by defining what an offer is. An offer is one of three solutions, no fourth (unless you pay the full amount of debt in cash.) If you have a tax problem with the IRS, you will end up doing either an installment agreement, seek to be declared uncollectible or non-collectible classification as sometimes they refer to it, or make an offer in compromise.

Offer in compromise is then one of IRS debt settlement solutions whereby we offer IRS an amount less than what you owe. The question is how much and how do we determine that? In general, you must think as follows: The IRS will not accept any amount less than they can grab from you. IRS is not in the business of charity. I have seen IRS seizure of cars of people who are on social security and have kidney failure!!  Ruthless? In this instant, yes. Is there a way to avoid this? Of course, and that is another animal unto its own.

So, we offer the IRS what they think they can take. If we have $500 that they see in our bank we must offer them that plus any thing else that they see we have equity in. To calculate the equity, we will only offer them 80% of the fair market value of the assets that we are reporting minus liability on it.

Here's an example:

John is unemployed with no income and owes the IRS $150,000. He has $750 in the bank. He owns his house with a fair market value of $100,000. The loan on the house is $75,000. His equity on the house according to this calculation is $25,000 (value of $100,000 minus $25,000 loan.) So, at first glance one may think that we should offer IRS $25,000 for the equity in the house and 700 for what we have in the bank for a total of $25,700. Correct? If you have done that, I have a water front property in Arizona, as they say to sell you. If we were to do that offer we will make an offer on the $150,000 IRS problem for only $5,700.

How did we figure the $5,700? Remember that I said that we will offer IRS only 80% of the fair market value of the house. Since the fair market value of that house was 100,000.  80% of this amount is $80,000.  Since we don't own the house outright and that the bank owns $75,000 in that house (the mortgage amount), what is left really is 5,000 after the bank gets his cut and title company when well the house. Add $700 which is in the bank to the offer of $5,000, that brings the offer to settle amount owed to IRS for back taxes to $5,700.

Notice in the example above that I said that John is unemployed. I did that not make an assumption that the IRS feels sorry for unemployed folks and thus accepts lower offer in compromise just for that, but the purpose was to say that he has no income that the IRS takes a stab at, either voluntarily or via income and wage garnishment. 

So, now we are ready to give John some monthly income to make the picture more realistic. Let us say that John makes $5,000 per month and his expenses are $4,900 a month.  That means he has $100 to spare every month. Does the IRS look for an amount as little as $100 per month. You bet. You will be surprised to know that the $100 a month could be worth $12,000 of debt owed to IRS, more of explanation to come later. Let us assume that the collection statute of limitation is still available in full to the IRS (10 years in which the IRS can chase the takes payer.)

In this case the IRS looks at the $100 as I stated above to be worth $12,000. How is that? $100 of monthly surplus means $1,200 a year. Since the IRS can take this amount via wage garnishment or by a negotiated settlement for 10 years then you are looking at $12,000. In this instance, John who has owes IRS 150,000 for back taxes and has a house worth $100,000 and $700 in the bank, we can offer the IRS the following:

Amount from house equity as we explained                                            $5,000

Amount from $100 monthly surplus that we must offer                             12,000

Amount we currently have in the bank                                                      700

The total for the offer then must be                                                    $17,700

To summarize, our offer now is composed of amount of income over expenses and the net assets.

More to come on following blogs