Surviving the dreaded IRS audit

Source: MARKETWATCH

Tips for dealing with an audit as well as reducing penalties

By Eva Rosenberg, MarketWatch

Last Update: 6:52 AM ET Jan 11, 2013

Its that time of year again, when tax questions start pouring in. Among the most frequently asked: Whats the best way to deal with an IRS audit and reduce any penalties? Here are some strategies to help you get past those fears and face the tax beast.

The Dreaded IRS Audit

Lets say youre facing an audit on your business taxes two Schedule Cs. You made a couple of mistakes on your tax return that are obvious, now that youre looking at it again. Should you just skip the audit and file an amended return?

Never, ever ignore an audit invitation. Call the phone number on the notice and discuss the arrangements or hire a tax professional to do it for you. The best person to represent you is the one who prepared the tax return. He knows what information was used to produce the numbers.

If you prepared it yourself and are afraid of audits, look for an enrolled agent. (www.naea.org.) These pros licenses are specifically for representing taxpayers before the Internal Revenue Service. Ask prospective CPAs whether theyre experienced with IRS audits. (www.cpadirectory.com) You probably wont need an attorney unless its a criminal audit or about to become one. (www.americanbar.org)

Regardless of who goes to the audit, you will have to gather records and documents for the IRS or your tax professional. Bear in mind that the IRS isnt just looking for proof that you spent the money shown on the expense lines of your tax return. They are looking for two more major things:

* That the expenses you reported really were business-related

* That you have actually reported all your income

The IRS examiner routinely adds up all the deposits to all the taxpayers bank accounts. Naturally, this total will prove that small business taxpayers have far more deposits in their bank accounts than their tax return shows as income. This is a trap: Beware. After all, when you use several bank accounts, you routinely transfer funds between them, have to redeposit bounced checks, or deposit cash advances and other loans.

To avoid being ambushed, read Chapter 13 of Small Business Taxes Made Easy. It walks you through the details of how to assemble a spread sheet to show the IRS which deposits were not income. The most important thing you will do in your audit is to identify all the non-income deposits in all the bank accounts.

This is especially important for a business showing losses. What did you live on during the year? Show proof of credit-card balance increases, cash advances, loans, or funds drawn from your own savings, investments or home-equity line.

Warning: If you have a full-time job and the business is just a sideline, the IRS will try to prove its a hobby. A business showing losses year after year will have a hard time proving its anything more than a hobby or a tax shelter designed simply to generate deductions. Thats where good tax planning comes in.

When making a major error say, entering $8,000 on one line instead of $800 be up front about it. It saves time and establishes your integrity.

Most businesses depreciate assets, some over several years. Find the original receipts for those items even if theyre form well over three years prior. The IRS has a right to demand the purchase documents for any asset still on your depreciation schedule.

You need logs for your vehicle usage. You must prove the total miles you drove the car during the year, as well as your business mileage. Recently, a Tax Court case had a rather distressing outcome: It didnt accept a taxpayers notations in his daily planner showing where he traveled to his appointments (the planner didnt list mileage to each location, show where each trip started from, or the cost of each trip or activity).

Planning tip: Anytime you use mapper software to locate your destination, save the file as a PDF file and attach it to your calendar. At least write down the total miles. That will help you prove the mileage later.

Naturally, theres a lot more work to surviving an IRS audit than this. But here are the thee key things you need to prove:

*That you dont have unreported income

*That your business is not a hobby

*That all your expenditures were business, not personal

And finally, if you are missing important documents to support your facts or deductions, find them, reconstruct them, or get written affidavits from people who can objectively verify the information.

Reducing Those Nasty Penalties

Lets say an accountant has a new client with several years worth of tax returns that were just recently filed with the IRS. Due to self-employment taxes, this client owes nearly $80,000 for 2007-10, including taxes, penalties and interest. Is there a way to reduce the penalties?

When filing a tax return late, with a balance due, there are two kinds of penalties that are charged instantly. A late-filing penalty and a late-payment penalty. The late-filing penalty is 5% of the balance due per month, up to 25%. The late-payment penalty is one half of 1% per month, up to 25%. There is also a minimum penalty, which is the smaller of $135 or 100% of the unpaid tax. (See IRS explanation.)

In addition, interest is charged on the total of the taxes and penalties each month, until the full amount is paid. So, the trick is, if you can reduce the penalties, the interest drops too.

What can you get waived? Typically, if you pay late, you cant get the late-payment penalties waived. The good news is, since the penalty is so low, it takes 50 months to reach the maximum penalty more than years.

But the late-filing penalty, which reaches 25% when youre only five months late? That can be challenged. What are explanations that the IRS will accept? Death, naturally. The taxpayer died and no one knew he or she never filed the tax returns. Your death? Thats hard to explain if youre the one making the request for penalty abatement. (Although, if you were brain dead or in a coma thats an excellent excuse. Be sure to provide proof.)

Illness or incapacity can be a valid excuse. Mental illness and substance abuse are considerations when it comes to being incapacitated. Get written evidence from a physician, therapist or substance-abuse facility. If thats not possible (as in the case of substance abusers), look for other objective, third-party evidence police reports or written affidavits from those whose lives have been affected by the illness or abuse.

Death of a spouse or partner who always handled the tax reporting is a good explanation. You need to prove that you had no experience, didnt know where to start, were totally befuddled and perhaps even dealing with depression or shock.

Dealing with the stresses of an elderly or dying family member who is far away wont work. If you cant prove that you were constantly on the phone helping out, making arrangements, overseeing the care, and flying back and forth, the IRS will not accept your stress as an excuse. (Its been tried often.)

Being too busy at work or in your business is not an excuse the IRS will accept for a late-filed tax return. The fact that you were able to effectively do your job, but not your tax return, will weigh against you heavily when trying to get penalties waived.

And of course, saying its just not fair? Well, that will get you nowhere.

However, if youre ready for an adventure in research, read the IRSs own employee manual Chapter 20 of the Internal Revenue Manual. Youll find their own internal criteria for getting penalties waived. Shh its a secret. Dont tell anyone.

Eva Rosenberg is the publisher of TaxMama.com, where your tax questions are answered for free. She is the author of several books and ebooks, including Small Business Taxes Made Easy. And she teaches tax courses at IRSExams.com and CPELINK.

Note: links have been removed from this article.

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