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Caught In An IRS Audit

How to avoid being a target for an audit

By Mark Battersby

The good news is that the rate of audits by the Internal Revenue Service has been steadily declining in recent years. The bad news is that the IRS's current budget allocates more funds to "taxpayer compliance." Many sign professionals have discovered that avoiding audits or emerging victorious from those audits that can't be avoided has never been easier. Now, however, the IRS has proposed a research plan that will mean more audits as well as better targeted audits.

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  • For many years, the IRS conducted a Taxpayer Compliance Measurement Program (TCMP) in conjunction with their routine audits. That program involved time-consuming, thorough, in-depth audits of a selected few taxpayers while the results allowed the IRS to better target those tax returns -- and those taxpayers -- most likely to err or to cheat. After many complaints, Congress abolished the program.

    Now, with more and more taxpayers successfully battling IRS examiners, the IRS has come up with a replacement for the old TCMP audits, a research program that they will increase the effectiveness of those audits they do perform. In an effort to reduce the burden on taxpayers, many sign professionals and vendors may not even be aware that their returns or those of their businesses -- are being examined.

    The IRS's "National Research Program" (NRP) will give the IRS a much-needed road map for selecting future audits -- a crucial point because audits of compliant tax returns are unnecessary and burdensome for taxpayers and costly for the IRS.

    In order to estimate which returns have the highest likelihood of error, the IRS will use information from these audits to update existing screening techniques to select tax returns for audit. When these screening techniques are up to date, the IRS avoids auditing taxpayers whose returns are accurate and helps the IRS audit those returns that are truly in error.

    Beginning in September 2002, NRP will begin working on less than 50,000 audits out of the 132 million individual returns filed. There are four categories of audits included in this, ranging from no contact with taxpayers to scaled-back audits that will require less taxpayer substantiation than previous studies. Of course, about 2,000 NRP audits will check each line of the tax return. In a major change from earlier studies, however, these will not require explicit "line-by-line" substantiation by taxpayers of each part of the return so they will not as burdensome.

    Who wouldn't like to ensure that their returns -- or their sign business's returns -- are never targeted by the IRS for examination? A few sign professionals have discovered one, very dangerous and illegal way: don't file one. At the opposite extreme, a sure-fire way to ensure that your return is selected is to take big time losses, operate the sign business as a cash business and keep sloppy records. Don't report income earned from third-party players (who report it to the IRS) and take unusual or extremely large deductions.

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    The returns of most sign professionals fall between these two extremes. There's no justification for sacrificing valid deductions, even if large or unusual. All income and deductions must be reported and reported truthfully. If that means a higher chance of audit, so be it. Fortunately, there is some maneuvering room that may help reduce the odds of being targeted for an audit:

    • Report all third-party payor income;
    • Use the proper forms;
    • Operate a noncash business;
    • Use only employees, not independent contractors;
    • Use a corporations or partnership, not a proprietorship;
    • Avoid unusual deductions -- or at least provide documentation or an explanation with the return. Often the documentation will be enough to prevent a full scale audit even though the unusual deduction may trigger a closer look by the IRS;
    • Keep an eye on your lifestyle -- After all, the question of how does he or she do it, is one that your competitors, enemies and the IRS often ask;
    • Hire a professional.
    • Keep the evidence. In this case, good records can often stop an auditor from digging too deeply.
    Obviously, avoiding an audit should never be any sign professional's goal. Even the IRS encourages taxpayers to take any deduction to which they may be entitled. Keeping good records and preparing all returns carefully and on time should reduce -- but not completely eliminate -- the possibility of an audit. If an audit cannot be avoided completely, it can often be won with the right strategy.

    Among the more important rights given any sign professional whose returns are targeted for further examination, is whether to be represented by a tax professional or whether to attempt to answer the IRS's questions alone. Another important consideration for every sign professional being audited is where to hold that meeting.

    Should the meeting be in the accountant's office where all of the working documents are easily accessible? Should it be at the sign professional's place of business, the place where all the records are kept, in order to demonstrate to the IRS auditor that there is nothing to hide and that the sign operation is a legitimate one? Or, should the professional and/or his or her representative trudge down to the IRS office armed only with the specific documents and information requested by the IRS auditor? There is no one right answer.

    Because of the the complexity of our tax laws, it is the rare IRS auditor who cannot, if pressed, find some point to contest. Fortunately, however, even if the results of the audit are unfavorable that doesn't necessarily mean that additional taxes must be paid.

    Until the sign professional agrees with the IRS, the appeals process remains open. Most importantly, from the initial screening for accuracy that each return receives up to the final appeal has been exhausted, mistakes in the favor of the taxpayer are discovered in more than 25 percent of all cases.

    The IRS is usually quite sympathetic to honest mistakes and more than willing to discuss underpayments of taxes that may result from the many so-called "gray" areas of our tax rules. They'll frequently negotiate the amount of tax due on occasion. But they don't like fraud.

    Generally, all income taxes must be assessed within three years after the original return is filed. Unfortunately, tax may be assessed -- or a court proceeding to collect tax may be commenced -- at anytime if (1) the return is fake or fraudulent, (2) there is a willful attempt to evade tax or (3) no return is filed.

    The majority of sign professionals and vendors, however, file relatively honest returns and only occasional misinterpretations or honest disagreements result in additional tax assessments at the audit level. Should the sign professional question the additional assessment or any findings by the auditor, the first step of appeal is at the appellate level of the IRS.

    A disagreement over an auditor's findings is usually referred to the appellate level where the IRS' representative is usually more knowledgeable and empowered to be more lenient. Of course, even here, the sign professional does not have to agree. Naturally, while the additional taxes demanded by the auditor go unpaid, the interest and any penalties continue to accrue. But further appeal is still possible.

    The main purpose of the U.S. Tax Court is to review deficiencies asserted by the IRS for additional income, estate, gift or self-employment taxes. The Tax Court is the only judicial body from which relief may be obtained without the payment of tax.

    The Tax Court maintains relatively informal procedures for the filing and handling of cases where neither the tax deficiency in dispute nor the amount of claimed overpayment exceeds $50,000. Usually, the sign professional represents him- or herself, although they may be represented by anyone authorized to practice before the Internal Revenue Service.

    Unfortunately, decisions by the small tax case division of the U.S. Tax Court neither set a precedent which can be used by others in similar circumstances nor can the decision be appealed -- by either the sign professional or the IRS.

    Naturally, any sign professional who loses in regular tax court may appeal the case to a proper U.S. Court of Appeals merely by filing a notice of appeal with the clerk of the U.S. Tax Court. But the free ride ends with the Tax Court's ruling. If the Tax Court decides in the IRS's favor, future appeal requires an "appeal" bond guaranteeing payment of any tax deficiency finally determined.

    The IRS's new research program should allow them to better target the few tax returns that will produce the most results for their budget dollars. Those already good odds can be further reduced by every sign professional and vendors who take a few prudent steps to audit proof his or her return. And, finally, if all else fails, remember that many sign professionals have successfully battled the IRS.

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