The Nightmare Audit ... and How to Avoid It

Don't you hate picking up your mail and finding the IRS logo on an envelope? Regardless of the contents, you cringe. The notice inside says "Your return has been selected for an audit." Your terror is justified. Or is it? This year, I've dealt with several audits. Some easy - no change or sizable refunds. Others were (or still are) a nightmare. Why?

The NIGHTMARE AUDIT

CZ was audited for 1989. His tax professional had handled the audit. He didn't take care of the fundamental preparation needed for an audit. Result: IRS assessed CZ $174,000 in taxes, interest and penalties.

They got an audit reconsideration. They went in with little additional information. Result: a reduction to about $138,000.

CZ came to me. He told me "It's not right. I didn't make this much money. Help me." His is a common problem in audits, so I'll describe the problem.

TOO MUCH CASH

The IRS assessed CZ because deposits into his main account were over $600,000. Although most of that money came from loans or transfers from other accounts, his tax professional didn't prove this to the IRS.

RIOTS, FIRE, FLOODS AND THE BANK-CLOSURE PLAGUE

By 1995, some of CZ's records (and one of his bank's) had been destroyed in the Los Angeles riots. Another bank had changed hands so many times since 1989 that their records were lost. CZ made a good-faith effort to reconstruct the information. He had a correspondence trail a foot high. But no proof of his innocence.

What was the crime?

BEING A TAX OUTLAW

Tax Outlaws fudge their tax returns. Tax Outlaws hide out and don't file tax returns. But, the easiest Tax Outlaw to find is the one who lies blatantly on tax returns. From the looks of the deposits, the IRS thought he might be such an Outlaw.

PENNY WISE, CASH FOOLISH

Presently, competent tax professionals take two things for granted about audits:

1. The IRS will do a proof of cash.
2. The IRS will look at lifestyle costs.

It's no longer enough to substantiate the expenses to the penny.

Proof of cash: The auditor will total up all your deposits to all bank and brokerage accounts. If you cannot identify the transfers, the cash advances from credit cards, gifts of money, inheritances, the loans from banks, mortgage companies, family and friends, the IRS will assume it is income. It's up to you to prove otherwise.

Lifestyle: Look at where you live, what you drive, where your children go to school, what you wear, where you worship. The IRS knows all this about you, too.

Aside from the information on your tax return, they might research your credit, contact the motor vehicle department, the county recorder and all other public sources of data. In fact. many auditors are requesting completion of a form which spells out all your living expenses.

The goal is determine whether or not you can live on the income you reported on your tax return. If you can't, you had better be able to prove cash advances, loans, gifts, etc. that you used to pay all those expenses. If you cannot prove where the funds came to support your lifestyle, you might find yourself being assessed for unreported income - along with fraud, negligence and late payment penalties plus interest.

Solutions for a better future:

1. It is wise to photocopy all deposits, especially those that are NOT income.
2. Get written documentation of all loans from ALL sources, even personal.
3. File gift tax returns, where applicable. Otherwise, get written proof of the gifts.
4. Funds received from insurance settlements - get a written description of the cause of the judgment. Some or all that money may be taxable.
5. If roommates shared your expenses or you had other non-cash subsidies, get objective verification and put it in the file.
6. Keep your business accounts totally separate from personal funds.

WAKING UP FROM THE NIGHTMARE

What happened to CZ? We got the assessment reduced to $2,981. And we finally got the levy released too!

How did I do it? Sorry, we've run out of room!