WHEN I CHAT with clients about the IRS and mention audits, many turn white with fright. To alleviate angst, I explain that years of underfunding have forced an understaffed IRS to significantly scale back its enforcement efforts. But my reassurances are insufficient to assuage the fears of some clients, so I alert them to tactics that can make audits less traumatic and expensive.
Let’s start with the bad news: Audits are basically adversarial proceedings. Even worse: They differ from criminal trials, where defendants are presumed innocent. In disputes with the IRS, the burden of proof generally falls on taxpayers, not the IRS.
Take deductions. The IRS doesn’t have to show that taxpayers didn’t incur and pay the expenses. Instead, the burden is on taxpayers to show they did. What if they can’t? “Nyet problemy,” says the IRS. It simply disallows the expenses.
The agency admonishes its examiners to insist that taxpayers provide the following kinds of evidence. First, establish that they had the expenses. Bills can take care of that. Second, show that they paid them. Canceled checks, credit card statements and the like are usually sufficient. Third, they have to establish that the items in question qualified as deductible expenses.
When it comes to business expenditures, they must be “ordinary and necessary,” though the IRS will often cut you some slack. Among other things, it acknowledges that an individual’s business ventures needn’t be fulltime. They can be part-time, as when a person moonlights from her home as a writer and has a fulltime job elsewhere.
Taxpayers may also have to persuade skeptical examiners that other kinds of write-offs are allowable. Some examples: dependency exemptions and itemized deductions claimed on Form 1040’s Schedule A for outlays like charitable contributions, medical expenses, casualty and theft losses, state and local income taxes, and property taxes.
What if taxpayers are unable to satisfy all three requirements? Their deductions fail to pass muster; two out of three isn’t a passing grade.
That said, staffers have some leeway to let taxpayers get by with incomplete verifications when they come up with reasonable explanations. That’s why I remind clients to cooperate and answer questions politely. But I caution them to provide only those checks, receipts and whatever else is necessary to substantiate their positions.
What shouldn’t taxpayers do? Don’t show up with hardly anything in the way of supporting documents; tell sad stories about dogs eating the checks and other records; or explain that the records have unaccountably vanished. A better approach: Ask for more time to get what’s needed to satisfy the IRS. I also urge clients to confine their answers to the questions raised. Otherwise, they might wind up with more auditing than they bargained for.
When does it make sense for taxpayers to appeal the findings of examining agents? It depends on the issues and amounts involved, and on the IRS’s policy in settling similar disputes. But the agency’s own statistics reveal that it settles many appeals for far less than examininers demanded.
Suppose an agent’s superiors agree to reassess the case, but the taxpayer and the IRS still can’t reach an agreement. Or suppose the taxpayer decides to skip the agency’s appeals system and take the dispute to court.
If taxpayers want hearings before judges who are independent of the IRS, they’ll opt for the Tax Court, a forum that allows them to make their arguments without having to first pay the taxes in question. Should they lose, they then have to pay the taxes, plus interest and penalties. Still, the Tax Court is especially advantageous for folks whose cases involve no more than $50,000 in taxes and penalties (but not interest) for all years in dispute. The court settles such “small tax cases” with as little formality, expense and delay as possible.
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator). His previous blogs include An Ode to Owing, Right on Schedule and No Substitute. Information about his books is available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.