Audits 101

How does the state choose who to audit?

In an effort to close the tax gap, New York State has partnered with IBM to create a new program called the New York State Case Inventory Selection System. It reviews every single tax return in a computerized way, using data mining techniques and different models to select certain returns for further review.

NY State is investing a significant amount of money in this system to increase tax revenue by going after dishonest taxpayers. It also streamlines the processing of returns and issuing of refunds and paves the way for faster service to the honest taxpayers who aren’t taking advantage of the system.

One of the areas they will be monitoring is the earned income credit. The earned income credit is based on the taxpayer’s marital status and number of dependents, which usually means how many children are in the household. Unfortunately there are dishonest taxpayers who try to claim more of the earned income credit than they’re actually entitled to.

More importantly, there is a renewed emphasis on self-employed or Schedule C individuals, targeting certain deductions that do not appear to be authentic, real business expenses. Upon analyzing a return with entertainment or legal professional fees that are too high for a particular industry, the system will select the return in question.

Because the state has to allocate its resources accordingly, it cannot perform an in-person audit with everyone. When someone is singled out for further scrutiny, many times the state will send out an inquiry letter instead, asking something like: “You claimed $10,000 in legal fees. Please send us the 1099 you sent to that attorney.” Depending on your response, you could end up triggering a full-blown audit – or they could be happy with it and leave you alone. My advice to clients is that if you do not have sufficient proof and it is a questionable expense, just go ahead and pay the tax.

If you are going to contest the tax or fee, hire a professional to go to bat for you. Generally, when you meet with an accountant they’ll say, don’t go to the audit yourself. That’s one thing that is very important to know; When taxpayers represent themselves, the result is usually not favorable.

We don’t recommend going to the audit, even with your attorney or accountant. Since you’re paying them anyway, let them go without you. If you do go with them, the IRS or the state can ask you a question directly and you may not be prepared to answer it. This way if your representative goes without you, he or she can make a note of it and ask you later – and the two of you will have time to prepare your answer. An audit is rarely a one-day process. Usually it is at least a few weeks with correspondences back and forth between everyone involved.

If you’re curious about how the IRS conducts its audits, there is an internal guide the agency was forced to divulge due to the Freedom of Information Act called the Audit Technique Guide. This is the handbook that revenue agents follow when conducting an audit and will prove very insightful to anyone facing an audit.

It is always important to keep good books and records, even on a personal level. Some things to keep in mind about keeping good books and records:

It is not the best practice to pay in cash, but if you do, keep track of the cash you’re paying. Keep a log of who worked for you and how much you paid them.
Cancelled checks, credit cards receipts and bank statements are ideal for justifying an expense because they offer concrete proof that you actually incurred that expense.
The state has been known to disallow hand-written receipts. A typed invoice is more credible if you ever have to prove an expense to the state.

One last thing to remember is that when you are signing your return, whether you‘ve done it yourself or had a CPA or tax professional do it, you are personally affirming that you have proof for all your deductions. You’re attesting to the fact that somewhere in your home or your office you have receipts, invoices or some other kind of proof that you have in fact incurred all those expenses. At the end of the day, you are on the hook if you get audited.

If you receive any type of notice from the IRS or state, we highly recommend meeting with a CPA or tax professional to get his or her opinion on it. Here at Armel Tax & Accounting Services, we are happy to offer free consultations. We’ll offer our services If we feel you need our help, but if it is something you can do on your own, we’ll let you know. We run a very transparent, honest office; We will only suggest a client hire us if we feel it will benefit them.

Do you know what’s on your tax return? Have you reviewed it? Are you comfortable that your return honestly represents your tax situation?