If you ever get audited by the IRS, here are some helpful hints. First, playing the aggrieved taxpayer doesn't work. Forty million or so people before you have tried that. Second, throwing out your business records, because you don't want to remember that year, is also a bad idea. I am in the middle of an IRS audit gone bad.
This audit should have been a relatively easy exercise. I have a client who lost a bunch of money in real estate a couple years ago. By a lot of money, I mean middle six figures. Not surprisingly, the IRS wanted a little look see to see if the losses were legitimate. We knew when the notice came in, that the primary issue would be supporting the real estate losses.
Normally this isn't a complicated type of issue. We keep detailed workpapers that show the calculation of the loss. We have to be able to show proof of the sales price as well as proof of the purchase price and documentation for any expenses related to the sale. I said “normally” this isn't a complicated issue. It does become considerably more complicated when the taxpayer throws out all of his records for the year. You might legitimately ask why some numb skull would toss all his records from two years ago. I asked just that question. He responded that he had moved and didn't want any reminders of his real estate losses. So he tossed the records at the dump when he moved.
This was bad news for yours truly, but not a deal breaker for the audit. We had proof of the sales price from a bank statement and a 1099 form. The problem was going to be proving the original purchase cost of the real estate. I had a plan for this. It was such a good plan. It even stood a small chance of succeeding......
However, when the IRS audits someone who owns a business, they don't just audit the obvious issues, like the real estate losses in this case. The auditor asked for a plethora of documents supporting various expenses such as materials and subcontractors for the client's construction business. She also asked for information related to mortgage interest and real estate taxes on his residence. We had the information related to his residence in our files already. However, because of the volume of information involved with businesses, we don't keep copies of all of the canceled checks and receipts for the business. Our clients are supposed to keep that. After all, we aren't a data storage facility, although a lot of days it feels like we are.
The auditor, a newbie with very little experience, conducted a routine audit test called a completeness test for unreported income. She added up all of the deposits from the client's bank statements and compared them to the income reported on the tax return. The idea behind the test is that if the deposits into bank accounts exceed the income reported on the tax return, there is income that should have been reported that was not. Somebody owes some taxes. Of course, there are a whole bunch of legitimate reasons why the bank deposits could exceed the income on the tax return. The obvious one is loans received by the taxpayer. So if you can explain why the bank deposits exceeded the income on the return, you are in the clear.
What was interesting in this instance was the the bank deposits were less than the income reported on the tax returns. This threw our newbie auditor for a loop. Any accounting major, who stayed somewhat awake during her first auditing course, knows that a completeness test only works one way. In this case, the test could reveal unreported income but nothing else. Bank deposits less than reported income means nothing. On the surface, it may look like income was over reported on the tax returns, but what it really means is that not all income got deposited into the bank account. This can be common in cash based businesses. In this case, the test results meant absolutely nothing. But our newbie auditor smelled a rat. She insisted that the test failure was significant and needed explanation.
This wasn't my first audit rodeo. I've been bucked by a few idiot auditors in my career. I had a plan to deal with this one. My plan was to admit the test failure was an unresolved issue and offer to meet with the newbie's supervisor to discuss the issue. The thing to know about IRS employees is that the higher up you move in the IRS food chain, the better your chances of finding someone with a brain. I know the supervisor is going to want to discuss this issue with me about as much as she would like a good venereal disease. She knows that the completeness test is only valid in one direction and would politely decline my request. Then she would bitch slap the newbie back into reality for wasting her time on the obvious. That was my diabolical plan.......
Despite revealing my masterful plan to the client, he became frustrated with the auditor. The completeness test wasn't the entire reason for his frustration. He was upset that she was asking for so much information that he was having difficulty producing. Of course, throwing away his records might have had just a little to do with his problems.
One afternoon during a meeting with the auditor, he went into aggrieved taxpayer mode and exploded. I have seen people go into aggrieved taxpayer mode before, and it isn't pretty. They talk about their Constitutional rights and ask why Bill Gates never gets audited. Actually we don't know if Bill Gates gets audited. Audits aren't public record. I do know the IRS at least looks at the records of a lot of large companies. When I worked at PEPCO in the 1980's, the IRS had a permanent office at PEPCO headquarters. I suspect they have one at Microsoft as well.
Facts and reason never stop someone in aggrieved taxpayer mode. It is a form of mental illness that resembles multiple personality disorder. One moment you have a sane adult in front of you. The next you have a raving lunatic mumbling about due process, the right to bear arms, and the founding fathers. My client started missing document delivery deadlines with the auditor and even pulled a no show for a meeting. There is no known cure for aggrieved taxpayer syndrome. It is frequently terminal for someone's business.
Here's something else you should know about aggrieved taxpayer mode. It doesn't work – ever. IRS auditors have an audit plan, which is a detailed set of procedures they must follow in every audit. An auditor's job is at risk for not following the plan exactly in every detail. When a taxpayer doesn't cooperate with the plan, the information requests don't just go away. They multiply. Audits are about credibility. If you can easily produce the information an auditor requests, the requests come to an end. If you can't meet the requests, you get more requests as a result and then even more requests. Aggrieved taxpayer mode finally results in a notice of assessment based on numbers compiled from failed audit tests. Surprise, surprise Gomer Pyle, when you fail audit tests, the numbers don't work out in your favor.
My dastardly plan never had a chance once the client descended into aggrieved taxpayer mode. Now I am stuck in IRS audit hell. An audit that should have been over in thirty days has taken four months, and there is no end in sight. Pray for my soul.
Last night Laura and I watched the Caps beat the Rangers at the Verizon Center in DC. I don't want to accuse the Rangers of being a bunch of wussy divers, but their team doctor is a gynecologist. I'm just sayin'....
Thanks for reading. Please visit the main S&K web site at www.skcpas.comfor real tax and accounting advice. LET'S GO CAPS!
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