What may trigger an IRS audit?

The dreaded Internal Revenue Service audit is one of the universal concerns for companies everywhere. While there is no guaranteed method to avoid an audit, a variety of situations may increase the chance for examination.

IRS officials are naturally reluctant to share details of the audit selection process. But it makes sense to direct attention to the areas where the Service has focused attention with “Market Segmentation Specialization Program” (MSSP) efforts.

IRS Audit

While the Service won’t provide a road map for avoiding an audit, there is certainly adequate information about “areas of interest” and therefore, seemingly, audit risk. The MSSP process aims to develop highly trained examiners in specific areas with the objective of ensuring taxpayer compliance.The IRS has developed literally dozens of industry guides to assist auditors in their pursuit of enforcement. These audit technique guides are highly detailed, and they reveal considerable investment by the IRS. The documents are public and available on the IRS website (www.IRS.gov).

Common wisdom and the IRS website advise us that returns have a higher likelihood of being selected for examination if the reporting entity has involvement, or potential involvement, in abusive tax avoidance transactions.

In other words, returns may be selected for audit based on information obtained by the IRS through efforts to identify promoters and participants in these sorts of transactions. Returns are often selected when a company is involved as a related party or a party to general transactions with other businesses, partners or investors whose returns were selected for examination.

The IRS uses a Discriminate Function System (DIF) to correlate return statistics based on a company’s return with past IRS experience or similar returns using the Unreported Income DIF. A return’s DIF indicates the potential for questionable issues. The highest-scoring returns are often subject to selection for evaluation of items requiring review.

Local compliance projects may increase the likelihood for audit, as may the sheer size of the company. Many large corporate returns are examined annually, and there seems to be an indication that the cash basis of accounting could bring Uncle Sam around for a sniff at the substantive reasons for selecting the cash method.

Like so many rules and regulations, there are always exceptions. But if the IRS is talking about it, then you should be thinking about it.

Taxable income in foreign accounts is a key initiative of the Service. The recent Offshore Voluntary Disclosure Initiative was designed to bring offshore money back into the U.S. tax system, and it likely provides additional data for the IRS selection matrix.

A reputable CPA is a key component to your overall business strategy and could have an impact on audit exposure as well. If the IRS believes a preparer is claiming inappropriate deductions or taking other fraudulent steps on client returns, the preparer’s clients are at risk for an audit.

And it isn’t only the federal return. The IRS has information-sharing agreements with the states. If you are audited at the state level and you owe additional taxes, your state will share that information with the IRS. Receiving notification from the state may prompt the IRS to contact you to ask for additional information or to audit your return in depth.

Recent accounting pronouncements have many businesses concerned about providing an unintended road map for tax examiners relative to “uncertain tax positions.” The Internal Revenue Code includes provisions for compensating informants and whistle-blowers that provide specific and credible information to the IRS if the information results in the collection of taxes, penalties, interest or other amounts from the noncompliant taxpayer. Check out IRC Section 7623 and the “Whistleblower – Informant Award” on the IRS website if you are curious about this initiative.

Taxpaying entities should avoid claiming deductions that are inappropriate or unsupported. But if a business is entitled to a tax deduction – even if “high” compared to the amount of income – it should claim the deduction.

The 2012 federal budget calls for expanding the IRS auditor ranks in an effort to shrink the nation’s “tax gap.” The IRS has estimated this gap at nearly $300 billion.

With revenue of this magnitude at stake, rest assured that enforcement and collection initiatives will remain at a high level of interest for the IRS. As with many things, the best offense is often a good defense.

This brings us back to the reputable CPA: Be sure to consult with one soon.

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