How to handle the growing risk of an IRS audit

Click here to enlarge image

Congress is planning for substantial increases in IRS audits. Here’s how to minimize your risk!

Agrowing federal budget deficit has Congress eying ways to increase revenues. One target is trying to close the “tax gap,” the difference between what taxpayers should have paid and what they actually paid in federal income taxes. The tax gap is estimated at more than $290 billion in 2001, the last year for which records were available.

As a result, Congress is planning for substantial increases in Internal Revenue Service audits. Congress recently raised the IRS’s budget to $10.68 billion, which includes a substantial increase in money earmarked for audit and other enforcement activities.

Continued increases in IRS funding and new technology will shift more IRS personnel from data entry into audit and enforcement activities. As a result, doctors should expect the IRS audit rate to increase each year.

Who’s in the IRS crosshairs for future audits?

Doctors making $100,000 a year or more.
Self-employed doctors.
Doctors operating as Subchapter S corporations and who are taking a disproportionate percentage of profits in the form of dividends, rather than salaries.
Doctors involved in tax shelters, or transactions with no clear purpose other than avoiding taxes.
To avoid an IRS audit - or minimize the damage if you’re selected - doctors should use the following 16 strategies:

Report all income. Most doctors are convicted of tax fraud as a result of failure to report all income, and are typically turned in by vengeful ex-spouses, jilted lovers, and/or fired employees.

Claim only the actual deduction amounts - do not claim deductions that don’t exist. Moreover, do not round up or down your actual deduction amount, but deduct only the actual amount that can be supported.

Attach documentation to the tax return to support large deduction items, especially for medical, interest, casualty or theft losses, and charitable contributions.

Know the “audit triggers” - tax shelter losses, home office deductions, hobby losses, foreign bank accounts, offshore transactions, large deductions relative to the doctor’s income, complex investment and business transactions without proper substantiation, and sloppily-prepared tax returns. These are all “red flags” which may trigger an IRS audit.

Maintain good records. Make sure you have proper backup documentation for each and every deduction claimed, including receipts for credit card statements, automobile mileage log, trip and continuing- education itineraries, meal receipts, etc.

Detail a “talking” argument for all deductions claimed. Doctors should write out their argument in advance and place it with that year’s tax returns in case it’s needed. Furthermore, support deductions with outside sources such as letters, documents, and legal cases from the past that are favorable to your case.

Respond promptly in the event of an IRS audit notice. Respond within the time allotted, since failing to do so will result in a disallowance of deductions as well as the imposition of interest and penalties.

Use a CPA/tax attorney to represent you in the audit. This can be a savior if the potential tax risk justifies the cost.

Obtain an extension of time to respond. This gives you time to get your advisor educated on the issues and to plot strategy.

Move the site of the IRS audit from the doctor’s home or office to your tax advisor’s place of business. This can help contain the audit and keep the auditor from opening up other issues.

Answer only questions that you’re asked and never volunteer information. Make sure the auditor receives only one piece of information or one document at a time. Instruct your advisor to take back that document and put it back in the files before delivering the next. Don’t allow the auditor to dig into your files or sort through cancelled checks or paid bills carte blanche.

Provide only the specific information requested. Do not include general books and records that were not covered by the IRS audit request.

Keep a list of documents that have been reviewed. Track all documents reviewed by the IRS auditor, as well as the questions he or she asks. Furthermore, photocopy any records the auditor requests in duplicate. Make one copy for the auditor and retain the other for your files. These records may save you money if you decide to appeal the IRS assessment. You may be able to show that the auditor did not have documentary proof to support the deductions disallowed.

Avoid showing up for the IRS audit if you are represented by a tax attorney or CPA.

Consider tape recording all IRS audit proceedings.

Reconstruct records when necessary. This can help substantiate deductions for which you did not keep proper documentation.

Following these rules will minimize your risk of being selected for an IRS audit, and reduce the risk of additional taxes, interest, and penalties if you are selected.

The above article was reprinted with permission from The McGill Advisory, a monthly newsletter devoted to tax, financial planning, investment, and practice management matters exclusively for the dental profession, available for $209 a year from John K. McGill & Co., 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217; or call (704) 424-9780 for further information.