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AUDITS
Internal Revenue Service (IRS)
Computerized Scoring Causes Most Audits. Most IRS audits are initiated by a computerized scoring of the income and deductions numbers on your return. The IRS computer compares the size of various categories of your income and compares them to your deductions, then determines whether you are a likely candidate for the IRS to make an adjustment to your return.
Types of Audits. IRS audits are two types. The first is a computer automated audit where you will deal with an IRS auditing group that is normally located outside of your local area. This type of audit usually involves omitted income (such as interest, dividends, salary or wage income, 1099 income or sales of property) or mathematical miscalculations on the return. The second type of audit is generally handled by a single individual auditor who works locally (although sometimes due to heavy workloads, this type of audit may be handled by an auditor who is located in another part of the state). These audits generally begin with a letter that identifies specific documentation which the IRS wants to review and it asks you to come to the local IRS office for an appointment. The types of requested documentation are identified by the IRS based on categories of income and deductions which were correlated in the scoring of your return.
The first type of audit (computer automated) will provide numbers for the proposed adjustments that the IRS wishes to make. You will be able to assess your potential exposure in this type of audit because the IRS automatically calculates the tax, penalty and interest in the first notice you receive. The second type of audit does not provide you with any particular proposed adjustment to your taxes. It simply identifies documentation that will be needed for the auditor to complete the audit and he or she will make calculations at the conclusion of the audit. It is typical that the auditors expand the document categories and raise new issues after their first meeting with you or your attorney. Persons under this type of audit should be aware that the IRS often expands its areas of inquiry after the auditor reviews your returns and your receipts. Having a qualified tax attorney can be a critical component in reaching a “no-change” audit result. Many people damage their position at the first meeting by making innocent comments to the auditor, which are interpreted as indicative of a “tax cheat”. Trying to handle an IRS tax audit without an experienced tax lawyer may cause additional problems because the IRS very often misinterprets completely innocent statements made by the taxpayer.
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Franchise Tax Board (FTB)
Franchise Tax Board audits are of three types. The first type involves automated notices that calculate a proposed tax and invite you to respond by mail if you disagree with the proposed increase in tax. The second type is a “piggyback” tax audit. In this type of audit, the Franchise Tax Board makes the same adjustments that were made by the IRS in an IRS audit. The IRS does routinely notify the Franchise Tax Board of its audit results. You should also be aware that you are legally required to notify the Franchise Tax Board yourself (i.e., turn yourself in) of any IRS audit changes (and you may be subject to penalties if you fail to do so). The third type of tax audit is an audit of specific items on your return. This is similar to an IRS audit and a special auditor will be assigned to handle the case. This type of audit is fairly rare but does occur.
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Sales Tax (SBE)
The California State Board of Equalization (SBE) is in charge of administering sales taxes in California. Sales tax audits are uniquely different from income tax audits. They usually involve “sampling” techniques to search for supposed errors on your returns. “Sampling” is not a true science and it is not the type of accounting that most of us are used to because it involves estimates by the auditor. “Sampling” involves rough estimations of total sales and additional estimations to arrive at a “percentage of error” in your sales tax reporting. Short periods of time are reviewed by the auditor. After deciding on a deficiency in your tax reporting, numbers are extrapolated out over longer periods of time, generally three years. If you have taxable and non-taxable sales, this “sampling” can be very problematic because a simple error by the auditor during the sampling period will be multiplied many times over as the auditor extrapolates out the proposed sales tax over several years. Additional issues typically arise in these audits because sales taxes can be calculated in a number of different ways. The same business may be subject to half a dozen or more different potential ways to calculate the tax depending on its method of sales. Professional help is often necessary in order to avoid being re-categorized by the auditor into a different category, for the sole purpose of increasing your sales tax.
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Employment Taxes (EDD/IRS)
An employment tax audit can result in tremendous tax debts. Most employment tax audits begin with an IRS audit or, most often, an independent contractor filing for unemployment benefits. When that happens, the Employment Development Department (EDD) is the auditing agency. If employment tax audit adjustments are made to your account, those changes will also be reported to the IRS for a potential adjustment to your federal employment taxes. There are a number of safe harbor rules that will protect you from IRS adjustments. Businesses employing independent contractors need to be especially careful because EDD employment tax audits can be financially devastating, resulting in tax debts over a period of many years. In addition, the law of independent contractor status strongly favors the EDD in an employment tax audit. There are many strategies to reduce or eliminate payroll tax increases. For instance, if the independent contractors have actually paid their own state income taxes, a partial credit for the full amount we are able to prove may be available to reduce these tax debts.
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Payroll Taxes (IRS/EDD)
IRS payroll tax audits are typically initiated during an income tax audit. They also sometimes occur if you are in collection for overdue or unpaid payroll taxes. Payroll tax audits are serious business. Even if your business is incorporated (or is an LLC or LLP), personal liability of the owners and/or managers may attach for a payroll tax liability. Both the IRS and the Employment Development Department (EDD) can be quite aggressive at imposing personal liability for these taxes. The personal liability is sometimes referred to as “the 100% penalty”, because 100% of the trust fund portion of the taxes are imposed on the persons who are deemed to be “responsible parties”. Trust fund taxes are the amounts that are withheld from the employee’s pay. A qualified tax lawyer should be consulted before responding to such an audit.
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