The topic of our December CFO/Controller Roundtable centered on tax audits. Timothy J. Hilligoss, CPA, MST, Shareholder of International Accounting Services and Practice Leader for Asia at Clayton & McKervey, P.C., discussed the likelihood of an audit at the individual and entity level, “red-flags” often resulting in being selected for examination, areas of particular concern where auditors will focus their attention, and how to prepare once selected for an audit.
The scope of the roundtable discussion included federal and state income tax, workers compensation, unemployment insurance, personal property tax, sales, use and withholding, and 401(k) audits.
Summarized below are some of the key points discussed.
While the IRS does not publish its audit selection process, the IRS does publish statistics such as the percentage of returns examined and the percentage of examinations that result in an increase or decrease in tax or no change at all. The IRS also publishes the average additional tax due as the result of an examination. An excerpt of these statistics is provided below:
- Individual returns have a 1.1% probability of being selected for an audit. The chance is based upon the level of income shown on the return selected. The likelihood of an audit when income exceeds $1,000,000 reaches 12.5%
- Partnerships and S Corporations have a .4% probability of selection for an audit
- C Corporations have a 1.6% probability of being selected for an audit. The chance is based upon the level of assets shown on the return selected. The likelihood of an audit when assets are between $10,000,000 and $50,000,000 is 13.3%
Statute of Limitation
With regard to federal income taxes, the IRS is barred from making an assessment of additional tax due beyond a period which extends three years from the date which the tax return in question was filed or the original due date of such return, whichever date is later. Keep in mind the statute of limitations NEVER begins to run in cases where fraud exists (a willful attempt to evade tax or the filing of a false return) or where a taxpayer fails to file a return at all.
The State of Michigan statute of limitation is extended one year beyond the federal statute to a period of four years.
Areas of Audit Exposure
As previously mentioned, the IRS does not publish its exact audit selection process; however, there are factors that either increase the likelihood of being selected for an audit or once selected are key areas on which the IRS will focus their attention. These key areas include:
- Stock-based compensation
- Non-performing loans
- Repairs vs. capitalization change in accounting method
- Research credit claims
- Transfer of intangibles/offshore
- Outbound/inbound international issues
- Personal use of company cars
- Subject to specific exclusion, fringe benefits are taxable to employees; one example of a taxable fringe benefit is the personal use of a company automobile. See IRS Publication 15-B (irs.gov/publications/p15b/ar02.html)
- Meals and entertainment
- Employee vs. independent contractor
- The IRS has provided, via Revenue Ruling 87-41, 20 factors that may indicate an employer/employee relationship exists
- The IRS provides Form SS-8 “to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding”. There is no fee associated with filing Form SS-8 (irs.gov/pub/irs-pdf/fss8.pdf)
- Additional information regarding the classification of individuals as employees vs. independent contractors may be found by viewing the “Independent Contractor (Self-Employed) or Employee?” (irs.gov/Businesses/Small-Businesses-&-Self-Employed)
- Evidence of unreported foreign bank transactions
- Certain high-risk or cash-based industries
Audit Techniques Guides
The IRS publishes Audit Techniques Guides or (ATGs) that are intended to assist IRS staff in the successful completion of an audit. These industry specific guides can be found on the IRS website . IRS ATGs are available to the public and may provide insight as to what to expect if selected for audit.
IRS Criminal Investigation Division
If, in the course of an IRS audit, the revenue agent assigned to your case believes fraud has been committed, your case will be forwarded to an IRS special agent within the Criminal Investigation Division. At the first mention of a “special agent,” it is highly recommended to seek outside counsel if you have not already done so. The Internal Revenue Code provides for criminal convictions for those who willfully attempt to evade any tax, file false returns, or files no tax return at all.
Factors to Consider when Selecting Representation
If chosen for an audit, your first decision should be whether or not you will have the representation of a CPA, or even an attorney. One of the benefits of representation includes the ability to separate company personnel from the IRS auditor resulting in less disruption to your day-to-day activities. Also, representation provides the ability to separate the agent’s question from the response.