The Audit Process:

Deception Vs. Oversight

In case you didn't know, it is a crime to cheat on your taxes! Not that that stops all of us, at least not if we are a part of the .0022% of the taxpayers who were convicted for tax crimes in a recent year. Since that percent roughly amounts to only 2,500 of the 120 million taxpayers in this country, it's apparent that your chances of getting nailed are very minute. According to the IRS, 75% of the offenders who are caught are middle-income individuals, while corporations do the rest of the cheating. Most of this cheating stems from the underreporting of income.

Now that it has been determined that something fishy took place on your return, it is up to the auditor to decide if the discrepancy was a result of negligence (a non deliberate mistake) or full-on fraud (a willing lie). The difference between the two is enormous in terms of the penalties that may await you. While a common or overlooked mistake might get you a 20% penalty added onto your tax bill, tax fraud can get you an enormous 75% penalty! Although auditors are trained to look for signs of fraud, they also know that the tax law are complex and will usually give you the benefit of the doubt, unless of course the item in question is a blatant example of tax fraud. Such examples would be businesses without any records or presenting false receipts with your return.

Since the IRS rarely comes across direct proof that a taxpayer has been committing tax fraud, they tend to rely on indirect methods of providing proof.

The four basic methods they use for determining fraud by indirect methods are as follows:

  1. Bank Deposits- This method is most popular with IRS agents because it is so easy for them to find what they are looking for. All they have to do is add up all the deposits that have been made into your account and if they total more than your reported income, you may become a suspect in tax fraud. Of course, you may have many viable excuses for this. The deposits may have been made with inherited, borrowed or gifted money. If this is true for your situation, advise your auditor of this information.
  2. Net Worth - If it is determined that your net worth has increased without an increase in income from the previous tax year, you may be suspected of underreporting your income. Once again, there may be valid reasons for this increase in your net worth, such as those previously mentioned.
  3. Specific Items - If you do not enter all transactions into your business' books and the IRS comes across multiple checks in your business's name that were cashed and pocketed, once again you maybe in trouble with the auditor and the IRS. A couple of items may have been mistakenly left out of the books, but if you have 20 or 30 missing entries for transactions, this will be seen as a pattern by the IRS and don't expect be let off the hook so easily by playing dumb.
  4. Expenditures - The auditor will calculate your living expenses in this method. If it turns out that you paid out more in expenses than you reported as your taxable income, tax fraud may be suspected. To figure out your living expenses, an auditor will often ask you to fill out Form 4822, Statement of Annual Living Expenses. It is often highly recommended that you do not comply with the IRS' wishes by filling out this form. It is not required that you fill this form out, and the IRS cannot hold it against you should you choose not to. It is the auditor's job to figure out your living expenses, not yours.