Jim Buttonow
Find unreported income to avoid IRS fines

Use five IRS audit techniques to find potential unreported income—and protect yourself from an IRS-imposed fine.

September 30, 2013
by Jim Buttonow, CPA/CITP

Unreported income on tax returns is a real problem for the IRS. And when the agency discovers that a taxpayer has unreported income, it can quickly become a problem for the tax preparer, who may face IRS-imposed fines as a result. Let’s look at the issue and review ways preparers can prevent such a predicament.   

According to the most recent IRS tax gap study, which was released in 2012, the U.S. Treasury loses $376 billion each year due to inaccurate tax returns that underreport income and overstate deductions and credits. IRS data indicate that the taxpayers most likely to underreport income are small businesses and high-income individuals, both groups that receive few information statements that the IRS can use to electronically track income.

For the past year, the IRS has made some progress looking for potentially unreported income by comparing Forms 1099-K, Payment Card and Third Party Network Transactions, to business returns. However, most IRS efforts to combat small business and high-income underreporting involve face-to-face examinations of taxpayers.

In these face-to-face examinations—also called office and field audits—the IRS looks at each taxpayer’s facts and circumstances to determine whether all income was reported. When preparing their clients’ taxes, tax professionals should conduct due diligence and “ask the second question” to determine whether all income is properly reported on the return. If tax professionals fail to conduct due diligence, the IRS could propose preparer penalties. Moreover, when an examination reveals substantial amounts of unreported income and results in a substantial understatement penalty to the taxpayer, IRS procedures require the agency to also consider preparer penalties.

In conducting due diligence prior to tax preparation, tax professionals should take a closer look at their clients’ records and small business operations. Here are five common IRS audit techniques you can proactively use to test the validity of your client’s reported income and avoid potential surprises in an IRS audit.

1. Financial status analysis

The IRS refers to this procedure as a “T account” analysis, which compares sources of cash on the left and cash expenditures on the right. This process looks a lot like budgeting. For an individual taxpayer client, the question you should answer in this analysis is: “Does my client have sufficient funds for even the minimum personal living expenses?” For a ballpark estimate of your client’s minimum living expenses, use Bureau of Labor Statistics data, which the IRS uses in examinations. When performing this analysis, you should also account for sources of cash and expenditures of cash reported on the tax return that are not related to personal living expenses.

If there isn’t enough income to support basic living expenses, you should address the imbalance and ask about other sources of funds such as loans, gifts, and other sources of revenue. As the IRS instructs its auditors in its Internal Revenue Manual, “When completed, the analysis should indicate that either income is sufficient to support the taxpayer’s financial activities or there is a significant imbalance indicating the potential of unreported income.” When the imbalance is $10,000 or more, the IRS examines income more closely.

2. Bank deposit analysis

In an examination, the IRS usually analyzes bank deposits to determine whether income is properly reported. You can also compare deposits for all bank accounts to gross income reported on the return. For unexplained or unrecorded deposits, determine whether the deposit reflects income that should be reported on the return. Significant nontaxable deposits, such as loans or gifts, may require you to ask a few additional questions to confirm the amounts are not taxable. 

3. Website and e-commerce analysis

If your client has a website and/or conducts e-commerce activity, the IRS will scrutinize these operations for additional income. Websites provide insight into lines of business and products sold, types of payment accepted, and customer information. Perform a quick review of your client’s website; it may trigger questions about possible additional income. Many taxpayers are making additional income from online auction sales, website advertising sales, and fees for customer lists sold to referral partners.

4. Reconciling revenue reported on specific information statements

For individual and business returns, it is important to ensure that each information statement is reflected on the return. For business operations, it can be helpful to test income reported on an information statement by tracing it back to the customer. For example, if your business client receives a Form 1099-MISC, Miscellaneous Income, for payments totaling $100,000 from its customer XYZ Co., your client’s records should reflect the same amount paid by XYZ Co., or your client should have a valid explanation for why the amount is different. 

Because the IRS now uses automated programs that match individual and business returns against information statements, this test provides the added advantage of preparing your client for potential matching discrepancy questions from the IRS. For business returns, you can include an explanation with your client’s return. For example, in the IRS’s pilot program comparing Forms 1099-K to business returns, the IRS has found many inconsistencies due to businesses sharing merchant card machines. You can explain this discrepancy in an attachment to your client’s return. This can prevent a Form 1099-K discrepancy notice because the IRS is manually reviewing the discrepant return, including attachments, before sending a notice to the taxpayer.

5. Ratio analysis

Do financial ratios make sense for your client’s small business? What are your client’s gross and net profit ratios? Are these ratios in line with your client’s industry? Is the amount consistent with prior years? Do you have clients in similar industries or professions whose information you can use to compare ratios? IRS agents use business ratios from BizStats.com, which contains data on various industries and professions for corporations and sole proprietorships. The site contains gross and net profit ratios, as well as other information, such as ratios on certain business expenses to sales.

Karen Hawkins, director of the IRS Office of Professional Responsibility, has pointed out that “don’t ask, don’t tell” and “willful blindness” policies do not meet the standard of practice under Circular 230 (speaking at the IRS Tax Forum, Charlotte, N.C. (Aug. 8, 2012)). To rely on client data, a tax professional must ask the client “reasonable questions” in tax preparation due diligence.

No tax professional wants to explain to the IRS why a client did not report all of his or her income. Taking a few extra due diligence steps and asking the second question, especially as it relates to income, can protect you and your client in an IRS audit.

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Jim Buttonow, CPA/CITP, is co-founder of Beyond415. He has more than 26 years of experience in IRS practice and procedure.