Back on September 8th, the IRS announced plans to hire an additional 3,700 tax agents in an attempt to, in their words, "restore fairness in tax compliance."
Each agent is estimated to earn an average annual salary of $125,000, thus you can rest assured these bean counters will stop at nothing to find something wrong with your return and yield a positive ROI for this massive IRS investment.
In other words, more audits are coming!
Who's at risk if an audit? 👇
✅ High-income earners
The IRS stated they'll be targeting those making more than $1 million per year and with recognized debt of at least $250,000.
If you read further, however, the IRS noted audit rates wouldn't increase for those taxpayers earning less than $400,000, which to me, means this is their real income base for audits, not $1 million.
✅ Wealthy investors
No specific numbers were disclosed regarding personal asset values, but if your net worth is well into the seven-figure range or higher, and you have pass-through income from real estate, privately held businesses or alternative investments, you're more likely to be on their hit list.
✅ Large partnerships
In addition to individual taxpayers, the IRS will be closely scrutinizing partnerships with at least $10 million in assets on their balance sheet citing multi-million-dollar discrepancies between end-of-year balances compared to the beginning balances the following year.
How to prepare in case you're audited
The initiative is set to start in 2024, so if you think you may be at risk of an IRS audit and want to be adequately prepared, here are 4 best-practices you'll want to consider:
⚠️ Identify high-risk areas
If you're making over $400,000 and most of your income is derived from W-2 wages and dividend income from your stock portfolio, it's likely there aren't too many skeletons the IRS will find in your closet.
Who might be higher on the IRS's audit list? High-income earners should keep a watchful eye on these line items more likely to catch the attention of an auditor:
Significant pass-through income (or losses) from privately held businesses
Income solely from a single-member LLC or sole-proprietorship reported on Schedule C
Substantially higher pass-through income from your S Corporation than what you're drawing in salary
Multi-million dollar real estate portfolios with tens of thousands in deductions
Gains or losses from extensive crypto-currency trading
Large business deductions resulting in a realized loss used to offset ordinary income
Exercising and/or selling stock options that have significantly appreciated in value
Reporting any one or all of these items on your tax return doesn't necessarily guarantee the IRS will come knocking at your door. It simply means there's a higher likelihood your return could get audited and as such, you'll want to be prepared for scrutiny on these high-risk areas.
🗂️ Over-document everything
Believe it or not, the IRS makes mistakes.
They're responsible for sifting through millions of tax returns each year and are bound to challenge a position you took on your return and attempt to penalize you, even if you operated entirely within their guidelines.
After assessing your high-risk areas of tax activity, be sure you have sufficient documentation to support any and every pertinent activity.
It goes without saying that tracking receipts for large asset purchases resulting in tax deductions or credits is an absolute must.
👉 In taking your documentation process a step further, you'll also want to keep track of:
Any manual calculations, whether performed by you or a professional, used in determining the amount of a tax deduction or credit
Correspondence from third parties where financial data was used in said manual calculations
Links to the applicable IRC code supporting the tax deduction, credit, or calculation
IRS notices and your follow-up correspondence with dates clearly marked, as applicable
If you're working with a professional, an email archive of correspondence pertaining to the deduction, credit or tax notice in question
A good example of tax activity in which this level of documentation is essential is a gain on the sale of stock held in a dividend reinvestment plan, or DRIP, for decades.
Since the IRS won't be able to determine your total cost in the stock given the variability in price and numerous purchases made over the years, you or your accountant will have to go back through years of investment statements, review historical stock prices on various reinvestment dates and calculate the cost basis in that stock over the years.
The amount calculated will have an impact on your tax liability and will differ from what the IRS has record of, thus making it more likely they'll scrutinize a transaction like this in an audit. The more supporting documentation you have, the higher likelihood you'll make it through an audit unscathed.
📗 Maintain proper books and records
In addition to having a thorough documentation process, you'll also want to keep accurate and up-to-date books and records, specifically for business owners and those with ownership in privately-held corporations or investment real estate.
Sadly, I have encountered million-dollar-plus businesses using Excel to account for their business activity. This just isn't going to cut it, even for a small business with a few hundred thousand in revenue.
If your tax return is pulled for an audit and you own a privately held business, the IRS will likely want to review your books and records to ensure financial activity flowing through your business accounts is adequately reflected on your tax filings. Ultimately, your banking activity is the most credible support you have to justify the numbers reported on your return as it's maintained by a third-party financial institution.
🙏 At a minimum, you should be performing:
Monthly bank and credit card reconciliations
Ongoing bookkeeping through a double-entry accounting system like QuickBooks
These tasks are common practice for larger businesses employing accounting staff and outside professionals, but should be conducted even at smaller companies or by individual investors with a handful of rental properties.
🔎 Periodically review and update
Implementing the above strategies isn't complete without periodic reviews and updates.
Let's face it: Things slip through the cracks. You're busy managing investment property or running the day-to-day of your business and may forget to document or account for one transaction in the process that could end up costing you dearly in an audit.
Take a little time each month to thoroughly review your financial activity, especially within the high-risk areas noted above, and ensure you're keeping sufficient documentation and that your books and records are up-to-date.
👨💻 And as always, engage a tax professional early and often.
If based on what I discussed today you feel you may be at risk for an IRS audit, please give me a call or shoot me an email. I'll respond to you personally.