While tax preparers are not required to audit their clients’ records before filing returns, there are several client profiles that may require a closer look to ensure an accurate tax return and avoid potential civil and/or criminal fraud allegations.
Compliance studies by agencies such as the Treasury Inspector General for Tax Administration (TIGTA) and the U.S. Government Accountability Office (GAO) have shown significant tax return errors across several taxpayer types. The IRS has responded by targeting the following taxpayer profiles in audits:
Small retail businesses
The IRS knows that small business is the largest taxpayer segment that underreports income, largely because these businesses receive few or no information statements, resulting in little or no audit trail for the IRS.
When you’re closing a client’s books and preparing a client’s return, analyze the client’s bank accounts. Reconcile your client’s bank deposits to total revenue reported on the return. Significant, unexplained deposits should be examined to determine whether income is being reported. It’s rare for a retail business to receive Forms 1099-MISC, Miscellaneous Income, but if your client’s business receives one, determine whether your client properly recorded the income source.
Pay particular attention to clients who receive Form 1099-K, Payment Card and Third Party Network Transactions, for debit and credit card payments. The IRS is starting to use this information to question business tax returns. If your client’s business records credit card sales in its accounting system, reconcile total credit card sales to Form 1099-K at the end of the year. If your client doesn’t record merchant card transactions, consider comparing the amounts received from merchant card transactions by month to your client’s sales. Look for inconsistencies each month in the proportionate amounts to overall gross receipts.
Noncash contributions
Twenty million individual taxpayers deduct noncash charitable contributions each year. In 2012, 60% of taxpayers who claimed more than $5,000 in noncash contributions did not comply with the recording requirements. The study indicated that the main error was inaccurate Forms 8283, Noncash Charitable Contributions. Other errors included missing appraisals, incomplete donor acknowledgments, and unclear or incomplete descriptions of donated property and contribution dates.
If your client has a noncash contribution this year, make sure that Form 8283 is accurate and that your client provides all required documentation. If your client donated a vehicle, make sure your client receives Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, from the charitable organization, attaches the form to the return, and does not overvalue the donation
Rental property
In 2001, 53% of individual taxpayers made significant reporting errors by overstating expenses, understating income, deducting amounts in excess of passive activity loss limitations, and not applying limitations on deductions due to personal use of the rental property.
When you’re preparing returns with rental property activity, ask clients to substantiate expenses. According to the GAO, 35% of taxpayers with rental property deduct a nonallowable personal expense or can’t substantiate a reported expense. Nineteen percent did not fully report an expense that would have been allowed.
You should also look closely at depreciation deductions; many taxpayers incorrectly includ the value of their land within the depreciable basis of their properties.
Partnerships and S corporations
In 2012, the IRS increased audits of partnerships and S corporations by 18.7%. A more considerable concern for the IRS in this area is the deduction of flowthrough losses from these entities. Many times partners or shareholders recognize a loss in excess of the amount allowed due to basis limitations.
The IRS expects compliance help from tax practitioners. Most flowthrough entity returns are prepared by a paid professional, who also may prepare the shareholder/partner’s Form 1040. When the practitioner doesn’t prepare both returns, it may be challenging to resolve issues that carry over from the entity to the shareholder or partner.
Look for the IRS to pursue preparer penalties for paid professionals who don’t conduct their due diligence in calculating basis and allowable losses.
