IRS Audit: Are You in Danger?

Have you ever received a "clarification letter" from the Internal Revenut Service? Uh-oh. For some it's the start of an unpleasant journey. For others, no big deal.

On this episode of Motley Fool Answers, our on-call CPA Megan Brinsfield discusses how to steer clear of IRS scrutiny and reveals what to do if you do are called out. Plus, we fess up to our own audit near-misses and, finally, review wacky excuses people use to get out of paying taxes.

Subscribe to our new Motley Fool Answers podcast for free on iTunes or Stitcher , or savor every single word in the transcript that follows.

Transcript

ALISON SOUTHWICK:

Talking about taxes is so much fun. We're dedicating two -- yes, two -- shows to the topic, and today we're talking about red flags the IRS looks for when deciding who to audit. See? Fun! By the end of the show, you'll have a better idea of your chances of getting audited and then we're going to talk about some of the wacky excuses people give to the IRS for not filing their taxes. And so we're all happy to have Megan Brinsfield joining us again today and we're going to about audits!

MEGAN BRINSFIELD:

My favorite.

ALISON SOUTHWICK:

I think it's everybody's favorite. So we're going to talk about...

DAYANA YOCHIM:

...everybody's nightmare.

ALISON SOUTHWICK:

Yeah. The basics of an audit. Is it really a nightmare? Should you really freak out about it? And also what are some of the red flags that would trigger an audit with the IRS. So, Megan, thanks for joining us.

MEGAN BRINSFIELD:

Thank you for having me.

ALISON SOUTHWICK:

All right. Let's start off with an audit. What is an audit? What happens? And, seriously, should I be freaked out?

MEGAN BRINSFIELD:

First, a big rain cloud descends over your home ... then you receive a letter in the mail. Usually an audit starts with just a clarification letter. The IRS sends you a letter that says, "Hey, we have some numbers. They don't match the ones that you had. Please explain."

DAYANA YOCHIM:

Math is hard.

MEGAN BRINSFIELD:

Yes. And most of the time that's associated with a big payment like, "If everything we said was wrong was actually wrong, you would owe us some grandiose amount." And so a lot of times those types of audits can just be fixed with a letter explaining the amounts that you claimed, assuming they are actually legitimate.

But the longer those things go -- like let's say you just ignore the letter because you know it's wrong -- the IRS will start peppering you with more and more letters. They'll become certified letters. They'll become tax liens. So that's sort of an automated audit.

There are also audits that are performed by IRS examiners, and those are also initiated with a letter that you'll have a name associated with the person that's actually performing your audit.

DAYANA YOCHIM:

And then a guy in a dark suit shows up on your doorstep.

ALISON SOUTHWICK:

Well, yeah. Like in the movies or in TV shows. Like when you picture someone getting audited, they have to go to the sad, little IRS office. They've got this big box of random papers, and receipts, and McDonald's napkins. And they sit down and this stern-looking guy at a desk is basically like, "Prove to me that you're not a total mess-up in life and that you didn't do it."

MEGAN BRINSFIELD:

Right.

ALISON SOUTHWICK:

And it sounds like a very scary, intimidating thing.

MEGAN BRINSFIELD:

It's very judgmental...

ALISON SOUTHWICK:

Even the letter sounds a little passive-aggressive, right? They're like, "Hey... just so we're clear, it seems like maybe you got something wrong. Just let us know." And then the next thing you know, your house is like getting taken over from underneath you.

MEGAN BRINSFIELD:

Luckily, the IRS doesn't move that fast. And the timing of audits, too, is important to note because a lot of people think, "Oh, as soon as I file my return, if it's wrong, I'm getting audited." That's really not the case. Usually it's like two years after the fact. So the IRS generally has three years after you file to audit you. And they usually don't get around to it for a while, to be honest.

But, yeah, the process is not necessarily as judgmental as that. A lot of times you can resolve it just by sending in the documentation and not actually showing up with a box of documents and reference letters or anything like that.

DAYANA YOCHIM:

Dog hair and dust bunnies and...

ALISON SOUTHWICK:

Yeah. I remember -- so, can I admit to this? -- that I went to school overseas for like a year and I didn't file my taxes for a little while. But it was like 10 years ago. Do I need to worry about that?

MEGAN BRINSFIELD:

Probably not.

DAYANA YOCHIM:

Now you do.

ALISON SOUTHWICK:

Now I do. Well, like should I admit to this? I mean, I probably wasn't making enough money to even be on their radar, but still, I was kind of worried. Not worried enough that I actually filed those taxes, but...

ROBERT BROKAMP:

But that is a good point. As long as you're a U.S. citizen, you owe taxes no matter where you live.

ALISON SOUTHWICK:

But I'm OK, right? Because it's been more than three years.

ROBERT BROKAMP:

Can you give us your address, real quick, while we're on the air, Alison?

ALISON SOUTHWICK:

My Social Security number and everything else?

MEGAN BRINSFIELD:

The statute of limitations doesn't start running until you actually file a return. So if you don't file, theoretically it's open forever...

ROBERT BROKAMP:

[Groans]

DAYANA YOCHIM:

[Gasps]

ALISON SOUTHWICK:

[Laughs]

MEGAN BRINSFIELD:

The good news, however, is that not everyone is required to file a tax return. Even if you had income, if it's below certain thresholds, you might not have to file a return at all, so it doesn't sound too worrisome. And if you were over those thresholds, I'm sure you would have gotten many letters by now.

ALISON SOUTHWICK:

OK, yeah. Because I hardly made any money when I was overseas.

DAYANA YOCHIM:

You're looking super worried there...

ALISON SOUTHWICK:

Of course, I'm worried. I thought I was OK!

DAYANA YOCHIM:

OK, confession time. So I got this little postcard years ago from the IRS saying, "We never received..." It was the passive-aggressive, "How you been? It's a nice day." I can't remember, even, exactly what it was, but I looked at it and it was definitely like, "I totally mailed that in. What are you talking about?" So there was a phone number. I called and talked to Doug, you know, the person and said, "You got that. I'm totally right." And then it was cleared up.

My cousin, who was doing my taxes at the time, said, "No! You never call them! You tell me! You send that correspondence directly to me!" I guess I shouldn't have taken matters into my own hands.

MEGAN BRINSFIELD:

As a tax professional, I tell my clients to never take things into your own hands, either. I always want to be the communicator -- because what ends up happening, a lot of times, is people overdivulge. Like the IRS will ask you a question about your charitable deductions and then you totally reveal that you had a rental property that you never claimed income on. and you just get nervous. That's the main fear, is that you'll divulge something that wasn't even on the IRS' radar.

DAYANA YOCHIM:

You have to invoke that, "You're going to have to talk to my lawyer. I have no comment."

ALISON SOUTHWICK:

So when we talk about how we're getting into audits, Rick, our guy in the studio, said, "Yeah, but if I do TurboTax, then TurboTax is going to deal with it if I get audited." Like what's the deal with TurboTax?

DAYANA YOCHIM:

And other off-the-shelf programs. What do you think of those?

ALISON SOUTHWICK:

If I don't have a Megan, what do audits mean to me?

MEGAN BRINSFIELD:

So audits typically just mean a lot of headache. It's not necessarily that you'll actually end up owing money. It's just more of an inconvenience that you have to pull up old documents and send things in and...

ALISON SOUTHWICK:

Right. But if I have TurboTax, will TurboTax deal with the audit?

MEGAN BRINSFIELD:

No.

ALISON SOUTHWICK:

Are they my person or am I on my own with TurboTax?

MEGAN BRINSFIELD:

They're a person, but you still have to provide everything to them. So they'll write a letter for you, but you have to give them information to write that letter. I also believe that some off-the-shelf programs have a one-year rate. They cover you for a year after your tax return is filed.

And that's not even long enough for the IRS to really process and come up with an audit in most cases, so you're getting audited after the period that it covers you for. I don't know. I think a lot of times they charge you and it's not really worth the coverage that you're getting, because you're going to have to do the same amount of work, whether they're "covering you" or not.

DAYANA YOCHIM:

OK. So Megan, I'm doing my taxes, either with TurboTax or another off-the-shelf product or by hand. What is going to get me in trouble? I have heard that actually doing your return by hand -- like writing it in pencil and then going over it with pen -- is something that would trigger an audit. Is that true or not?

MEGAN BRINSFIELD:

I don't know about that. I know everything is so automated now at the IRS. They want you to e-file. Every time they get a return, if it's handwritten, they're going to scan it in. And they have software -- I'm assuming but I haven't witnessed this -- that reads your handwriting and turns that into a database entry somewhere that they can actually monitor.

So I don't know whether handwritten returns are a higher or lower chance of audit, but anecdotally, there are people that say, "Well, if I file on the very last day that I can possibly file, Oct. 15, that I have less chance of being audited." And people follow that and I think it's just one of those things that's an old wives' tale.

ROBERT BROKAMP:

You hit upon something that I don't think a lot of people are aware of and that is anyone can get an extension to Oct. 15,

MEGAN BRINSFIELD:

Yup.

ROBERT BROKAMP:

People listening heard you say October and they're probably like, "Oh, she must have meant April." But, no. You can get the extension, but you still have to pay some money if you owe taxes, right?

MEGAN BRINSFIELD:

Right. It's an extension of time to file the paperwork but not to pay the taxes.

ROBERT BROKAMP:

Right. So if it's like April 15 and you don't have everything, it's still a form you have to fill out, but it's very simple. You just send it in and then you've got until Oct. 15.

MEGAN BRINSFIELD:

Right. The key is that the IRS wants your money...

ALISON SOUTHWICK:

[Laughs]

ROBERT BROKAMP:

Right.

ROBERT BROKAMP:

So what do you tell people in terms of like, "OK, I'm going to file my extension. I know I owe some money. I don't know how much. What should I do? Should I just come up with a number? Write the check? Send it in knowing that I'll get money back if I pay too much?"

MEGAN BRINSFIELD:

That's definitely what I recommend. Overpay or overestimate -- not by a ton -- but allow yourself some wiggle room so if you do your taxes and see that you owe $279.50, just call it $300.

DAYANA YOCHIM:

Rounding is fine here...

ROBERT BROKAMP:

As long as you're rounding to the IRS' benefit.

DAYANA YOCHIM:

Other triggers for audit: I've heard that anything to do with the home business or home office -- that's like a third rail.

MEGAN BRINSFIELD:

Right. The home office is definitely a target item for the IRS because it's so frequently overclaimed or overdeducted. The rule is that the home office has to be used exclusively and regularly for business. So the likelihood that your living room is a home office is very slim, but people will say, "Well, I do work there," and that's not really the threshold, unfortunately. That is just a prime place for audits, because you're really taking an expense that's personal (your utilities, your maintenance costs of your home) and trying to turn that into a deduction. The IRS looks at that very closely.

ALISON SOUTHWICK:

OK. What are some other red flags that our listeners should consider?

MEGAN BRINSFIELD:

Anytime you have a business that does not have any income, that's typically a red flag if you're just trying to take deductions. Other business types that the IRS views as hobbies -- traditionally like gambling or horse racing. There are a lot of cases about those types of businesses that you have to go the extra mile to prove that you really are doing these things for profit -- that you're not just running a horse farm in your backyard -- like so many people.

DAYANA YOCHIM:

For someone who's in a struggling Indie pop band, for instance...

ROBERT BROKAMP:

Hypothetically speaking. ... And have you heard the theme song to our show yet?

DAYANA YOCHIM:

[Laughs] So, yeah. Getting a new cello? I mean, we're in it for the love. Let's be honest, what we make off of the cover charge people pay at bars is not so much.

MEGAN BRINSFIELD:

The IRS always wants you to claim that income. It's just whether or not you can claim the expenses.

DAYANA YOCHIM:

Oh, I mean that we make nothing (ahem) ... when we play.

MEGAN BRINSFIELD:

High-fives and hugs. That's all.

DAYANA YOCHIM:

That's it, yeah.

ROBERT BROKAMP:

That's it.

ALISON SOUTHWICK:

So what about just your general income? Like if I make more money, does that mean I'm more likely to get audited?

MEGAN BRINSFIELD:

From a statistical perspective, yes. The IRS -- they have really limited resources. They want to deploy people where they're going to have the biggest bang for their buck -- and most of the time that's in returns that have a lot higher income. So if you look at the overall audit rate for everyone, it's about 1%, but if you're at a higher income level, that can go as high as a 27% chance of being audited. So once you get over that $10 million threshold, just bank on it, pretty much.

ROBERT BROKAMP:

Wow! Dayana's close.

DAYANA YOCHIM:

I'll keep that in mind. OK. So as a rental property owner, do I need to be nervous about anything when I'm filing?

MEGAN BRINSFIELD:

People that have rental properties -- if you're trying to take a lot of excess losses -- that can be a red flag because you have to be either qualified for a special deduction and have relatively moderate to low income to take that or you have to be a real estate professional, which has a totally different set of criteria, meaning you basically do real estate as your job and document that. So without either of those two cases happening, you really shouldn't have any rental losses on your return.

One that is a very high audit rate is mortgage interest...

DAYANA YOCHIM:

Oh!

MEGAN BRINSFIELD:

... especially if you have a loan that has a very high principal amount. So the IRS limits you to deducting interest on the first $1.1 million of mortgage interest. So if you have a mansion in Beverly Hills and you don't actually limit that deduction, it's really easy for the IRS to do. They take $1.1 million times whatever the going interest rate is now -- say, 5%. If your deduction is more than $55,000, we're auditing you. Easy for them...

ALISON SOUTHWICK:

Rich people problems...

DAYANA YOCHIM:

Yeah! [Laughs]

ALISON SOUTHWICK:

So it turns out I'm not the only one who maybe forgot to file a tax return. But it turns out there are people out there who -- it's not just a matter of they were young and stupid. They're old and stupid...

ROBERT BROKAMP:

They're just stupid...

ALISON SOUTHWICK:

And they think that they don't have to file a tax return. And Megan, you actually have a few reasons why people claim they don't have to file a tax return.

MEGAN BRINSFIELD:

Yes. If you can believe it, someone at the IRS, their whole job is to put together a report, annually, of the ridiculous reasons that people use not to file their taxes or not to pay taxes. And some of them are like, "The tax system is voluntary, so I'll just opt out."

ALISON SOUTHWICK:

I had no idea!

MEGAN BRINSFIELD:

I would like to not participate, please.

ALISON SOUTHWICK:

[Laughs] Thank you very much -- no, thank you.

MEGAN BRINSFIELD:

Moving on. And that's because the basis of our tax system is considered voluntary as opposed to some other countries. Filing a tax return is voluntary, but payment of the tax (that's the important part) is not voluntary.

ROBERT BROKAMP:

I know a guy who would not pay full taxes because he didn't agree with how much was going to the military. So he said, "I'm only paying for this. I'm not going to pay this much for the military." He still ended up paying it, of course, but he was trying to make his point about how, "I only want to pay for the roads. I don't want to pay for the guns!"

ALISON SOUTHWICK:

Yeah, that would be nice, if you could just choose...

ROBERT BROKAMP:

À la carte taxes, yes.

ALISON SOUTHWICK:

Yes, and allocate it. There's some other ones, like arguing about terms like "citizen." "United States." I'm doing air quotes for the people at home.

MEGAN BRINSFIELD:

Right.

ALISON SOUTHWICK:

"Person?"

MEGAN BRINSFIELD:

Yes. So people will say things like, "I'm not actually a citizen of the United States. I am a citizen of Texas..."

ALISON SOUTHWICK:

Of Texas?

MEGAN BRINSFIELD:

"... and therefore the United States has no bearing on whether or not I pay taxes." And so you can relinquish your United States citizenship -- that's a thing -- but you do pay an exit tax for the privilege. You can ask some people at Facebook about that if you're really interested.

ALISON SOUTHWICK:

Did people at Facebook do that?

MEGAN BRINSFIELD:

One of the Facebook founders...

DAYANA YOCHIM:

Oh, yeah. The founder...

MEGAN BRINSFIELD:

Yeah. He relinquished his citizenship and moved to Singapore.

ROBERT BROKAMP:

Didn't want to pay the taxes. It's actually an increasing trend among very wealthy people.

ALISON SOUTHWICK:

Really!

ROBERT BROKAMP:

Yeah.

MEGAN BRINSFIELD:

Yup.

ALISON SOUTHWICK:

And Singapore's the place to go.

ALISON SOUTHWICK:

I'll keep that in mind for when I become very, very wealthy.

ROBERT BROKAMP:

Once you hit that $10 million...

MEGAN BRINSFIELD:

Yup.

ALISON SOUTHWICK:

All right, let's do one more. What is one more crazy reason why people say they don't have to do their taxes?

MEGAN BRINSFIELD:

I thing arguing on religious grounds. Or, "it's my First Amendment right that I object to paying taxes." You know, using the Constitution as some argument that they shouldn't have to pay taxes. And the interesting thing is there are websites dedicated to this. It's like people's jobs are defending against these letters. They'll receive this letter from the IRS and post it online, and the IRS is saying, "This is a totally ridiculous tax position. Please file an actual tax return. We implore you to file a tax return." And the person posting it is like, "Ha, ha, ha. Another cat and mouse game with the IRS."

DAYANA YOCHIM:

They have a lot of time on their hands because they're not actually having to do their taxes.

ROBERT BROKAMP:

There are some things people didn't think they had to report. Like forgiveness of a loan, for example. It has to be reported.

MEGAN BRINSFIELD:

Right. Which is an honest mistake.

ROBERT BROKAMP:

Right. That's an honest mistake. Or if you exchange services -- I'll do this for you and you do this for me -- that is also something that has to be taxed, but they didn't know that that was supposed to be reported.

MEGAN BRINSFIELD:

Yeah, as opposed to...

ROBERT BROKAMP:

They may not agree with it, either, but they still have to do it.

ALISON SOUTHWICK:

So the moral of the story is taxes -- pay 'em ... even if you're young and dumb or old and dumb.

ROBERT BROKAMP:

In the U.S. or otherwise.

ALISON SOUTHWICK:

Yeah. So no matter where you live -- taxes -- pay 'em. I want to thank Megan Brinsfield for joining us today to talk all about taxes. I think we had fun. Dayana, did we have fun?

DAYANA YOCHIM:

What? Oh. Yeah!

ROBERT BROKAMP:

As much fun as you can have with taxes.

DAYANA YOCHIM:

Actually, we really did. 

MEGAN BRINSFIELD:

We just woke her up. 

ALISON SOUTHWICK:

As much fun as you can have with taxes, you're going to have it here at Motley Fool Answers. Theme music is written, composed, produced...

ROBERT BROKAMP:

And deducted by...

ALISON SOUTHWICK:

And deducted by Dayana Yochim.

DAYANA YOCHIM:

You didn't pay me! 

ALISON SOUTHWICK:

And the show is edited by Rick Engdahl. If you have questions, send an email to [email protected] and remember, don't forget to tell your friends to listen because, come on. It's good for them. All right, for Robert Brokamp, Dayana Yochim, and Megan Brinsfield, I am Alison Southwick. Fool on!

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