Avoiding an Audit

The Internal Revenue Service (“IRS”) recently released its Strategic Operating Plan outlining priorities which include its plan to increase audits on the wealthiest taxpayers. According to the plan, audit rates will rise more than 50% for those with income over $10 million. While this may be unwelcome news for those taxpayers, there are certain strategies that these taxpayers should avoid to lower their chance of triggering an audit.

First, taxpayers facing audits need to remember that an audit doesn’t mean that the taxpayer, or their advisor, did anything wrong. An audit simply means that the IRS wants to understand the position that the taxpayer took. Taxpayers who keep good records and document everything are more likely to survive an audit without significant changes in their tax picture. Seasoned tax attorneys provide value for their clients by reminding taxpayers to keep meticulous records along with all forms, documents, and records. Sometimes, though, even the most prepared taxpayers find themselves facing an audit. Below are several other flags that will garner unwelcome attention from the IRS.

First, any taxpayer entering into a “listed transactions” found here on the Recognized Abusive and Listed Transactions list raises a red flag for the IRS. The IRS considers the transactions found on this list to be abusive tax schemes. The IRS updates this list whenever necessary. Additionally, each year the IRS publishes a list of the “Dirty Dozen” tax scams that it also considers abusive transactions. This list changes each year and it’s good practice to review it often. Taxpayers should strive to avoid any transaction found on either of these lists as those transactions increase the likelihood of an audit. Note that any tax professional advising a client on an aggressive tax strategy or assisting with navigation of any transaction on the Dirty Dozen list needs to file a material advisor form disclosing that the advisor “materially advised” the client with respect to a strategy that the IRS considers aggressive. It’s akin to waiving a big red flag saying “audit me.”

In addition to undertaking any of the transactions noted above on either list, taxpayers can attract IRS attention by using passive losses to offset active income. The IRS defines a passive activity as one in which the taxpayer does not materially participate in the activity. That means that the individual does not run the business or is not involved in its daily operation. The most common types of passive activities involve rental real estate, equipment leasing, limited partnerships, and limited liability companies. Taxpayers desiring to write off passive losses can only do so against passive gains. In addition to mischaracterizing losses, taxpayers often fail to provide a complete picture of their income. When taxpayers fail to report their income, it’s usually because the income was reported on a Form 1099 or K-1. Employers and financial institutions provide copies of these documents to the IRS which gives agents the ability to compare the data reported by the taxpayer with the data provided by the employer or institution and catch the mistakes. It’s vital to provide a complete picture of income.

Partnerships, while a popular Estate Planning strategy, provide fertile ground for audit.

Many states use partnerships as the default entity for two or more individuals in business together. Sometimes the partners have a formal agreement called a partnership agreement, and sometimes it’s just a handshake, which only increases the ability to manipulate or hide things. The Internal Revenue Code classifies partnerships as flow-through entities, and partnerships do not pay income tax at the entity level. Further, tiered partnerships, or partnerships that own other partnerships, allow the partners an opportunity to hide income.

Finally, any taxpayer taking aggressive valuation discounts could subject themselves to audit. While many Trusts and Estates practitioners help their clients obtain valuation discounts either through Family Limited Partnerships or through fractionalization of real estate interests, this advice may be problematic if the discount is too aggressive or if the taxpayer seeks to have one discount apply for income tax purposes and another apply for estate tax purposes. The historically high exclusion amounts mean that more and more taxpayers are opting to transfer their wealth to the next generation during life. Of course, taxpayers want to transfer as much as possible and discounts provide a method through which a taxpayer can transfer more of an asset using less of their Applicable Exclusion Amount.

As this article demonstrates, certain strategies are more likely to trigger tax audits. Inexperienced attorneys may not understand the ways to keep their clients safe. If you have questions about tax advice that you have received, reach out to a qualified Estate Planning attorney to make sure that the transaction passes the “sniff” test or whether it’s likely to lead to an audit. You won’t regret it.

Tereina Stidd, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com