Being Audited? What are the Chances?

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Good question. On average you have less than a one percent chance, as an individual, of being audited by the IRS. Don’t get complacent though, that figure is only part of the story. Only when you crunch the numbers does a more nuanced picture emerge regarding your chances of being audited.

First, you have to understand that the IRS does not do audits at random. The IRS does not consult tea leaves or throw darts against a list of taxpayers to select a return for audit. Instead the IRS uses two major methods of choosing individuals for audit: information provided by third-parties and by use of a computer algorithm.

Information provided by third-parties is easy enough to explain, if the IRS learns that a taxpayer may be hiding income or taking excessive deductions then it may select the return for audit. The classic example is an ex-spouse informing on his or her former partner but it can also include an audit triggered by information provided by banks or other financial institutions. For example, banks are required to report cash transactions exceeding $10,000 which may indicate potential tax evasion.

The other and far more prevalent method of identifying returns for audit is the use of various, and undisclosed, algorithms. The IRS is very tight lipped about what goes into its software but it has said that these algorithms use data gathered during audits and from other sources to develop a norm against which a taxpayer’s return is compared. The taxpayer’s return is scored based on how it deviates from the norm; the higher the score, the greater the chance of being audited. The algorithm also is weighted to increase the rate of audits where the IRS perceives certain types of returns have a higher potential for abuse or for positive audit adjustments. As you will see below, taxpayers who claim the earned income tax credit have an increased chance of being audited which is a response to a recent flood of fraudulent returns claiming the credit.

Regardless of the method of selecting a return for audit, once a return is selected an examiner will review the return to determine if there are grounds to  hand the return off to an IRS agent to be audited. The IRS only wants to audit returns where there is the potential to recover money for the Treasury; the IRS does not want to waste valuable time and money handling low-return audits, it would rather concentrate on audits that will justify its efforts.

Here are some stats from the IRS’ latest report, based on tax returns examined during 2015:

  • Overall, taxpayers face a 0.8% chance of being audited.
  • This rate increases if the tax return includes the earned income tax credit, up to 1.7% for those tax returns with gross receipts of less than $25,000; this decreases to 1.0% if gross receipts are $25,000 or more.
  • Tax returns that have total positive income under $200,000 and which do not include any income from operating a business and which do not claim the earned income tax credit have a 0.3% chance of being audited.
  • Tax returns that have total positive income under $200,000 and which include income from operating a business and which do not claim the earned income tax credit have between 0.3% and 2.0% chance of being audited, depending on the type of business and total gross receipts from the business. The breakdown is:
    • 0.3% for tax returns which include a Sch. F (farming activity)
    • 0.9% for tax returns which include a Sch C with gross receipts less than $25,000
    • 2.4% for tax returns which include a Sch C with gross receipts of at least $25,000 but less than $100,000
    • 2.5% for tax returns which include a Sch C with gross receipts of at least $100,000 but less than $200,000
    • 2% for tax returns which include a Sch C with gross receipts of $200,000 or more
  • Tax returns with a total positive income over $200,000 but less than $1,000,000 have a 1.8% of being audited, which increases to 2.9% chance if the return includes income from operating a business.
  • Tax returns with total positive income $1,000,000 and up have a 9.6% chance of being audited

Note: total positive income is the sum of all positive amounts shown for the various sources of income reported on the individual income tax return and thus, excludes losses.

As you can see, depending on your taxpayer profile, for lack of a better term, you may have a higher risk of audit than the average would lead you to believe. This doesn’t take into account your particular return which may deviate further from the norm than other returns in your category which can make it even more likely your return is audited. Like the old G.I. Joe cartoon always said, now you know and knowing is half of the battle.

You can read the full report here: 2015 IRS Data Book. There is a great deal of other interesting information on this report and it is worth perusing.

Image courtesy of 401kcalculator.org

 

Famous People Who’ve Filed Bankruptcy

Article I of the Constitution grants to Congress the power to establish uniform bankruptcy laws throughout the country. While initially a device for creditors to divide up a debtor’s assets, over time bankruptcy has become more debtor friendly and now it is means for debtors to obtain a fresh start free from burdensome debts. Unfortunately, while the purpose of bankruptcy has changed over time, the stigma of filing bankruptcy has still remained. While I don’t advocate intentionally or recklessly getting over your head in debt, I do certainly see the advantages to clients of being able to file bankruptcy when it’s in the clients best interest. Nothing can be more destructive to a family than to be crippled with overwhelming debt and no chance to save money for retirement. To help erase some of that stigma, I have listed famous people who have filed for bankruptcy. I do not list these names for purposes of ridicule but to point out that bankruptcy is there for both rich and poor, famous or infamous. Properly applied, bankruptcy can be a life preserver for those in need.

  • Rapper 50 Cent
  • Marvin Gaye
  • Kim Basinger
  • F. Lee Bailey
  • Meat Loaf, the singer.
  • Cyndi Lauper
  • MC Hammer
  • Francis Ford Coppola
  • Larry King
  • Curt Shilling
  • Larry King
  • Mike Tyson
  • Dave Ramsey
  • Walt Disney
  • P.T. Barnum
  • Mark Twain
  • Henry John Heinz, of Heinz Ketchup fame
  • Milton Hershey, of Hershey’s Chocolate fame
  • Henry Ford
  • J.C. Penney
  • Mickey Rooney
  • Debbie Reynolds

And there are many more that could be listed…

If you are over your head in debt and need help, please call my office for a free initial consultation. My firm is a debt relief agency, as provided under the Bankruptcy Code, and I assist debtors file for bankruptcy.

 

Bankruptcy Basics: The Chapters of Bankruptcy in a Nutshell

Filing for bankruptcy is more than merely filing a petition in court; the Bankruptcy Code provides for five different chapters under which a debtor can file. Much work has to be done before filing to select the appropriate chapter for the client as each chapter has its own unique rules and restrictions as well as pros and cons. Selecting the proper chapter, at times, can be more art than science. The purpose of this post is to introduce the various chapters of bankruptcy and some of the issues that go into deciding which chapter to file.

Who Can Be a Debtor?

Bankruptcy is not available to everyone. Certain entities, such as railroads, banks and insurance companies, are barred from filing for bankruptcy. Additionally, even if a person or entity can file for bankruptcy does not mean that every chapter is available. Only individuals can file under Chapter 12 and 13; Chapter 9 cases are exclusively for municipal government. Who or what can file bankruptcy and under which chapter is another topic for another time but it is worth mentioning early on.

Chapter 7

Chapter 7 is the “liquidation” chapter of bankruptcy[1]. When a debtor files for Chapter 7, his or her assets, at the date of filing, become part of a bankruptcy “estate.” The trustee, who is the person appointed to administer the case, will sort the debtor’s assets into exempt and non-exempt categories. This distinction is important for liquidation purposes as exempt assets are protected from the claims of creditors. As a quick example of an exemption, under Maine law a debtor can exempt $5,000 in equity in one car. Non-exempt assets, on the other hand, are collected by the trustee and sold, with the funds being distributed to creditors in full or partial payment of their claims. Exempt assets are released back to the debtor at the end of the case, when the debtor receives a discharge. More often than not Chapter 7 cases are “no-asset cases”, meaning that the debtor’s exemptions cover all of his or her property, leaving nothing for creditors[2]. A common misconception about bankruptcy is that debtors will lose all of their assets when filing under Chapter 7 but often that is not the case because of the exemptions.

This ability to protect most, if not all, of a debtor’s assets while getting an immediate discharge of any debts is what makes Chapter 7 the most attractive chapter to file but there is a one little hitch: the “means test”. The means test is designed to prevent certain debtors from filing Chapter 7, those have mostly consumer debts and who make more than the median income[3]. The ostensible purpose of Congress was to force those consumer debtors who have sufficient income to pay something back to creditors. Much ink has been spilled poking holes in the reasoning behind the means test (or in pointing out how the test can be gamed, rendering it useless for its purpose) but for now it is an impediment to anyone who wants to file Chapter 7.

Chapter 9

Chapter 9 covers municipal bankruptcies and thus unlikely to be of interest to the casual reader. This area of bankruptcy law has seen a great deal of activity in recent years with the bankruptcy filing by Detroit and San Bernadino.

Chapter 11

Chapter 11 is a “reorganization” chapter. Rather than liquidate all of the debtor’s non-exempt assets, in Chapter 11, the debtor proposes a plan to creditors on how creditors will be paid back, whether in whole or part. The plan can be a mixture of a payment plan or funded through the sale of assets, all of which is handled through the “confirmation process.” Confirmation is the actual means by which a plan is proposed to the creditors and approved. Failure to have a plan approved usually means the debtor will have to dismiss the case or convert to Chapter 7. Filing a Chapter 11 case is an expensive proposition and requires a great deal of expertise, so the typical Chapter 11 debtor tends to be a large corporation or an individual with significant income, who does not otherwise qualify for Chapter 7, 12 or 13.

Chapter 12 and 13

Also reorganization chapters, Chapters 12 and 13 are much less complicated than Chapter 11, though both are much more complicated than Chapter 7. Both chapters share similar procedures but they differ in which debtors can file for relief under each chapter. Chapter 12 is restricted to individuals who are farmers or fishermen while Chapter 13 is reserved for individuals who have regular income (meaning that the individual has a consistent source of income) and whose liabilities do not exceed certain debt limits: $383,175 in unsecured debts, like credit cards, and $1,149,525, in secured debts, like mortgages.

Like Chapter 11, the debtor will propose a plan and seek to have it confirmed (in Chapters 12 and 13, however, only the debtor can propose a plan). Once confirmed, the debtor contributes his or her disposable income, earned over the term of the plan, to the trustee to be paid to creditors; if during the plan’s term, the debtor receives an inheritance or other assets then this may have to be turned over to the trustee for payment to creditors. Plans under Chapter 12 can last up to 10 years while Chapter 13 plans by law cannot last more 5 years.

Structuring a plan in Chapter 12 and 13, even using the simplified procedures allowed to debtors, is still a complicated and time-consuming process which makes these chapter more expensive to handle than a Chapter 7 (though 10 times easier and cheaper than Chapter 11). As you can imagine, much can happen over the plan term and very often a debtor loses a job, gets divorced or gets hurt which makes regular plan payments impossible. I have been told the success rate for debtors completing their Chapter 13 plan is hovering just above 60%.

In spite of the difficulties in proposing and maintaining a plan in Chapter 12 and 13, there are many advantages for the debtor who can complete the plan. Here are just a few: first, the debtor can keep non-exempt assets, rather than surrendering them to the trustee, by paying the value of the asset into the plan; second, mortgage arrears can be paid, or “cured”, through the plan, without interest; third, any c0-debtors (someone who is liable along with the debtor) is protected by the automatic stay – meaning no collection action can be taken against them while the debtor is in bankruptcy. There are other benefits to filing Chapter 13 but these are some of the better ones. In my experience, though, most debtors prefer Chapter 7 over 13 and will resist filing Chapter 13. I believe this is due to the uncertainty with what can happen over a number of years that most turns people off. Still there are times when Chapter 13 (and Chapter 12, if you qualify) can be a great tool for obtaining debt relief.

Conclusion

Much more can be written about each chapter but this quick summary  explain some of the basics. In future posts, I intend to add more detail about Chapter 7 and 13 cases, as both of those chapters are the most common encountered for individuals debtors, my core clientele. Once you understand the basics of each chapter then you can see how bankruptcy can be used to help debtors get a fresh start.

[1] And the chapter most frequently used by debtors. In Maine, Chapter 7 cases make up the majority of filings in bankruptcy court. In 2015, 1,551 out of 1,867 cases were filed in the District of Maine were Chapter 7 cases, which comes out to 83% of the case filings. It is my understanding that across the states Chapter 7 cases far exceed other cases. Here is a link to the Bankruptcy Court for the District of Maine’s website: http://www.meb.uscourts.gov/meb/pdf/web_stats_2015.pdf

[2] Exemptions will be discussed in more detail in a later blog post.

[3] Exceeding the median income is not an immediate disqualification from filing Chapter 7 but it does make it much harder. I will be posting a much more in-depth discussion in the near future. You can find the median income for your state here: http://www.justice.gov/ust/eo/bapcpa/20151101/bci_data/median_income_table.htm

Medical Marijuana Businesses Run Afoul of the Internal Revenue Code

Beck v. Commissioner, T.C. Memo. 2015-149 Filed August 10, 2015.

Certain states may have legalized medical marijuana but Federal law still lists it as a controlled substance. This means that medical marijuana dispensaries are still subject to punitive rules that apply to other forms of drug trafficking, such as cocaine or heroin. When I was perusing the Tax Court opinion page this week, I found the Beck case, listed above, and I was reminded that under the Internal Revenue Code, businesses that engage in trafficking scheduled drugs are not allowed any deduction or credit related to that business except for cost of goods sold (i.e. the cost to produce or sell goods). In practice, this means that taxable income for medical marijuana dispensaries is calculated as follows: gross income less cost of goods sold = taxable income. Expenses such as rent, insurance, wages, hell even postage, are not deductible…period. As you can imagine, the amount of taxes assessed may be in excess of the actual cash profit such a business makes. Negative cash flow is not a great way to conduct business (in Beck’s case, he was assessed 1.2 million in taxes and penalties).

It will be interesting to see how this all plays out, no matter your view on the merits of medical marijuana. The trend seems to be that more and more states are passing laws regarding medical marijuana, At some point, the subject of amending 280E will come up and likely amended or “clarified”. In case you are interested, here are two other cases involving medical marijuana dispensaries: Olive v. Commissioner, 139 T.C. 2. Filed August 2, 2012Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 14. Filed May 15, 2007.

Business Planning Using Your Rear-View Mirror

A colleague of mine uses the phrase, “See me before you need me,” in her advertising which makes me think of another phrase, “Failure to plan is planning to fail.” Ok, maybe that last phrase may be a bit overblown as most of us go through life on a minimum of planning, for example my daily wardrobe, and do just fine. While most of us can afford that luxury, as a business owner failing to plan may cost you, maybe even result in the loss of your business. Be not disheartened! With some proper planning many common business problems can be mitigated or avoided before they occur, not to mention at less cost and aggravation!

Successful strategies are like old time sea captains. While at sea, the captain scanned the horizon with a periscope to looking for pirates (Y’argh!), I mean problems; with advance warning of a problem he could plan what to do next. However, not all problems are readily apparent and so the captain surrounded himself with able hands, such as the pilot who could warn the captain of dangerous obstacles. So breaking that lovely analogy down a bit, successful planning requires a business owner to consider the future and see what problems may be lurking while also consulting with advisers to plan for those problems that are yet unseen.

Unfortunately, most business owners plan like they are alone in a car while driving ahead using the rear-view mirror. Not a strategy likely to succeed. Without concentrating on the road ahead, and with no one to keep you on track, the owner may quickly drive off course and end up in the ditch or worse. Here are some common planning fails:

  • Hiring employees without understanding the law or all the recordkeeping requirements.
  • Not properly managing cash flows.
  • Failing to consider how the business should be managed, especially when problems arise between owners.
  • Not talking with an insurance agent to obtain the proper coverage for your business.
  • Failing to properly set up a bookkeeping system or to find someone qualified to properly manage the books.
  • Not properly segregating the business from the owners’ personal lives, i.e. treating the business like a piggybank.

Let me be clear, I am not saying that all problems result from poor planning. I am saying planning can help avoid or mitigate many problems, especially if you have advisers to help you. So plan ahead! Get an accountant! Get a lawyer! And get an insurance agent! Ok, that is enough soapbox speechifying for now. Do right by your company and start planning!

Tax Court Double Feature; Two Taxpayers Get in Trouble Over Treatment of Alimony Payments

Two recent Tax Court opinions highlight the danger of ignoring the Internal Revenue Code 71 when handling spousal support issues.

Christina Mehriary v. Commissioner, T.C. Memo 2015-126, issued July 9, 2015

Taxpayer tried to deduct the transfer of the home she was given in the divorce as an investment loss. In the divorce she owed a substantial amount of alimony to her ex-spouse and he agreed to accept the home in lieu of cash payments of alimony. Ultimately the Tax Court found that the transfer was a transfer incident to divorce and thus no loss can be recognized; additionally, the court found that the transfer was not considered alimony because it was not cash payments as required under IRC 71. This was in spite of the ex-spouse’s agreement to accept it as alimony. “[T]he intent of the parties does not determine the deductibility of a payment as alimony under section 71.”

Michael Muniz v. Commissioner, T.C. Memo 2015-125, issued July 9, 2015.

Taxpayer tried to deduct a lump-sum alimony payment on his tax return. Under Florida law, lump sum alimony payments are payable to the ex-spouse’s estate if the ex-spouse dies before receipt. This fact alone converted the alimony payment into a transfer incident to divorce and therefore not deductible. IRC 71 is very clear that a payment obligation to the recipient’s estate is not alimony.

Both opinions make clear that intent of the parties and labeling of the payments do not override the Code. I am not sure if either taxpayer spoke about the tax consequences with either their divorce attorney, accountant, or tax attorney (though Muniz was formerly an attorney and CPA), though they should have.

http://www.ustaxcourt.gov/InOpHistoric/MehriaryMemo.Nega.TCM.WPD.pdf

http://www.ustaxcourt.gov/InOpHistoric/MunizMemo.Nega.TCM.WPD.pdf

I Fought the Law and the Law Won: Error by Tax Preparer Does Not Absolve Taxpayer

In Devy v. Commissioner, T.C. Memo. 2015-110, a recent tax court opinion, Mr. Devy found out the hard way that his trust in his tax preparer, aptly named Tax Whiz, was misplaced. Tax Whiz prepared his return and claimed for him an education credit of $2,500. After taking into account the credit, Devy’s return showed an overpayment of $1,863 but sadly Devy did not get to enjoy the refund as it was intercepted by the IRS to pay past due child support to New York. Poor Devy. Later the IRS audited Devy and denied the tax credit when he admitted that he had no proof that he had any educational expenses  for that tax year. Now instead of a $1,863 overpayment, he owes the IRS $637, plus interest and penalties. Poor, poor Devy!

Devy responded by saying, ok maybe I didn’t deserve that credit and maybe the American taxpayer just paid a portion of my child support but it’s not my fault. I trusted my tax preparer! Hey, with a name like Tax Whiz who wouldn’t trust them! Sadly, for Devy, it is the taxpayer’s responsibility to ensure that the tax return is done correctly and not the tax preparer; if the tax preparer screws up then you might have a claim for malpractice but taxpayer alone is responsible for payment of the correct tax, no matter what.

Often missed in the frantic rush to cash any tax refunds is this statement sitting above the signature line, which states: I “have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.” Notice the statement does not say: “I gave a bunch of stuff to my accountant (which may or may not be complete or accurate), answered some questions and now I can just go and cash my refund check. Thank you very much.” Ignorance is not bliss where tax returns are concerned. Even if Devy was telling the truth and he did not know Tax Whiz claimed the credit without his knowledge (either fraudulently or inadvertently) he still stands responsible for the tax due. That is true even if never benefited directly from the improper tax credit! I wonder if Devy will go back to Tax Whiz next year to have his taxes done…