April 1, 2024 – What are the key areas the IRS looks for in conducting an audit and what steps should you take if you receive a notice? Today, Jim Puplava of Financial Sense Wealth Management speaks with tax and litigation expert Dan Pilla on why there's been an increase in IRS tax audits and IRS collection efforts. Dan discusses some of the criteria the IRS uses to determine if an audit is necessary using a computerized scoring system, how they notify you, the process taxpayers will go through during an audit, how to appeal your case to an appeals officer, and the range of compromises that can be made should the IRS seek collections.
Dan also dispels a number of misconceptions when it comes to taxpayer rights, number of audits of wealthy individuals and corporations vs. the middle class and small businesses, news reporting around an aggressive IRS hiring campaign, and much, much more. If you've ever wanted to understand the IRS auditing process more, the areas and groups mostly targeted, and what to do if you receive an IRS auditing notice, this is one interview you won't want to miss.
Dan Pilla's website: Tax Problems Solved - Dan Pilla | There is no such thing as a hopeless tax problem (taxhelponline.com)
Dan Pilla books and resources: Shop | Tax Problems Solved - Dan Pilla (taxhelponline.com)
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Transcript:
Jim Puplava:
Well, we're still in the midst of tax season. That's not going to end until April 15. But you might want to be aware if you're behind in your taxes, the IRS could come calling. Joining us on the program is tax litigation expert and specialist Dan Pilla. Dan, you recently wrote an article. I know, during COVID and the lockdowns, the IRS kind of suspended some of the collection efforts it was making, but now they're back at it again. Explain what's coming.
Dan Pilla:
Yeah, that's exactly right, Jim. The IRS suspended a lot of its collection notices during COVID because frankly, it was overwhelmed with the responses. Between the filing of tax returns, amended tax returns and the millions of responses to outgoing IRS notices and letters from individuals replying to them, the IRS became overwhelmed with 35 million documents. They were backlogged, which they have finally now worked, dug out from underneath the blizzard of paperwork here in middle of 2023. So they've started the notice machine up again. So for the millions of taxpayers out there that owe money to the IRS, that thought the agency just went away because they haven't been receiving any notices. Well, those folks are getting a rude awakening now because the IRS has restarted that notice machine. So all the collection letters, the sequence of collection notices are going out now, including the ominous final notice of intent to levy and notice of your right to a hearing. This is something now that the IRS is engaged in at full scale.
Jim Puplava:
Let's take two situations. Let's say I'm a taxpayer. I pay my taxes. I'm up to date on my taxes. When I file in, let's say I'm filing my tax return, I owe a little more, I pay it. I have nothing to worry about.
Dan Pilla:
Well, you have nothing to worry about in the sense that you're going to get some arbitrary collection notice. That's certainly true. But you do need to realize, I wouldn't use the word worry, Jim. I don't want to have people sitting up at night speculating about what might happen. Because the fact of the matter is we don't know this, but the IRS, IRS does. Look at every return that's filed. They put it through a computer analysis. It's called the DIF score discriminant income function system is what the program is. It compares every line of your tax return with national regional statistical averages for a person in your same income category and profession. If any one line of your return is out of sync with those averages. The difference is scored. It's called a DIF score. The higher the score, the more likely it is you are to be audited. So, yes, you paid your taxes. Yes, you filed your return on time. That's great. From a collection standpoint, you're in the clear. You don't owe the IRS any money. But that doesn't mean they can't audit the return and make a determination that you owe more money. And if they do that, of course, that determination is subject to appeal and review and subject to tax court litigation. If you want to push it that.
Jim Puplava:
Far, let's go the other direction. Let's say that I owed some money and back taxes. I haven't got any notices during the period that you were talking about where they were kind of running behind. Now they're catching up. What can I expect?
Dan Pilla:
Yeah. That is where the IRS is going to begin its collection notice sequence. So the first notice in the sequence is a. Is a friendly reminder letter. Okay. And I'm not going to give you the letter numbers. It's confusing to people. But what happens is they send you this first notice that says, hey, you might have overlooked the fact that you owe us $5,000, right. That's the very first notice in the sequence. It's an account change letter. We've changed your account. You used to owe x, now you owe x. Plus they ask, of course, for the money, and they give you a due date by which they want that money. And that's the date on which the interest starts to accumulate even further from what's expressed in the notice. If you don't pay by that date, Jim, then there's a series of three additional notices that the IRS mails out. And those notices get progressively more stern in their collection language. Send us the money. We need the money. Where's the money? Why haven't you sent us the money? This type of language is used in the letters, and then the final letter in the sequence is what I alluded to earlier. It's the final notice of intent to levy a notice of your right to a hearing. Now, that letter comes from either the IRS service center or it comes from a revenue officer. Depending on how much money you owe, the IRS. If it's six figures, Jim, the case will be assigned to a revenue officer, a human being, for collection. If it's less than that, then their computers do the collecting through their automated notices. And that final notice says, this is your final notice. This is our notice to you. Of our intent to levy your assets, paycheck, bank account, income stream, you know, whatever the case may be, automobile, unless you pay within 30 days, or else. Now here's what the "or else" is: "or else" you have an opportunity to appeal, and that is called a collection due process appeal. It is a very, very important right for taxpayers that they need to understand how to use that collection due process appeal. Right, because that is the, that is the, in my opinion, the single most important right the taxpayers have when they're dealing with the IRS. It's the one that levels the playing field.
Jim Puplava:
Jim, if you were to appeal it, you're obviously going to go to court. That's going to involve legal costs and the government has unlimited resources. So let's talk about that appealing the.
Dan Pilla:
Collection notice, the final notice of intent to levy does not automatically get you into court. When you appeal that final notice of intent to levy, that goes to the IRS's Office of Appeals. All right. Now this is very important. It's an administrative process that allows you to negotiate with an appeals officer. Again, we're talking about a human being here that is framed in a number of important aspects of collection. First of all, there's a number of things that happen in favor of the taxpayer when you do this. Number one, it operates as a collection hold, an automatic injunction, if you will. It doesn't use the word injunction, but it's a collection hold that stops all collection action while your case is on appeal. So they can't levy so much as a postage stamp while your case is on appeal. That's number one. Number two, the appeals officer, that that person within the IRS has an affirmative duty to verify that the assessment is correct. So if you've got some reason to believe that the assessment is wrong, that you don't really owe the tax, that there is some grounds for believing that you owe less than what they say, that appeals officer has to engage that conversation. Number three, if you do owe the tax or any amount of tax, they have to consider a collection alternative. So this is the opportunity for a taxpayer to present a negotiation option. Jim, for example, an installment agreement, or maybe you're unemployed or underemployed and so you're going to argue for what's called uncollectible status, or maybe you're entitled to penalty relief, or maybe there's some innocent spouse issues that arise, or maybe you can do an offering compromise because you can't pay the tax at all. Any one of these items that I listed is considered a collection alternative and the IRS has the affirmative duty to consider any collection alternative argued or presented by the taxpayer. This is a very, very important right because this gives you, as I said, right to keep the IRS from going into enforcement mode and negotiating something less than full enforcement on your part.
Jim Puplava:
Dan, all the things you just mentioned are really great, but if I'm a taxpayer ignorant of the tax code or ignorant of all my rights, what would you recommend somebody do going into, let's say, this negotiation process?
Dan Pilla:
Well, that's a good question, Jim, and the answer is my book, how to get tax Amnesty. I mean, that's the book how to get tax amnesty is written to lay people. It's written based on the assumption that you know nothing about the IRS or the income tax. And it takes you step by step by step through this entire process. I've got two chapters in there that deal with the collection, due process, appeal. I've got a chapter that deals with the offer and compromise. I take you all through these various, various elements that we've discussed here. Penalty relief, innocent spouse. All of that stuff is laid out there to give the layperson with no experience the step by step guidance they need to get through this.
Jim Puplava:
Yeah, because you have to have some kind of help or expertise or knowledge going into this. Dan, I want to talk about something that's come out of the Biden administration. They're going to hire 80,000 IRS agents. I heard they even want to arm them. I assume they're not hiring them to go after Elon Musk and Bill Gates. Well, they want us to believe that they're only going after the richest, the people making more than $400,000 a year, the richest people in the country. But that's simply not true. And the proof of that is the collection function that we're seeing going on in the IRS right now. They turn the notice machine loose, Jim, on everybody, not just people making more than $400,000 a year. Now, there's no question that the IRS is looking into that segment of the population, no doubt about that.
Dan Pilla:
But the fact of the matter is the overwhelming majority of income is not earned by those people in that bracket, Jim. It's earned by the greater population that's making less than that amount of money. There's just no question about that. Now, as far as the 80,000 agents are concerned, yeah, the IRS, the Biden administration made it clear and funded, Jim, with the inflation Adjustment act that was passed in the summer of 2022 funded 80,000 additional IRS employees. However, and this is the, this is the great misunderstanding about this plan, and I'm not defending the plan, you understand, but I do want to be accurate about this. The great misunderstanding is that people believed that they were going to be hiring these 80,000 people over the next weeks and months following the Inflation Adjustment act. That is not true. And it never was the plan that they were going to beef up the IRS by 80,000 people, you know, essentially overnight. That 80,000 people is spread over ten years. All right? So they've got a very specific plan spread over ten years to hire those people. Now, here's the interesting thing about it. Right now, the IRS has, currently has roughly 85,000 employees, all right? So the IRS wants to add 80,000 to that over ten years. You think to yourself, oh, my goodness, the size of the IRS is going to double. Well, no, and the reason is because over the next two to three years, the IRS is going to lose roughly 25% of its workforce to retirement and attrition. So over that span of ten years, my projection is that the IRS is basically going to stay even with the number of employees that has. It might increase them somewhat, but it certainly is not going to double the workforce. There's just no doubt about that.
Jim Puplava:
But even if they are going to add some additional agents, I mean, who are they going after? One of the things that we saw with the pandemic, a lot of businesses went under, especially a lot of small businesses, because they were shut down, they couldn't operate. And now that we're getting into recovery, people are just getting back and people are going back to work. Who are they, who are they targeting?
Dan Pilla:
Well, they're targeting businesses, Jim. You know, it's interesting when you look at the literature and you really parse their claim that they're only going after the people making $400,000 a year or more. And they say that they are not going to go after small businesses and self-employed people at any levels other than historic levels. That's the phrase that we see in the literature over and over again, that it's going to be considered. They're going to go after low income or I should say small businesses, self-employed people, consistent with historic levels. Well, here's the problem with that. Historically, small businesses and self-employed people have been the most targeted by the IRS of any group of taxpayers. If you look at the various categories of taxpayers that the IRS has broken down. There are 14 different categories. You've got high income people, you got corporations, you got big partnerships, you got self-employed people, you got wage earners, you got exempt organizations, you got government entities. All right, there's seven I named off the top of my head. There's seven more of them. Total of 14 different categories. When you look at the litigation and the audit levels and litigation levels that the IRS imposes on those 14 different categories, 60% of the attention is paid to just one category of taxpayer, and that's small business and self employed. The IRS is completely convinced, Jim, that small businesses and self-employed people essentially cheat across the board on their taxes, not so much by inflating deductions, but rather by hiding income. They believe that these people are principally responsible for over half of the tax gap, and they think that that is attributable to small businesses hiding their income, and that's where they're going to go. So I don't take any comfort in the administration's claim that they're going after rich people predominantly, and they're not going to increase the attention on small businesses any greater than historic levels. Historically, 60% of their attention is focused on this one group of taxpayers.
Jim Puplava:
Now, you say they believe that most small businesses are cheating on their taxes by not reporting income. What has been their experience with auditing small businesses?
Dan Pilla:
Well, that's a good question. And that's where the disconnect comes in. When the IRS audits a tax return, Jim, they make corrections to, quote, unquote, corrections to that tax return. About 88% of every tax return that goes through an audit is found to owe more money. All right? Only 12%, either no change or a refund. So that's a very small, very small segment of the audit population, right. That's considered, quote, unquote, correct return. You did it right. 88% are wrong. But here's what the problem is, and here's what the disconnect is. All of those tax gap numbers and all of that data that, that says small businesses cheap by hiding income is based on audit results. All right? But it's not based on appeal results. Here's what happens when you appeal your case. When we're talking about an audit determination here and you appeal your case, the IRS auditors are found to be wrong between 60% to 90% of the time, depending on the issue we're talking about. And when the issue is unreported income, then we're in that 90% bracket of errors. So the IRS uses data from the examination division, but they don't adjust that data for the changes that are made based on appeals.
Jim Puplava:
Do these agents that are going in, let's say I got an agent auditing my tax return, are they paid incentives? Like if they audit me and they come up with an extra $5,000 that I owe on taxes, do they get a piece of that?
Dan Pilla:
No. No, they do not, Jim. That is, that, that has never been the case. There have been allegations to that effect off and on over the years. I've been doing, I've been in this business over 40 years, close to 45 years, and I've heard these allegations on and off over these several decades. But no, it's not true. They do not get, they, they get, they get paid based on their government G's, government service rating. So G-S, twelve G-S, 14 G-S, whatever it is, that's how they get paid.
Jim Puplava:
Now, I remember a number decades ago, I got audited and they came in and what I see them do, and maybe, correct me if I'm wrong, Dan, they come in and they disallow certain deductions. So if they disallow certain deductions, that means you have more taxable income and hence you owe more taxes.
Dan Pilla:
Yeah, that's exactly right. That's precisely what they do. And actually, there are two elements of every audit. Every single audit focuses on two potential change items. Number one is the income.
We talked about that a small business person reports $100,000 worth of income on their tax return. The IRS does an audit and says, oh, no, no, no, we think you had $150,000 worth of income. Well, that can increase your, your taxable income as well. And then the second component, what you just named is the element of deductions. So every business has their business expenses that they write off, right. Their advertising and their travel and their automobile expenses and their rent and utilities and on and on and on. And the IRS looks at each and every one of those items and they say, well, you can't, you didn't prove this. You didn't prove that. You didn't prove this. So we're disallowing this. We're disallowing that. So between the combination of the two things, increase income and disallowed deductions, that’s where the increased tax liability comes from.
Jim Puplava:
So what do you do? I mean, you’re going to have to get an expert. If the IRS challenges you on deductions, as you say, they lie. Sometimes they use misinformation because they’re going to try to extract more revenue out of you by, in many cases, for most individuals, its probably going to be the disallowance of deductions.
Dan Pilla:
Yeah, that’s true. First of all, you got to understand how to prove a deductible expense. I wrote a book called how to win your tax audit, Jim, where I lay out step by step in great detail exactly how the IRS attacks a tax return, both from the standpoint of income and deductions, precisely how to defend that tax return from the standpoint of income and deductions. And when we're talking about deductions in particular, because that's generally where they approach, where they attack, they look at income, no question. But the most adjustments we see is in the area of deductions. All right. No question about that. And so you need to know how to prove your deduction. First of all, businesses, every taxpayer needs to understand that the burden of proof is on the taxpayer when it comes to deduction items. The IRS does not have to prove that you're not entitled to the deduction. You have to prove that you are entitled to the deduction. And in the overwhelming majority of cases, Jim, this is a paperwork issue. Do you have the documentation? Cancel checks, receipts, invoices, logs, statements, whatever documents you need to support the expenditure, you need to understand what that document needs, a documentation needs to look at. And I spend a great deal of time on this in the book, how to win your tax audit, where I walk you step by step through the six different ways there are to prove a deduction, what the documentation is that you need to prove that deduction and how to present it to the IRS. Now, here's the reality. Even if you do everything exactly correctly with the audit unit, the fact of the matter is that you might end up with a tax bill with a, with an adjustment letter. The IRS calls it an adjustment letter that says, well, we've disallowed this, we've disallowed this. We've disallowed this. You owe us ten grand. It is vitally important for people to understand that this almost always happens when you come out of the audit unit, because their job, Jim, is to get the money. Take all 4 million words of the internal revenue code, you can boil it down to just three. Get the money. And that's what the audit function is all about. So this is why you need to understand how to appeal the case and deal with the appeals office, because it is at the appeals office that you're dealing with a better educated, more experienced individual who understands the law and understands how to evaluate the evidence in light of the circumstances of the case. And this is where you get the best resolution to your situation. And this is why the overwhelming majority of cases that go to appeals end up with a false, far, far more favorable settlement in favor of the taxpayer than they ever do out of the audit function.
Jim Puplava:
Dan, is there anything that really stands out in terms of deductions that they really look at closely or disallow? I could think of things like charitable contributions, especially if it's not cash. Like you're donating something to charity, goodwill, a church or whatever, or things like home office deductions. Any of those stand out?
Dan Pilla:
Yeah. Yeah. If we're talking about businesses, which is, you know, the primary, the primary audit target, you named one of them home office. No question about it. Is one thing that the IRS looks at carefully. The other thing is, is the mileage expenses that are claimed by, by small business people. For most small business people, Jim, their mileage expense is their largest expenditures, the largest deduction on the tax return. And this requires careful documentation. And frankly, a lot of small businesses don't keep the documentation. About two thirds of all the problems we see with tax audits with small businesses are records related. In other words, the business is not keeping the records necessary to support the deduction, which is another important element of my book, how to win your tax audit. I show you how to keep these records so you're doing it correctly, but businesses need to keep the records, and this is where they get into trouble. All right. Another area of problems with small businesses that we see a lot is this profit motive issue, where if you got a business that has lost money for one or two or three years, the IRS might come in and say, ah, you don't have a legitimate business because you don't have a profit motive. This is really just a hobby, and you're losing money just because you're in business for the fun of it. And it's not really a business. It's a, it's a hobby or a recreational activity. So you don't get any deductions in connection with that activity. So they disallow all expenses of that business. And that ends in, adds insult to injury because we're already talking about a business that has lost money here. Now the IRS wants to disallow all their expenses, increase the tax liability considerably as a result.
Jim Puplava:
And what's the best defense? Because one of the things that we saw as a result of COVID in the lockdowns even, and this applies to major corporations, they decided they didn't need as much office space. A lot of employees, especially in the tech space, are working remotely from home. So if they're working remotely from home, I have a lot of tech people that work remotely for some of the big tech companies, and they work from home. So they have an office, they have to have computers at home, Internet service, all those kind of things. There's a big change coming out of COVID. How easy is it to defend that, given how the workplace has changed?
Dan Pilla:
Well, that's a darn good question. And this surprises and shocks a lot of people, Jim, and that is this. If you're an employee working for an employer and you're working from home, you don't get a home office deduction. All right. The home Office deduction is available for self-employed people. But in order to claim a deduction for a wage earner, all right, that is a miscellaneous itemized deduction. And miscellaneous itemized deductions were written out of the law. It's temporary. We'll see what happens if they, if they extend the Tax Cuts and Jobs act. If Congress extends it, I seriously doubt they're going to extend all of it. But one of the things that the Tax Cuts and Jobs act changed in 2018 was the elimination of the, of the miscellaneous itemized deduction, the deduction for unreimbursed employee expenses. Right. Which a home office is unreimbursed employee expenses. That deduction has been eliminated in favor of doubling the standard deduction. So the standard deduction went from about 6000 to about 6500 to 13,000 for single people and to about 24 and a half, $1,000 for married people. And it's up from there. Now, because of inflation adjustments, you don't get a separate deduction for a home office as an employee. Now the employer can provide the tools and equipment and the employer can get a deduction for the tools and equipment. But in terms of the space used in the home and the, and the allocation of expense related items for such things as utilities and maintenance and taxes and so on. An employee does not get that deduction.
Jim Puplava:
Well, let's reverse that. Let's assume you are the employer. You were self employed, or you own a business, but you work from home because of space, convenience, and things like that. Is that allowable?
Dan Pilla:
Yeah, absolutely. If you're a self-employed person and you are the business, you are the worker, then the space that's used in your home regularly and exclusively for business purposes is deductible. The key here is that it's got to be exclusive business use. So if you've got a space in your home, let's say it's a spare bedroom, and it's just pick a number. Let's say it's 300 sq ft. All right? Okay. That room has to be used only for business. You can't use it as an office during the day and a tv room for the kids at night or an office during the week. And then, you know, kids come home from college on the weekend, and that's where they sleep in that spare room. That's not exclusive use. When it, when the space in your home is used for business, it must be exclusive use. And it can't be mixed use. That's where people run into trouble.
Jim Puplava:
Dan, I want to talk about the tax law that expires in 2026. So we know that they brought the corporate tax rate from 35 down to 21 for C Corps. They did a number of things, including limited the amount that you could deduct for property taxes, state taxes. What happens in 2026, in your opinion? Where do you think we're going to go with that?
Dan Pilla:
Well, what you're talking about, Jim, is the Tax Cuts and Jobs act that was passed during the Trump administration took effect in 2018. It's a temporary tax law. You're exactly right. It expires at the end of 2025. And the question is, what's going to happen? And as we sit here right now, nobody knows. I believe that the Democrats want that law to expire in its entirety. They want it all to go away. They want the corporate tax rate to go back to 35%. They want to eliminate the business tax deduction that was, that was the 20% business tax deduction that was instituted. The corporate rate went down. But for individuals that operate as sole proprietorships and partnerships and so on, they had a deduction equal to 20% of their net business profit that got them on par with that corporation deduction. The tax brackets were changed if more people were taken off the tax rolls, the standard deductions, as I mentioned earlier, doubled both the standard deduction for single people and married people in every category, all five categories of tax return filers, they essentially doubled. All of these things will go away if that law expires, Jim. And I personally believe that that's exactly what the Democrats want to do because it will lead to a tax increase for virtually everybody in the country. The Tax Cuts and Jobs act was vilified by the folks on the left as being tax cuts for the rich. Anytime. The conservative element in the lawmaking world here in the lawmaking country, I should say, in America here, does some sort of tax relief. It's always billed as tax cuts for the rich. The fact of the matter is, the demonstrable fact is that the tax cuts and Jobs act lowered taxes for the bottom 80% of income earners. And for the top 20%, their tax liabilities either stayed the same or went up. So it absolutely, definitely was not tax cuts for the rich. However, when that is all reversed, then the tax burden for just about every American is going to increase. And I think that's what they want.
Jim Puplava:
This is interesting because we're doing a lot of Roth conversions right now during this open window. And for a married couple, Dan, you can go all the way up to, I think it's 384,000 and remain in the 24% tax bracket. If we go back to the Obama rates, that goes to a 25% tax bracket on almost half of that.
Dan Pilla:
Yeah, see, them, people don't understand this, Jim, and they listen to the media that continues to recite this mantra with religious fervency that says rich people pay no taxes and that says that every tax cut coming from the conservative side of the aisle is tax cuts for the rich. And it's just simply not true.
Jim Puplava:
Yeah, I think this is going to be a great wake up call. It'll be interesting, Dan, because a lot of your middle-class people on lower income levels, they're not going to realize this if they let this expire until they walk into their accountant and file their 2026 tax return in 2027.
Dan Pilla:
Yeah, you're exactly right. They will get the, they'll get the spanking at that point, but they won't know who to blame. Jim, this is the problem is they don't know who to blame.
Jim Puplava:
Well, Dan, what would you recommend? You've got a number of books. One is tax amnesty. The other one is how to win your tax audit. And you've also got a book on small business tax guide. Talk about those briefly as we close.
Dan Pilla:
Yeah, the Small Business Tax Guide, Jim, was written to businesses to keep them out of trouble with the IRS. I've taken my 40 plus years of litigation experience in fighting the IRS and tax court and courts around the country. And I built the small business tax guide using probably 17 or 18 of the most common problems that businesses face. And I show you how to avoid those problems. So any small business person, any self-employed person is going to benefit from this book. I mentioned the book how to get tax amnesty, which shows folks how to negotiate with the IRS to reduce or eliminate tax debts they can't pay. And then my book, how to win your tax audit, is the most comprehensive guide there is to guiding a person through a tax audit with the IRS.
Jim Puplava:
So if our listeners would like to find out more about these books and more about you, Dan, how can they do so?
Dan Pilla:
Yeah, they do so at my website, Jim. Taxhelponline.com. It's all one word, no spaces. Taxhelponline.com. You buy any book off my website at any price point, it doesn't matter what it is, you get a free 15 minutes consultation directly and personally with me. So go to taxhelponline.com.
Jim Puplava:
All right, Dan, well, listen, it was a pleasure speaking with you. And just heads up, everybody. Taxes are going to be going up in the next couple of years and you better start planning.
To speak with any of our advisors or wealth managers, feel free to Contact Us online or give us a call at (888) 486-3939.
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