By David W. Klasing, CPA, Esq., Law Offices of David Klasing– December 18, 2023
Staying off the IRS’s audit radar is a shred goal for all, especially concerning Foreign Bank and Financial Accounts (FBAR) reporting. Although evading audits entirely is impossible, adopting smart practices can certainly reduce the chances of triggering one. Following are some essential strategies for avoiding IRS audits and inquiries, particularly focusing on FBAR filers.
Uncovering Audit Triggers
IRS audits typically stem from discrepancies on tax returns, though random audits also occur. The IRS’s computer system employs the Discriminant Information Function (DIF) program, flagging unusual tax returns. This algorithm identifies anomalies, comparing returns against a baseline established by taxpayers in similar income brackets. Anything from dubious deductions within the taxpayer’s tax bracket to wrongly claiming dependents can trigger an audit. Common triggers include:
- Failing to report all income
- Reporting significant business gains or losses
- Operating a cash-intensive business or making substantial cash deposits
- Engaging in freelance or contract work
- Claiming home office deductions
- Misrepresenting hobby expenses as business costs
- Possessing financial assets abroad, with specific attention to FBAR implications
Furthermore, an audit might be prompted by an event in another person’s tax return. If one’s business partner is audited, his or her return could also be selected. The IRS terms these as “related examinations.” In cases of fraud within one business, the IRS might audit multiple firms in the same industry.
Occasionally, audits are completely random. The IRS employs statistical formulas to pick a percentage of returns for unplanned audits. Those required to file an FBAR face a higher likelihood of being audited.
Cracking the FBAR Audit Code
While FBARs aren’t automatically audited, existing audit selection processes for tax returns can apply to FBARs. Seeking assistance from a tax attorney specializing in international tax law can prove invaluable.
The FBAR mandates reporting financial interests abroad. This applies to citizens, residents, corporations, partnerships, trusts and estates. An FBAR might be necessary even if foreign accounts don’t generate taxable income.
The most significant FBAR audit trigger is failing to meet the deadline. Taxpayers must report financial accounts with a cumulative value exceeding $10,000 at any point in a year. Incorrect FBAR filing can lead to penalties of up to 50% of offshore funds, possibly escalating to criminal charges.
Mitigating the IRS Audit Risk
While complete immunity from IRS audits isn’t guaranteed, prudent steps can minimize the risk significantly. Accurate income reporting, meticulous record-keeping and truthful filings are paramount in sidestepping audits.
Reviewing tax returns for errors and inconsistencies drastically reduces audit risk. The stress of tax preparation can lead to overlooked details. Seeking a tax attorney’s neutral assessment is advisable. Waiting for all income data before filing prevents errors due to incomplete information. Complete all sections, even if with zeros, to avoid audit complications.
Honesty and precision with deductions and credits are crucial. The IRS is skeptical of “perfection.” Avoiding rounded figures for deductions and handling losses cautiously reduces suspicion. Evaluating whether a business loss qualifies as a hobby is wise.
Prioritizing FBAR Compliance
FBAR compliance is critical, aided by data-sharing agreements between the U.S. and more than 100 nations. Filing by April 15 and enrolling in the Offshore Voluntary Disclosure Program for delays are wise moves. Prolonged FBAR delays jeopardize penalty reductions.
Facing an IRS Audit
In an audit, collaboration is key. Attempting to conceal actions during an audit is counterproductive. A skilled tax attorney can help leverage your rights to address the situation effectively. An audit response starts with a thorough review of tax records. You might possess evidence of accurate filing or need to explore reconciling options.
David W. Klasing
David W. Klasing Esq., CPA, M.S.-Tax, has earned dual California licenses that enable him to simultaneously practice as an attorney and as a CPA in the practice areas of taxation, estate planning and business law.
FAQs
Never give the auditor more information than requested. Answer only the questions asked. Provide succinct answers, and always respond honestly and briefly. If you're unsure of how to answer a question, make a note of it and offer to get back to the agent with answers.
Does filing an FBAR trigger an audit? ›
FBARs will not be automatically subject to audit but may be selected for audit through the existing audit selection processes that are in place for any tax or information returns.
What is the audit rate for the FBAR? ›
9 Yet the FBAR audit rate is less than one quarter of one percent.
What is most likely to trigger an IRS audit? ›
Unreported Income
Taxable income that is not reported on your tax return is likely to trigger an IRS audit. Common kinds of unreported income include: Income from a hobby or side hustle. Freelance income.
What is the IRS 6 year rule? ›
6 years - If you don't report income that you should have reported, and it's more than 25% of the gross income shown on the return, or it's attributable to foreign financial assets and is more than $5,000, the time to assess tax is 6 years from the date you filed the return.
How do you write a good audit response? ›
Responses should be as concise and to the point as possible, and directly relate to the issues and recommendations identified in the report and planned corrective actions. Responses should be written and returned within the time period prescribed by policy.
What is a reasonable cause for not filing FBAR? ›
For those penalties where reasonable cause can be considered, any reason which establishes that the taxpayer exercised ordinary business care and prudence, but nevertheless was unable to comply with a prescribed duty within the prescribed time, will be considered.
How many years back can you file for FBAR? ›
File an Amended FBAR
Because of the 6 year statute of limitations, a filer need not correct an error on an FBAR filed more than 6 years ago. Filing an amended or delinquent/late FBA R outside one of the IRS's penalty relief programs provides NO penalty protection and therefore requires very careful consideration.
Are bank statements enough for IRS audit? ›
Your bank statements and cancelled checks are a good starting point, if you still have access to these documents. If you're a business that deducted expenses and you no longer have receipts, it may be logical that you would have expenses that the IRS should allow even though you don't have a receipt.
Does IRS look at FBAR? ›
Unlike Form 8938, the FBAR (FinCEN Form 114) is not filed with the IRS. It must be filed directly with the office of Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury, separate from the IRS.
Noting, criminal FBAR penalties are rare, so if you are speaking with tax professionals who are goading you into believing that you are criminal because of your FBAR non-compliance, it is important to realize they are probably trying to fear-monger you into believing you may be subject to criminal enforcement when that ...
Which filing status is most audited? ›
This higher rate is because many of these taxpayers claim the earned income tax credit, and the IRS conducts many audits to ensure that the credit isn't being claimed fraudulently. Also, as you might expect, wealthy taxpayers are audited more often than the less affluent—after all, that's where the money is.
What are red flags for an IRS audit? ›
Another easily avoidable audit red flag is rounding or estimating dollar amounts on your tax return. Say, for instance, you round $403 of tip income to $400, $847 of student loan interest to $850, and $97 of medical expenses to $100. The IRS is going to see all those nice round numbers and think you're making them up.
What income level gets audited the most? ›
The two groups most likely to get audited are those earning more than $10 million and taxpayers who claim the Earned Income Tax Credit, who tend to be low- or middle-income workers.
How far back can the IRS audit you? ›
Generally, the IRS can include returns filed within the last three years in an audit. If we identify a substantial error, we may add additional years. We usually don't go back more than the last six years. The IRS tries to audit tax returns as soon as possible after they are filed.
How do you respond to audit questions? ›
Honesty, sincerity, and straightforwardness should be the touchstones of your responses. An auditor is looking for the truth. A guess, even if it is an educated guess, is not the truth.
How do you answer audit interview questions? ›
Practice audit interview questions responses
Be sure to sound natural when sharing your responses during the interview by using the STAR method , which is an acronym for situation, task, action and result. This method helps develop strong examples to interview questions.
How to prepare for an IRS audit interview? ›
Gather all information the IRS has requested and prepare to present it to the IRS. Prepare for possible questions from the IRS, such as those concerning unexplained bank deposits or additional income. The IRS agent will also ask about your job, family, and any outside businesses.
What does the IRS look at during an audit? ›
An IRS audit is a review/examination of an organization's or individual's books, accounts and financial records to ensure information reported on their tax return is reported correctly according to the tax laws and to verify the reported amount of tax is correct. Why am I being selected for an audit?
