Take a closer look at these four clients before filing their returns
Preparers should consider extra due diligence as the IRS scrutinizes taxpayers and practitioners.
March 11, 2013
CPAs and tax preparers are not required to audit their clients’ records before filing their clients’ returns. However, for certain clients, you may want to step up your quality review check before you file. Doing so will ensure that your client files an accurate tax return and can protect you and your client in case of an audit.
Although taxpayers are responsible for return accuracy, the IRS has increasingly been holding tax preparers responsible for due diligence in preparing returns. Preparer penalties and IRS attempts to regulate unlicensed tax preparers are part of the strategy to shift more accountability to practitioners to help close the tax gap.
Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), Sections 10.22 and 10.34 allow tax preparers to rely on client data in preparing tax returns. However, tax preparers must perform adequate due diligence and make reasonable inquiries when information furnished by a client appears to be incorrect, inconsistent, or incomplete. The IRS Office of Professional Responsibility (OPR) states that “willful blindness” and “don’t ask, don’t tell” approaches are not acceptable. For example, in Director, OPR v. Kaskey, Complaint No. 2009-26 (Dep’t of Treas. 5/28/10) (final admin. review), Treasury and the IRS held a CPA responsible for a lack of due diligence in preparing clients’ tax returns, in violation of Circular 230.
In addition to shifting more accountability to tax practitioners, the IRS is also scrutinizing certain taxpayers—and for good reason. Compliance studies by agencies such as the Treasury Inspector General for Tax Administration (TIGTA) and the U.S. Government Accountability Office (GAO) have shown significant tax return errors across several taxpayer types. The IRS has responded by targeting these taxpayer profiles in audits.
Before finalizing your clients’ tax returns this filing season, consider taking extra due-diligence steps for these four client profiles:
Small retail businesses
The IRS knows that small business is the largest taxpayer segment that underreports income. This is largely because these businesses receive few or no information statements, resulting in little or no audit trail for the IRS. According to the IRS tax gap study released in 2012, 56% of taxpayers who receive few or no information statements misreport income on their tax returns.
When you’re closing a client’s books and preparing a client’s return, analyze the client’s bank accounts. This is one of the IRS’s first tests in an audit. Reconcile your client’s bank deposits to total revenue reported on the return. Significant, unexplained deposits should be examined to determine whether income is being reported. It’s rare for a retail business to receive Forms 1099-MISC, Miscellaneous Income, but if your client’s business receives one, determine whether your client properly recorded the income source.
Pay particular attention to clients who receive Form 1099-K, Payment Card and Third Party Network Transactions, for debit and credit card payments. The IRS is starting to use this information to question business tax returns. If your client’s business records credit card sales in its accounting system, reconcile total credit card sales to Form 1099-K at the end of the year. If your client doesn’t record merchant card transactions, consider comparing the amounts received from merchant card transactions by month to your client’s sales. Look for inconsistencies each month in the proportionate amounts to overall gross receipts.
Twenty million individual taxpayers deduct noncash charitable contributions each year. In 2012, a TIGTA study found that 60% of taxpayers who claimed more than $5,000 in noncash contributions did not comply with the recording requirements. The study indicated that the main error was inaccurate Forms 8283, Noncash Charitable Contributions. Other errors included missing appraisals, incomplete donor acknowledgments, and unclear or incomplete descriptions of donated property and contribution dates. In one IRS audit project on noncash contributions, 72% of the returns had errors resulting in additional assessments.
If your client has a noncash contribution this year, make sure that Form 8283 is accurate and that your client provides all required documentation. If your client donated a vehicle, make sure your client receives Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, from the charitable organization, attaches the form to the return, and does not overvalue the donation.
In a 2008 study, the GAO reported that in 2001, 53% of individual taxpayers with rental real estate activity misreported income. The study found that taxpayers made significant reporting errors by overstating expenses, understating income, deducting amounts in excess of passive activity loss limitations, and not applying limitations on deductions due to personal use of the rental property. In 2010, TIGTA reported that the IRS should conduct more audits on rental property due to significant misreporting.
An alarming finding from the 2008 GAO study was that about 80% of individuals who reported rental real estate activity used a paid tax preparer. The IRS will look to practitioners for more due diligence in this area.
When you’re preparing returns with rental property activity, ask clients to substantiate expenses. According to the GAO, 35% of taxpayers with rental property deduct a nonallowable personal expense or can’t substantiate a reported expense. Nineteen percent did not fully report an expense that would have been allowed.
You should also look closely at depreciation deductions. In the GAO study, many taxpayers incorrectly included the value of their land within the depreciable basis of their properties.
Losses taken on personal returns from partnerships and S corporations
In 2012, the IRS increased audits of partnerships and S corporations by 18.7%. Studies show that the IRS finds significant errors when it audits these entities. For example, in 2011, the average adjustment in a partnership examination was $137,000. A more considerable concern for the IRS in this area is the deduction of flowthrough losses from these entities. Many times partners or shareholders recognize a loss in excess of the amount allowed due to basis limitations. A 2009 GAO study found that S corporation shareholders who took losses in excess of basis misreported their income by an average of $21,600 per return.
The IRS expects compliance help from tax practitioners. Most flowthrough entity returns are prepared by a paid professional, who also may prepare the shareholder/partner’s Form 1040. When the practitioner doesn’t prepare both returns, it may be challenging to resolve issues that carry over from the entity to the shareholder or partner. The GAO concluded in a 2009 study that tax preparers may actually be contributing to errors made—71% of S corporations that used a paid preparer submitted returns that contained errors.
Look for the IRS to pursue preparer penalties for paid professionals who don’t conduct their due diligence in calculating basis and allowable losses.
Prevention is best
If the IRS examines your client’s return and finds misreported income, the IRS will likely pursue accuracy-related penalties. Significant amounts of unreported income or overstated deductions/credits can result in a more expansive audit and the potential for the IRS to pursue civil and/or criminal fraud allegations. When that happens, tax preparers often regret not taking a closer look at their client’s records.
This filing season, before you e-file your client’s return, take a few extra due-diligence steps. It is OK to do a mini-audit on your client. Your client and liability insurance agent will appreciate these efforts if your client is selected for an audit—and chances are you’ll be glad you took a closer look, too.