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Tax Preparer Audit Red Flags

Why the IRS Investigates Preparers

Tax Preparer Audit

Profiling is illegal in criminal court, but it happens all the time in tax court cases. That’s especially true among tax preparer investigations, as T-men usually look for “red flags” to decide which tax prepares to audit.

Some red flags in personal 1040s include even-number deduction claims (e.g. monthly utilities are $200 twelve months out of the year, employee payroll is always $1,000 a month, and so on). These kinds of figures often indicate that either the claim is entirely fabricated or, at the very least, the taxpayer lacks documents necessary to support these claims.

What are some of the red flags that often lead to tax preparer investigations?

Method of Compensation

Many tax preparers charge nothing upfront and take a portion of the refund instead. This setup works well on many levels. It’s attractive to taxpayers, easy for tax preparers to manage, and gives businesses a competitive edge over some other tax preparation firms.

Unfortunately, such arrangements may also attract unwanted attention. The IRS may assume that the tax preparer alters the submitted returns to maximize refunds and therefore maximize his/her own fees. As unfair and untrue as that assumption it, it is also commonplace.

To avoid tax preparer investigations, preparers might consider charging mixed fees, such as a low upfront payment and a lower percentage of the refund. Or, instead of a percentage, charge flat fees that come out of the refunds, so the sizes of the refunds make no difference to the tax preparers.

Avoid Written Guarantees

Sometimes, the compensation-method red flag is more of a yellow flag warning that merits closer attention. If a cursory internet search reveals advertisements that promise or imply big refunds, that’s not good.

Avoid such language like the plague. Small disclaimers at the bottom, such as “each return stands on its on merits,” may keep the business out of trouble with the Federal Trade Commission and other regulators, but they do nothing to break up the gathering storm clouds of tax preparer investigations.

EITC Refunds

Since many tax preparer investigations involve Earned Income Tax Credit fraud, this area is a natural place for auditors to look before they decide to take the case to the next level.

A quick comparison usually suffices. Nationwide, about 19 percent of taxpayers qualify for an EITC refund. The percentage varies significantly by jurisdiction, since for example, number 1 Mississippi had almost a 33 percent EITC rate, and number 50 New Hampshire had just over a 12 percent rate.

There is little that can be done to avoid EITC-based tax preparer investigations, since the filers either qualify or they do not. However, if your firm’s rate is substantially above the state or regional average, and there is at least one other warning sign, expect an inquiry if not a full audit.

The Next Step

If auditors decide that tax preparer investigations are warranted, an IDR (Information Document Request) is usually the next step. In November 2016, the agency issued a directive that limited and clarified the use of IDRs, but they are still powerful and intimidating tools.

At this point, attorney intervention is critical. A tax defense lawyer shows the Service that you are serious about the matter, and that often has a beneficial deterrent effect. The schoolyard sociopath is less likely to accost you for your lunch money if your big brother is nearby. Even if the IRS does persist, an attorney can often get an early idea of the Service’s evidence and theory of the case based on the IDR.

In a nutshell, although it’s impossible to audit-proof your tax preparation business.  There are some steps to take to avoid red flags to reduce the possibility of tax preparer investigations audits.

Venar Ayar, Esq.

Venar Ayar, Esq.

Attorney-at-Law, Master of Laws in Taxation
Principal and founder, Ayar Law

Venar is an award-winning tax attorney ranked as a Top Lawyer in the field of Tax Law. Mr. Ayar has a Master of Laws in Taxation – the highest degree available in tax, held by only a small number of the country’s attorneys.