Category Archives: Audit

Can You Discharge Those Unpaid 1040 Taxes in Bankruptcy?

by Larry Goldsmith, CPA, JD, CFF, MAFF

Last week, I reviewed a new client’s IRS transcript. The client apparently filed his individual income tax returns late and wanted to file bankruptcy to discharge his 1040 tax obligations. I subsequently learned that the IRS filed substitute individual income tax returns on the client’s behalf and issued an income tax deficiency before the income tax returns were filed.

 The question was: if the Internal Revenue Service files a substitute tax return on behalf of the debtor/ taxpayer, before the taxpayer files their own income tax returns would that late tax return be considered eligible for a bankruptcy discharge under Section 523 tax return?

I have to admit that it was my belief at the time that if the late filed tax returns increased the income tax assessment, the late filed tax returns would be dischargeable if the tax returns qualified under the various timing constraints. However, after further research, examining several court cases, I have concluded that if the income tax returns were filed after the IRS had issued a substitute tax return, or issued a deficiency, a bankruptcy discharge is not attainable, even where the debtor subsequently filed an income tax return.

It appears that the bankruptcy courts have not consistently held on issues of discharge where the debtor filed a late tax return prior to the IRS issuing a notice of deficiency. From the Appellate court statements I doubt if the courts would favor the discharge of the late filed income tax returns.

Here are a couple of cases exemplifying the court’s consistency in this matter:

IN RE PAYNE 431 F.3D 1055 (7TH CIR 2005)

The taxpayer failed to file a 1986 tax return, and the IRS subsequently filed a substitute tax return for the debtor. In 1992 the taxpayer filed an offer in compromise that was rejected. The taxpayer filed a Chapter 7 in 1997. The bankruptcy court discharged the 1986 tax debt.

The 7th Circuit Court of Appeals stated that, the substitute tax return and an offer in compromise do not constitute a tax return and therefore the income taxes were not dischargeable.

MALLO V. INTERNAL REVENUE SERVICE

A married couple filing jointly, the Mallos filed their individual income taxes several years after the IRS issued notices of deficiency. Two years after filing the income tax returns the Mallos filed bankruptcy seeking to discharge the income tax obligations.

The Mallo bankruptcy court held that post assessment filings do not constitute tax returns and are therefore excepted from discharge under 523(a)(1).

The Court of Appeals held that tax debt was not dischargeable because, “the filing of a return after an assessment negates an honest and reasonable attempt to comply with tax law”.

The Court of Appeals held that, “if a Form 1040 is filed late, the tax debt is non-dischargeable under 523(a)(1)(b)(i). The court reasoned that a late tax return is not a return as defined by Section 523(a); it does not satisfy applicable filing requirements.

The Court observed that the definition of a filed tax return differs from the IRS’s definition.

The U.S. Supreme Court acknowledged the different interpretations and stated that further review was not warranted, thereby upholding the U.S. Court of Appeals for the Tenth Circuit findings.

My advice after researching this matter? Always file your tax returns in a timely manner.

Questions or comments? E-mail me at larry@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

Larry Goldsmith is an experienced Financial Forensic expert and CPA who investigates and verifies financial income and assets in matrimonial matters. CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. 

Partnership Audits Increase; Other Business Audits Drop In FY 2014

Michael Blitstein, CJBS

Michael Blitstein, CJBS

by Michael W. Blitstein, CPA

Just released IRS audit coverage statistics show a slight increase in audits of partnerships, but decreases in audits of large corporations and S corporations in fiscal year (FY) 2014. For all types of businesses, the FY 2014 audit coverage rate was 0.57%, representing a decline from 0.71% in FY 2012 and 0.61% in FY 2013.

Audits of large corporations experienced the steepest decline, according to the IRS, but must balance its audit work with available resources.

Partnerships

Unlike other categories, audits of partnerships increased in FY 2014. In FY 2013, the audit coverage rate for partnerships was 0.42%. The audit coverage rate for partnerships increased slightly to 0.43% in FY 2014.

Since FY 2007, the audit coverage rate for partnerships has been in the neighborhood of 0.40%, the IRS reported.

Large and small corporations

For large corporations (corporations with assets more than $10 million), the audit coverage rate in FY 2014 was 12.23%, compared to 15.84% in FY 2013 and 17.78% in FY 2012. The FY 2014 audit coverage rate was 0.95% for small corporations (corporations with assets less than $10 million). The rate was unchanged from FY 2013 but reflected a decline from FY 2012, when the audit coverage rate for small corporations was 1.12%.

IRS highlighted the decline in audits of large corporations. Audits for corporations with more than $10 million in assets fell by 20% between FY 2013 and FY 2014.  Audits for large corporations are at the lowest rates in a decade.

S corporations

The IRS also reported that audits of S corporations declined. The audit coverage rate for S corporations in FY 2014 was 0.36%, reflecting a decline from 0.42% in FY 2013, and a decline from 0.48% in FY 2012.

Impact of budget cuts

IRS Commissioner Koskinen attributed the decline in audit coverage to recent cuts in the agency’s budget. The IRS budget has fallen by more than $1.2 billion in the last five years. Like overall IRS staffing, the number of compliance employees who conduct audits has also fallen sharply during this period.

The Consolidated and Further Continuing Appropriations Act, 2015 reduced the agency’s FY 2015 budget by approximately $346 million. President Obama has proposed to fund the IRS at $12.9 billion for FY 2016, reflecting a $2 billion increase over FY 2015. This would help the IRS stop this decline in enforcement efforts and help improve critical taxpayer services, Koskinen predicted. Koskinen is scheduled to testify before House and Senate panels this week about the agency’s FY 2016 budget request.

Michael W. Blitstein, CPA is a partner with the firm of CJBS, LLC, in Northbrook, Illinois. Michael advises his clients on tax, business and retirement planning, developing short and long-term strategic plans designed to achieve success for business owners and their businesses.

He can be reached at michael@cjbs.com

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Tax Audit Red Flags

by Michael W. Blitstein, CPA
The IRS audits only slightly more than 1% of all individual tax returns annually. So why do they pick some returns to investigate and ignore others?  Although there’s no sure way to avoid an IRS audit, you should be aware of the following red flags that could increase your chances of drawing unwanted attention from the IRS.

You Have Foreign Assets…

Stashing money overseas? Then you’re probably well aware that the IRS has been ramping up its efforts to rein in offshore accounts.  Launched in 2009, the agency’s voluntary disclosure program has already raked in more than $5 billion in back taxes, interest and penalties for illegally hiding assets in offshore accounts.

Taxpayers are asked to check a box on Schedule B if they have an ownership interest in foreign accounts. If they then fail to provide information about those assets, it will undoubtedly trigger an audit.

Indicating on your return that you do business in foreign countries or take many trips abroad for work could also raise eyebrows if no foreign assets are reported.

Your Return Has Too Many Zeroes…

While rounding numbers on your tax return to the nearest dollar is okay, rounding to the nearest thousand is not – especially when itemizing deductions like business expenses, unreimbursed employee expenses and job hunting costs.  If you submit figures like $5,000 in auto costs, $2,000 in gas mileage and $4,000 in lodging, it may look like you pulled those numbers out of thin air or inflated them by rounding – since it’s unlikely that every single expense was a perfect multiple of $1,000.

You Have a Home Office…

Just because you do some work on your couch while watching TV doesn’t mean it counts as a home office.

After years of watching people abuse the home office deduction, the IRS is on the look out. In order to avoid being scrutinized, make sure you only claim reasonable expenses – and only those that directly apply to the part of the home used as an office.  Remember, the credit can only be claimed if the home office is your primary place of business and is used exclusively for work. People get into trouble when the IRS suspects they are mixing personal costs with their business costs.

You Forgot Some Income…

For people who earn money from various places, remembering to report every single cent can be difficult. But ‘I forgot’ isn’t a good enough excuse for the IRS.  For any miscellaneous income over $600 you received throughout the year, the company you worked for should send you a Form 1099. If you don’t receive it for some reason – it was mistakenly sent to a previous address, for instance – you can be sure that the IRS will still get it.  You can either request the missing form from the employer or simply report the income without the form. This is why it helps to track your income throughout the year.

Of course, some people earn money that may not get reported on.  Even if the IRS doesn’t know about it, you must report this income as well or you risk the agency finding out.

You Exaggerate Donations…

Even good deeds can spark suspicion at the IRS.  If you report extremely high charitable contributions – especially relative to your income – make sure you have the proof to back it up.  Receipts for cash donations of more than $250 are required in the event the IRS comes knocking.  Donating items gets a little trickier, because it’s common for people to think the items are worth a lot more than someone will actually pay for them. So it’s important to be reasonable with your valuations.

You Own a Money Losing Business…

If you own a business that is reporting losses year after year, the IRS may grow suspicious that it’s actually a hobby.  There’s a rule-of-thumb saying you must have a profit in two [out] of five years – if you don’t have a profit they’re going to look at it as a hobby.  To fend off the IRS, make sure to keep diligent financial records and do little things like have business cards and company letterhead.

You Have a Shady Tax Preparer...

If your tax preparer tries to convince you to claim deductions that sound too good to be true or to report income that doesn’t line up with what you would have reported, watch out.  You want a preparer that will get you the best refund possible – but not if it means breaking the law.

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

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IRS Increases Audit Examinations

by Michael W. Blitstein, CPA 

The Internal Revenue Service has stepped up its examinations in the past year of taxpayers with high adjusted gross income.

The IRS released its 2012 IRS Data Book on March 25th, providing a snapshot of agency activities for the fiscal year. The report describes activities conducted by the IRS between October 1, 2011 and September 30, 2012, and includes information about returns filed, taxes collected, enforcement, taxpayer assistance and the IRS budget and workforce, among others.

The IRS said it examined just under 1 percent of all tax returns filed and about 1 percent of all individual income tax returns during fiscal year 2012.  Overall, in fiscal year 2012, individual income tax returns in higher adjusted gross income (“AGI”) classes were more likely to be examined than returns in lower AGI classes.

The IRS examined about 12.1 percent of the 337,477 tax returns reporting income of $1 million or more, compared to 2.8 percent of those reporting at least $200,000 and under $1 million, and 0.4 percent of those reporting income under $200,000 who didn’t file a Schedule C, E, F or Schedule 2106, and 1.1 percent of those with income under $200,000 and filing Schedule E or Form 2106. Of the 1.5 million individual tax returns examined, nearly 54,000 resulted in additional refunds. In addition, the IRS examined 1.6 percent of corporation income tax returns, excluding S corporation returns, in fiscal 2012.

During fiscal year 2012, the IRS collected almost $2.5 trillion in Federal revenue and processed 237 million returns, of which almost 145 million were filed electronically. Out of the 146 million individual income tax returns filed, almost 81 percent were e-filed. More than 120 million individual income tax return filers received a tax refund, which totaled almost $322.7 billion.

IRS acknowledged that one of the biggest challenges confronting the IRS today is tax refund fraud caused by identity theft. The IRS has more than doubled the number of staff dedicated to preventing refund fraud and assisting taxpayers victimized by identity theft, with more than 3,000 employees working in this area. As a result of these increased efforts, the IRS during fiscal year 2012 was able to prevent the issuance of more than 3 million fraudulent refunds worth more than $20 billion. Despite these efforts, much more work remains on identity theft as well as on overall refund fraud.

The IRS made significant progress last year on international enforcement, specifically in its efforts to combat the practice of illegally hiding assets and income in offshore accounts. They have continued a two-pronged approach: offering a voluntary disclosure program for those who want to come in and get right with the government, while at the same time pursuing tax evaders and the promoters and banks assisting them.

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

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IRS Ramping Up For Increased Tax Audits

by Michael W. Blitstein, CPA 

One of the greatest fears of taxpayers is facing an audit by the Internal Revenue Service.  Many clients we have represented in IRS audits liken the experience to going to war.  There is the mentality of “us vs. them”.  And this mentality is often warranted.  Even though virtually every Federal agency is under budget scrutiny in Washington, the IRS has been provided with additional resources to add personnel to conduct taxpayer audits.

Back in the late 90’s, Congress was very critical of the IRS for aggressive collection tactics used on individual taxpayers.  Staff and budgets cuts followed.  Now, the IRS has been given initiatives to grow.  The 2012 budget calls for a 9% increase in funding.  Administrators are looking to spend $339 million with the goal of raising $1.3 billion from taxpayers. The IRS states that about 84% of taxes are paid voluntarily.  The difference is the gap they aim to reduce.

In 2006, tax returns with $1 million or more of income were audited 5.25% of the time.  By 2010 this rose to 8.36%.  Similar percentage increases exist for taxpayers with lesser income.  Businesses with less than $10 million of assets were audited just 0.32% of the time in 2004.  By 2010, that percentage almost tripled to 0.94%.

Many of these audits will be correspondence audits.  That is, rather than having to go in and meet with an IRS agent, requested information is mailed to the IRS.  Correspondence audits are less expensive for the IRS to conduct and are becoming more frequent.  Of more than 1.6 million audits conducted last year, 78% were correspondence audits.  This represents a 13% rise in audits from 2009, and a 93% increase from 2003.

While the chance of being audited may be minor, taxpayers should be aware that the possibility of selection is increasing. Compliance and documentation are key factors in navigating your way through an audit successfully. Please contact us with any questions you may have regarding your status, or if we may assist you with any audit examination matters. 

CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. E-mail me at michael@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

Should a Not-For-Profit Form an Audit Committee?

by Andrew Lotts, member, CJBS

With the Sarbanes-Oxley Act (SOX) of 2002, there has been limited direct impact on nonprofits, remembering that SOX is law for publicly traded companies only.  However, many forward-thinking not-for-profits are asking themselves what parts of the SOX they should consider enacting as a part of best-practices. In fact, the Attorney Generals of several states have already implemented some Sarbanes-like reforms. Others are still in the study stage.

A recent trend among nonprofits is to adopt an audit committee structure. There are some pros and cons to this: If implemented correctly, an audit committee should provide the Board with a clear, independent voice to address financial matters. It also establishes that the auditors are neither engaged by nor report to management, but rather, the Board, through its audit committee. On the down-side, the committee members will need to devote the time and develop the expertise to effectively monitor increasingly complex financial practices.

Some of the duties of an audit committee are as follows:

  • Engage the auditing firm
  • Review the audit with the auditor
  • Present the audit to the Board
  • Provide an outlet for confidential reporting of any impropriety suspected by an employee with fear of management’s retribution (whistleblowers)
  • Review the appropriateness of major accounting and internal control policies
  • Protection of assets

Some major characteristics of an audit committee:

  • Should have at least one member of the Board (preferably more than one)
  • Should have a least one “expert” in the field on non-profit accounting/auditing (you may consider engaging such an individual if none are available from your volunteer base)
  • Should meet several times a year
  • Staff members normally do not serve on the committee
  • Boards with high turnover may consider longer terms to retain institutional memory

Many nonprofits will find it difficult to populate such a committee with qualified individuals. If you create an audit committee, it has to actually do what it is designed for. Also, members of an audit committee face strong fiduciary responsibilities, though its presence does not diminish those of the Board itself; it’s important to remember that the creation of an audit committee does not absolve the individual directors on the Board from their director responsibilities.

Another alternative to consider is to augment the mission of an already standing finance committee. Such a committee may already possess individuals with the knowledge necessary. If this is the direction you wish to take, the Board would need to pass a resolution empowering the committee to do such work and the committee name should have “audit” in it; for example, “finance and audit committee.” The drawback to this approach is that if the finance committee makes major financial recommendations, the same committee would not be able to independently review these decisions.  However, your existing finance committee is distinct from employee management so there is already a checks and balance system in place to a degree.

The bottom line is that people expect more from audit committees today, and the summary information below provides insight into audit committee leading practices that can help committees meet those expectations.

1. Financial Reporting and Disclosures

Financial reporting disclosure requirements have been steadily increasing for a number of years, in tandem with the complexity of accounting standards. Regulators and financial statement users continue to press companies for more information and to get that information sooner. This environment makes the audit committee’s responsibility to oversee the company’s financial reporting more difficult. The committee must be aware of the financial reporting risks to focus its attention appropriately. And it cannot lose sight of the need to maintain its skepticism.

2. Risk Management and the System of Internal Control

Given how many risks — known and unknown — a company faces, it’s a challenge for a board or audit committee to be assured that the organization is addressing risk appropriately. One of the difficulties facing the audit committee is clearly defining its risk responsibility relative to that of the entire board. While the company’s system of internal control is designed to help mitigate risk, the audit committee focuses particularly on controls relating to financial reporting, fraud, and compliance. Most existing finance committees have a history of handling these matters.

3. Oversight of Management and Internal Audit

The audit committee needs to oversee management while taking care not to step into management’s role. Establishing an effective relationship with management is essential — it allows the committee to effectively monitor the company’s financial reporting practices and evaluate management’s competence. Similarly, the committee relies heavily on internal audit or the external auditors to provide an objective view on how the company is handling a number of key risks, including those relating to financial reporting and compliance. (Traditionally, non publicly traded entities and not-for-profits do not specifically have controls tested as this is typically outside the scope of a financial audit.)

4. Relationship with External Auditors

The audit committee has to select the right external auditors to conduct a quality audit. As part of executing their audit plan, the external auditors provide the audit committee with assurance regarding the company’s financial reporting. Additionally, external auditors are in a unique position to provide unfiltered and unbiased feedback to the committee about management and the company’s processes.

5. What to Do When Things Go Wrong — Financial Statement Errors and Fraud Investigations

At times, breakdowns in financial reporting processes lead to potential errors in previously issued financial statements. Management and the audit committee have to assess whether an error is material and, if it is, take steps to resolve the situation. The situation can become more complex if the error results from fraud.

6. Committee Composition

Composition and leadership are critical in supporting the audit committee’s ability to carry out its responsibilities effectively. The committee needs the right combination of skills and experience. It also needs a chair with the knowledge and commitment to drive the committee’s work.

7. Meetings

To ensure committee meetings run well, the committee needs to have the right agenda and receive the right materials beforehand. The attendees, and how they interact with committee members, also influence the success of meetings. Given how many responsibilities the committee has, it needs to ensure it is meeting often enough and at the right points during the year.

8. Supporting Committee Effectiveness — Charter, Evaluations, Resources, and Training

The audit committee’s charter helps distinguish the committee’s responsibilities from those of the full board of directors. An audit committee that periodically evaluates its performance will be able to identify ways to improve its effectiveness. Orientation training for new members and ongoing development for all members are essential, particularly given the velocity of changes to financial reporting and governance standards.

We have found that maintaining a sub-committee for dealing specifically with auditor level matters and other potentially sensitive areas has been an effective tool for many of our not-for-profit clients.  The rigid audit committee structure, separate charter and additional layer of communication are often just too much to maintain effectively for many of our clients.  The key still gets back to effective communication and efficient dissemination of important information, responsive management and implementation of controls within the organization to ensure successful outcomes.

In general, we find that larger not-for-profits, typically greater than $25 million in gross receipts, with complex programs, multiple sites, and relatively large volumes of transactions have audit committees.  We believe that the relative complexities found at the larger organizations necessitate the use of an audit committee because it enhances communication and strengthens the organizations that have these characteristics.

Once again, having an audit committee is not a requirement for nonprofits, but in today’s marketplace, with its heightened scrutiny, everyone should explore all alternatives to best safeguard the resources they have been entrusted with. This is only a snapshot of some of the considerations involved. To discuss any of these issues or for more information, please feel free to contact me.

Best regards,

Andrew Lotts, CPA
Phone:  (847) 580-5422
E-mail:  mailto:arl@cjbs.com