Red Flags That Increase IRS Tax Return Audits
What Can Trigger IRS Audit for Income Tax & Reporting: There’s nothing fun about receiving an audit notice from the Internal Revenue Service. Most of the time, it is not really that bad and can be resolved without much issue. The water starts to get a bit murkier when the flagging involves international and offshore tax-related matters… not that there is anything inherently evil about noncompliance, but the penalties can be significant. Oftentimes, penalties involving issues such as IRS Form 3520, 3520-A, and 5471 are not based on unreported income but rather just the non-filing of the form. Let’s review the basics of What Can Trigger IRS Audit for Income Tax & Reporting.
Common IRS Audit Triggers to Avoid
Let’s go through some common IRS Audit Triggers, and specifically five common reasons why a tax return may be audited for international offshore-related purposes:
8938 FATCA Reporting Does Not Match FFI Records
FATCA is the Foreign Account Tax Compliance Act. More than 110 different countries and over 300,000 Foreign Financial Institutions have agreed to reciprocal reporting with the United States. For US Persons filing 1040 tax returns, they report their foreign asset values on Form 8938. Sometimes, the Maximum Account Value reported by the taxpayer on Form 8938 does not match the financial information provided by the Foreign Financial Institution. This may lead to the Internal Revenue Service issuing a soft letter to the taxpayer asking them to resolve the issue or clarify the discrepancies in the balances.
Income was Reported under FATCA
In addition to reporting account values, Foreign Financial Institutions also report whether there was any income associated with the accounts. Sometimes, the income that is associated with the reported account might be tax-exempt in the foreign country — or taxes were already withheld at source in the foreign country, so the taxpayer did not think they had to also include that information on their US tax return. This may also lead to a soft letter or other IRS notice to the taxpayer asking them to resolve or clarify the discrepancy.
Only One Joint Account Holder Reported
Sometimes, a taxpayer will simply not be aware that they are required to disclose certain foreign account information to the IRS. In a not uncommon situation, siblings or other family members might jointly own an account — or one of the family members may simply be a signatory on the account but has no financial interest. For FBAR, a person must report the account information if they are an owner, co-owner, or even merely just a signatory. If only one person reports but other family members or other account holders do not report, it may lead to an audit or inquiry from the IRS.
Foreign Tax Credit
This is a very common IRS audit trigger. Depending on the amount of the foreign tax credit, some taxpayers may be subject to audit even though there is literally nothing incorrect about their IRS Form 1116. Taxpayers who use more than $50,000 of foreign tax credit in a single year almost automatically have their tax returns go to the “Exam Unit.” This is something additional to keep in mind for Taxpayers who submit to one of the offshore streamlined programs. There is some bad information out there about who gets audited and when, but if a US taxpayer submits to the Streamlined Program and has more than $50,000 in foreign tax credits, there is a good possibility that they may be audited for the foreign tax credit — which may further lead to questions about the submission in general.
Incomplete Reasonable Cause Statement
This is also a very common IRS audit trigger. Many statutes involving penalties include a statement that the taxpayer is not subject to penalties if they can show Reasonable Cause and not Willful Neglect. Reasonable Cause Statements should be a comprehensive and persuasive statement as to why a penalty should not be issued. Sometimes, a Taxpayer or their Tax Representative will simply write a Reasonable Cause sentence or two on an amended return — which is not sufficient to provide Reasonable Cause existed. This may lead to the tax return being audited or the taxpayer otherwise being contacted by the IRS for further exam purposes.
Avoiding IRS Audit Triggers for Income Tax & Reporting
While the chance of audit or examination is not high, each year numerous taxpayers are contacted by the Internal Revenue Service for either an audit, examination, or other inquiry. When the matter involves international and offshore tax-related matters, significant penalties may be at issue so it is important to try to handle the matter as effectively and expeditiously as possible.
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