Tax Law: Individual
Individuals who earn a minimum level of income are taxed on that income each year by both the federal government and by the state. The laws upon which those taxes are based are too complex for this discussion. Instead, we'll focus on the tax area where experienced lawyers are a must: income tax audits.
Tax planning. The goal of any taxpayer's tax planning approach is to pay as little tax as possible, within the rules and limits allowed by law. There are several approaches. One approach is to reduce the amount of income that is subject to tax. Another is to qualify for the lowest possible tax rate for the income that is subject to tax. A third is to reduce the taxes owed by claiming tax credits. The fourth is to manipulate when the tax liability will arise and when it must be paid to gain the maximum tax advantage.
In any event, while one goal is to avoid taxes as much as possible, surely another is to avoid being audited. Even those who have done nothing wrong have found the process to be burdensome and time consuming. Unfortunately, however, audits do occur. If you receive notice that you're being audited, the first step should be to contact an attorney experienced in tax audits.
Audits. No one outside of the IRS really knows all the factors that it uses to decide who to audit in given year. In 2002, for example, following media reports that a disproportionate number of audits were of low- income earners, the IRS shifted approaches and promised to go after a disproportionate number of high- income earners.
In deciding which returns to audit, the IRS looks for certain discrepancies and what are referred to as red flags. Red flags are areas where the IRS believes a significant amount of abuse has been taking place, and thus it targets returns that take advantage of that area. For example, the IRS at one point believed that significant numbers of taxpayers were abusing the earned income tax credit, and it began red-flagging returns that claimed an earned income tax credit. Because low-income earners use the earned income tax credit, a disproportionate number of their returns were audited, which explains the media reports mentioned above.
Among other standard red flags that the IRS looks for are particularly unusual deductions and significant travel and entertainment expenses written off by home-owned business that doesn't make any money. The discrepancies that the IRS looks for include differences between the amount reported on a W-2 and what appears on your tax return; math errors, which are far more common than you might imagine; and incorrect social security numbers for dependents.
A second method the IRS uses is picking returns completely at random, which means that a taxpayer could be audited for no reason at all. Because some auditing is entirely at random, a taxpayer shouldn't necessarily conclude that an audit notice means that the IRS thinks the return is in error. The IRS uses random selection to keep taxpayers honest - those who may be tempted to cheat in an area that the IRS hasn't red-flagged know that they still might get caught.
Procedure. The process begins with a letter to the taxpayer from the IRS. Contrary to popular belief, not all audits involve a personal visit from an IRS agent. Some audits are resolved over the phone. If the audit is not resolved over the phone, the next step is an audit meeting between the taxpayer and the IRS agent.
The IRS cannot audit a return more than three years old. Under certain conditions, it can demand records up to six years old, but it cannot audit a return after three years. Thus, a taxpayer can dispose of tax records that more than three years old, unless they might affect a future return, in which case they could be demanded as part of a later audit. For example, if a taxpayer intends to receive a gain at some from the sale of real estate, the records should be kept until the gain is reported on a tax return.
Burden of proof. The burden of proof in a tax audit is on the taxpayer. If the IRS challenges something on a tax return, the taxpayer must prove that what is being challenged is justified, which is why keeping good records is so important.
Taxpayer rights. The taxpayer has the right to be told what the IRS believes is in error in the return prior to the audit meeting. The taxpayer has the right to bring someone to the audit with him or her, usually the accountant who prepared the return or an attorney. The taxpayer has the right to record the audit, but the taxpayer must inform the IRS at least 10 days in advance. The taxpayer has the right to have any confidential information disclosed to the IRS during the audit kept private. The IRS, however, is permitted to disclose such information in certain situations, such as where the IRS believes criminal conduct has occurred and wants to refer the case to the Justice Department. Whenever the IRS requests information, the taxpayer has the right to be told why.
Defenses. A proper defense to the IRS's claim that the return is in error is that the taxpayer was acting on advice from the IRS. The burden, however, is on the taxpayer to verify the defense with written records of any phone conversations with IRS agents or other proof. Another defense, of course, is to prove that the IRS is wrong, which does happen. Again, the burden is on the taxpayer to prove that the IRS was wrong.
Options. Assuming that neither of those defenses is successful, the IRS will send the taxpayer a letter that outlines the IRS determination of how much is owed by the taxpayer. The taxpayer has 30 days to respond. At this point, the taxpayer has several choices. One option is to admit error and pay the difference between what the taxpayer paid and what the IRS said was owed, plus any penalties and interest.
A second option is to do nothing, which will generate a second letter from the IRS called a notice of deficiency. The notice of deficiency gives the taxpayer 90 days to settle up or file suit against the IRS. If the taxpayer believes that the IRS claims are correct, it is in his or her best interest to pay up as early as possible because interest and penalties continue to accumulate.
A third option is to file an appeal with the IRS. An IRS appeals officer will hear the appeal. This option is quicker and much cheaper than filing an appeal with a federal court.
If, however, the taxpayer believes that he or she is right, and doesn't believe that IRS internal appeals will be worth the time, the taxpayer can file suit in federal court. An example of where a federal suit might be appropriate is where the taxpayer and the IRS disagree over an interpretation of one of the tax laws. If the IRS has one interpretation of the statute, and the taxpayer believes that they are wrong, internal appeals probably won't be fruitful.
There are several different federal courts that the taxpayer could file suit in. The U.S. District Court, the U.S. Tax Court, and the U.S. Claims Court are all possible choices. A taxpayer wanting to file suit should discuss the options with an attorney experienced in tax appeals.
State tax disputes. Disputes between taxpayers and the state of Illinois are relatively rare because the state tax system is so much simpler than the federal system.