IRS Audit Red Flags: A Rebuttal of Robert Flach

IRS Audit Red Flags: A Rebuttal of Robert Flach

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Red Flagtransitive verb red-flagged – flagged′ – red-flagging – flag′·ging – “to mark, designate, or otherwise call attention to as being risky, unsuitable, etc.” 

– Webster’s New World College Dictionary –

Robert Flach of The Wandering Tax Pro blog took exception to my blog post titled 5 Slam Dunk IRS Audit Red Flags.

Here is my response to Robert’s counter argument titled Red Flags? .

The Existence of a Red Flag Deduction Doesn’t Mean a Taxpayer Will Be “Automatically Audited”

Robert begins by saying,

I think Pete is somewhat misleading in his post. When he refers to these items as “red flags” I do not think that it is true that anyone who claims one of these items on their Form 1040 will automatically be audited – or even that their existence on a tax return will substantially increase the chance of an audit (with a possible exception discussed below). (Emphasis Added)

I did not say nor did I imply in any way that a taxpayer would “automatically be audited” if he or she claimed one of the 5 deduction items I mentioned.
 
I merely said that the claiming of any one of these deductions would generate greater IRS scrutiny and increase a taxpayer’s chances of being audited. 
 
I thought I had made it clear in my original post that red flags generally arise only after the IRS has assigned a DIF score to a return and sent it to a regional examiner for further scrutiny. 
 

Here’s what I actually said:

Because in any given year the IRS is able to select for audit only a small percentage of tax returns, it employs a sophisticated system for choosing which returns to examine and which returns to accept as filed. The IRS assigns a numeric value to each tax return known as a DIF score. Returns with a DIF score higher than a pre-specified number are flagged and sent to IRS regional examiners for further review and analysis. The IRS examiners are trained to look for tax return items that indicate a high probability of error or fraud.
IRS examiners quickly scan the returns assigned to them looking for high risk areas. These high risk areas are called “red flags.”
 
(See the definition of “red flag” at the top of the page)
 
Greater Scrutiny of a Deduction Means a Greater Chance of Audit
 

Robert then says,

The mere fact that you claim a deduction for employee business expenses will not increase your chance of being audited.

This is an entirely false and dangerous statement.
 
The Employee Business Expense is one of the most frequently abused deductions (especially by unscrupulous preparers) and for that reason alone the IRS gives it greater scrutiny.
 
And greater scrutiny means a higher chance of audit.
 
Contrary to what Robert says, the mere existence of a job expense deduction will, in fact, increase a taxpayer’s chances of being audited because it does, in fact, get heightened IRS attention.
 

And the same holds true for the other items listed in my original post:

  • A tax return with rental losses is more likely to be audited than one without them.
  • A tax return with job expenses is more likely to be audited than one without them.
  • A tax return with excess Schedule C losses is more likely to be audited than one without them.
  • A tax return with a home office deduction is more likely to be audited than one without one.
  • A tax return with a disproportionately large charitable contribution deduction is more likely to be audited than one without one. 
Of course, it is true that enhanced IRS attention won’t guarantee an audit.
 
Managing Red Flags is a Means of Risk Management
 
When we talk about audit red flags we are merely talking about risk management and when we talk about risk management we are simply talking about statistical probablities i.e. what is more or less likely given a particular set of facts.
 
What I am suggesting is that taxpayers (and their tax preparers) weigh the benefit of taking a red flag deduction against the cost of the increased risk of IRS scrutiny.
 
To the extent Robert is saying that all deductions and losses are equal in the eyes of the IRS, I respectfully and emphatically disagree.
 
I believe it is a grevious mistake for a tax preparer not to tell his client that the claiming of certain types of deductions may result in greater IRS scrutiny and, consequently, greater risk of audit.
 
The taxpayer has the right to decide whether the risk of heightened scrutiny is worth the tax savings that will inure as a result of claiming the red flag deduction.
 
Some taxpayers will want to take the risk, others will not.
 
It’s the taxpayer’s not the preparer’s call.
 
Robert Disagrees with My Advice for Reducing the Risk Associated with the Claiming of Red Flag Deductions
 
Robert also takes exception to my advice to taxpayers and tax preparers who do decide to take a red flag deduction or loss: 
 

Pete provides the following “final thoughts” for those with potential “red flags” –.

If you do decide to take one or more of the above deductions, there are several things you can do to dilute their red flag status.

1. Timely file your return;

2. Use a recognized software program to prepare and print your return;

3. File the return electronically;

4. Have a respected CPA, tax lawyer or IRS Enrolled Agent sign your return as tax preparer; and

5. Attach explanatory statements to your return where necessary

I do not agree with most of these thoughts.

On more than one occasion in his blog Robert has implied that a CPA tax preparer has an ulterior and self-interested motive to promote the not so novel idea that CPAs tend (not an absolute, Robert) to be more qualified than non-CPAs in the accurate preparation of tax returns.

In the following example (one of several I could have chosen) Robert questions the motives of one Martin S. Kaplan, CPA for having the unmitigated temerity to advise taxpayers to choose tax preparers who are either CPAs, tax lawyers or IRS Enrolled Agents:

[J]ust because a person has the initials CPA after his name does not mean that he is an expert when it comes to federal and state income taxes.

You will notice the initials after Kaplan’s name. (Emphasis Added)

And here’s a comment Robert left on a post I wrote titled 59 Tips for the Self-Employed in which I listed as #1 “Incorporate:”

No disrespect meant, Pete, but I am not surprised that a lawyer would list “incorporate” as #1. As a general rule lawyers often get a huge fee for having their secretary type up some proforma papers and selling a corporate “kit”. (Emphasis Added)

So I trust readers will forgive me if before I address Robert’s thoughts about my “final thoughts” I note that both Robert and I come to this debate with built-in biases:

Robert reserves his most passionate comments for two of my observations: 1) that tax returns signed by a CPA, tax lawyer or IRS Enrolled Agent are less likely to be closely scrutinized by the IRS than those that are self-prepared or prepared by a non-licensed preparer (like Robert); and 2) that a computer generated return is less likely to be flagged for audit than a manually prepared return (like the ones Robert has been filing for 37 years).

These are obvious and indisputable facts. A dash of common sense and a dollop of research reveals this to be the case yet Robert still chooses to take exception to their mere utterance.

Why?

I’ll let you decide the answer to that question.

Now let’s address Robert’s specific points:

1. Timely file your return 

Robert agrees with me on this one (although I suspect for different reasons) so we’ll leave it alone.
 
2. Use a recognized software program to prepare and print your return
 
It must come as a shock to IRS examiners to see a handwritten tax return prepared and signed by an experienced tax preparer.
 
I know of no one (other than Robert) who would intimate that using a computer software program makes tax preparation less reliable and less efficient.
 
Of course, everyone knows the opposite is true.
 
And everyone includes the IRS.
 
We are in the 21st century and to propose (apparently with an uncrooked face) that a computer generated return receives the same level of IRS scrutiny that a manually prepared return receives is a bit like suggesting that a job application chiseled in stone receives the same consideration as a job application filed electronically.
 
That parrot won’t talk.
 
It is common knowledge that sloppy returns are more likely to be audited than neatly prepared, computer generated returns.
 
Robert may not like this fact, but it is, nevertheless, a fact.
 
And it makes perfect sense.
 
The IRS rightly has long recognized that the sloppier a return is the more likely it is that the preparer was lax when he prepared it.
 
Common sense and experience tells us that hasty or negligent preparation increases the chances of error.
 
Again, it is important to remember that we are talking about red flags that are raised after the returns are assigned DIF scores and sent to a regional examiner for hands-on review.
 
Sloppy recordkeeping has always been a sufficient reason for IRS examiners to expand their audits into other tax years.
 
Is it not reasonable, then, for the IRS to assume that a tax return that is prepared manually is more likely to contain errors than is one that is prepared by computer?
 
Why, of course it is.
 
A return containing a red flag deduction that has been prepared manually is more likely to garner examiner attention than is an identical return that has been prepared by computer.
 
The veracity of this statement is in no way diminished by the fact that some competent preparers do not use a computer software program to prepare their client’s tax returns.
 
3. File the return electronically
 
IRS statistics show that tax returns filed electronically are generally more accurate than are paper returns.
 
Consequently, it is reasonable to assume that they receive less scrutiny.
 
This does not mean electronic returns aren’t scrutinized, it merely means that an IRS examiner, all other things being equal, is less likely to select an electronically filed return for audit than he is a hard copy return.
 
A return that contains a red flag deduction and has been filed electronically is less likely to garner examiner attention than is a return that contains a red flag deduction and has been filed by mail.
 
4. Have a respected CPA, tax lawyer, IRS Enrolled Agent sign your return as tax preparer 
 

Robert says,

[T]he IRS knows full well that there are incompetent and unethical CPAs, lawyers, and EAs, just as there are incompetent and unethical “unenrolled” preparers. The IRS does not say, “If the return was prepared by a CPA it must be accurate”. That is utterly ridiculous.

Robert has misquoted me so often that I am beginning to suspect him of moonlighting for the National Enquirer.
 
I did not come close to saying that the IRS considers returns prepared by CPAs to be presumptively accurate.
 
I did, however, suggest that, all other things being equal, the IRS is and should be more suspect of returns prepared by unlicensed preparers than those prepared by CPAs, tax lawyers and IRS Enrolled Agents.
 
Given the choice to audit one of two identical returns, one self-prepared or prepared by a non-licensed preparer, the other prepared by a licensed preparer, the IRS will always choose to audit the former.
 
Naturally.
 
In short, while there are some excellent non-licensed preparers out there (and I believe Robert to be one of them), statistical probability says that it is more likely that a non-licensed preparer will make preparation errors than a licensed one.
 
It doesn’t take a human genome scientist to know that the odds are better that a return will be accurately prepared by someone who has more training in tax law than by someone who has less training in tax law. 
 
IRS has published statistics that show that tax returns that are prepared by licensed tax preparers versus those that are self-prepared or prepared by unlicensed tax preparers contain fewer errors and mistakes.
 
Finally, when an IRS examiner is reviewing a DIF scored return to determine whether or not to select it for audit, he is much more likely, all other things being equal, to select for audit a return that is not prepared by a a CPA, tax lawyer, or IRS Enrolled Agent than one that is self-prepared or prepared by a non-licensed preparer.
 
Again, this is just common sense.
 
Incidentally, Robert himself recognizes that there is a qualitative difference between returns prepared by licensed tax pros and those prepared by unlicensed preparers. He has been a very vocal proponent of the IRS’s implementation of a licensing regime for otherwise unlicensed preparers. 
 

5. Attach explanatory statements to your return where necessary 

Robert and I generally agree that the attachment of an explanatory statement should be made on a case by case basis and that no hard and fast rule should be applied to all circumstances and all returns that contain a red flag deduction item.

About Peter Pappas

Peter is a tax attorney and certified public acccountant with over 20 years experience helping taxpayers resolve their IRS and state tax problems.

He has represented thousands of taxpayers who have been experiencing difficulty dealing with the Internal Revenue Service or State tax officials.

He is a member of the American Association of Attorney-Certified Public Accountants, the Florida Bar Association and The Florida Institute of Certified Public Accountants and is admitted to practice before the United States Tax Court, the United States Supreme Court, U.S. District Courts - Middle District of Florida

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Comments

  1. Are the “5 Reg Flags” more folklore or has the IRS issued statements identifying these red flags?

  2. David,

    Thanks for visiting.

    It’s not folklore.

    These are areas that the IRS has identified as being historically rife with abuse, therefore, it follows that IRS examiners would more closely scrutinize them.