Travel, entertainment, and business gift deductions often trigger audits for
professionals
Tax preparers are often asked, “What are the chances that I will be audited?”
Statistically, the chance of being audited is quite small. Due to limited resources, the
Internal Revenue Service can examine only a small portion of returns.
While the precise criteria used to determine whether a return is audited is not known,
other than to the IRS, returns are selected by computer formulas. Tax returns are selected
for examinations by using scoring systems such as the “discriminate income
function,” which measures the probability of error. Also used is “total positive
income,” which sums positive income numbers and treats losses as a zero. This method
increases the audit selection of high-income taxpayers with substantial losses. During
processing, a return is screened for different items on the return and a score is
assigned. The higher the score, the higher the probability of a review.
Once the computer has selected a return, the IRS further reviews the return manually to
determine if it warrants an audit. The computer does not read statements or notes that may
be included in the return. A classifier, for example, might determine that an unusual
deduction is sufficiently explained with documentation included with the tax return, such
as a receipt for a large noncash charitable contribution.
Many deductions may “flag” a return for audit, such as large deductions for
travel and entertainment expenses, unallowable deductions (for example, personal credit
card interest), or substantial amounts of expenses in relationship to the income reported.
If a return is selected for audit, a letter is sent to the taxpayer stating the scope
of the examination, which is generally limited to two or three areas of the tax return. At
this point, a taxpayer should seek the help of a tax preparer. A tax preparer can assist
the taxpayer in gathering the documentation requested and then represent the taxpayer,
through a limited power of attorney, before the IRS.
Taxpayers are required to keep accurate and permanent books and records for at least
the period of limitation for that return, or for as long as they may be
“material” for any federal tax purpose. This is never more obvious than when a
return is being audited. Legitimate deductions can and will be disallowed if complete or
proper documentation cannot be produced by the taxpayer. Expenses such as travel and
entertainment, business gifts, vehicles, and computers must be substantiated as to amount,
time and place, and business purpose. The business relationship of the person being
entertained or receiving the gift must also be substantiated for entertainment and gift
expenses.
The following are more detailed examples of deductions that may flag an audit,
particularly if they seem excessive, are not deductible, or do not have a business
purpose. These deductions seem to be the types that trigger audits for professionals.
1) Home office. Deductions are not allowed by taxpayers for any
expenses in using their homes for business purposes, unless the expenses are for a portion
of the home used exclusively on a regular basis as the principal place of business used by
patients in meeting with the taxpayer in the normal course of business. For example, a
home office used for business and personal purposes on an occasional basis—such as
bringing home office paperwork in the evening—would not qualify as a deduction if
such an office exists at a normal place of business.
2) Travel. While business travel is deductible, personal travel is
not.
If a business trip is extended to include vacation travel, only the portion related to
business is deductible. For example, if a 2-day seminar extended to a long weekend, only
the 2 seminar days would be deductible.
Travel expenses are not allowed for a spouse, dependent, or friend included in a
business trip unless the individual is an employee or serves a bona fide business purpose.
Meals and lodging away from home on business cannot be lavish or extravagant.
3) Entertainment, amusement, or recreation. These are allowed as
deductions only if they are directly related to the conduct of a business or are
associated with such business directly before or after a bona fide and substantial
business deduction. Deductions are generally not allowed for entertainment facilities such
as yachts or hunting lodges. Business deductions are not allowed for club dues, such as
social, athletic, luncheon, sporting, airline, and hotel clubs. However, professional or
public-service organizations, such as chiropractic associations or Kiwanis and Rotary
clubs, are deductible.
Food and beverages cannot be extravagant. The amount allowable is generally limited to
50% of the meals and entertainment expenses
4.) Business gifts. Deductions are limited to $25 per recipient per
year.
Fraud or indications of fraud are usually discovered during the course of an
examination. Recommending fraud penalty is a serious matter and demands careful
consideration of the circumstances of each case.
All taxpayers have the right to reduce, avoid, or minimize their taxes by legitimate
means. The distinction between avoidance and evasion is fine One who “avoides does
not conceal or misrepresent, but shapes and preplans events to reduce or eliminate tax
liability, then reports the transaction on the return.
Civil and Criminal Fraud
Civil fraud cases are actions taken by the government to assess the correct tax
and to impose civil penalties in addition to the tax owed. Criminal fraud cases are
punitive actions with penalties of fines and or imprisonment. Civil penalties are assessed
and collected from an administrative standpoint. Criminal penalties are enforced only
through prosecution, and are designed to punish the taxpayer for fraud. One offense may
result in civil and criminal penalties.
The 3-year statute of limitations does not apply in civil fraud cases. Taxes and
penalties may be assessed at any time regardless of the years involved.
The limitations for criminal prosecution—usually 6 years—start from the time
the offense was committed. It is not necessary for criminal prosecution to begin in order
to assess civil penalties.
The major difference between civil and criminal fraud is the degree of proof required.
In criminal cases, the proof must be “beyond a reasonable doubt.”
A lesser degree is required to prove in civil fraud cases.
Three major elements of fraud are: false statement of a material fact, willfully made
with knowledge of the false material fact, and intent to deceive.
In civil fraud cases, the tax liability is assessed against the taxpayer whose return
is involved. In a criminal action, prosecution may be against all people involved. This
includes all corporate officers, bookkeepers, accountants, and attorneys.
To establish tax fraud, two facts must be established:
- that the tax liability was understated, and
- that the understatement was due to deliberate intent to evade taxes.
The first facts that need to be proven are:
- The taxpayer failed to report the correct tax liability;
- The taxpayer understated taxable income; and
- The income is subject to tax that was not reported on the return.
Proof may come as direct evidence not on the return or through indirect measures to
prove the inaccuracy of the return by certain methods of tax-return reconstruction.
The next facts that need to be proven are:
- Deliberate and intentional understatement of tax liability took place. This may be due
to a mistake, reliance of professional advice, or negligence, none of which constitutes
intentional fraud.
- The taxpayer knows that the understatement or misrepresentation was false. This action
constitutes intent and deception. CP
Kenneth Ross, DC, JD, is a former criminal law enforcement officer with 18 years of
experience. He teaches and specializes in tort law, negligence, risk management, medical
records, expert witness, and criminal issues involving practice boundaries. He practices
chiropractic in Orlando, Fla. He can be reached at (866) 225-5055 or via email at backdoc2@prodigy.net.
Debra Gamel, CPA, practices in Daytona Beach, Fla. She can be reached at (386)
760-1299.
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