An IRS audit has to be one of the most stressful experiences that someone can have.
Do you have problems just finding records from a year or two ago? Just wait until the IRS comes knocking and asks for all your relevant records from several years in the past.
The good news for taxpayers in my home state of Tennessee as well as throughout the United States is that the odds of being audited by the IRS are relatively low–hovering somewhere around 1%, perhaps a bit less.
Of course, your own personal return may make you a more inviting target for an audit than the next person–the IRS has a proprietary system of selecting returns for audit based on your tax return’s DIF score. Essentially, the IRS has a complex algorithim that compares your return with averages in a number of categories to see if you stray and by how much from the average return.
The Tax Court on July 1 decided a case, Hunter v. Commissioner, that also provides a valuable lesson to taxpayers interested in avoiding an IRS audit.
The facts in Hunter are very complicated. In essence, the taxpayers in question entered into a transaction that generated capital losses, which were then used to offset the taxpayers’ significant gains.
The problem according to the IRS, however, was that the transaction that generated the capital losses lacked economic substance. The bottom line in the IRS’s view was that the transaction was entered into for the purpose of saving taxes, not for a valid business reason with economic substance apart from the tax savings purpose.
Keep in mind that a transaction must have economic substance in order to be respected by the IRS for tax purposes.
If you want to avoid an IRS audit or at least reduce your chances of being audited, be wary about entering into any transaction just to save on taxes–each transaction you enter into should have a valid business purpose and have economic substance apart from tax savings.