Dealing with the IRS: Innocent Until Proven Guilty

In our capacity as Certified Public Accountants and Enrolled Agents, our office has had the delightful opportunity to deal with the Internal Revenue Service and the California Franchise Tax Board regarding client notices from taxing authorities.

When a taxpayer receives a letter that states something like, “We have determined that you owe us a bunch of money”, their tendency is to just get out the checkbook and pay the amount the taxing authorities say is due. After all, they are the government, they must be right, and we don’t want to mess with them because they can hurt us with penalties, interest, intimidation, etc.

The interesting thing we notice when our clients bring us such letters, is that quite often the government is wrong. That being said, unless you have good records to show the taxing authority they are wrong, you do owe the tax they assert you owe them.

The taxing authorities’ philosophy is, in essence, you are guilty until you can prove they are wrong, which runs contrary to the basic premise in our court systems that we are innocent until proven guilty. So how do you protect yourself from the often incorrect assertions of the taxing authorities? The best way is to keep good records of your financial transactions.

In an audit, or tax inquiry, if you cannot demonstrate you are right, you are presumed wrong.

It matters not that it is unfair, it only matters that unless you can prove they are wrong, you lose.

What is worse, if they can prove your negligence or disregard for governmental rules and regulations, or if you have substantially understated your income, they have the ability to tack on a penalty equal to 20-percent of the tax you underpaid, so they can charge more interest on the higher balance you owe them. Not very nice is it?

One of the best and easiest ways to shift the burden of proof in income tax matters is to keep good records of the sources of your income and tax deductions. In an audit or examination, the IRS assumes all money passing through your banks or investment accounts is income. So if rich Aunt Martha left you $20,000 when she died or you transferred $5,000 from savings to checking, it would behoove you to document that, otherwise it becomes “income” they will desire to tax. It is not their responsibility to prove the money going through your accounts is not income; that responsibility is yours. If you are prepared, ye shall not fear.

Similarly, keep track of your tax deductible expenses, such as medical expenses, property taxes paid, the deductible portion of car license renewal fees, charitable contributions, union dues, and unreimbursed employee expenses. Keep records for the cost of investments purchased, and anything that may be taxable if you sold it.

For those of you who have businesses, keep your business income and expenses separate from your personal income and expenses. The best way to do this is to keep a separate checking account for your business, and keep a record of transfers between the business and personal accounts. The presumption is that items in the business account are business related, and those in the personal account are personal. If you are audited and you have business and personal items mixed together in one account, the auditor is not going to want to sort them out, and will most likely deny your assertion that the expenses you claim are deductible are legitimate. If you want to be treated as a legitimate business, act like one.

Keep your personal and business expenses separate. An easy way to further substantiate the difference between personal and business expenses is to have separate charge cards for personal and business (if you purchase things on credit), then pay the credit cards out of the appropriate business or personal checking accounts.

If you have personal and business expenses combined on one credit card, or paid out of one combined checking account, you are placing the burden of proof on yourself to prove the legitimacy of the business expense. If you consistently keep the business and personal separated and can show it, you have demonstrated intent to comply and it is much more likely an auditor will focus on the business account and not worry about going through your personal items.