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How the IRS selects returns for audit, part 3
IRS audits happen. They can be annoying, even nerve-wracking, but understanding how IRS selects returns for audit can help relieve some of that stress.
The IRS has four reasons for selecting returns for audit:
- Statistical analysis
- Missing information from third-party reporting
- Taking a questionable tax position
- Reliable reports raising suspicion
This part discusses the third cause, taking a questionable tax position. A future post will look at reliable reports raising suspicion.
For most individual taxpayers, tax reporting is straightforward: income is reported to you, you qualify for some deductions and credits, and the net result is your balance due or refund.
However, both individuals and businesses have opportunities to report transactions that seem ambiguously covered by tax laws.
Sometimes audit risk isn’t about the math or the documentation. Despite the length and detail of the Internal Revenue Code (the “tax code”), along with the accompanying Treasury Regulations, Revenue Procedures, Revenue Rulings, and decisions in federal court cases, a lot of gray areas still exist.
Cryptocurrency, for example, has opened a new set of gray areas in tax planning and preparation. Consider staking, an alternative form of verification that lets holders of some currencies temporarily contribute tokens in exchange for rewards, usually in the form of more tokens.
From a tax perspective, staking offers two possibilities:
- The rewards are taxed when earned. This matches with how we treat interest or dividend income. (Tax authorities currently do not treat cryptocurrency as currency, but rather as property.)
- The rewards are taxed when sold, converted, exchanged, or otherwise disposed. This matches with how we treat goods or intellectual property produced for sale.
Depending on fluctuations in the value of the tokens, either approach could produce a better tax result. Many cryptocurrencies are worth very little initially, so taxing tokens derived from staking at creation may result in very little taxable income, especially compared with a currency that dramatically increases in value since creation. But that treatment does not match with how we treat other goods or property produced by the holder.
This is just one of the most recent examples of ambiguity in tax law. Many other examples exist as well.
In fact, there are so many plausible yet contentious positions possible that an entire federal judicial system—the US Tax Court—exists just for these questions. (More on options for challenging the IRS in court later.)
Sometimes the IRS wins in judicial cases, but sometimes taxpayers prevail. Despite the opportunities to successfully defend an aggressive tax position, there are rules about supporting such a position and potentially severe penalties for taking a position without sufficient support. (More on these points later.)
Moreover, there are special penalties for tax preparers that help a taxpayer take an egregious position, in addition to the penalties assessed on the taxpayer. This is part of why your tax advisor may seem skittish or less "creative" than you might like. It also helps explain why many preparers have increased their fees over the past few years as new technologies and compliance reporting has made tax return preparation more complex than ever.
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