Filled with important IRS websites, state hot lines, and more than a thousand insider secrets, this widely acclaimed book--a Business Week bestseller--reveals critical strategies that the best CPAs use for their clients to file shrewd, legal, money-saving returns. With tax laws constantly changing and existing regulations hidden in voluminous tax codes, businesses and individuals in every income bracket need expert advice that cuts through IRS bureaucracy and prevents taxpayer horror stories. In this completely updated version, the authors explain the latest IRS targets and weapons, how to work with the IRS personality, and the thirty-three biggest misconceptions taxpayers have about their returns, from IRAs, refunds, gifts, and inheritances to audit selection and more. There's also brand-new information on home-office deductions and surefire ways to reduce penalties.

Martin S. Kaplan has been a certified public accountant for more than thirty years and is a member of Geller, Marzano & Company, CPAs, P.C. The firm performs audit and accounting work, represents clients in IRS matters, and focuses on financial and tax-planning opportunities. As president of Naomi Weiss Communications, Naomi Weiss writes fiction and nonfiction on a broad range of subjects. Ask Martin S. Kaplan a tax question at www.irsmaven.com

Acknowledgments
Why Every Taxpayer Must Read This Book
CPAs Grade Clients
The IRS Personality: Playing It to Your Advantage
Events That Shaped the IRS Personality
Never Forget!Acknowledging Dedicated IRS Personnel
Who Runs the Show: What You're Up Against
The Image
What It Looks Like from the Inside Out
The Organization
What You Need to Know about the Examination Division
What You Need to Know about the Collection Division
What You Need to Know about the Criminal Investigation Division
What You Need to Know about the Taxpayer Services Division
IRS People: Whom You Need to Know
What They're Really Like
How to Work with Them
Standard Operating Procedures
The IRS Chain of Command
Who Runs the Show?
The Examination Division
The Collection Division
The Criminal Investigation Division
The Upper Echelons
Offering a Bribe-What Are the Consequences?
Standard Operating Procedures
Neutralizing the IRS's Power
The IRS Power Base
Power from Information Resources
Power from the IRS's Unique Legal Standing
Power from Its Unique Role as a Law Enforcement Agency
Power from Its Unique Legislation-Creating Authority
Power to Make Mistakes without Consequences
Power from the Freedom to Do What It Wants
Why Does This Continue?
IRS Technology: What Works, What Doesn't Work
The Processing Pipeline
The Nonprocessing Pipeline
The Rest of the Process
Where the IRS Technology Works
Where Mistakes Are Made in the IRS Matching Program
Where the IRS Technology Falls Short on the Income Side
Where the IRS Technology Falls Short-Mortgage Interest and Real Estate Tax
Where the IRS Technology Falls Short-Nonfilers and Underreporters
Where the IRS Technology Falls Short-Lack of Reporting Requirements for Corporations
Where the IRS Technology Falls Short-The Audit Level
Technology Overhaul a Fiasco-Still
IRS Targets and What to Do If You're One of Them
Are You in the Line of Fire?
Target: The Self-Employed
Target: Cash-Intensive Businesses
Target: Industries in the Market Segment Specialization Program
Target: Nonfilers
Target: Tax Cheaters-Omission of Income
Target: Tax Delinquents and Tax Scam Artists
How to Completely Avoid an Audit
Don't Fear Audit Statistics
Audits at an All-Time Low."Live" Audits Are Aimed at Corporations
Audits of Estate and Gift Tax Returns
How to Prevent Audit Problems Before They Occur
How Long Should Taxpayers Keep Records?
How to Completely Avoid an Audit
Small Business Corporations (S Corporations)
Limited Liability Companies and Partnerships
Partnerships
Business Ventures and the Hobby Loss Rule
Businesses That Include Merchandise Inventory
Securing a Tax-Advantaged Life
The Twenty Greatest Taxpayer Misconceptions
How to Hold On to More Money: Overlooked Credits and Deductions
Selling Securities from a Dividend Reinvestment Plan
Identifying Specific Securities That Are Sold
Unamortized Points on a Home Mortgage
Deductible Interest on a Home Equity Loan
Unused Losses, Expenses, and Credits
Self-Employed Deduction for Health Insurance
Charitable Donations-Securities
Charitable Donations-Household Items
Social Security Tax Overpayments
Job-Hunting Expenses
State Income Tax Deductions
Parental or Grandparental Support
Federal Income Tax Withheld on Form 1099
Classroom Expenses for Teachers
Ten Ground Rules Never to Break to Win with the IRS
Rule
Always Report Income on Your Tax Return That Is Being R
Table of Contents provided by Publisher. All Rights Reserved.

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Why Every Taxpayer Must Read This Book

Welcome to the year 2000. The World Wide Web. Cell phones. E-mail. Eight point four gigabyte hard drives. Genetic engineering. Cloning. Viagra. Capabilities unheard of even one year ago abound.

There's a new IRS commissioner, and a fresh, spiffy vision for reorganizing the IRS has been set in motion. But when it comes to paying taxes and dealing with the IRS, what really has changed thus far?

Each year hundreds of reputable books are written about taxes, audits, and the Internal Revenue Service (IRS). No-nonsense, definitive, and powerful, the titles practically scream out ways that we can deal with the IRS: Fight, Win, Battle, Negotiate. Words such as The Only or The Best followed by Audit, Tax Forms, Small Business, or Corporate Tax Guide Book You'll Ever Need appear more than enough to guarantee results. Worried about the IRS, or in doubt about your personal tax situation? The confidence and warm cozy feelings titles such as these bring give a clear and unmistakable message to the taxpaying public: "Buy me," these books say, "and all of your tax problems will be resolved." So each year thousands buy these books, or select them off library shelves, hoping to discover the secret to keeping their tax payments low and their returns away from the scrutiny of the IRS.

Unfortunately, the information taxpayers really need to satisfy these goals rarely, if ever, surfaces. No matter how much information taxpayers read, hear, or research on the subject, they still remain easy targets for the IRS. In the IRS ballpark, despite living in a megatechnology environment, and with periodic promises about a more consumer-oriented IRS, some things have changed, but very little.

Isn't anyone aware of the self-generating scam that keeps taxpayers in semidarkness and the IRS operating the way it always has? There is a very specific group of people who are aware. They just aren't talking.

The time has come to deal with some clear-cut, shocking truths about what's behind the unsettling phenomenon that perpetually keeps blinders on the taxpaying public. This requires exploring the overall phenomenon, and then examining why those in the know have remained silent.

First the scam. Let's face facts: the IRS has a reputation for being all-knowing, all-powerful, and ruthless (many would say vicious). It is seen to have extensive manpower and technological resources, and the law is on its side. Without actually knowing what the IRS is and how the organization really works-or, perhaps more important, how it doesn't work-the public remains in the no-holds-barred grip of the IRS's reputation as the Big Bad Wolf.

Millions of taxpayers live with the fear that one day an IRS agent will single out an item from their tax return, decide an audit is in order, and come after them. Fingering alleged cheaters and exacting retribution is, after all, the acknowledgment IRS agents crave. In fact, the IRS is often referred to as an agency out of control-and with good reason. Once it selects its culprits, it chooses the punishment and proceeds to administer it with very little containment from any other governmental or nongovernmental agencies. So it's really not surprising that most taxpayers envision the IRS as harassing and abusive, using its power in an uncaring, even brutal way to possibly destroy their careers and families.

Taxpayers are consistently so fearful of dealing with the IRS that they rank it as an event as traumatic as divorce or having their house burn down. This paranoia shows how enormously successful the IRS has been in creating its all-powerful-and-untouchable image. By sustaining these fears, the IRS maintains a status quo that actually prevents taxpayers from

*        Questioning how much of the IRS's reputation is actually true.

*        Considering why a never-ending body of information, designed by well-meaning authors and "tax experts" to help them pay less in taxes and better manage the demands of the IRS, never genuinely helps them accomplish those goals.
Now let's talk about those who know exactly what is going on and find out why they aren't talking. Any good Certified Public Accountant (CPA) or tax professional knows how to beat the IRS at its own game. But an unwritten law among tax professionals has traditionally prevented this vital information from being revealed publicly.

What is this law based on? It's based on tax professionals' healthy fear that the IRS will turn against them.

When filling out their clients' tax returns, tax professionals use information they have gained as experts in their field. But these very same professionals do not traditionally disclose, in anything resembling a public forum, information in three crucial areas that can make a huge difference in the lives of the millions of taxpayers who aren't their clients:

1. What the IRS really is and how it thinks, responds, and operates, or, more precisely, doesn't operate.

2. Endless loopholes in our tax laws that can be used in the preparation of an individual tax return.

3. How both of these can be used consistently to benefit taxpayers.

Tax professionals have made it a practice NOT to reveal such information-and with good reason: They've seen firsthand how people can be destroyed by both warranted and unwarranted IRS attacks. Why would CPAs, or any professionals in the tax field, put their lives, families, careers, and futures on the line? The answer to this question has traditionally prevented tax professionals from publicly explaining why the right kind of information never gets to the taxpaying public. It also keeps them from revealing that information on a broad scale.

So, to prevent an all-out personal conflagration and probably endless repercussions, tax professionals continue to offer whitewashed material that promises to tell taxpayers how they can disappear from the IRS's view. In fact, much of this information is correct and does work. But it is not the whole story. Too much information is left out, and no one knows this better than the authors themselves.

After almost 34 years as a CPA, I have consistently watched how the IRS can financially ruin all kinds of people: rich, middle-class, the average working family-people exactly like you.

In mid-1997 a fascinating case involving IRS wrongdoing hit the newspapers. It had begun simply enough in 1993.

Mrs. Carole Word accompanied her son to an audit of their family business, three children's clothing stores in Colorado Springs. Because the audit was going poorly, Mrs. Ward spoke up to the female IRS revenue agent, saying, "Honey, from what I can see of your accounting skills, the country would be better served if you were dishing up chicken-fried steak on the interstate in West Texas, with all that clunky jewelry and big hair."

Four weeks later, IRS revenue agents raided the family's stores, padlocked all three of them, and posted notices in the windows that implied that Mrs. Ward, who was 49, was a drug smuggler. The IRS then imposed a tax bill in the amount of $324,000.

Mrs. Ward hired two attorneys and sought press coverage to publicize her plight. The IRS countered with a publicity campaign that included sending a letter to the editor of the local newspaper giving details of Ward's case and providing a fact sheet about it to the TV show Inside Edition.

Three months after the raid, the government settled the tax dispute for $3,485, but a week later the IRS district director appeared on a radio show detailing the IRS's position against Ward but failing to mention that the bill had already been settled for little more than 1 percent of the original amount.

At this point, Ward sued the IRS for disclosing confidential information from her tax return. Until the case was brought to trial, Ward's daughter had to quit high school because the IRS statements led students to believe the family was engaged in drug smuggling. The family went from having no debts at the time of the raid to owing $75,000. The lease on one of the stores was lost. And only two thirds of the goods and equipment seized in the raid were returned, much of that badly damaged.

During the nine-day trial the IRS and the Justice Department, which defended the lawsuit, denied any wrongdoing. In a harshly worded 17-page opinion, Judge William Downes of the federal district court in Denver found that one of the IRS agents had been "grossly negligent," had acted with "reckless disregard" for the law, and had made three false statements in a sworn declaration. The judge awarded Mrs. Ward $4,000 in damages for improper disclosures, $75,000 in damages for the emotional distress the IRS caused her to suffer, and $250,000 in punitive damages, giving "notice to the IRS that reprehensible abuse of authority by one of its employees cannot and will not be tolerated." The judge also criticized the IRS district director who had made the radio appearance.

"I never should have spoken condescendingly," Ward later said, "but what they did to me for mouthing off was criminal."

Never forget-the amount awarded by the judge, and the fact that such a case was settled in the taxpayer's favor, comes because of almost 20 years of private citizens fighting for retribution in thousands of similar cases but receiving nothing except bureaucratic doors slammed in their faces. The government and the Justice Department have just begun to accept some limit, if only slight, upon the unbridled power of the IRS over the rights of taxpayers.

Here's another case that demonstrates the blatant and unmitigated arrogance of the IRS.

A high-level executive in a nationally known insurance company was the subject of an extensive IRS investigation. Allegedly he owed $3,500. The taxpayer agreed to admit to tax evasion, and the IRS promised, in a written agreement, to keep the matter out of the public eye. When the executive informed his employer of his tax problem, he was told that the one thing he must avoid was a public scandal. Since the agreement with the IRS seemed to preclude this, the matter should have ended there. But it didn't. About three months into the investigation, the IRS issued to more than 21 sources news releases that included the taxpayer's name, his address, and the name of his employer. The taxpayer promptly lost his job, had to move out of town, and never again regained his prominent position.

Why was the IRS so interested in pursuing a case in which the tax liability was less than $3,500? The answer was revealed about two years later at a trial resulting from a suit the executive brought against the IRS. Here's what really happened:

Initially, when the taxpayer found out that the IRS was investigating him, he asked the agent assigned to the case what he had done wrong. He was told that his wife had made some bookkeeping errors in managing his records, resulting in the amount owed. But a transcript from the trial showed the real reason for the extensive investigation. "The only publicity that is good for the IRS is when it brings a big one down," were the agent's words. Since the taxpayer was a prominent figure in his area, he satisfied that need, although the agent admitted that he didn't think there was any real proof that the taxpayer even owed the IRS money. In April 1998, after a 20-year battle, the case was settled to the tune of $3 million for the much maligned insurance executive.
Now let's talk about those who know exactly what is going on and find out why they aren't talking. Any good Certified Public Accountant (CPA) or tax professional knows how to beat the IRS at its own game. But an unwritten law among tax professionals has traditionally prevented this vital information from being revealed publicly.

What is this law based on? It's based on tax professionals' healthy fear that the IRS will turn against them.

When filling out their clients' tax returns, tax professionals use information they have gained as experts in their field. But these very same professionals do not traditionally disclose, in anything resembling a public forum, information in three crucial areas that can make a huge difference in the lives of the millions of taxpayers who aren't their clients:

1. What the IRS really is and how it thinks, responds, and operates, or, more precisely, doesn't operate.

2. Endless loopholes in our tax laws that can be used in the preparation of an individual tax return.

3. How both of these can be used consistently to benefit taxpayers.

Tax professionals have made it a practice NOT to reveal such information-and with good reason: They've seen firsthand how people can be destroyed by both warranted and unwarranted IRS attacks. Why would CPAs, or any professionals in the tax field, put their lives, families, careers, and futures on the line? The answer to this question has traditionally prevented tax professionals from publicly explaining why the right kind of information never gets to the taxpaying public. It also keeps them from revealing that information on a broad scale.

So, to prevent an all-out personal conflagration and probably endless repercussions, tax professionals continue to offer whitewashed material that promises to tell taxpayers how they can disappear from the IRS's view. In fact, much of this information is correct and does work. But it is not the whole story. Too much information is left out, and no one knows this better than the authors themselves.

After almost 34 years as a CPA, I have consistently watched how the IRS can financially ruin all kinds of people: rich, middle-class, the average working family-people exactly like you.

In mid-1997 a fascinating case involving IRS wrongdoing hit the newspapers. It had begun simply enough in 1993.

Mrs. Carole Word accompanied her son to an audit of their family business, three children's clothing stores in Colorado Springs. Because the audit was going poorly, Mrs. Ward spoke up to the female IRS revenue agent, saying, "Honey, from what I can see of your accounting skills, the country would be better served if you were dishing up chicken-fried steak on the interstate in West Texas, with all that clunky jewelry and big hair."

Four weeks later, IRS revenue agents raided the family's stores, padlocked all three of them, and posted notices in the windows that implied that Mrs. Ward, who was 49, was a drug smuggler. The IRS then imposed a tax bill in the amount of $324,000.

Mrs. Ward hired two attorneys and sought press coverage to publicize her plight. The IRS countered with a publicity campaign that included sending a letter to the editor of the local newspaper giving details of Ward's case and providing a fact sheet about it to the TV show Inside Edition.

Three months after the raid, the government settled the tax dispute for $3,485, but a week later the IRS district director appeared on a radio show detailing the IRS's position against Ward but failing to mention that the bill had already been settled for little more than 1 percent of the original amount.

At this point, Ward sued the IRS for disclosing confidential information from her tax return. Until the case was brought to trial, Ward's daughter had to quit high school because the IRS statements led students to believe the family was engaged in drug smuggling. The family went from having no debts at the time of the raid to owing $75,000. The lease on one of the stores was lost. And only two thirds of the goods and equipment seized in the raid were returned, much of that badly damaged.

During the nine-day trial the IRS and the Justice Department, which defended the lawsuit, denied any wrongdoing. In a harshly worded 17-page opinion, Judge William Downes of the federal district court in Denver found that one of the IRS agents had been "grossly negligent," had acted with "reckless disregard" for the law, and had made three false statements in a sworn declaration. The judge awarded Mrs. Ward $4,000 in damages for improper disclosures, $75,000 in damages for the emotional distress the IRS caused her to suffer, and $250,000 in punitive damages, giving "notice to the IRS that reprehensible abuse of authority by one of its employees cannot and will not be tolerated." The judge also criticized the IRS district director who had made the radio appearance.

"I never should have spoken condescendingly," Ward later said, "but what they did to me for mouthing off was criminal."

Never forget-the amount awarded by the judge, and the fact that such a case was settled in the taxpayer's favor, comes because of almost 20 years of private citizens fighting for retribution in thousands of similar cases but receiving nothing except bureaucratic doors slammed in their faces. The government and the Justice Department have just begun to accept some limit, if only slight, upon the unbridled power of the IRS over the rights of taxpayers.

Here's another case that demonstrates the blatant and unmitigated arrogance of the IRS.

A high-level executive in a nationally known insurance company was the subject of an extensive IRS investigation. Allegedly he owed $3,500. The taxpayer agreed to admit to tax evasion, and the IRS promised, in a written agreement, to keep the matter out of the public eye. When the executive informed his employer of his tax problem, he was told that the one thing he must avoid was a public scandal. Since the agreement with the IRS seemed to preclude this, the matter should have ended there. But it didn't. About three months into the investigation, the IRS issued to more than 21 sources news releases that included the taxpayer's name, his address, and the name of his employer. The taxpayer promptly lost his job, had to move out of town, and never again regained his prominent position.

Why was the IRS so interested in pursuing a case in which the tax liability was less than $3,500? The answer was revealed about two years later at a trial resulting from a suit the executive brought against the IRS. Here's what really happened:

Initially, when the taxpayer found out that the IRS was investigating him, he asked the agent assigned to the case what he had done wrong. He was told that his wife had made some bookkeeping errors in managing his records, resulting in the amount owed. But a transcript from the trial showed the real reason for the extensive investigation. "The only publicity that is good for the IRS is when it brings a big one down," were the agent's words. Since the taxpayer was a prominent figure in his area, he satisfied that need, although the agent admitted that he didn't think there was any real proof that the taxpayer even owed the IRS money. In April 1998, after a 20-year battle, the case was settled to the tune of $3 million for the much maligned insurance executive.
Furthermore, the idea that only wealthy individuals, those who hire expensive tax attorneys, or those in the know can avail themselves of aggressive tax information is false. Anyone has the right to receive the same kind of information and advice on how to best handle the demands of the IRS, particularly the average taxpayer. No one is too small to DEAL SUCCESSFULLY with the long, powerful, and often ruthless and arbitrary arm of the IRS.

I intend to set taxpayers free by offering them a brand-new foundation from which they can deal with the IRS, one based on expert knowledge never before revealed publicly. For example, did you know the following?

*        Despite spending billions of dollars, most of the technological advances the IRS predicted for the year 2000 will not happen.

*        In 1994 the IRS restated its statistical tables back to 1988, to make the percentage of audited returns appear higher than it actually was.

*        Each year the IRS loses files on which audits have commenced; the audit is then abruptly terminated.

*        Travel and entertainment are still the first areas that are examined by an IRS auditor, because a partial disallowance of deductions is virtually certain.

*        You should never represent yourself at an IRS audit. Such an ego trip usually ends up costing taxpayers dearly.

*        In the past, the IRS has claimed responsibility for almost 50 percent more prosecutions than recorded by the Justice Department and more than twice the number of individuals sentenced to prison.

*        You probably have a greater chance of being audited if you live in a certain part of the country.

With this information, and a great deal more like it, taxpayers will not only have a fighting chance in dealing with the IRS but can actually come out winners.

Now, let's enter a CPA's inner sanctum, a place most taxpayers are not privy to.

Over time it has become customary for tax professionals to "grade" their clients. Clients who make the highest grade from the tax professional's view pay less in taxes, are rarely audited, and have more money in their pockets. I would venture to say that in our profession we deal with three types of clients. Let's call them Type A, Type B, and Type C. Here's how this works.

Type A are the "good" clients. A good client is a person who heeds the professional's advice most of the time, but especially when the professional presents the advice in the form of a strong recommendation. The ideas presented in this book are strong recommendations, and nothing irks a tax professional more than when a client doesn't follow strong recommendations and ends up paying higher taxes or, worse, is audited.

Let's skip Type B clients for a moment and discuss Type C. Type C clients, because of their difficult behavior and negative attitudes, are at the bottom of the totem pole. The fee that they are charged is never commensurate with the time that is spent with them, both at face-to-face meetings or on the telephone. They are usually terrible listeners who refuse to hear much-needed information, which must therefore be continually repeated. Type Cs often argue against the recommended course of action because they usually have a know-it-all mentality. Type C's also receive the greatest number of notices from the IRS, simply because they do not follow the tax professional's instructions. In short, a Type C client causes the professional the greatest amount of aggravation, the professional earns the lowest hourly rate, and Type Cs are usually the first to complain that the bill is too high.

Type B represents all the clients who don't fit into Type A or C categories. As you might suspect, the majority of people are Type Bs. Although Type Bs aggravate you once in a while, they may overcome this by paying bills promptly. They may complain a lot, but they may also be a source of client referrals.

The dilemma faced by tax professionals concerning their client base should be becoming clear to you: Wouldn't it be great if we could drop Type Cs from our client roll, and have Type Bs gradually mend their ways and work themselves up to Type As? But, alas, this is a tax professional's fantasy. In reality, clients drop down from Type A or B to become a Type C, but a Type B or C rarely moves up to become a Type A.

Now that you are aware of this aspect of the tax business, I'd like you to benefit as fully as possible from it by incorporating what you have just discovered into your own thinking and behavior from this moment on, while you are reading this book. Here's how.

Most of the advice, recommendations, and tips contained in What the IRS Doesn't Want You to Know has not been made available to the average taxpayer before. Therefore, to receive the full value of what I am revealing, you need to respond like a Type A client. In fact, I'd like each of you to become a Type A client by the time you have completed this book. The closer you come to being a Type A client, the easier it will be for you to understand how your own thinking and behavior can positively or negatively affect how your return will ultimately be handled by the IRS. Behaving like a Type A or B instead of a Type C client can actually make the difference between an unnoticed return and an audit. Here's what I mean:

A Type C client, Mr. Richards, came to me with a problem. He had received a fee of $35,000, for which the payer issued a 1099-Misc form (Miscellaneous Income) listing him as the recipient. Mr. Richards claimed that the fee was actually earned by his son. I suggested that he contact the payer of the fee and obtain a revised 1099 in his son's name. Without any further explanation, Mr. Richards instead asked me if he should prepare a 1099 in his son's name showing that he paid the $35,000, acting as the boy's agent. I strongly advised against this course of action. If this was noticed and subsequently questioned, the IRS would ask for full documentation, including a contractual agreement and canceled checks. But Mr. Richards, acting like the perfect Type C, insisted that he knew better and refused to heed my advice. I knew it would be useless to argue further. He prepared the 1099 form showing the $35,000 payment to his son.
Six months later, when the IRS detected the existence of two apparently related 1099 forms, both belonging to Mr. Richards, they contacted him and, not satisfied with his explanation, proceeded with a full-scale audit. The audit encompassed all of Mr. Richards's personal and corporate activities, which were substantial, since he was a highly paid executive. An audit lasting more than three years culminated with Mr. Richards's paying the IRS $140,000 in tax, interest, and penalties, plus $25,000 in accounting and legal fees. To this day, Mr. Richards still insists that he knows best, and his behavior has not changed one iota, despite the fact that if he had listened to me in the first place, I could have made his life a lot easier and saved him thousands of dollars.

Finally, the most crucial ability for taxpayers to have, which they cannot acquire on their own, is the ability to understand how the IRS thinks, operates, and responds. This is definitely something you as a taxpayer want to learn about and put into practice, yet it is rarely, if ever, made available.

In my interactions with countless clients and with the IRS, a great deal of unofficial information surfaces that is often more important than a specific tax law. In fact, quite often what is most important is not what a tax law says, but how the IRS interprets and acts on it. This knowledge, which tax pros gain from years of working in the field and interacting at all levels with the IRS, is what enables them to complete your return and know how the IRS will respond to each individual item recorded. This is the kind of information I will be revealing in this book. Here is a typical case:

Early in 1997, a Mr. Graham, who owned an interior design business, came to me for the preparation of his 1996 tax return. In reviewing his file, I saw that both his 1994 and 1995 returns had been audited. On the basis of what I knew about how the IRS thinks, it seemed to me that the audits were triggered by two items: First, Mr. Graham's gross income for each year was over $100,000, which in itself increases the chances of an audit. Second, in both years Mr. Graham claimed about 30 percent of his gross income, an unusually large amount, for entertainment, auto expenses, and travel, as reported on his Schedule C, Profit or Loss from Business (Sole Proprietorship). IRS regulations require anyone who is an unincorporated sole proprietor to file this schedule.

I knew that my approach would have to be based on presenting Mr. Graham's expenses from one perspective in case he was audited. Any good CPA employs this kind of thinking automatically, but in this case it was more crucial because of the two previous audits. In addition, I had to eliminate, or reframe, whatever I could that had been previously questioned.

When my client and I set to work examining his business diary for 1996, one thing consistently kept showing up: Meal expenses on most days were for breakfast, lunch, and dinner. There is a rather obscure IRS regulation that some meals must be considered personal in nature. In other words, the IRS does not take kindly to three meals a day taken as a business expense. Mr. Graham was operating under the illusion that because these meals were business expenses, he would be able to reduce his overall tax bill by listing them that way. But he did not know that he was treading upon a favorite IRS attention getter: entertainment expenses.

I told my client about this regulation and promptly reduced Mr. Graham's business-related meals to two a day. To offset this loss, I also told him of another IRS regulation that would allow him to expense meals under $75 without a receipt if his business diary noted the person, place, and date of the meal, along with a brief description of what was discussed. With these additional diary entries, entertainment expense was back to its previous total, but because of the way it was presented on his return (and in backup material), I knew he would be safe if he was audited. I also insisted that my client substantiate every entertainment item above $75 with a receipt or canceled check, a practice he had previously been lax about.

Next, Mr. Graham's business diary showed $10,000 for out-of-pocket expenses but only $6,000 worth of checks made payable to himself. With his history, I knew the IRS would grab this in a flash. With a little investigation, I uncovered the source of the missing $4,000 — cash gifts from his parents made during the year. In this case I used as documentation a section from the Internal Revenue Code (IR Code) that allows each taxpayer to personally give $10,000 annually to any other person without filing a gift tax return. Now we could prove the source of the $4,000, and best of all, gifts of this nature are nontaxable. However, to clear him even further, I advised my client to have his parents write and sign a one-sentence letter that documented the fact that they had given him the money during the year as a gift.

Finally, to save Mr. Graham from ever having to file a Schedule C again, where his entertainment, automobile, and travel expenses would be placed under continued scrutiny, I strongly recommended that he change his business from a sole proprietorship to a new small business corporation, an S corporation. By doing this, Mr. Graham accomplished the following: He substantially reduced his chances of being audited (i.e., his $100,000 in personal income would not light up the IRS computers). As an S corporation, he had available to him new techniques for reducing Social Security costs that he didn't have as a sole proprietor. And he had all the other advantages of being incorporated (e.g., limited liability to creditors). The end result was exactly what I had hoped for: Mr. Graham's personal and business tax returns since 1996 have not been selected for audit by the IRS.

YOUR TAX-SAVING STRATEGY

Although the IRS no longer requires receipts for business transportation and entertainment unless the expense exceeds $75, detailed entries in your business diary are a must. Expenses for lodging require detailed receipts regardless of the amount.

Now, I have two requests of all taxpayers who read this book. First, I would like you to extract from the material all the points that have some relevance to your own situation. Then bring these points to the attention of your tax professional and ask for comments. If your tax professional says, for example, that you are too small to become an S corporation, ask for specific reasons to support that conclusion. If you are not satisfied with the response, find another pro for a second opinion.

Excerpted from What the IRS Doesn't Want You to Know: A CPA Reveals the Tricks of the Trade by Martin S. Kaplan, Naomi Weiss
All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.