Practical Steps to Avoid a Tax Audit

Mike Pine: [00:00:00] Welcome to the Hidden Money podcast. We're still in Season 3, and this time we're bringing back Gabe Hogan, our team member, who is a recovering IRS agent and tax attorney. First podcast went so well, we are glad to have you back, Gabe. Let's get some good tax knowledge about the IRS out there, so people don't have to be scared of the IRS.

Gabe Hogan: Yeah, thanks for having me on. I can't wait to dive in a little bit more, and help people understand the inner workings of what's happening, how the IRS kind of views taxpayers, and how they're trying to be able to operate in compliance.

Kevin Schneider: Cool.

Mike Pine: Let's get a little more theoretical, if we can, since we have you here.

Gabe Hogan: Love it.

Mike Pine: You and I haven't talked about this yet, although we did have some teams messaging back and forth. So, recently, the Supreme court came down and shot down the Chevron precedent. You're the lawyer.

Can you kind of explain what that meant? And then, I want to tie it in what is that going to do with tax law, and the Treasury Department creating whatever rules they want, whether they make sense or not?

Gabe Hogan: So, I'm going to give you the dumbed down, easy digestible version.

So, what typically happened in the past is that Congress would make laws. Well, these laws had a lot of holes and gaps in them, and so, they said, “There's so many gaps and holes that we can't wait for the court system to sort this out, and say what's legal, not legal, right or wrong, or for Congress to act.

So we need the agencies to help interpret this.” Well, the Chevron case said that these agencies could interpret the laws, and that became law.

Mike Pine: Let me just pause for one second to keep this dumbed-down so I can understand it. So, you're saying under the Chevron precedent, before it was overturned, the law of the land was if Congress writes a law that doesn't make sense or doesn't work, then these unelected bureaucrats who are working in federal government, they get to make the law.

We could take them to Supreme court, maybe, if you have 15 years and $150 million. That's the way it has been happening, right?

Gabe Hogan: Absolutely.

And so, the tax law, we have what we call the Internal Revenue Code, that's voted on by Congress. Well, then we have the regulations. The regulations are written by the IRS, and that's their interpretation of the Internal Revenue Code.

Well, up until overturning of the Chevron case, those regulations were still a primary and a secondary source in law.

And so, Chevron being clawed back, basically said they can interpret it all they want, but now it's opening the door for us to say we're pointing at the Internal Revenue Code, and what the politicians did, and we can disagree.

So, what it does in practice for tax professionals, it, kind of, takes the chains off a little bit. It allows us to be [00:03:00] even more aggressive and advantageous for our clients. Circular 230 is what guides all the tax professionals.

Now, we're able to say, 'Hey, if I want to go against the regulations, and as long as I have a reasonable or an defendable stance that is founded in the revenue code, and I'm interpreting it differently, then I'm able to ma ke it without having to have that fear of recourse. So, it does open up the playing field quite a bit. Accountants and tax preparers are not people that like to rock the boat. They tell their clients, “This is just the way it is.”

And opening it up and saying, “Hey, now you have the ability to be more creative,” you're basically telling a person that's not creative, they can be creative. So, I don't know if it's going to really change much in our industry, except for visioneers, like the ones on this podcast, and that's where it's going to get fun.

Mike Pine: I agree.

Let's take this full circle back where you are explaining how the IRS works. There is a designed fear element to try to keep people in compliance. And you should be scared of the IRS, if you're cheating on your taxes. You should be scared. But if you're not cheating, you should not be scared, and I've seen way too many people fearful of an IRS audit, and not take a tax deduction they were legally entitled to, or pay more taxes than they were legally obligated to pay.

I get it, but let's at least make sure you understand what the tax law is. When it's in your favor, understand it, but understand the risk, and let's go ahead, if we can. Build substantiation and supporting documents, so if you do get audited, you've already done all your homework.

Gabe Hogan: 100%. It's like shark week. More sharks are killed by humans than humans by sharks but Steven Spielberg did this thing back in the day, and created this movie that made everybody afraid of sharks in the water, even though, statistically speaking, your chances of being bit by a shark or dying by a shark attack is a statistical anomaly.

Very similar with the IRS. There's this inflated sense of fear, but that's by design. The IRS works on voluntary compliance, so you create voluntary compliance by keeping the risks high, the reward low, and being able to make the path easy.

So, we want the risks to seem high. If I was to have a file with a celebrity, a politician, a notable person, or notable situation, I have to contact this division, and they basically would help me walk through the file, and I would throw the book at him and make sure to make an [00:06:00] example out of these cases and these files. 

And then, there is a PR division that would take that, and then, they would run with it. They would send out press releases everywhere, and make sure to have as much media attention as possible for these tax cases, and for these people, and you see it all over the news. You always are seeing people get hit with tax.

What's happening is the IRS is ruling by fear, but it's because they don't have enough for compliance, and taxes are getting more and more expensive. And so, the reward for not paying your taxes is, “Hey, I can afford groceries, I can beat inflation if I'm cheating on my taxes!”  So, the IRS is revving up that volume on fear to try to counteract the reward of cheating on taxes.

We're getting into a weird area again like we saw in the '80s, where inflation's high, tax rates are high, reward is high for not complying because I'm able to provide for my family, and wages are not keeping up with everything right now, so it is a scary area. You do want to watch out. You do want to work with professionals. Understand, but don't be afraid of the water, go enjoy the ocean, go splash around and don't be afraid of that shark.

Mike Pine: Just don't cheat. Don't cheat on your taxes, but utilize and leverage with the tax code for your benefit. So, you mentioned, usually the IRS is a civil matter, but sometimes it becomes a criminal matter. Cheating has something to do with that, usually. Can you go into that? Why should people not cheat on their taxes?

I think it's pretty obvious for us because we've seen what happens when people cheat, but for someone that's just listening right now, why shouldn't you cheat on your taxes? What’s the difference? What can happen to you?

Gabe Hogan: So, yes, taxes is primarily a civil matter. With any criminal matter, whether it's tax or any sort of law, there has to be an element of intent. That means that you intentionally tried to do something. 

With taxes, it's real easy for us to throw out, “There's no intention. The professionals I hired misinterpreted. We made a mistake.” That doesn't fall into criminal. Criminal means that you took an action that shows that you were trying to do something wrong. When you get to that level, they have to prove it. There has to be a 'smoking gun'.

And then, it has to be a big enough dollar amount too, for it to even get there because the resources the IRS is going to use, and the special agents. So, the agents that carried guns, that's criminal division. I was civil division. We had some cases that would go back and forth,

but most of the time you're dealing with civil matters, which means you're not going to jail. You're going to get slapped with the penalty. You're going to get slapped with interest. You're going to get slapped with tax. They may come and seize your property and put liens on everything, but they're not going to take you, as a person, to jail, unless you are doing something [00:09:00] that is criminal. 

So, let's take the fear away. Nobody's going to show up at your door. Not only that, but nowadays, they can't. IRS agents can't show up unannounced. We had to always schedule the time we're coming by, and give notice. So, there's a lot of misnomers, and that's where I like to take away some of that because it's so freeing to take away that fear. 

And when you realize audit, the chances of audits are so low; we're seeing under 1% across the board; and when you have a tax professional, especially a good one, you should be feeling free and not losing any sleep at night.

Mike Pine: Amen.

Kevin Schneider: That gives me goosebumps, almost, because all that fear, it's there. Like Mike was saying, there is healthy fear. We should have healthy fear of our government, of police, because that's there for a reason.

It's there to keep you safe. It's there to help you make good decisions. Like you said, playing in the ocean, there's so much you can do in the ocean. There's so much fun to be had in the tax code. Just don't go out there with hot dogs strapped to your legs.

So, that’s what we get to do is, here at our firm, we get to cut the strings of the hot dogs. You get to play in the ocean, but you get to do it safe, and that is a passion of ours.

So, I remember in the COVID era, a lot of employees of the federal government actually lost their jobs, or they just quit.

So, after we, kind of, recovered from COVID, we saw the news article, and this could be the fear-mongering that they're placing on people. 80,000 or 90,000 IRS agents hired. Inflation Reduction Act's revenue going back into the government to beef up their audits and actual cases that they're winning.

But what's your take?

 Gabe Hogan: You're right, the PR spin on everything was to make the IRS seem like, “Hey, get your ducks in a row. Start complying because we're coming after you.” So, there was definitely an element of that in the way that it was spun.

To go back to some of the things I was saying is, the IRS has outdated infrastructure, outdated software, and we've seen staffing at the lowest it's been since 1996, so almost 30 years ago. So, with this hiring wave, it is needed for the IRS to just function properly, because we want the IRS to function properly, we want it to be better. 

You also don't want it to be such a skeleton that it's creating more havoc than it should. If it is a well-greased machine, and at least, well, properly funded, then hopefully, we're getting training. We're getting more people, and it's spreading out some of the distractions.

The people did leave at a pretty high rate, but the thing was, a lot of those were people that were slated for retirement. People had been 25, 30 years of government service, so it wasn't [00:12:00] a huge exodus that was unexpected.

Increase of audits, the audit rates have been so low. Back in the ‘90s and even in the ‘80s, they were almost double what they are currently. So, it's not that audits are going up beyond what historically has been there. They're just trying to get back up to where it is what we've seen historic, and has worked in the past.

If you have one police officer for a community, people know that, “Hey, I'm going to be able to get away with a lot more.” But if you have more police officers in a community, they know that they may be caught if they're trying to do something illegal or wrong.

You want to have enforcement, you want to have a safe community, but you also don't want it to be a military, or that overarching type of thing. And when you have less enforcers, it tends to be more militant. When you have more, it actually allows the people that are trying to work inside the guidelines of legality, have more flexibility and more freedom, and less fear.

Mike Pine: So, do you think you're going to see increased audit rates regardless of what Danny Werfel says for people making under $400,000?

Gabe Hogan: Absolutely. I hate that he came out and made those statements about, “Oh, we're not going to increase audit rates on anybody over $400,000," because that is so missing the mark, because there's that asterisk, 'beyond historical rates', but what's happening is, they're using some of that money to figure out where the inaccuracies are.

And that's where the audit rates aren't going to go up, but they're catching more people that are under that $400,000 mark, that are just inaccurate. Or they're going to be upping the audit rates to what historically has been. We're going to see audit rates and activity increase across the board, especially over $400,000 AGI and high W2.

So, if you have a high W2 or a high K-1, start fortifying those walls. Make sure that you've got a good tax preparer, and you have a plan, and you're not afraid of getting pulled over. Make sure your insurance and your registration are up to date. If that's good, and you're not going '80 in a school zone', you'll be okay.

Mike Pine: So, the Inflation Reduction Act has been passed almost two years ago. The funding is starting to come in. I think, it's something like $10 billion a year over 10 years, or something like that. When are we going to start seeing those increased rates? Because they're just hiring people off the street, it's going to take training. It's going to take understanding. When do you think people, our clients are going to start getting those increased audit rates?

Gabe Hogan: They have started. It takes two years to get through the training process with the IRS. So, for the first two years of an agent's career, they are under training, and all the cases they get are training.[00:15:00]

So, we will see more increase, generally, in a lot of other places. Here, in the next few years. We're already seeing an increase of audit rates in different sectors. I think that if you haven't seen those, yet, for your firm or as a tax professional, I would go back to what I was talking about how they select it.

If the returns you're putting in aren't good for these agents as a training case, they're not going to be selected. So, if you have good work papers, if the numbers make sense, and if you pass that 'smell test', you're not getting selected for an audit, and that means you're doing your work and your due diligence.

We will see increased audit rates. That's just inevitable. Take your head out of the sand, know what's coming, but just prepare for it. And know, if you have somebody that can navigate those audits, it's not like going to a proctology exam. We can make this a lot more pleasant for you.

Kevin Schneider: And that's why we've learned in our experience that we do a lot of due diligence on the front end. Our preparation fees when we're doing a preparation engagement, are going to be higher compared to your other sole practitioners, or other CPA shops, just because of the fact that we anticipate audits.

We don't expect them, but we're anticipating them to come. And so, for our due diligence, for Mike and I and our team to sleep at night, we want to make sure we're making the right calls. So, we do a lot of due diligence on the front end. We actually build an audit defense file for our clients on the front end, and you're going to have access to that. 

So, if the IRS does come knock, it's not a matter of panic. It's just a matter of handing over the audit defense files, our first line of defense. Now, there's going to be communication back and forth. There's going to be some give and take. There's going to be some representation on our end, but it will keep your bill down in the long run, if you are pulled for audit.

Audits vary in cost. The kitchen sink audit, where they're going to audit literally everything on your tax return, and if you're self-employed, they're looking at bank records, and yada, yada, that could be a $15,000.. $20,000 audit defense. If we're not self-employed, we're W2, but we need some charity.

We did, maybe, some loopholes here and there, we're going to already have that defense ready to go, and our documentation ready to go. It's not going to be a $20,000 defense. It might be a few grand, might be $5,000. I don't know. That's where as a professional, it's hard because if our client's picked for audit, we stand by our work, but we're net-zero control of what the IRS wants to do.

Mike Pine: Less than 1% of our clients have been audited historically speaking, but we don't know that could be 20% next year. The point is the way to control that fear. Not being fearful of the IRS is to be prepared, be ready, have your audit defense in mind before the tax year is even over. Plan your tax strategies, execute them, document the heck out of everything, have substantiation for all the positions you take, and then, don't be fearful.

File it, take advantage of the [00:18:00] tax code and the incentives it's provided for you, and if you get audited, you're prepared, but it does take a lot of upfront work to do that.

Gabe Hogan: It's like thinking of your tax situation, your financial realm, of being a vehicle. If you have a very prized car that you're very proud of, you're going to want to do the maintenance on it. You're going to want to make sure to keep it clean. You're going to want to make sure to do the preventative items, and if something does go wrong on it, you're not going to take it over to a Shadetree mechanic and have Bob duct-tape on your muffler.

You're going to take it to a licensed shop with professionals that know the ins and outs of that fancy car, and are going to treat it the way that you want. Bob may be able to do it for $200 and the shop may charge you $5,000, but if this is your pride and joy, it won't be hard for you to pick which shop you're taking your car to.

Mike Pine: Agreed. Except, there's nothing wrong with duct-taping your muffler on when you absolutely have to. I did that in college once and it worked, for almost a week.

Gabe Hogan: You're not going to go Turbo Tax your own personal return at this point in your life when you have a fancier vehicle, and that's where there's the time and place. One thing I also like to tell people going into audits, and going into any situation, is I always try to take a holistic mindframe when analyzing things at the front end, and say, “Let's not spend $100 to fix a $20 problem.” 

Going into an audit, what are they looking for? What are they going to find? They're chewing on this thing and trying to get us to spin our wheels, and it's going to cost you $1,000 if we let them have their way, and it's like 'Let them have it.

Close the file and let's get out.” Sometimes, that is the strategy to take instead of being right. Sometimes, I'd much rather lose and come out happy than be able to be right and wrong. That's something I learned in my marriage.

Kevin Schneider: It's very wise. 

With people just kind of getting into tax planning, their first instinct is, 'Can I do this? And am I going to get audited?' And it's going to be okay. You have the right team around you. You have the experience behind you. We know what we're doing. Hopefully, if you're not using us, your CPA does, but we'd be more than happy to help you out in any situation you find yourself in.

But Gabe, I think you provided a lot of comfort, actually, to people out there knowing that this machine that is trying to collect our tax dollars isn't so big and bad, so long as we play by the rules, and we do it wisely. So, any closing thoughts that you may have?

Gabe Hogan: No, I really enjoyed getting out some information, and hopefully allow people to sleep a little bit better at night.

Mike Pine: There you have it. Our second, but not our last podcast with Gabe Hogan. It was a pleasure, Gabe. We learned a lot and can't wait to have you on here again. Thank you for being here, man.

Gabe Hogan: Oh, thanks for having me. I'm looking forward to it.