Learn to protect yourself under these dire conditions, knowing how to reduce your assessed net worth can save you a lot of headaches and bundles of cash.

Franklin D. Roosevelt once remarked that "taxes are, after all, the dues we pay for the privileges of membership of an organized society".

It is, however, a universal truth that no one likes paying tax and most taxpayers will do what they can to reduce their tax burden. Most tax auditors assume everyone cheats on their taxes, even you, if you are chosen for an audit the burden will be on you to prove to them that you don't cheat. That is how the system works.

Tax cheats who get caught are usually careless in their personal and business dealings. They brag to their friends who at any given time can become jealous and report them to the authorities under the protection of anonymity. They post red flags and leave trails easily tracked down by eagle eyed government agents. They lead the auditors to their doors with the most obvious of all clues “under reported income and overstated expenses”.

The other kind of tax cheat tells no one of his dealings, keeps all his receipts in order and tries to be careful with his tax preparation but he can still be selected for a random audit and subjected to many disallowed expenses because of computer technology that uses a form of logarithms and mathematical hypotheses to single out potential individuals for further investigation.

What you should know

First: You don't want to risk it.

Second: You are guilty until you can prove you are innocent.

It's wise to follow all the rules, declare all your income and be aware of what sets off the alarm bells.

Unreported earnings

If you run a cash business and feel you can get away with ignoring some of your earnings think again.

Today's computer systems can match your revenue with your lifestyle. How can someone earning $25,000 a year drive a $50,000 car and live in a prestigious home?

This clue alone is enough to trigger off the alarm bells. Because of the information explosion the government knows all about you, where you live, the cars you drive, the properties you own the trips you take the banks you communicate with and the schools your kids go to and that is only a fraction of what information the government has at its disposal about you. There is no more privacy to speak of.

Overstated expenses

Entertainment deductions and car expenses are scrutinized closely by the examiners.

Are you prepared to respond to all the questions if someone come knocking on your door wanting intelligent answers?

Car expenses must be reasonable within the confines of your profession. What is reasonable? Auditors might accept a 75% deduction if you are a traveling salesman but you will be lucky to get away with 25% if you are a self employed individual in a home operated business. The key is to keep a log book in your car at all times, record your start and stop mileage and have credible documentation to substantiate your claim. You may find this a nuisance and time consuming but it is nothing compared to what happens when you are audited. Good clear documentation is also a sure fire way of stopping an audit in its tracks.

The same procedure serves the entertainment deductions as well. Keep all the receipts and a record of who you entertained and why. Having the proper support papers serves to quell the suspicions of the examiners and put an end to the audit. If they find the least discrepancy they will investigate further to find out what else you have been up to. Honest receipts and full reporting are your guarantees of leniency. Artificially exaggerated or forged receipts and sketchy documentation can get you in a heap of trouble.

Business losses

If you are an employed person who also has a self employed sideline at home that serves solely to reduce your employment taxes you could receive a phone call. Especially if you only become a loser due to deductions that outweigh any earnings you may receive.

Writing off expenses such as utilities, meals and car could be disallowed if you lose money every year. Previous benefits over a three year period will have to be paid back with interest and penalties to boot.

If you are running your own enterprise the tax man will flag your return the first year you report business losses and if you continue to claim losses in the following years you will be a prime candidate for a tax audit which involves a three year period. Pray that they don't make you pay back any benefits you received in consequence. Small amounts each year can reach astronomic proportions when cumulative penalties and interest are calculated. This alone forces many entrepreneurs to declare bankruptcy

Drastic changes

If you are self employed a drastic change in income or expenses from previous years will raise some eyebrows. If you have a large drop in your taxable income despite a gross income that remains stable they will probably call you to ask you why and to explain. If you have a large tax refund on relatively small earnings they may ask you if it makes sense. Make sure you have ironclad documentation on hand to settle the issue immediately.

If suddenly you have a significant jump in travel or entertainment outlays you are sending out smoke signals that initiates investigation.

High risk deductions

When a taxpayer reports losses from tax shelters, has significant interest deductions, high self employed business expenses, art donations, and other high risk items without a doubt he is asking to be audited. Examiners love to flag these extremely risky items because it gives them more potential revenue for the time spent. The deductions may be legitimate but they complicate tax issues. Make sure you have all the necessary information on hand when the dreaded examiner calls. If you are in this category he may be on his way to your place of business now.

If the government finds out that a deduction is nothing more than a wily loophole the hole will be closed and the taxpayer will find himself in a in a deeper hole.

A big claim for a combined business-pleasure trip will set off the fireworks. You will be asked to give full details about the nature of your trip as well as the time and money spent on business.

Your best defense is to have everything in writing. The time you spent at conventions, the people you dealt with and the restaurant and hotel expenses. Were you alone or did your family tag along?

Information on paper giving reasonable percentages of business and pleasure expenses can save you a lot of hassles in the case of being questioned. It also shows you to be an organized person with a reasonable attitude towards paying your fair share of taxes.

Your return must be prepared defensively to counter any attack by the taxpayer's enemy.

Avoid mistakes at all costs

Double check all your figures before you file your return. Make sure you sign it. Check to see if you have included all necessary information such as name, address, social security number and telephone number. These are very basic and hardly worth mentioning but a lot of people forget and end up getting calls from the taxman. Nervous reaction to questions and inappropriate responses could inspire the caller to investigate a little further. You must avoid mistakes as much as possible to keep the taxman from reviewing your return more closely.

Be certain you have included all your income including interest or dividends from all accounts and investments.

With today's computer technology cross checking is done automatically. Authorities will be alerted if you fail to include any of your income slips. The government gets all the same slips as you so if you miss one or two you will be contacted.

If you are claiming the use of a company car they will check to see if you if you have added the personal use of the car to your income.

Make sure moving expense claims are in accordance with the law. You must be a certain distance from your work to be valid. If you are audited checks will be made to see if you have been reimbursed by your employer.

Even though medical expenses are tax deductible they must be supported by receipts. Don't even think of claiming medical expenses that were reimbursed by your private or public medical plan. They will be on to you.

The greatest number of assessments is triggered by nothing more than mathematical errors. It pays to double check all of your additions and subtractions.

High risk professions

The government has identified certain professions as highly prone to cheating. Not everyone is dishonest but the shady operators are making it hard for everyone.

In the following industries tax returns are reportedly examined more closely.

Construction workers, sub-contractors, people who sell cars but are not registered, auto mechanics, independent couriers, direct salesmen, small storekeepers, restaurant owners and plumbers. In tax circles these workers have been labeled “prone to the underground economy”.

A carpenter may receive a cash payment and decide not to report it, a storekeeper could be tempted to ring up a no sale and keep all the money or have two cash registers, one for him and one for the government while others have similar options to have and to hold or to surrender in all honesty the governments rightful share.

Many feel that taking cash payments for services will get them out of paying taxes. Whether they realize it or not they can get caught quite easily.

Some customers become indignant when they see a cashier ring up a no sale after paying dearly for an item plus the sales taxes. Consequently they report the cashier to the authorities and the owner is investigated and selected for an audit.

Other times a tradesman may offer his tax free services to a prospective client only to find out the client works for the government. He will suffer the investigative eye of the authorities.

Tax dodgers may also suffer the penalties of cheating when jealous friends or family members report them.

One auditor claims that some days the phone never stops ringing as one informant after another, especially jilted lovers, spill the beans and lay bare all the underground activities of their targets.

All tips to the government are followed up in one way or another.

Garbage collectors

Household waste can disclose a variety of personal and incriminating information including medical data, choices of lifestyle, DNA samples and financial dealings.

It may well be a violation of the charter of rights but when someone is looking for information about you don't be surprised to see some of your garbage bags disappear before the collectors arrive to dispose of it.

Combing the garbage for clues is fair game and there are reports that it is not an uncommon practice during a criminal investigation.

New technology

New technology identifies tax payers who are prime candidates for an examination. Governments have been experimenting with statistical and mathematical data that looks at hundreds of variables and thousands of combinations. Immediately they can eliminate those who are honest and those who are compliant. Further manipulation of the data combined with the speed and accuracy of computers can eliminate up to 90% of the taxpayers who represent a low risk category.

The remainder is considered possibly non compliant. The computers randomly scrutinize what are considered distortions and join them together to arrive at an elite list of candidates for the dreaded audit.

Computers by the way can accurately check 100,000 returns every second.

The costs of reviewing or auditing a tax return are high. The government does not want to harass honest taxpayers. Examiners look for those where an audit promises a very high return for the treasury. If the treasure hunters select you for a net worth audit your situation could be serious to say the least.

Avoiding taxes on goods being sold on e-bay

The federal government is going after online merchants who fail to pay taxes on the goods they sell. On ebay thousands of profit seekers make all or a significant portion of their earnings by selling goods and services on the online auction website.

Such websites as Kijiji, Craig's list and ebay act as a clearing house where thousands of small retailers sell massive amounts of goods for cash and avoid paying either income or sales taxes.

The issue has become of keen interest to governments who are losing millions in tax revenues as a result of the underground economy online

Auditors are realizing now that there is a potential goldmine to be had from people making hundreds of thousands of dollars in revenue through sites like ebay and Craig's list and royalties through affiliate programs.

They are now turning their attention towards ebay with the intention of flushing out every major seller who has not declared income as a result of their ebay business.

Governments are now contemplating demanding information from sales sites on the internet to identify sellers making profits of as little as $100 a month to see if they have paid the proper taxes on their income.

Auditors will be looking for sales data for 2004, 2005, 2006 and 2007, creating thousands of potential serious reassessments.

In a case like this restating taxes voluntarily and paying what's due before disaster strikes may be the way to go to avoid penalties and prosecution

Bad news

You have hoped and prayed that it will never happen to you, but suddenly out of the blue you receive a letter or a phone call asking you to sit down and face a tax assessor.

Whatever you do, don't panic. Don't overreact and don't be paranoid. It could be just a routine call asking you to clarify a mathematical error or provide some documentation for a questionable expense.

Responding calmly to the questions may take only a few minutes and you may never hear from them again.

On the other hand they may wish to interview at your home or at your accountant's office or you may be invited to the local tax office.

This is an invitation you can't refuse although they will give you a nominal amount of time to prepare for the interview...

Whether or not you decide on your accountants help at this stage the meeting will set the tone for all your future discussions.

The meeting can be scheduled between 30 minutes to 2 hours. Stay calm; you will probably be face to face not only with the assessor but also his supervisor. The boss may act as the good guy while the examiner asks pointed questions and never smiles.

You may feel that the upcoming meeting is the beginning of an audit. Not necessarily it is merely an audition. The tax department may be following a procedure of selection.

An auditor usually processes five or six individuals simultaneously. After interviewing perhaps a dozen or so potential tax dodgers they will select those that promise the highest financial returns for their investment in time. The others are free for the time being although there is no guarantee that they won't be contacted again at a later date. At least the lucky ones get time to clean up their act.

Try to find out what items are in question before you attend the meeting. If the assessor can't or won't tell you ask to speak to the supervisor. Understanding why you have been selected will allow you the opportunity to explain the situation. If you can clear the issues with documented proof at the meeting you may never hear from the tax people again.

They may ask you to bring your ledger or proof that you actually are self-employed and they can request keeping these papers for further study. They do however need your signed permission to hold the papers.

If you are bringing important papers with you to the meeting make sure you copy everything beforehand. Even though you will have a receipt for the documents it's not uncommon for them to lose or misplace papers. These people have five or six audits going at the same time and mix-ups certainly do occur.

When your receipt is being prepared the auditor may try to cut corners and generalize; Example,” Received tax papers for 2007 from John Doe”.

Make sure the auditor lists each document item for item, when it's all over you want to get everything back in proper order.

Be composed if you possibly can during the interview and bear in mind you are not being audited at this point. You have been invited to the tax off ice to explain the type of business you operate. You will be asked pertinent questions about your business and each word of your answers will be noted for their records. Stay quiet and only answer the questions they ask you. Don't volunteer anything. You don't want to open another can of worms about something that they had no intention of pursuing. Solemnly think about every answer before you open your mouth. Sometimes a quick response is not entirely accurate and it may affect your credibility later if you have a different response to the same question.

The best policy is if a direct answer doesn't sufficiently cover the scope of the question, don't answer it .Ask for time to think about it and you will answer it in writing. Better still, when you make the appointment for the meeting ask for a copy of the questions that you are going to be asked so as you can study them and give them the full explanations free of all ambiguity. The auditing team may not want to do this as it would take away a lot of their leverage but is it not your democratic right also to have this information?

Some of the questions they ask may appear innocent enough at first sight, for example: “Does anyone live with you besides your spouse?” You may answer “No” even though your cousin or aunt, adult son or daughter or someone else actually did during certain periods in the past few years.{a yes answer could mean you can have up to $15,000 reduced from a possible net worth assessment if you are audited., more on this later.

Another example: “Have you ever won the lottery”? Thinking of the millions that got away you may automatically say “No”.

A “no” answer weakens your case in the event of a net worth audit while a “yes” response works in your favor.

The assessor records this response in his notebook for future reference. In actual fact in the three years precedent you may have won amounts like $500 at the racetrack $500 at the casino and other small amounts from lottery winnings which would add up to several thousands over a three year period. Count all your winnings from golf or bowling tournaments as well as winnings of family members living with you. Several thousands of winnings over three years would lighten your liabilities a lot if you are audited. [Select audits are usually performed for the three previous years. The auditors are also known to come back in the following year to assess the current year's reporting.]

If you answer “yes” to the question “have you inherited any money” They will probably drop the case against you and you will escape the dreaded net worth audit, of course you will need proof that you did inherit a substantial sum.

Additional questions will want you to explain your business operations; they will want to know the details of your travel, and if you receive clients in your home.

You will be asked to explain the use of your car for business and personal affairs and if someone else also drives it. Without a doubt they are going to ask you if you have a log book. If you do have your business travel logged in writing you will be in good shape at this point. If not you will have a lot of explaining to do and regardless they won't hesitate to reduce your claim at their supposition.

These are only a few of the questions you will be asked at the meeting be prepared for many others about your business dealings.

Sometimes a spontaneous question can knock you off your feet and you have difficulty with the answer, example: “How can you afford living in a $600,000 house, drive a $40,000 car and you only declare revenue of $30,000 annually?”

It would appear that you would be in a spot but there are times when something like this can occur. Your saving grace would depend on how conscientious you were with all of your documentation including historical if it provided income. Documenting all your business activities is time consuming and a pain in the butt but if you ever get audited you will be more than happy to have it

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This is the end of part one. To continue with the article and learn what happens if you are selected for an audit see the article entitled The Dreaded Net Worth Audit.

You will learn how to counter the examiner's assessments and reduce steep fines and penalties which could otherwise bankrupt you.

The article takes the mystery out of what to expect if you are selected for a tax audit.

Pity you if you cannot account for overstated claims or undeclared revenue, your troubles are only beginning.

We now live in the age of high technology. Information is intercepted instantly and freely between government departments, banks and businesses.

Assuming that the assessor checked the municipal tax roles and found you live in a high value district and learned from the license bureau that you drive a $40,000 car. Further computer checks would show that you also own a country place and a boat as well.

Yours is a cash business. Nobody knows how much you really make but your tax obligations have been practically nil because of substantial business and travel expenses which have always been accepted until now.

Unless you have proof of a large inheritance or a substantial lottery win you are a prime candidate for the Net worth Audit.

The concept of a Net worth Audit is simple. It is a tortuous, stressful and a long drawn out affair. Because of unexpected delays and complications the audit can go on for years Taxpayers often become angry and lose composure as every element of the business and private life is called to question. Documented proof is needed for every detail. Assessors carry with them at all times a security device on a key chain. They are always ready to press the panic button in case of trouble with infuriated taxpayers. Protection is never too far away for the auditor. They are well prepared knowing their work is going to create for you a nightmare of disturbing proportions.

An audit doesn't only concern a single tax year. You would be so lucky if this was the case. The Net worth Audit is normally for the three previous tax years. All final assessments carry penalties and high interest .Your spouse's returns are also checked whether or not you paid her or him a salary to lower your taxes.

If by chance the examiners discover false invoices [select invoices are scrutinized for irregularities] or other indications of fraud they will turn the case over to the department's special investigative branch that may show up at your door and seize all your files. This will not happen if you are on the level. If fraud is detected there are no limitations to how far back they can go in years or how much pressure they can apply to the transgressor.

The Internal Revenue Manual contains a long list of topics that the auditor must cover, including bank accounts, nontaxable sources, and a survey of personal assets (securities, stocks, bonds, etc.) as well as household assets.  The agent will also investigate liabilities, line by line.

If the taxpayer gave a financial statement, the agent will verify it line by line.  This includes all taxable and non-taxable sources, especially the “cash on hand” item.

The agent will also determine the taxpayer's living cost, as these must be added to the eventual net worth computation.  Case law allows the agent to estimate living costs when the taxpayer cannot furnish them.  Thus, the agent will consult living costs statistics that are widely available for the government and other sources for such items as clothing, food, transportation, and the like

Bank statements

Assessors assigned to your case will phone and politely request all of your bank statements for the three years selected. They will want to know how much money you had in the bank on December 31 prior to the audit period and how much you had at the end of the three year period on December 31.They not only want to see your business accounts but your personal accounts also. They will want all the accounts of your spouse as well. All of the information is laboriously entered in the computer for future study.

Perhaps a week or two later you will receive another request for all of your cancelled checks and your deposit and withdrawal slips. They usually call when you are having lunch or supper and make you feel like throwing up.

Business and personal expenses are separated, typed and stored in your dossier with the other information. If an inkling of a doubt exists a business expense is deemed personal for tax purposes.

Questions about various transactions require intelligent answers and clear explanations.

Delays between requests for documents are related to studying, typing and recording of the data. Assessors are also assigned to several taxpayers simultaneously, besides as long as they are confident of a big catch they really don't care how long it takes. The longer it takes the more the taxpayers repayments, penalties and interest liabilities add up.

Safety deposit box

You may feel your privacy being invaded when they demand to see the contents in your safety deposit box and there is little you can do about it but comply, the agents have rights which are almost obscene when it comes to tax matters.

This could open up a whole can of worms as you are required to provide the purchase dates and define the values of each item enclosed as well as justify the legality of any amounts of cash secured.

Computer records

You will be asked to provide computer records of your business dealings if the documents you provided didn't satisfy their curiosity. If they suspect fraud and can convince a judge to issue a warrant your computer and other files can be seized and carted away.

Credit cards

After they have scrutinized and recorded your banking information they will require your credit card and debit card statements. All of the purchases will be typed and stored under personal spending. Later on in the audit you will have meetings with an assessor to argue that it is not all personal spending but mostly business costs. In which case the auditor will require a legitimate document for each item deemed business. You may save yourself a lot of anguish by going through your statements before handing them over to the assessor and highlighting all of the legitimate business expenses with the assurance the documents will be provided if requested.

It is in your best interest to have as little personal spending as possible designated in your file. All personal spending is recorded separately. When personal spending exceeds reported income your case becomes very weak.

The examiner will study your credit card statements closely. Much more than your spending habits are revealed, your private lifestyle also becomes a point of interest and may well be the instrument that makes a solid case for the auditors.

Do you have a golf membership; are you a regular at the casino or the racetrack? Do you buy or sell items on the Internet, or purchase pornographic paraphernalia? Does your spouse purchase her clothes at high priced boutiques? What about those trips; Las Vegas or Switzerland? Don't even think of hiding any other credit cards that you and your spouse possess. The paper trail that you left behind will betray you and weaken your case.

Of course the examiner doesn't stop with your credit cards or debit cards. He will also request your spouse's credit cards, department store cards and courtesy cards as well.

Your nightmare is only beginning

All of your spouses spending habits will be under investigation and the information typed and stored into the computer file for deliberations.

When you claim an expense as business and not personal you will be asked for proof. Although you may be confident that your proof of purchase is legitimate and it may well be the assessor is looking beyond that. He takes notes of the information to see if the check or credit card number used for the purchases agree with the information they have in your file. Using this method the assessors often dig up undeclared charge cards and hidden bank accounts.

Phone bills

You will be asked to surrender for the three year audit period all phone bills, as well as the cell phones of you and your spouse and also of any children living with you. Nothing is left to chance when you're being audited.

Statements of this kind list all of your calls in chronological order with the corresponding names and numbers of those you are communicating with.

By studying these statements the examiner can tell approximately how much personal calling you did in the three year audit period. If you are claiming 100% business expenses for your telephone and it is loaded with personal calls you will be disallowed most of your business claims and the majority of costs will be deemed personal and typed into your personal spending file. The same investigative procedure applies to your cell phones.

The examiners will deliberate over your statements with eagle eyes. Woe onto you if they find a lot of your correspondence was to foreign banks or tax havens.

Investments

Get your investment statements in order, bond purchases, real estate deals, pensions and all other documents. You will be asked to present them where they will be typed and recorded into your growing personal file. All purchases are designated personal until they are settled and declared in your current tax reporting. In the case of bond purchases if they were purchased with money received from maturing bonds of previous years make sure you inform the assessor to prevent it being entered as undeclared income. Assessors are known to be quite zealous at times and are prone to dump as much as they can into your personal spending file.

If you had a lottery win or a gift that helped you pay for some of your investments present the information promptly and clear up the issue right away, save yourself from migraines later when the final report comes through. If you are unprepared and negligent the final report can be a real shocker.

Home office

The assessor along with a supervisor will request a visit to your home if you are claiming a home office. If you are claiming 30% of your of your home for business you better be able to prove it when they call. If you live in a 10 room house with one room being used as an office they will not comment on it during the visit they will later type into your file that they are reassessing you at 10% business.

This is a vicious reevaluation of your tax liabilities. It means that mortgage interest, electrical and heating costs, repairs and everything else pertaining to the home business is reduced by 20% over three years.

This one decision alone can mean thousands of dollars of tax liabilities when you consider the audit is over the three previous years with interest and penalties added.

If you are claiming a home office and other parts of your house you will need photos, floor plans and measurements of the areas that you use. You may not totally convince the examiners but at least you will have concrete evidence if you decide to appeal the assessment at a later date.

Car expenses

When the assessors question your car expenses your case will be very weak if you don't have a log outlining your business trips.

They will listen to you and note everything you say as you try to explain the reasons for your claims but they won't be convinced.

They expect a log to validate a reason for the trips, the start and stop mileage readings, the destinations and how they pertain to your business.

Without a credible log expect all of your claims for car expenses to be slashed to the minimum. That is if you are lucky, an examiner in a bad mood may deny your claims altogether until you can prove a genuine expense. Consequently your entire car related business expenses become personal and your account begins to look scary at this point. Auditors treat the newly defined personal expenses as undeclared income subject to penalties.

If you decide to appeal the assessment at a later date you will need credible documentation to have any chance of winning.

It may seem a nuisance at the time but logging all of your business trips and separating them from the personal ones is something every businessman should undertake to avoid problems with auditors.

Gas receipts and gas mileage

The examiner will check your receipts and compare them with the mileage you have recorded over the three year audit period. Taking into account the price of gas, the make of your car and the manufacturer's mileage recommendations they are able to suspect if you paid for all the gas you declared in your tax reports or if perhaps you had access to extra receipts from family members or friends. The extra money resulting from these seemingly harmless acts adds enormously to your net worth.

These will show up as undeclared income in the final audit assessment.

Meal expenses

Did you claim only those meals that were eaten with clients or did you claim all your meal expenses to reduce your taxes? If you claimed only a third of your meal receipts for business they won't bother you about this deduction but if you claimed 100% you will be grilled or toasted and your claims unmercifully slashed and deemed personal unless you can convince the examiners otherwise.

As a citizen your democratic right is innocent until proven guilty. As a taxpayer the opposite is true.

A self destructive trap that certain taxpayers fall into is to request receipts that increase the amount of the actual bill. As a result of a net worth audit all of the extra amounts are deemed unreported income because they show up in the final assessment.

Forged receipts, exaggerated receipts, found receipts or receipts from well meaning friends can add up to thousands of dollars over three years and when it all adds up at the end of the audit you will wish you didn't have to deal with paying taxes and penalties on money that you never earned or possessed.

What you believed was saving you taxes could very well be the nail in your coffin.

Travel expenses

Auditing this claim alone is a gold mine for the department of revenue.

Business trips combined with pleasure to fun areas are frowned upon as taxpayers tend to take liberties with the deduction and use it to reduce taxes and have a family holiday as well. In most cases when tax returns seem credible these deductions pass without problems. Not so if an audit is in progress. Practically every deduction has to be explained. Who accompanied you on the trip, what business was accomplished, what is the personal portion? When meal and bar tabs are presented, who did you do business with, can we call him? If you answer “no” it becomes another personal expense typed into your computer record. Other costs as well will be denied if there is any doubt at all.

During the audit pauses try to anticipate the questions that are going to be asked about your travel claims and have the answers in writing beforehand. Identify all of your claims and explain how the trip was essential for your business. Substantiate your position by bringing all the documented proof you have available. It is in your best interest if you can convince them not to tamper with your expense report. If you can't do this you have cause to be worried.

Sporting events

Is it really necessary to entertain a prospective client by taking him or her to a hockey game or other event? You'll have a lot of explaining to do if this is a regular tax claim.

You will need the documents to prove beyond a doubt that your business benefits from any form of entertainment.

Meal and bar receipts don't mean anything other than personal spending to an auditor.

The latter will want to know what the connection is to making a profit or loss. In other words if you can show that business flourished as a result you may be allowed a portion of your claim, if you cannot provide the goods your tax liabilities will mushroom.

Personal spending

A net worth audit is not complete until everything is considered.

Coming near the end you will be asked to give an account of your personal living and spending habits. How much do you and your spouse spend per year on personal entertainment? How much for laundry, hairdressing, movies, lottery tickets, groceries, gifts, golf, bowling to name just a few of the questions you will be asked. They need this information to complete the cycle which determines your total net worth. This is the final step before you are presented with the revelations that you are much richer than you imagined and you will be assessed for taxes accordingly.

At this invasion of privacy you will be reluctant to reveal anything about your personal life, your attitude will be,” How stupid do they think I am”? However, in your own best interest it is better to supply some accounting of your personal spending otherwise the auditor will deem an amount he considers applicable to your lifestyle and you can be sure it will be much more than anything you can come up with. The auditor is always motivated to enhance his work performance record rather than care about your problems.

At this point you may well realize that you are going to be nailed by the dreaded report which is near at hand.

And you have probably lost hundreds of productive hours already from your profession adhering to the demands of the auditors; finding documents, checking accounts, attending meetings, etc, all at your personal cost.

Deep down you will be sick of it all, the psychological stresses will get to you and you will experience real fear of the unknown. Try to relax if you can, it's not over yet. The mental torture continues and the worst is still to come.

The dreaded reassessment of your tax liabilities

You will be invited to the assessor's office to be awarded the final report.

The assessor will be accompanied by his supervisor; they will both have their panic buttons close at hand. Some taxpayers have been known to crack at this point.

They will hand you a stack of papers almost an inch thick and you will be told if there's anything you don't understand just ask and it will be explained to you. They always seem so nice and understanding when they tell you this, they certainly don't want to upset you any more than the breaking point.

Frankly you won't understand anything. The only thing you will see is a computer generated maze of figures page after page from one end of the manuscript to the other. There will be too much to study, too much to digest, too many references and too much confusion in the mind.

You will be presented with an additional document which you will meekly sign to acknowledge that you have accepted the report and that the consequences were explained to you.

They will mention that as a citizen you have the right to appeal if you do not agree with the assessment. They are not on your side when they tell you this they are obliged by law to inform you of your rights no more no less.

You will read and go over the documents dozens of times before you begin to grasp the full meaning of the figures along with the liabilities. If you have an accountant working on your case he will probably be just as confused as you for a while.

The realization of what it all means will scare the hell out of you. Every detail of your financial life will be documented, classified and cross referenced for the past three years. But it all boils down to two simple basics; Business expenses and Personal spending.

If your total spending amounts to more than your declared income over the three year audit period you better have a good explanation otherwise it is classified as unreported income and subject to fines and penalties.

Some of the shocks you will experience at this time are the disallowed business expenses.

They are presented to you as a worst case scenario and will be revised only if you can provide evidence to the contrary.

If you do not have a log documenting your car expenses at least half of your original claim will be disallowed.

If you have a box full of receipts for meals, travel vouchers and entertainment it won't matter. Most of them will be dismissed as unacceptable unless you can provide documented information outlining the people you entertained and the corresponding relationship they have with your business.

If all you have in your home is a basement or attic office from which you conduct most of your business and you are claiming 30% of your home it will be reassessed to 10% if there are 10 rooms in your house. That means mortgage payments; property taxes, heating, electricity and maintenance claims are slashed proportionately and transferred to your unreported income file.

Your telephone claims will also be revised unless you can prove all the personal numbers in your telephone statements were in fact business calls. The same applies to your cellular phone; examiners have been known to ring a taxpayer's cell phone to see if it is a family member who answers, in the event a family member or child answers it is deemed a personal phone and the onus is on you to prove otherwise. Phone statements also list the caller's activities for the examiners to see who you communicate with the most. Personal calls become disallowed expenses. Calls to financial institutions outside of those you claim to deal with will require explanations.

Only the basic items are mentioned here as they apply to all self employed taxpayers. Each individual has his or her own special deductions and each one of these undergo intense scrutiny during an audit.

Nothing is final yet

Nothing is final yet, you will go back home with your report enclosed in a brand new oversize envelope to digest at your convenience. You will have some time to plan your defense knowing that the burden is on you now to prove most of your claims are genuinely business. You will wish at this time that you will wake up and it is only your worst nightmare but in reality that is what it exactly is, you will also wish you hadn't tried to get away with trying to pay the least tax possible.

You will study the distressing report dozens of times before you begin to grasp the full meaning and the seriousness of the figures. It will scare the hell out of you. Assuming you weren't as organized as you should have been, your expenses were not fully substantiated with iron clad documentation and you were unable to convince the examiner that your claims were genuine, here is an example of the consequences.

The figures below are probably the minimum you will find when someone is selected for a net worth audit, they are approximate and are used solely to highlight the dire consequences of a person singled out as a potential tax cheat. The figures below do not cover cheaters who did not declare all of their income only someone who exaggerated on their expenses. Tax cheaters who under report their income can expect to be investigated and penalized much more...

In the eyes of the auditors all disallowed business expenses translate to undeclared revenue upon which taxes must be paid in addition to interest penalties and fines.

Each tax year

You claimed $15 000 car expenses which are denied by half……………. $7,500.

$5000 travel expenses disallowed by 50%...................................................$2,500

$$5,000 meal expenses reduced by 75%......................................................$2,500

$10,000 home office reduced by 75%...........................................................$7,500

$600 telephone expenses are cut to 50%.......................................................$ 300

$600 cell phone slashed to 25%......................................................................$ 450

Only six basic deductions are used for this calculation to expose how a net worth audit can bankrupt some taxpayers.

Just the basics alone in this example reduce your business expenses by a total of $21, 000. Net worth audits are generally over a three year period which would multiply the figures to a total of $63,000 considered as unreported income.

Assuming the penalty for unreported income is 100% the amount doubles to $126,000 {penalties can be assessed as high as 200%}.

Now you owe the government $126,000 before interest. This would average

10% over three years and give you a grand total of $152,000.

But that is not all, if the total of your business and personal spending is calculated as more than what your net worth should be in relation to your income the surplus will be added to your tax liabilities with interest fines and penalties also.

The three years selected for the audit are usually back dated two years prior to your current tax year so don't be surprised if the auditors return to see you again in a year or two after the audit to check on your current tax declarations and reassess you some more.

This is not a completely accurate accounting; it is used solely to emphasize the gravity in which the taxpayer may find himself under the circumstances. It could be much worse if you consider that when auditors take on a case they are expected to recover all the salaries of everyone involved as well as make a sizable profit for the treasury. They will also be looking at investments, income splitting, real estate deals, loopholes and tax shelters where the potential is greater.

Don't panic just yet

Don't panic yet! The assessors have given you their evaluations which are exaggerated and in their interest alone to say the least, but the assessments will stand unless you can prove otherwise.

Democratically a person is always innocent until proven guilty except in tax matters “You are as guilty as sin unless you can prove your innocence” and to do this you will have your work cut out for you...

Where do you begin?

Start by looking for double entries. The examiner during the course of the investigation types every expense both business and personal into the computer and because of the various methods of settling accounts the same expense can be entered more than once.

For example, your spouse purchases an outfit at sears for $500. This amount will show up on her Sears's card and is typed into the computer. You pay the amount by check from your personal account this also is entered into the computer resulting in $1000 being credited to your personal spending. Audits are notorious for this type of double entry and you can save yourself a good deal of money in the end by ferreting all of them out.

At this stage the report may qualify you as a delinquent taxpayer with untold thousands of dollars of unreported income based mainly on what they determine to be your net worth and by the amount of claims which have been disallowed.

Live in relatives

Early on in the investigation you may have been asked if someone lived with you other than your spouse and without thinking you answered no! Even though you had an adult relative who resided with you for the most part of the audit period. If this adult paid rent you would have to declare it as income, however, if this adult didn't pay rent but paid for the groceries each week for the household to the tune of $100 per week you would be able to reduce your undeclared revenue by $15,000 over the audit period of three years. Add to this all the monetary gifts you received from your daughters, sons or parents and you will save yourself a nice chunk of money.

To reduce your net worth further check your reported expenses to see if some of the items you claimed were given to you as gifts: items of office furniture, a computer, camera or something of the sort. If these items are essential to your business it is OK to claim them as an expense even if someone else paid for them but prove to the auditors that the money didn't come out of your pocket and the amounts should be deducted from your net worth assessment.

Always keep in mind that whatever you save is threefold and free from fines and penalties.

Revenue outside the audit period

You can reduce your net worth assessment further by identifying the receivables that were outside the audit scope but were qualified by the examiner as income during the period. For example; checks that were received in December before the audit period came into force but were deposited early in the following year while the audit was in progress. The same goes for the expenses that were incurred outside the time limits but were settled during both ends of the period.

Painstakingly going over every entry to try to reduce your net worth assessment is a lot of work and a pain in the ass but a necessary evil if you want to clear your name and eliminate as many liabilities as possible.

Roll over money

If you made transactions or cashed mature bonds or bills during the audit period and rolled over the money to purchase current bonds the assessors will not take this into consideration unless you make them aware of it, they will assume the money to be undeclared revenue.

The amounts you paid out to purchase the current bonds or bills will be added to your personal spending column for the audit period artificially bloating your allegedly unreported revenue account. Watch out for this type of discrepancy and present your documents.

Disallowed car expenses

Auditors take a hard line with regard to car expenses.

The only criteria acceptable to them is a running log of all your trips both business and personal, the odometer reading when you start and finish your trip and the reason the trip was made. But what if you had a log and lost it? In that case they would permit you to reconstruct one providing you had documents to back up your claims. It would be painstaking work but well worth it if you can persuade the assessors to allow you to claim more than the meager bare minimum amounts arbitrarily judged.

You would need to review your bills and receipts one by one and document them in ledger style, noting the trip the distance and relationship to your affairs. Once you have dispensed of your business receipts you can also use bank deposit slips that indicate trips to the bank, gas receipts as trips to the gas station, parking slips, garage repair bills, and car washes. These are all necessary expenses when running a business.

In some cases there are no receipts such as meetings although you should provide proof that such a meeting took place. Can you prove that you drove to the post office every day to pick up your mails if so ask the postmaster to affirm this on paper?

Your credit card statements may also have reference to car trips that were business oriented.

There is a lot riding on car expenses when you consider the thousands of dollars that are lost to depreciation each year as well.

In the end add up your total estimated mileage and compare it with your total mileage. If the auditors are reluctant to change the initial arbitrary assessment at least you will have the papers to sway the judge.

Meals entertainment and travel

The auditor will not budge an inch unless you can vouch for every item you have claimed.

Each receipt must bear the name of the client and the business association. The auditor is a tough customer even if it is a female who is five feet tall and weighs a hundred pounds. She considers all meals, entertainment or travel expenses as family affairs unless you can prove otherwise.

Disallowed home office expenses

The auditors arbitrarily reduced your home office expenses and now the onus is on you to prove that you actually used more space than they gave you credit for. You need iron clad documentation if you are going to convince the assessor [or the appeal judge if you go that far] which means you must get it all on paper. Measure the square footage of the entire living space in your home and record it. Measure your office.

If your office space is 400 square feet and your total home space is 2000 square feet already you are entitled to a one fifth deduction but that's not all.

The passageway to the front door is also a deductible if you regularly meet with your clients at home and who is to say that you don't? The passageway to your bathroom is also a necessity and don't forget the passageway to and including a storage area.

Having it all on paper strengthens your argument. If it fails to move the auditor you can be sure a judge will be more sympathetic in your favor.

Pictures are worth a thousand words .Support your documentation by taking pictures of your activities and the spaces that you use in your home location.

Do you need an accountant or lawyer?

During the course of an audit an accountant or lawyer can cause you to go bankrupt before the auditors finish the job.

Can you afford fees of $200 or $300 per hour if the audit runs for more than a year? Net worth audits take a long time, you are up against the ropes and these people know it.

If you happen to fall on an accountant without scruples blindly trusting that his final bill will be easily affordable it could end up costing you as much as the liabilities you owe the tax collector. Discuss fees before committing yourself and only use his service when you have no other alternative. Undertake to do all the legwork yourself, make your own phone calls to the auditor and above all do not give permission to the auditor to call any of your representatives on your behalf.

A joke around the auditor's lunch table highlights a $300 an hour lawyer spending hours negotiating a $10 deduction.

What should you do if you feel you can't handle it yourself use the services sparingly?

A lawyer can advise you about your rights but during the course of an audit there is very little else he can do.

The auditors run the show, they demand certain papers and you have to provide what they ask for. You may need a lawyer at the later stages when you are asked to sign certain papers that you are not sure of or if you eventually wish to appeal the assessment. Make sure you discuss the fees beforehand.

As for negotiating with the auditors there is very little you can do. They are however easily moved when your point is given and proved. Auditors are human beings although they have no feelings.

Settlement

When all is said and done, when all the adjustments and allowances have been made, the auditors will want to complete the report as much as you, they will listen to any arguments you may have and for the first time in the process they will offer to negotiate a settlement that will end it all.

If you don't agree with the assessment there is always the appeal stage but this could be expensive even if you win a few points and force you into bankruptcy if you lose.

Assuming that you come to an agreement with the assessors just to end it all they will ask you to sign a form to that effect.

Before you sign study it carefully. It may set limits on your future tax reporting based on the assessor's opinion of what you can deduct in expenses.

Don't be surprised if they show up at your door three years later. If your habits do not conform to their recommendations you may be audited again.

Note

This is the second part of a two part article describing the mental anguish of taxpayers who are suspected of overstating their expenses and who have been selected for a net worth audit.

The information contained in the first part can be found entitled:

Don't get caught cheating on taxes

Everyone is vying for how they're going to spend that shiny new rebate check, and yet, most Americans will stimulate the economy and have nothing to show for it by next year. Have you considered how you could possibly double its value by using some of it to invest in your business?

If you can hurry up and file your 2007 tax return before October 15th, I recommend four ways you can utilize your rebate check to maximize your business and save hundreds of dollars next year when you file your 2008 taxes.

1. Tools & Equipment

   Think of the new laptop you could get that would pay for itself in less than a year.

2. A “Conference” Vacation

   If your family insists on going out of town, why not find a location or cruise that also has a conference going on related to your business? That way the trip can be at least 50% tax deductible as opposed to 0% deductible if it was a personal vacation.

3. Marketing Budget

   How about funding that great advertising campaign that could get your business more name recognition. Sponsor a local event or get an ad in a local newspaper.

4. Pay Off Debts

   Make an extra principal, interest, or lease payment. Not only will it lower your liabilities, but it can be deducted next year if you file Schedule C.

Think of the long term gains that could be had if you earmarked some or most of that windfall from Uncle Sam towards these four financial strategies. You never know, those diamond earrings you were eyeing could come a lot quicker through your own business success if you consider investing in your business.

About the first I can only write in generalities. He regularly hid receipts in his own business so they wouldn't have to be reported as income and he paid people in cash so he didn't have to pay employment taxes. I have vague recollections of other practices that might be considered illegal or, at least, unprofessional and unethical.

In preparation for discussing the second CPA, let me give you some background information. In 1999 I was really in need of work and started with this small mortgage brokerage primarily as their telephone and computer technician. The boss found out that I knew something about bookkeeping and turned over to me the QuickBooks file and I found myself the bookkeeper for the company.

As just a worker bee in a small company I never begrudged my boss the fact that he was living very well and I was just barely squeaking by.

He owned a horse. All the stabling fees were paid by the corporation as rent and all the veterinary bills were paid by the corporation as medical expenses. The trainer was paid by the corporation and charged off as consulting fees or automobile expenses.

He also owned a boat. The slip fees were charged off as rent and all the maintenance was covered under automobile expenses.

Neither the horse nor the boat was corporate property so these expenses could not be considered business expenses. To the best of my knowledge he never had a party on the boat to which he invited clients and he never allowed clients to ride his horse. Thus it would seem the total amounts paid were income for him and unreported to the IRS. This is only conjecture on my part.

His monthly car payments and maintenance expenses were paid by the corporation. The monthly insurance payments were also paid by the corporation and charged off as automobile expenses. None of his cars were ever brought in as corporate assets so these payments all represented unreported income for him.

His home rent was paid by the corporation. His phone, electric, water, trash, and gas were paid by the corporation as corporate expenses. His home association fees were paid by the corporation as building maintenance. None of these were ever reported to the IRS as income.

He claims to have been audited three times by the IRS and twice by HUD, so possibly these income questions have already been addressed. This treatise, however, is not about him, but the corporation's CPA.

The aforementioned were intended merely as an introduction to our accountant, Rxxxxx Lxxxx Dxxxxx, a licensed California CPA, license number 6xxxx (see editorial note at the end). Each year, in order to be certified by HUD, we had to submit audited financials along with our application and the boss retained Dxxxxx to conduct those audits. In all the years we were HUD certified and I was with the company, Dxxxxx never once conducted what I would consider to be an actual audit. He prepared all the HUD required documentation without looking at any of the accounting procedures we followed or any of the supporting paperwork.

His audit consisted of having me send him a trial balance, printed out from QuickBooks, then having me adjust various amounts so certain ratios were not too high. The only paperwork he looked at was the trial balance I sent him and the bank statements with associated cancelled checks. Never once did he ask to see any bills or invoices.

Was he aware that the financials he was preparing for HUD were inaccurate and (in my opinion) fraudulent? Consider these two points. First, one year my boss was thinking about bringing his boat into the corporation as an asset so he had me carry all the expenses honestly as “boat expense.” For whatever reason, at the end of the fiscal year, we had not made the boat a corporate asset so Dxxxxx told me to change all the “boat expenses” to “automobile expenses” and resubmit the trial balance. The second point is that in 2001 our accounts payable were around $22,000 and Dxxxxx said that was too high. The solution? He had me simply delete bills from the books to lower the payables to around $5,200 and resubmit the trial balance.

HUD required that the audit be conducted by an independent CPA. That implies one who is, although paid by the company, working on behalf of the U.S. Government to ensure compliance with “generally accepted accounting principles.” In two years (2000 and 2001) he was paid $4,700 for the preparation of two reports that were used to secure HUD certification for the company. This was in addition to the fees paid to him for the preparation of the corporate tax returns and the boss's personal tax returns.

Both his 2000 and 2001 audit reports reflected the same thing as summarized in the 2001 report, “In my opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Xxxxx, Inc. dba XXX as of April 30, 2001 and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.”

Prior to submitting this I showed it to my old boss and his comment was, “Maxi, That is a cute fictional story. FYI an audited financial is what is required by HUD and that is based on canceled checks, reports etc. Dxxxxx never went off of your reports which were usually way off.”

To my way of thinking, the boss made two critical errors in making this statement. First is the fact that paragraph 4.27 of the Government Auditing Standards (July 2007 Revision) says:

“4.27 Under both the AICPA standards and GAGAS, auditors should plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Recognizing the possibility that a material misstatement due to fraud could be present is important for achieving this objective. However, absolute assurance is not attainable and thus even a properly planned and performed audit may not detect a material misstatement resulting from fraud.”

If Dxxxxx didn't use my reports for his audit report, he must have used only the cancelled checks. When I entered the checks into or printed out the checks from QuickBooks I'd put something on the memo line regarding slip number (F34) or the boat's name (Cra Sea Horse). When the boss wrote them manually he sometimes included that information and sometimes didn't. Whether there was anything on the memo line or not, one would have to assume that even a high school bookkeeping student would question one thing. There were many checks made out to Newport Dunes Resort Marina, Super Clean Yacht Service, Ricardo's Boat Service, Newport Landing Fuel Dock, Kanqui Diving Service, Green Willow Quarter Horses, Wild West Trailers, and Pacific Coast Hull, Inc. All of them were charged against rent and automobile expenses. Also, a check made out to Charles Liskey, D.V.M. and carried as a medical expense should have raised a red flag, and didn't.

The second error is that an audit is designed to catch procedural errors in the accounting system of a company. If my reports were “way off” that would indicate that our company had procedural errors. If so, why did Dxxxxx not make some comment regarding the poor bookkeeping procedures used by the corporation? A follow-up question would be if he only reviewed the cancelled checks and not my trial balance, how did he come up with amounts for accounts receivable and accounts payable?

All of these instances beg the question of why a licensed CPA would submit a report he knew was erroneous or (again, in my opinion) fraudulent? Was it just a matter of money or does it go deeper? Is there something wrong with the licensing procedure? Does the California Board of Accountancy just issue a license and then wash their hands of any responsibility for the conduct of its licensees? Yes, there is a complaint procedure, but who, in this case, would use it. Certainly not the company as the CPA's report showed it to be doing everything right. Who else but the government would care? Is the federal government going to file any sort of complaint with the board?

I wish I could say I had an answer. I cannot see any way the board can realistically police its licensees. Maybe the moral fiber of the licensees is at question. Can students be taught morality in school? Can teachers or professors do more to ensure graduates actually abide by the publicly expressed high ideals of board members?

Perhaps it goes even deeper and calls into question the integrity of all California licensed CPAs. Following that line of logic, if other states use the same licensing criteria, does that indicate a failure on the part of every CPA in the United States?

[Editorial note: I had originally included the CPA's actual name and license number as well as the corporate name. I was, however, advised by a friend in the legal community that I probably didn't want to do that. Even though I still have the QuickBooks file and copies of the HUD audits and tax forms, she felt it would be better to blank out some information.]

Taxable wages have to be reported to the federal government when anyone makes more than $600 in a calendar year or taxes have been withheld. This is true for federal, state, and local income taxes and Social Security/Medicare taxes. Any taxes withheld have to be recorded and sent to the Internal Revenue Service of the correct governmental division.

The forms themselves can be obtained for free in small quantities for small businesses. To produce large numbers of forms automatically, the forms must be purchased as continuous form documents for tractor-feed printers or created by computer program as they are produced. The type of form needed depends on your method of producing them. If you are going to produce your own forms from blank paper, the right type of stock with perforations needs to be secured.

You will need certain information available before beginning to prepare the actual forms. The form requires you to have the employee's name, address, and social security number regardless of whether it is a 1099-misc. or a W-2. You will also need the business name, address, and federal and state identification numbers.

Once you have the identifying information, for W-2 forms, you need to know the amount of taxable wages for all governmental levels affected. You will need to make sure that any non-taxable items are withheld from the appropriate boxes. For example, if you have 401k deductions or deductions for a similar type of retirement account, these wages are not taxable and should be excluded from the taxable wages boxes. The same is true for approved health care type deductions.

The gross wages should be included in the proper box for reference purposes. These wages will only be listed once. The taxable wages must be repeated for federal, state, and local wages in the correct box in that area of the form. The taxes should be listed in the box next to the taxable wages for federal, Social Security/Medicare, state, and local taxes. Once these numbers are in place, the W-2 form is normally complete. If other special cases have been used for your system of payroll, consult with the instructions or an accountant for proper usage. There are too many variable to cover all of them here.

When completing the 1099-misc., the only real information needed after the employee and company data is the taxable wages. Since contract employees have no taxes withheld, there are none to report. The government considers these people to be self-employed.

Some classes of employees are considered self-employed, but should receive a W-2 form and not a 1099-misc. The primary example of this would ministers who receive a salary from a church body. For these employees, the W-2 is filled out with just the taxable wages because no taxes are withheld.

The reason for this oddity is that churches are not taxed. This means they are not liable for the 7.65% of wages that employers remit for Social Security/Medicare taxes. The minister who still participates in the Social Security program is required to pay the entire 15.3% of the tax just as self-employed people do.

A copy of all W-2 and 1099-misc. forms are kept by the employer and a copy sent to the government. Enough copies of the forms are given to the employees so that a form is available to them for each type of taxes withheld. If the employee worked in multiple states, a separate copy must be given for each state.

The wages and taxes from the forms must be totaled and recorded on a cover sheet. For form W-2, this is a W-3 statement. Only one W-3 is filed regardless of the number of W-2's attached. W-2 forms are to be left as near to continuous-form as possible. Under a separate cover, the employer remits taxes on form 941 to the federal government at the same time.