The word “audit” is enough to raise anyone’s blood pressure. If the IRS agent then tells you they want to see bank accounts and personal records you may need a heart monitor. Should this happen to you, you could be in a process known as a lifestyle audit.
The lifestyle audit was a tool used by auditor’s to ascertain if the income you claim on your tax return can support how you live.
As an extreme example, perhaps you claim $30,000 in taxable income, but drive a Ferrari and you have a $700,000 mortgage. Most of us would have a hard time believing the income claimed on this tax return could support this lifestyle.
Historically, tax returns that have a history of cash transactions would be a target for lifestyle audits. So if you ran a small business (schedule C) or worked in an industry like construction, fishing, and retail you could experience this lifestyle audit.
As you might imagine, being the subject of a lifestyle audit is stressful. It could be a more involved process than responding to a letter from the IRS questioning part of your tax return. The best defense for this type of review is good record-keeping. Here are some tips:
Understand your lifestyle risk. Do you think you can substantiate how you live with the level of claimed income on your tax return? Most of us can, but if you inherited money that allowed you to buy a new house, car or other luxury items it might raise questions. If this is the case, keep copies of documentation that supports the event.
Awareness of gift limits. Remember, you may receive up to $15,000 in gifts from any individual in any given year without tax consequences. If you receive gifts from someone, please keep record of the event.
Sales receipts. For every small business deposit in your bank account have a supporting document that substantiates the deposit’s source.
Separation. Keep separate business and personal bank accounts and credit cards. It is easier to substantiate your lifestyle spending when you do this.
Ask why. The passing of the 1998 IRS Restructuring and Reform Act limits the ability of IRS agents to conduct lifestyle audits. In current practice, a lifestyle audit may only be undertaken if the IRS agent has a reasonable cause to conduct the review. The cause might be based on information provided on your tax return or based upon information reports it has received from others. It is reasonable for you to ask for clarification from the auditor as to why they believe a lifestyle audit is in order. Perhaps proper documentation may be all that is required to answer the auditor’s questions.
Ask for help. Remember, should you receive notice by the IRS with questions regarding your tax return, ask for assistance. The same is true with notices from any other taxing authority. You are not going to be as well versed in the tax code as your auditor, so why not ask for help from someone who is.