Desk Audits — More Common Than You Might Think
As the IRS workforce steadily declines, so does the number of field audits that are conducted. Examination staffing in FY 2016 reached a 20-year low, 23 percent lower than FY 2012 with the number of examinations down 32 percent from FY 2012. While fewer field audits are taking place, there does not appear to be any reduction in the number of “desk audits” being conducted. A desk audit rarely involves a meeting with an IRS auditor. Typically, there is not even a verbal communication. Rather, a CPA, on behalf of their client, simply responds in writing to the IRS tax notice generated by the taxing authority. While the New Jersey Division of Taxation audit workforce has not seen a reduction on par with the IRS, it also conducts a significant number of desk audits.
The IRS typically generates CP2501 or CP2000 notices that identify discrepancies between third-party information such as W-2 and 1099 forms and K-1s. The notice simply challenges the taxpayer to explain that there was no under reporting of income. While sometimes accurate, these matching notices are often incorrect. Examples of common issues include documenting timely rollovers of retirement plan distributions or the use of Sec. 529 plan withdrawals for qualified tuition expenses.
Deductions claimed on Schedule A, namely charitable contributions and mortgage interest, are also commonly scrutinized via desk audits. For charitable contributions, the taxpayer will need to provide copies of all contemporaneous written acknowledgements for donations of $250 or more, as a cancelled check will only suffice for a donation less than $250. For home mortgage interest, the taxpayer may need to provide the loan documents, deeds proving ownership and the calculation of deductible interest reported. Some taxpayers improperly claim a deduction for more than the interest paid on their principal residence and one secondary residence. Other taxpayers will fail to adhere to the $1,000,000 acquisition indebtedness (reduced to $750,000 for residence acquisitions after Dec. 14, 2017) and $100,000 home equity indebtedness (eliminated by the Tax Cuts and Jobs Act) limitations.
The New Jersey Division of Taxation focuses most of its desk audits on the resident credit claimed for taxes paid to other jurisdictions. Typically, a taxpayer receives an innocuous letter stating that in order to complete its review of the Form NJ-1040, the Division of Taxation needs to be provided with a full copy of the Federal Form 1040, copies of nonresident state income tax returns and copies of K-1s. As commercial tax software cannot be relied on to make accurate resident credit calculations involving pass-through entities, the Division often generates an assessment from these desk audits absent the tax preparer having circumvented their tax software to arrive at the proper credit. If there is an error, besides the underpayment of tax, the taxpayer will be charged interest, a 5-percent late payment penalty and, depending on the tax period, a 5-percent “amnesty eligible” penalty.
Another area for New Jersey desk audits is where there are sizable differences in the interest, dividends and capital gains reported for federal purposes, which are communicated by the IRS to the Division en masse. The New Jersey gross income tax does not piggyback the Internal Revenue Code. Whereas for federal purposes interest, dividends and capital gains are reported separately, if received via a partnership or S corporation, they are reported in those categories for gross income tax purposes. That pass-through income could conceivably be offset by losses from other pass-through entities. Additionally, there may be significant nontaxable interest reported either from New Jersey municipal or U.S. Treasury obligations that the Division seeks to verify.
Responding to Notices
IRS desk audits are generally not assigned to an identified auditor; however, for the state, the opposite is true as most desk audits have an assigned auditor. IRS CP2501 and CP2000 notices have a section for a limited Power of Attorney for only the notice at hand, which, if completed, allows the CPA to follow up with the IRS practitioner hotline regarding the status of the response. There is no harm in executing a Form 2848, “Power of Attorney and Declaration of Representative,” but it often is unnecessary. When responding to a New Jersey desk audit, one can complete a Form M-5008-R, Appointment of Taxpayer Representative, to be able to communicate openly with the assigned auditor.
This article appeared in the July/August 2019 issue of New Jersey CPA magazine. Read the full issue.