Read The Transcript Below:

Steven (00:52):

Hello everyone and welcome to the next episode of the Retirement Tax Services podcast, Financial Professionals Edition. I’m your host, Steven Jarvis, CPA, and this week is an extra special episode because it’s airing on my birthday. So you’re welcome to take a minute, blow out a candle for me. Chocolate cake with mint frosting is my favorite if you want to be real specific. But the IRS is not big on birthdays, and this was a little early anyways, but my most recent interaction with the IRS was actually in the form of an audit. Now, this wasn’t an audit of my personal return, but a return that we filed in 2022 for a taxpayer for one of our financial advisors, taxpayers that we do returns for through our RTS Premiere program, they got randomly picked for audit. Now, a couple of things to talk about before we dive into what that experience was actually like, which is what the goal of this episode is, is to share that experience both from my perspective and then hearing from the client as well.

(01:54):

Now, audit is a big scary word, but the IRS uses the word audit very specifically. So when I have clients reach out to me, which happens fairly often with the concern that they are being audited, the first thing I do is ask for the letter where they were informed about the audit. Because unless the IRS uses the word audit, you are not being audited. The IRS sends out thousand millions of letters every year of all sorts of types and varieties, some of which are to let someone know that they’re being audited, most of which are not. A lot of them are automated messages, they’re mismatched letters, they’re just notifications of some kind or another. Since I’m a paid preparer, I have started regularly getting notices from the IRS that they’d like me to complete a survey, which I don’t get excited when I see the Department of Treasury in my mailbox either.

(02:46):

So getting these giant envelopes that are ultimately just requesting that I do a survey is not exactly what I’m looking for. But when we’re working with clients who are getting communications from the IRS want to make sure that we’re reinforcing that the IRS is going to initially reach out through physical mail. They’re keeping USPS going and that we’re looking really specifically for does it say you are being audited? What year is being audited? And then we can go from there right out of the gate when you get communication from the IRS. This is a good gut check of how you feel about your approach to taxes because again, I’m never going to be excited when I see the IRS in my inbox or my mailbox, but I don’t get scared. I really don’t even get concerned. I get really curious. I might get a little bit annoyed.

(03:31):

I’m not going to volunteer for extra communications with the IRS, but I take this approach of wanting to pass the straight face test on every tax return I do for this very reason. It is a very small percentage of returns that will ever be selected for audit or for additional questions or inquiries, but I want to approach every single tax return as if I knew that it was going to be selected for audit and that if it were to be selected for audit, I would not be concerned. So that’s always a good place to start from just so that we know going in, we don’t have to have that moment of panic or fear of, oh no, what did they find? Okay, great. Let’s take the time to explain to them what happened and then we’ll move on with our life. So in this case, client reached out to let us know they’d gotten this letter.

(04:16):

It was in fact an audit. It was for 2022. The initial letter just provided some basic information about how the process was going to work. It let the taxpayer know that they needed to call the IRS to schedule their actual audit. It was going to be an in-person audit at a local IRS office. And so the taxpayer called the IRS agent that was listed in the letter. I was not on that initial call, but just talking to the clients, it’s really just some high level questions just to make sure that they were going down the right path as far as how to get the audit scheduled, some just basic demographic and just kind of high level questions to set the stage. So from that call, they scheduled the in-person meeting. It was a few weeks out, so it wasn’t the next day. They didn’t have to rush out and do it.

(05:03):

They were able to schedule it a few weeks out in part because they knew that one of the services that we offer for our taxpayers that we do tax returns for is that if they get audited while they’re a client with us that we’re going to support them through that audit. Our name goes on the tax return next to theirs, and so we’re going to stand behind the work that we do. So they were able to get the audit meetings scheduled before that meeting. They got a second letter from the IRS agent that went into a little bit more detail about what it is the audit was going to focus on. And so it started and just basically said, Hey, we’re going to have an interview and we can ask you whatever we want. Not exactly how it was worded, but pretty close. But then it got into a couple of specific areas and for this client, for the tax return under audit, they had sold a rental property.

(05:51):

And so that was highlighted. They specifically wanted to ask some questions around depreciation around the basis of the property, and they specifically called out repairs and maintenance. And in that letter they said, Hey, please have supporting documentation, have the depreciation schedules, the calculations have receipts for what you called repairs and maintenance. They were spelling out, here’s what we need to see. The other area of emphasis for this audit was form 8606, and the IRS agent didn’t use the words backdoor Roth, and we’ll get into that more in just a second, but they were focused on the form 8606 and they called out the fact that the client had had a non-taxable IRA distribution during the year and that they had done this conversion to Roth and they had filled out some information on the 8606 and that from the IRS’s perspective, it looked like some things might be missing.

(06:42):

This letter was not accusing the client of doing anything wrong, was not really even suggesting that anything had been done wrong. It was just asking for support and documentation for some of these areas. So I was able to work with the client and say, okay, here’s things that we already have that we’re going to pull together for you. Here’s some things that you are going to need to go and pull. And the reason there’s things that the client needs to pull that the tax preparer is not going to have is that as a tax preparer we’re not required to, and we don’t typically take the time to get every receipt for every expense that goes on a tax return. Now, I do have to apply my professional judgment and there are some things I’m going to look at, but at the end of the day, my job is to report what the client gives to me.

(07:23):

And so for a rental property, for example, if the client comes to me and says, Hey, I’ve got a hundred thousand dollars of repairs and maintenance. None of this needs to be depreciated. It’s all repairs and maintenance, but I’m going to pause for a second and say, Hey, we are going to need to see receipts, purchase orders, we’re going to need to understand better what’s going on here. But, having worked with this client and knowing about their rental property, they had about $5,000 of repairs and maintenance as they were getting ready to sell the property. That felt really reasonable. And so we didn’t collect all of those receipts. But the conversation I always have with clients, whether it’s about rental properties, about small businesses, about charitable giving, Hey, I don’t need the receipts, but you need to keep record of them. If the IRS were to ever ask questions, we would need to provide those.

(08:03):

So that’s exactly what happened to this situation. Taxpayer kept really great records and so they were able to bring those receipts to that meeting. So we fast forward a couple of weeks and the client has their audit meeting with the IRS. They go into the IRS’s office. There were two agents there, your kind of junior agent and then the supervisor, and then they had meet dial in. I was on a conference call because I was not there in person. It was not in my home state, but the agents were really great about that. There wasn’t any issue or concern with having me on the call. There are forms you need to fill out if a person’s ever going to do an audit on behalf of someone, you have to get a power of attorney in place. There’s some other legal things, but the taxpayer’s allowed to have someone else participate in the process.

(08:47):

So in total, it was about an hour long. It kicked off. Honestly, on a very friendly note, the IRS agents are there to do their jobs. They’re not awful people. I know that might come as a shock to you, but for the most part, the people who work at the IRS are people like you and me who are trying to do the best they can with the job they’re in. And that’s an important reminder, and I liken this to if you ever get pulled over for speeding, when you are in that situation where you’re talking to law enforcement or a regulator of some kind, we’ve got to remember that they hold all the cards and it doesn’t help us to be witty or to be snide or cynical or any of those things. We’ve got to remember that that person in front of us is not the one who made the rules that we don’t like.

(09:32):

And so that is not the time to a TSA is another great example. When you’re going through the airport, your jokes about the TSA are not accomplished anything. They’re just making that person’s day worse and in turn, they’re probably going to make your day worse. So we started the conversation with the IRS agents. It really just started with that open-ended interview that they said they would have. They were asking a lot of questions just about the taxpayer’s life, and for someone who is taking an overly aggressive or kind of underhanded approach to tax planning, those could easily turn into really problematic questions. If you are not approaching your tax return with that straight face test in mind, that’s when you would have to be really thinking about what you put on your original tax return, which I don’t like playing those games. And so again, I had no concern as the clients answering all these questions about their marriage status and their state of residency and these different things that feel, that can feel like just a casual conversation.

(10:27):

But that IRS agent was definitely taking notes. And if there would’ve been things that didn’t line up in that casual interview with what was on the tax return, those would absolutely have come back to bite the taxpayer. And so we got to remember that from start to finish of that tax return. Anything we put on there, we are signing our name saying, Hey, this is accurate. And if it turns out later and it comes up during audit that we weren’t being honest or that there were mistakes in there, we can pay the price for that. So after the high level interview, just going through those general questions, we did get into these specific areas of emphasis that the IRS had called out in the letter and we started with this rental property. We’re able to go through the facts and circumstances of what had happened with the sale and with the rental for years before that went through the depreciation schedules.

(11:15):

That was all really quick, just needed to provide them to the IRS. The client, like I said, kept great records, was able to bring in those receipts for the repairs and maintenance all checked out. It was really a very smooth process. The IRS agents weren’t just really drilling or hammering on individual receipts and saying, Hey, why wasn’t it a hundred dollars more? Or, Hey, this doesn’t look right again because the taxpayer took really good records and we were approaching it from that straight face test approach of we only want to put things on the tax return that we can sit down across the desk from a IRS agent with a straight face and explain what we did.

Commercial (11:51):

Hey, listeners, want to save more on taxes? Download our free desktop guide to retirement planning contributions, packed with strategies to help you navigate contribution limits. This guide is perfect for W2 employees, business owners, financial advisors, and tax preparers. Visit retirementtaxservices.com/contributionguide and get your free copy today.

Steven (12:13):

Where it got a little bit more interesting is when we got to the piece about the 8606 and again working with these two IRS agents, I don’t have any idea how much experience either of them had. I know one was a little bit newer, and one was a supervisor of some kind. So I don’t know if that means a year or five years or 10 years or six months, but neither of these agents had ever heard of a backdoor Roth contribution either by name or by concept. I appreciate that they were really friendly, but they were both clearly curious and probably a little bit concerned that something incorrect had happened. They weren’t accusing us of intentionally doing anything wrong, but the questions they were asking, the way they were asking the questions definitely indicated that from their perspective, something was wrong on this return. And so we started going through this and one of the things that was really interesting to me since the client was there in person, I was on the phone, the client was the one responding first to all of these questions, and he would kick it over to me for more explanation where it was needed.

(13:09):

So the IRS agents ask about this form 8606 and just some really high level, Hey, what was going on here? And the client basically responds with, oh, this was a strategy that we worked on together because my income was too high to contribute directly to a Roth, but we still wanted to get money into a Roth. Steven, does that sound about right? Can you provide some additional details? And I thought that was a really great moment because it reinforced the value and the importance of doing education with clients. And I won’t take all the credit for the client’s understanding of this concept. He had been working with his advisor for years before I came into the picture on fact Roth contributions, and he clearly wasn’t an expert in it, but he doesn’t need to be. But his advisor hadn’t just ramped through this strategy that the advisor thought was a good idea.

(13:58):

He had taken the time to say, here’s why we’re doing this and why it makes sense. And I do really think that those kinds of things help in that audit process that the client can articulate in some way. Here’s what we were trying to accomplish, and then I can jump in as the expert in the room and say, here’s how this works in practice. And so we went through together, I talked them through the logic of a backdoor Roth contribution and they were inquisitive. They asked good questions throughout. They were clearly taking notes. It did give them just a little bit of pause that this isn’t a clear cut strategy in the tax code, but we were able to kind of talk through some of the different ways that precedence has been set around this strategy, including that in the actual document of the Tax Cuts and Jobs Act, however many hundreds or thousands of pages long that is, there are a couple of footnotes from Congress or the congressional aids that wrote it that reinforce that a backdoor Roth is in fact an acceptable strategy.

(14:57):

They don’t call it a backdoor Roth there either, but they specifically talk about using this indirect method of getting money into a Roth account even when your income limit is too high. And so that’s about the most authoritative place that really we can point to on backdoor Roth contributions. When you’re in an audit answering these questions, it doesn’t do you any good to allege that this has been done thousands, if not hundreds of thousands of times it’s been being done for 14 years now or whatever it is. We need to point to guidance and which I totally get if I’m the IRS agent, my job’s being evaluated, my performance is being evaluated, it’s not going to look good for me if I just say, oh, hey, this random CPA guy Steven Jarvis, he got on a phone call with me. I hear he wrote a book or something.

(15:39):

He said, it’s okay, so it’s fine. That’s not going to cut it. And so they asked their questions. I sent them some information on where to find this in the Tax Cuts and Jobs Act. There’s also a quote from an IRS Commissioner a few years back, more or less accepting that this is a valid strategy. I think they even specifically talked about how they don’t love the name of it, but that hey, this is something that you can do. And so what went through this process is spent probably 10 minutes on this topic educating the IRS on their own rules. Now, there’s definitely a piece of me that is in the back of my mind thinking, really, do I have to educate the IRS on their own rules? But we’ve got to keep in mind that the tax code is just as complicated if not more complicated for the IRS agents than it is for the rest of us.

(16:24):

I don’t know how the audit process works on their end to know if the agents get to focus in specific areas. I don’t know if this is the first time they’ve come across the 8606 or the 1700th time, but we got to remember that the tax code is 80,000 pages long for them as well. And again, similar to going through TSA or getting pulled over for speeding, you got to remember that in that situation, you are not going to be better off by treating this person poorly. I’m creating a better client outcome, a better client experience by taking the time to patiently explain how this works and make sure that the client gets credit for the great tax planning that they did. As this episode’s releasing, we are still finalizing a couple of things on the audit, but we have received a letter from the IRS where they use the words Backdoor Roth and acknowledge that it is an acceptable strategy.

(17:13):

They want to clarify a couple of record keeping things on the individual years, which is another interesting and pretty frustrating reminder, but important to remember is that just because the IRS gets copies of the 10 99 Rs, they get copies of the 5498, they get copies of these tax documents that the custodians put out at the end of the year. It doesn’t mean that the specific IRS person working on your case has all that information in front of them or understands that information. And so again, we could throw a fit and throw it back in their faces of, Hey, go pull the information yourself. You already have it, and that’s going to create one kind of experience, but that’s not the kind of experience that I want to create. Instead, the rare occasions that this comes up, because it still is the very rare exception that something like this comes up under audit.

(17:59):

When it does, I’m going to take the time to as graciously as possible, provide the information to the IRS, including the supporting documentation so that this strategy that I worked hard with the client to implement gets recognized and they get the full benefit out of it. That we were intending that conversation with the IRS agents wrapped up with them letting us know that they were going to look into this 8606 information we had provided, but as far as they were concerned that we had provided the support that we needed to and that there were no adjustments proposed from the audit, which that’s a fantastic outcome. So like I said, we’re wrapping up a couple of minor record keeping things at this point. So the whole process has been open for probably about a month and a half to two months at this point. I would expect it’ll be open for about three months in total, but it’s been relatively straightforward.

(18:47):

Anytime I talk about IRS audits, one of the questions that I get is, well, why did this client get picked for audit? How do we avoid getting picked for audit? What are the audit red flags? And these are all great questions, but some of them are ones that we don’t have super clear answers on. From everything I can tell, this particular client got picked randomly. There wasn’t anything egregious on their return. They made less than $400,000 a year, which for some reason, that always gets thrown out by politicians as kind of the threshold for where they want to focus on enforcement. But I don’t know how accurate that is to real life. The IRS has not sent me their criteria for picking returns for audit, but we do know that some percentage, some very, very small percentage is going to get picked randomly each year.

(19:33):

As far as red flags go, there are a couple of different software platforms that will highlight potential red flags, but again, that’s really based on historical data and it is guessing to some extent as far as I can tell. The biggest red flags are just doing things that just fly in the face of the IRS is looking for. And so conventional ones, they’re usually on people’s lists of red flags are Schedule C businesses that run huge losses or that appear to be hobbies, outsized expenses compared to revenue deductions that don’t make sense given your income level, not reporting income consistently, constantly having differences between the tax documents that the IRS is getting and what you’re reporting on your return. These are all things that certainly could elevate your risk of audit. But again, for me, and maybe this is just part of it, is the type of clients I work with.

(20:27):

I’m not trying to prove how aggressive we can be with our tax planning. We want to understand the tax code and make decisions that will be in our favor over the long run. But at the end of the day, anything I do on a tax return, I’m only going to sign my name to that tax return. If I feel confident that with a straight face I can sit through one of these audits and explain to the IRS what our approaches. Now, there absolutely are areas of the tax code that are a little bit gray or a little bit murky, haven’t totally been sorted out yet, and I have definitely worked on and signed off on returns that have issues that are in some of those gray areas. But for me, this isn’t a wink, wink, nod nod. It’s a gray area. This is legitimately there isn’t clear IRS guidance on how this specific situation is going to be handled.

(21:16):

And in those cases, we’re still going to take the same approach of we need a supportable, a defendable rationale for why we did it, and we need to be able to document that in some way. And so having receipts, having the calculation that we did, having some kind of, let’s pull the guidance that we did reference in making this decision, those are all things that are going to be in our favor if we were to get selected for audit. So while not the birthday present that I would ask anyone for, again, because of the way I approach these tax returns, when I find out that something’s getting audited, it’s not a moment of panic or fear for me, it’s some mild irritation. Again, would prefer not to do any more audits than I have to. But I know how we approach these returns and that’s part of the peace of mind that I’m trying to give to clients is that yes, questions can come up and we’re going to work through them together, but if they do, we’re going to sort this out.

(22:11):

So that’s my most recent audit experience. It sounds like it’s all going to be a happy ending, and it was glad that I could relay some of the insight from doing this so that other people can learn from it without having to go through it for themselves. It’s actually a big part of the reason that we started Retirement Tax Services that I spend so much time working with financial advisors through RTS is being able to help advisors get to clear answers faster without having to go through some of the pain themselves. In fact, through Wednesday of this week, today’s November 4th, as this coming out through November 6th, we’re actually in the process of welcoming new members to our RTS community. This is an opportunity for advisors to join a group that’s getting access to CPA like me who’s doing this stuff firsthand. We have a whole list of benefits that advisors get from being a member, including monthly content that comes out, webinars that we do, tax return reviews, white label resources and reference guides.

(23:09):

But as of late, I think one of the biggest values I’m seeing, I’m hearing from the advisors who are part of this, is the office hours that we do is the access they get to A CPA who will return their calls, who has scheduled time to get in and answer questions that they have so that when their clients get letters from the IRS when an RMD gets missed or inadvertently, completely converted to Roth, instead of doing the RMD first when a 1031 exchange comes up and there’s no documentation to support why it was done, when these different questions come up and the advisor is either left with going to Google and sifting through a hundred million results or pinging the CPA, that doesn’t return their call for three months. This has turned into a fantastic resource for our RTS Premiere members. And like I said, through Wednesday through November 6th, we have spots available for additional advisors to join.

(24:02):

So if you go on to retirementtaxservices.com, you can see a bit more about what that membership entails and why it’s such a great benefit to the advisors who are already a part of it and how you can get access to learn even more about how you can deliver more value to your clients through tax planning. Super excited about the growth of this program and how many advisors are leaning in and participating and doing more for their clients and would love to welcome you to that as well. So retirementtaxservices.com or send an email to advisors@rts.tax and Jen on our team will get any questions you have answered. And until next time, good luck out there. And remember to tip your server, not the IRS.