When most individuals think about a tax audit, they likely envision a face-to-face encounter with an auditor from either the IRS or a state taxing authority, such as the New Jersey Division of Taxation. Field audits, where an audit is conducted at the taxpayer’s home, place of business, or accountant’s office, fall into this category of audit. During such meetings, tax practitioners often represent their clients, having been authorized to do so after executing Power of Attorney forms.

Much more common than a field audit is something called a “desk audit.” Both the IRS and the New Jersey Division of Taxation conduct large numbers of desk audits, which are effectively high level tax notices.

Which tax items are most often subjected to federal desk audits?

The IRS concentrates desk audits on questionable deductions, the most common being home mortgage interest and charitable contributions. The Internal Revenue Code limits the home mortgage interest deduction for a taxpayer’s principal residence plus one secondary residence to $1,000,000 of acquisition indebtedness – incurred on the purchase or after making substantial improvements to an existing residence. It also includes new construction and $100,000 of home equity indebtedness where the borrowing does not need to be invested in the residence. The IRS actually has audit personnel specifically focused on challenging mortgage interest deductions reported on Schedule A of Form 1040. Loan documents will be requested to ascertain loan balances, along with deeds to prove ownership.

Considerable emphasis has been placed by the IRS in scrutinizing charitable contributions, as the perception exists that there is substantial non-compliance in this area. Any donations of $250 or more require corresponding acknowledgment letters stating that the taxpayer received nothing in return for their donation aside from intangible religious benefits. While these rules have been in the tax code for more than 20 years, many charitable organizations continue to fail to issue proper acknowledgements. For donations under $250, a canceled check will suffice as substantiation. The same rules exist for non-cash donations. Many taxpayers donate clothing and household goods to charities such as the Salvation Army and Goodwill Industries. In this instance, Form 8283 must be filed when total non-cash donations exceed $500.

Which tax items are most scrutinized by the New Jersey Division of Taxation?

State desk audits often involve challenges to the resident credit that is claimed when income is taxed by a nonresident state. Many New Jersey residents file nonresident state income tax returns as a result of deriving income from nonresident states. The most basic situation involves wages where a New Jersey resident works in Manhattan.[1] While this situation is rather straightforward, issues often arise when a taxpayer is an owner of a pass-through entity, either a partnership or S corporation that conducts business in other states. In order to claim a resident credit, the taxpayer must incur both nonresident tax and New Jersey tax on the same income. Often, commercial tax software is unable to correctly compute the credit. The Division of Taxation has auditors who focus exclusively on challenging the resident credit. As a result, New Jersey has a long line of court cases addressing the resident credit.

How should a taxpayer respond to a request for audit?

Responding to an IRS desk audit notice is often perplexing. The notice will list a telephone number. However, calling the number typically leads to a recording that the user’s voice mail box is full, and thus it is not possible to leave a message. A detailed submission in response to a desk audit is sometimes greeted by a complete disallowance of the deduction in question, necessitating a duplicate submission of the documentation.

What may look like an innocuous tax notice actually may be a desk audit. Taxpayers should never ignore such correspondence, as failing to respond can only have negative ramifications.