Prepare for an Offshore IRS Audit

Don’t be a snitch! Never volunteer information in an IRS audit and this goes double in an offshore IRS audit. The agent is NOT your friend. He’s there to find errors and extract a penalty for those mistakes. While you must always be honest, only answer questions that are asked. Never volunteer new information or expand on a subject beyond the question. You might think you are helping, but you’re just making things worse.

The same goes for documents. Never give more paper than is requested. You might think it shows good faith, and you’d be wrong again. More documentation just gives them more ammunition. More chances to find an error or a discrepancy.

Review your bank statements. Go through your bank statements and understand each and every deposit. Those that are income should be identified as such. Those that are nontaxable, such as loans and gifts, should have supporting documents. The first line of attack in an offshore IRS audit is the bank statement, so be ready to prove up all nontaxable items.

At the same time, identify and find documentation for all business expenses. If you deducted it, have an invoice or receipt ready to go. Never be caught off guard when the agent asks, “What’s this payment for?” Have an answer with proof ready.

Remember that, so long as you are a U.S. citizen, the IRS has a right to audit your offshore company and international business activities. Therefore, you must maintain records of income and expenses for offshore transactions just as you would for a U.S. based business.

I understand that sometimes practices in foreign countries conflict with your desire to document expenses. For example, it is common to pay employees in cash in South America, but it’s hard to prove this as an expense to the IRS.

What I’ve found successful in offshore IRS audits is a log book. Keep a book of each cash payment including the date, employee (independent contractor), brief job description, amount, and their signature. So long as you keep a signed log, cash payments will usually be accepted by the IRS.

Don’t file a tax return during an offshore IRS audit. If you file new or delinquent returns during an exam, the audit will usually expand to add those years. If you file a return claiming foreign sourced income during an audit, you might be admitting to a crime ... something you should never do. If your audit is going on around April 15, get an extension for last year’s return until October 15.

If you have unfiled returns, the agent will probably ask you to file them with him. Assume they’ll be audited and be prepared to prove each item. If you have unfiled returns and offshore issues, see Rule 1: Hire a Professional Immediately.

Foreign Earned Income Exclusion (FEIE): If you are living and working abroad, and qualify for the FEIE, you can earn nearly $100,000 per year tax free in a salary. However, if you don’t file a return, and get mixed up in to an offshore IRS audit, you can lose the FEIE entirely. That’s right, if you don’t take the FEIE you can lose it if you’re audited. If the IRS hasn’t contacted you yet, remember, use it or lose it and file as soon as possible.

Get your records in order. Begin to get your documents and supporting proof together the day you receive the IRS letter. Don’t delay and don’t put it off. I can’t tell you how many people hide their heads in the sand for weeks after receiving an offshore IRS audit notice. Don’t waste a minute. Get ready to meet the enemy in combat as soon as possible. The day of reckoning is coming and you are well behind in the count. You need every second to get ready.

It will take longer to organize your paperwork than you expect. Also, being proactive will give you time to develop a plan of defense and order any missing documents from banks, brokerages, etc. Remember that you never want to answer a question with “I don’t know.” You need to be ready and organized on day 1 to show you’re not the easy target the auditor is looking for ... not a pushover who’ll go quietly, but rather someone who’s prepared and knows his rights.

* Note that all records must be printed. The IRS auditor won’t accept electronic files.

Try to be nice. Even if you have to fake it, be nice and courteous. Most IRS auditors are just doing their jobs ... which, unfortunately, is to separate you from your money. They view you as one of their 100+ cases. Don’t be rude or do anything to get on their bad side. Remain one of 100. There is no reason to draw their ire or special attention.

If you are unable to deal professionally with an offshore IRS audit, don’t get involved and see rule 1 again. Hire a professional and stay out of the room. One of a tax lawyer’s more important skills is to treat the auditor with respect and direct them away from areas of concern.