Arm yourself with knowledge about tax audits and how being audited works so you can avoid an audit in the future.
Getting Audited: How You Get Picked
Each year the IRS selects about 2 percent of all returns to be audited — a process they now prefer to call examination. The majority of the returns are picked by computer according to a technique called discriminant function (DIF), which is based on criteria updated periodically with information produced from about 50,000 thorough audits under the Tax Compliance Measurement Program (TCMP). The forms to be audited for TCMP are picked randomly by social security number, so anyone could be picked for a TCMP audit. The majority of audits, however, are selected at the National Computer Center in Martinsburg, W.V., from the DIF list of items — the contents of which are a closely guarded secret.
We do know that the DIF system divides returns into 10 taxpayer categories, so that the data from TCMP can be applied selectively and boundaries for deductions can be set up. If one or more of your deductions exceeds the amount DIF has decided is appropriate for your category of taxpayer, the computer tallies points for your return. Other flags may be included, such as tax assessment changes made in previous audits. Should the total points you score be above the threshold for your category, your return will be flagged for audit.
Once flagged, the information is sent to the IRS district office in your area, where an experienced agent classifies all selected returns according to audit priority. Some may be disqualified from audit, but none may be added. In general, the returns with the highest possibility of producing large tax assessments are given greatest priority. Obviously enough, audits that have proven lucrative in previous years are likely to be repeated. Those with lower priority may not be audited, simply because the IRS hasn't the staff to get that far down the list.
Other returns may be selected for audit at the district office for a variety of reasons. For example, returns prepared by "notorious" tax professionals — the IRS has a program to identify such persons — are often selected. This is also the place where audits can be initiated by people reporting others for suspected evasion. The IRS encourages this program by offering anonymity and rewards of up to 10 percent of the additional tax assessed. Furthermore, district auditors may decide to examine your return because they've found irregularities on a return of someone with whom you have business dealings. For example, if one person's claim reveals a problem with a real estate partnership, then every partner will probably be audited.
Returns may also be selected for audit at the regional service center, where they are screened for such things as mathematical errors, unallowable deductions, improper head-of-household claim, multiple filing, federal-state cooperation and agreement with information returns. The IRS now matches up close to 90 percent of information returns to 1040's. Large cash transactions must be reported: The IRS has caught a number of people who bought houses with cash from unreported sources.
How to Avoid Getting Audited
As we've already mentioned, the methods by which the IRS picks returns for auditing are very secretive, but there are a number of approaches that can lessen your chance of being audited — all of which could be summed up under "keeping a low profile."
Deductions that are out of line with your income level are likely to make the DIF buzzer buzz. Deducting sales tax on a $30,000 car when your income is $12,000 per year is one example of a sure tip-off. If you end up in such a situation, attach an explanation to your return.
The IRS is also set up to single out tax protest-related actions. Deducting the percentage of the military budget is sure to bring the revenuers down on you, as will religious deductions for mail-order churches. The IRS also devotes attention to seeing that members of organized barter groups report income from such activities.
You can also help ward off an audit by preparing your return neatly and accurately and by listing your deductions clearly on separate sheets. All it takes to send the computer into a DIF frenzy is a transposed or misplaced number: Let's say you inadvertently drop a $3,600 employee business expense figure from line 24 (its proper place) to line 25a on Form 1040. As far as the computer is concerned, you've just exceeded the maximum IRA contribution by $1,350.
While you should cooperate fully with the IRS, you needn't volunteer more information than is required. On the other hand, don't force an auditor to prospect. When you're listing deductions, don't round off figures to the nearest $25, $50 or $100. Report the exact amount (to the nearest dollar), so that an auditor doesn't assume that you've just estimated the figure.
Finally, the signature of a qualified tax prepared — as long as that individual hasn't made the IRS list of notorious professionals — may be some assurance to the IRS that the return was prepared competently and honestly. Tax professionals are known to the IRS, just as tax professionals know IRS auditors.
What Happens in an Audit?
The most common type of audit will not even require you to meet with an IRS agent. The service center computer will spit out your return along with a letter describing the deficiency it has identified, and you'll get a notice by mail of a change in tax due. Or the computer may ask for more information about the deductions you've claimed. Though these form letters aren't nearly as intimidating as a phone call requesting that you appear at the district office, they're not to be ignored. You'll be much better off in the long run if you cooperate and attempt to resolve the discrepancy immediately — before an agent gets hold of your return and decides to look into it more carefully. One CPA friend got such a letter the year after he married a woman with two kids — the IRS wanted to know why his return listed four exemptions, when the previous year's listed only one.
The other two types of audits are office audits and field audits. The former usually involves specific aspects of your return, and you'll be asked to appear at the district office with paperwork to confirm your claims. Office audits generally don't last very long, and are limited to parts of your return that the agent has already identified and studied in advance. Office audits may be conducted by a relatively inexperienced IRS employee. Since you know what's on your return and have had more time to study it, you may be more knowledgeable than the auditor concerning the legal points of your return. Be careful: Don't let the auditor intimidate you into accepting something that isn't correct.
Field audits, on the other hand, are more like fishing trips through your return, and the agent — who's likely to be quite experienced — will often prefer to do the audit at your home or business. If someone drops in on you and claims to be an IRS employee, you should first establish the person's credentials and position with the service. Find out whether the person is actually a field auditor or an IRS special agent. If the person is a field auditor, ask the nature of the visit, and schedule an appointment allowing yourself sufficient time to round up all needed paperwork. If he or she is a special agent, call your attorney.
It's too big an undertaking for us to try to explain in this article the whole audit process and what you should do to prepare. We suggest, however, that it's a good idea to get professional assistance for office and field audits. This may not involve actually having an accountant or attorney attend the audit with you, but you should get competent advice in advance on how to deal with the audit.