IRS reinstates random, detailed audits

Dubbed "audits from hell," taxpayers who have endured these detailed inspections say the name is well deserved. Before they were discontinued five years ago when Congress legislated a more customer-friendly IRS, auditors studied chosen returns line-by-line, demanding filers justify each entry.

"I went through this with one client and it absolutely was the audit from hell," says Diane Kennedy, a CPA and founder of DKA, a Phoenix-based tax strategy and accounting firm. "The examiner went through every single line item."

Eva Rosenberg, a Southern California enrolled agent and the Web's TaxMama, had a similar experience with one of her clients. Even insignificant items, she notes, prompted intense scrutiny.

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Neither Kennedy's nor Rosenberg's clients were tax scofflaws. The original Taxpayer Compliance Measurement Program (TCMP) wasn't designed to collect from suspected cheaters. Rather, returns were arbitrarily selected just so the IRS could get a close -- very close -- look at a wide range of what taxpayers were writing off.

Law-abiding filers are again spending time with tax examiners under the renamed National Research Program (NRP), the latest incarnation of the old TCMP-type audits. And many of these taxpayers will have to pay, not necessarily because the audits will up their tax bills, but because they should hire tax professionals to guide them through the process.

Four types of audits
IRS officials promise, however, that the new NRP won't be as arduous for the roughly 49,000 taxpayers who will face it. Call it the audit from purgatory.

The IRS expects only about 2,000 filers will have to explain their returns line by line in what the agency now calls calibration audits. These filers also will have an advantage not afforded previous audit-from-hell victims. Although the IRS will look at each line on the return, this time the examiner will not expect explicit substantiation of each entry.

The majority of taxpayers, an estimated 30,000, will face a more-limited in-person audit. Instead of the line-by-line approach, the IRS will gather data from its records beforehand and then focus only on certain portions of the return. These examinations will be comparable to normal tax audits.

Nine thousand filers will never meet an auditor. Rather, they will explain specific return entries to the IRS entirely through correspondence.

And another 8,000 returns will be inspected, but their owners won't even know their 1040s are getting another going-over. The agency will simply review the forms and never contact the filers.

Tax-dollar drain
The IRS readily admits that the revival of random audits is part of an effort to collect more tax dollars. In late 2002, the agency refined its audit strategy to focus on what it calls high-risk areas of non-compliance.

IRS officials see the NRP audits as a way to establish a baseline by which to measure tax cheats and the billions they cost the U.S. Treasury. The latest estimate: $250 billion uncollected each year because of taxpayers who underreport income and claim fraudulent deductions. This amount has grown steadily, from $170 billion uncollected in 1996.

Why the tax-dollar drain? Some of the losses can be traced directly to the 1998 IRS Reform and Restructuring Act that reorganized the agency and mandated a softer touch when dealing with taxpayers.

After the law took effect, auditors didn't approach the task with their previous aggressiveness. And while the law's administrative changes were phased in, the IRS simply didn't concentrate on tracking down tax cheats.

Practice makes perfect
Practice makes perfect in everything, so when the IRS eased up on audits, its institutional database on tax evasion became outdated.

The IRS argues that it can better target audit efforts if it knows what tax tricks filers employ. Rossotti says the random audit process, which is a component of what is known officially as the National Research Program, will update and rebuild that information.

Kennedy doesn't doubt the IRS is sincere in its claim that the audits will help the agency learn how to do future audits.

"Now they're looking for a good, solid baseline. They are looking for the data to get the statistics to do a sample of various taxpayer filing numbers," says Kennedy. "For example, the information they get from audits of retail operations will set up really good numbers for them to use as a gauge to do future audits of similar businesses."

The problem, according to Kennedy, is that such statistics categorize people and could make subsequent audits unfair.

"All retail stores are not created equal, but from the random audit data the IRS might say 20 percent goes through salaries," notes Kennedy.

A store that deviates from that number might find an IRS examiner taking a closer look.

Rosenberg believes the detailed audits were a good idea years ago when the agency didn't have the technology to utilize all the data it collected. But improved computer capabilities now allow the IRS to sort taxpayers in multiple ways, says Rosenberg.

"They can tie in and identify inconsistencies," she says, "so they don't need the random audits."

And Rosenberg thinks the recent focus on audits is a calculated maneuver.

"The random audits are political," says Rosenberg. "It's all for show and a waste of money."

Added audit costs
It's not just IRS money that's being spent. In addition to being "horribly terrifying and inconvenient," Rosenberg says anyone who gets tagged for the audit should immediately call a tax pro. Such counsel during a detailed IRS examination is not cheap.

"If you pay someone to represent you," says Rosenberg, "it could cost you $2,000 even if the IRS doesn't change a line, just because they want to do statistical sampling."

Kennedy agrees: "This is my biggest complaint about the process. It's an unfair burden for the client."

Unfair, maybe. Necessary, yes. The presence of an experienced, and personally uninvolved, tax pro should help ensure that all of the IRS' detailed questions are answered satisfactorily -- and without additional damage to the filer's bank account.

Rosenberg has found that most taxpayers are honest, straightforward and want to be helpful. They'll try to explain everything on the return, even things they didn't intend to, and that could be a big mistake. That's why she doesn't even want her clients to show up for audits. Attendance isn't required when a taxpayer is represented by a CPA, tax attorney or enrolled agent.

"They say things, innocent things, in conversations," says Rosenberg, "and auditors are trained to listen, especially for lifestyle comments."

Most people generally don't view such comments as important to the IRS. But that's exactly what the agency is looking for with the random reviews: statistical corroboration of the various deduction types and amounts that are claimed by taxpayers within certain income ranges.

"People walk into them very simply and very naively because they don't understand the system," Rosenberg says. "They don't have the mentality to cover their butts."

New auditor concerns
Then there's the issue of just who will be conducting the audits.

The IRS, Kennedy says, will need to hire and train more people to do the random examinations or transfer current employees from other audit duties. Either option, she fears, could mean additional problems for taxpayers.

After years of lobbying Congress for money to hire additional personnel, in 2001 the agency added more than 1,000 collection agents and tax examiners. It was the first time in six years, Rossotti told lawmakers, that the IRS was able to "replenish these critical compliance positions."

When it comes to the line-by-line audits, Kennedy wants to be sure that all IRS auditors, veterans and new hires, are up to the task.

"The person doing these really needs to be a little smarter than the average auditor," says Kennedy, author of Loopholes of the Rich and strategist for Legal Tax Loopholes. "Most office audits, where a taxpayer gets called in to go over a return, are conducted by people who don't have accounting degrees. All they do is check to see if the filer has receipts."

But with a line-by-line examination, Kennedy says ideally the examiner should have a more complete understanding of the tax laws.

"When you're having an extensive audit, you'd much rather have a smarter auditor," says Kennedy. "If you don't, then you have to teach them accounting on the client's nickel."

And both Kennedy and Rosenberg recommend that rather than worry about the possibility of a random -- or any -- audit, taxpayers should concentrate on tax preparedness. Get your records in shape, operate your business professionally, and know the laws so that you legitimately take advantage of tax breaks.

"The IRS is bigger than you are," says Kennedy, "so learn to make them a partner."

-- Updated: Feb. 19, 2003