Pushing tax deduction limits could make
an IRS auditor your new best friend
By Kay Bell • Bankrate.com

April 13, 2000 -- It is the most dreaded letter a taxpayer can receive.

Dear Taxpayer,
Some of the information that you provided to us does not agree with the information we received from other sources.
The Internal Revenue Service

You've just joined an elite club, one where the initiation is an Internal Revenue Service tax return audit. Unfortunately, you can't refuse membership -- and the dues could be astronomical.

Since enactment in 1998 of the IRS Reform and Restructuring Act, with its focus on taxpayer rights vs. collection activities, the number of audits -- or examinations, as the agency prefers to call them -- has dropped dramatically. Even before then, only a fraction of taxpayers were audited. In 1997, the last year for which the IRS has complete data, only 1.2 percent of the 122.5 million individual returns were audited.

But the statistical remoteness of an audit doesn't matter if you're one of the unlucky few. And the chances of being selected are greater if, in your zeal to cut your tax bill, your return sends the IRS the wrong message.

What's the DIF?
"Don't draw any more attention to your return than you need to," says Robert G. Nath, author of The Unofficial Guide to Dealing with the IRS. "Simple, plain vanilla returns are fairly safe."

That's because most returns chosen for audit are flagged by an IRS computer program known as the discriminant function system or DIF, in official tax parlance. The actual scoring formula to determine which tax returns are most likely to be in error is a closely guarded secret. But Nath, a Washington, D.C.-area tax attorney and tax expert, says it's no mystery that the system is designed to screen for returns that could put more money in the government treasury.

What triggers a discriminant function red flag?

• Higher incomes
• Income other than basic wages; for example, contract payments
• Unreported income, such as investment returns
• Home-based businesses, especially when in addition to salary income, and home office deductions
• Non-cash charitable deductions
• Large business meal and entertainment deductions
• Excessive business auto usage
• Losses from an activity that could be viewed as a hobby rather than a business
• Large casualty losses

Returns claiming the earned income tax credit also have been getting more IRS scrutiny lately. The credit was designed as a tax break for lower-income wage earners. The credit's complexity often results in legitimate mistakes on returns. Some filers, however, have been caught making false claims to increase the payment the credit provides.

And, just to keep all taxpayers honest, the IRS also randomly selects thousands of returns each year to audit.

Don't cheat yourself
But don't let fear of a potential audit discourage you from filing for credits or taking legitimate deductions.

Although some tax return actions are likely to flag your return, Nath says that doesn't necessarily mean you'll be audited.

Even if your return is questioned, it's not a foregone conclusion that you'll end up owing the IRS. As long as your deductions and expenses are legitimate and you have documentation, Nath notes, they will be allowed.

Three types of audits
If your return is selected for a closer look, don't panic and don't ignore IRS inquiries.

If you're in the audit majority, you'll fall into the least intrusive category, the correspondence audit. This is the easiest process for both the taxpayer and the IRS. In this case, the IRS sends the taxpayer a letter asking for more information about one or two relatively simple items.

"Just because you get a correspondence audit letter, there's no need to panic," says Nath. "In fact, if you get a letter instead of a call, that indicates the IRS views the inquiry as not particularly earth shattering."

Once you provide the requested information, the case usually is closed. If not, you'll get another letter describing the additional taxes to be paid.

If questions about your tax return are more serious, you'll be asked to meet with an examiner at an IRS district office near your home. These agents generally have more training and experience with complex returns. Bring only the documentation needed to answer the IRS' specific questions, but don't bring or volunteer other data unless you want to open up those records to examination, too.

Finally, there's the field audit. This investigation is done at the taxpayer's home or business and is more wide-ranging. Wealthy taxpayers and businesses are generally the target of a field audit, which gives agents a chance to conduct a "lifestyle" audit. Here an IRS agent gets an up-close-and-personal look at a taxpayer's house, neighborhood, car and everything else on hand to see if it meshes with the return's stated income. If a taxpayer has a new Jaguar parked in the garage of a six-bedroom house and reports income of $40,000 a year, he likely will have some explaining to do.

When you get a notice of any type of audit, respond immediately. After you've acknowledged the audit notification, you usually can get a postponement if you need time to gather records. And it's never too late -- even after the audit begins -- to get professional help, such as a tax attorney, certified public accountant or Enrolled Agent.

"You have rights to contest audits," Nath notes, "at every level of the process."

Those rights, the audit process and how to appeal are explained in IRS Publication 1, Your Rights as a Taxpayer; Publication 5, Your Appeal Rights and How to Prepare a Protest if You Don't Agree; and Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

Established in 1997, Audit Protection Institute began selling policies the next year, offering Golden State taxpayers coverage against the audit-associated costs, as well any additional tax owed. For a flat fee ranging from $67 for $2,500 in coverage to $321 for $7,500 worth of protection, depending upon coverage options, a return is covered for four years -- unless an audit turns up evidence of tax fraud.

Dan Walker, API's founder, chief executive officer and a former tax auditor, says the company is on schedule to offer its policies nationwide by the end of the year. By that time, he notes, the IRS should be gearing up its inspections of 1999 returns.

Walker acknowledges that the possibility of audit now is low, but notes that when a taxpayer faces one -- and loses -- the filer usually pays dearly. "When the audit comes in," he says, "IRS stats show the average additional taxes paid, even for returns reporting less than $25,000 a year, are about 3,500 bucks."

API has taken those IRS numbers and produced its own audit risk evaluator. By plugging in income, general residence and tax filing method data, API projects the odds of a return being pulled by the IRS and what the added costs might be.

More audits on the way
More taxpayers may be looking for audit insurance if the IRS gets its way. In the last few years, the agency has sought more money from Congress, with a larger portion of it going specifically to bolster tax return examination efforts.

Also on the way are technology improvements, again mandated by the IRS reform act, that will allow agents to more precisely target suspected tax cheats.

A planned new data management system will replace the antiquated IRS master taxpayer file and enable the agency to conduct immediate searches of returns. This real-time search feature, IRS executives told tax professionals at a recent agency modernization conference, also will include upgraded fraud filters to identify taxpayer patterns.

With the enhanced fraud detection and the ability to look at questionable returns soon after they are filed, the IRS believes taxpayer compliance will improve, either voluntarily or through added and more specific audits.

IRS officials hope to start moving taxpayer data from the master file to the new data system in late 2002 or early 2003. If it works as planned, it should help the agency become more business-like in conducting audits. And that is the ultimate tax collection goal.

As one tax professional puts it, the IRS is looking for profitable audits, not just ones to be a pain in taxpayers' keisters.

-- Posted April 13, 2000