IRS reinstates random, detailed audits
The Internal Revenue Service has resurrected a random
audit program that's sure to be a horror for thousands of taxpayers.
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.
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
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
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.
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
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
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
"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
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
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 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
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
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