Bankrate's 2009 Tax Guide
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taxes
Tempting the tax auditor

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 whose initiation ritual is an IRS audit. Unfortunately, you can't refuse membership -- and the dues could be astronomical.

When the IRS Reform and Restructuring Act was enacted in 1998, lawmakers ordered the agency to focus more on taxpayer rights instead of collection activities. Not surprisingly, the number of audits -- or examinations, as the agency prefers to call them -- dropped dramatically.

The first year of the kinder, gentler IRS, about one of every 79 tax returns were audited. By 2003, it was even easier for tax scofflaws; that year, according to IRS data, only one of every 150 individual taxpayers were audited.

But the tax times, they are a-changing.

More audit attention

IRS Commissioner Doug Shulman says he wants to balance his agency's enforcement and service responsibilities. To that end, he has announced programs designed to take into consideration the financial struggles that many taxpayers are encountering in today's economy.

But balance doesn't mean taxpayers are off the hook. The IRS has made it clear it intends to ramp up enforcement among three groups of taxpayers: high-net-worth individuals, U.S. businesses with international operations and large corporations.

Some of those higher-income individuals have been under the tax gun for more than a year as the IRS has been investigating accounts held by U.S. taxpayers in European tax-haven countries such as Liechtenstein and Switzerland. In its most recent effort to get information on accounts that tax investigators believe are used to shield income from U.S. taxes, federal prosecutors have filed a lawsuit against Swiss banking giant UBS to force it to waive the country's secrecy rules and release the American account holder information.

But the rich, and big business aren't the only targets. Overall in fiscal year 2008 (Oct. 1, 2007 through Sept. 30, 2008), the IRS took a second look at almost 1.4 million returns. That's the highest number of audits since 1998.

There are anecdotal reports that the IRS is paying closer attention to returns that contain large mortgage interest deductions on Schedule A. And if you're a small business person, either as a partnership or a Schedule C filer reporting self-employment income on your personal tax return, make sure you take extra care with your returns.

There's a good reason for the IRS' increased interest in small business filers. Because self-employment income typically has no verification mechanism (i.e., the IRS can't double check much of it in the way it can verify wage income via an employer-issued W-2), tax officials believe that many small business people underreport their income. That will change somewhat in 2011, when some new third-party reporting requirements kick in, but until then, the IRS will be on guard for any income overlooked by filers.

Crackdown to continue

Washington, D.C., lawmakers, who once demanded the IRS give taxpayers the benefit of the doubt, are applauding the new aggressive approach.

The reason? Members of Congress are hoping that enhanced enforcement efforts will help close the $345 billion tax gap. That amount, based on 2001 figures, represents the difference between what taxpayers should have paid and what they actually paid. Without some help from additional IRS collections, Capitol Hill faces the politically unsavory prospect of raising taxes.

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One of the best ways to avoid ending up in the IRS audit sights, whatever your income level, is to be sure that in your zeal to cut your tax bill you don't send the wrong message on your 1040 form.

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."

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