Tempting the tax auditor

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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.

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.”

“There are several ways a return can be selected for audit and the first way is what we call computer-scoring-termed DIF, or Discriminate Information Function,” says Nancy Como, small-business/self-employed examination policy senior program manager for the IRS. “It’s sort of a random selection. The IRS evaluates tax returns based on IRS formulas, and this is based on deductions, credits, exemptions with norms for taxpayers in each of the income brackets.”

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, says it’s no mystery that the system is designed to screen for returns that could put more money in the government Treasury.

How do your deductions compare?

Tax experts believe one discriminate function component looks at average deduction amounts. This allows IRS examiners to spot inconsistencies, such as a high mortgage interest deduction and low income.

Tax specialists at CCH Inc. examined 2006 return statistics, the latest complete data, and came up with the following itemized deduction averages. These are for illustrative purposes only. CCH experts note that the IRS takes a dim view of taxpayers who base their claimed deductions on these figures. The numbers can be useful, however, in giving you a general idea as to whether certain deductions on your return might seem out of line.

How do your deductions compare?
Income range $15,000- $30,000 $30,000- $50,000 $50,000- $100,000 $100,000- $200,000 $200,000

or more

Medical expenses $6,720 $5,791 $6,354 $9,302 $29,509
Taxes paid $2,837 $3,665 $5,815 $10,445 $39,234
Interest paid $8,362 $8,451 $9,813 $12,892 $23,274
Charitable contributions $1,897 $2,123 $2,673 $3,860 $18,539

Allison Einbinder, owner of Dollars & Sense, a tax and accounting firm in Oakland, Calif., recommends that all filers review the differential comparisons. How you stack up against a national standard, she says, will give you an idea of whether the IRS might take a closer look at your return.

So what is likely to trigger a discriminate information 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.
  • Noncash 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, designed as a tax break for lower-income wage earners, also catch IRS eyes. 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.

Don’t cheat yourself

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 says, they will be allowed.

The groundwork you put into preparing your return will pay off in an audit situation. “Be confident in what you entered,” says Einbinder. “That’s easy when you have good records to support your tax return entries.”

Electronic anti-audit assistance

Electronic options can also help. If you’re preparing your return yourself, most tax software programs point out some obvious audit issues. The programs have improved over the years to ask more, as well as more personal, questions so that you don’t make mistakes that prompt immediate IRS questions. Some even give you a side-by-side comparison of the national deduction averages, says Einbinder.

Other software manufacturers tout audit defense help if worse comes to worst. Remember, though, says Einbinder, that in that case, you’ll have to relay your tax information to a person and explain why you claimed an item in the first place. If you’re concerned that some claims you plan to make might prompt IRS questions, consider taking them to a tax professional at the beginning of the process. It’s generally preferable to answer or prepare for potential inquiries when you file, rather than defend your filing choices months or even years later.

E-filing helps too, in that the software that transmits returns looks for a lot of little errors, says Einbinder. It makes sure you’ve entered Social Security numbers where necessary and queries you about birth dates that are critical to some tax claims, such as child-related credits and contributions to retirement accounts.

Three types of audits

If your return is selected for a closer look, don’t panic and don’t ignore IRS inquiries. But even tax professionals admit that’s easier said than done. “If I get a letter about one my clients,” says Einbinder, “I still get that panicky feeling and I’m a professional.”

Once you get past those initial inquiry butterflies, determine exactly what the IRS wants and how much time it will take to give them the answers.

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.”

After you provide the requested information, the case is usually closed. If not, you’ll get another letter describing the additional taxes to be paid. In these cases, says Einbinder, the IRS is not necessarily putting your return under a lot of scrutiny. “They just want questions answered — some clarity,” she says.

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 specific IRS 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 will likely 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.

Regardless of what kind of audit you might face, the key is to be prepared. Remember, an IRS inquiry does not restrict your ability to ask your own questions and make sure the examination is conducted appropriately.

“You have rights to contest audits,” Nath says, “at every level of the process.”