What every taxpayer should know

Mention "IRS audit" and most people envision a steely-eyed agent in a stuffy room questioning everything on their return. In reality, there are five types of audits.

Correction letter. Least threatening is the correction letter. Not a true audit, the correction letter highlights apparent mathematical errors or other discrepancies on your return. Most common are the inconsistencies found by the IRS "matching" program, where the IRS cross checks income reported by payers on Form 1099 (interest, dividends, etc.) with income reported on your return.

Correspondence audit. The next level is the correspondence audit. Similar to the correction letter, this type of audit requests verification of items reported on your return. Usually the IRS will request documentation to support a particular item on your return. This type of audit is usually easy to resolve by mail.

Office interview. The office interview usually indicates that the IRS has a more serious concern about your return. You or your representative meets with the agent at the IRS office. The agent can review any aspect of your return, but usually focuses on a specific area - capital gains, business deductions, or the like.

Field audit. The field audit is usually associated with business audits. Here the auditor comes to you and may examine all income and deduction items.

TCMP. The Taxpayer Compliance Measurement Program (TCMP) is the "super audit." In this type of audit, you may be required to verify every item on your return - even your name and social security number! The IRS uses the results of his program to highlight areas of noncompliance and to determine where to focus their regular audit efforts.

Your odds of being selected

Chances are only about 1% that you'll be audited in any given year. However, the higher your income, the greater your chances of an audit. The main tool used by the IRS in selecting returns to audit is the Discriminate Income Function (DIF). Each return is scored by the DIF for audit potential. Income is compared to deductions and "red flag" items are noted (for example, tax shelters, home office deductions, etc.). Absent fraud or substantial understatement of income, the IRS has three years from the due date of your return to initiate an audit. Typically, most returns are selected within two years of their filing date. As you might guess, many things are forgotten over two years. Consequently, when preparing your return, it pays to document and support the items on it.

Higher risk areas

Your chances of being audited are higher than normal if you fall into certain categories or report certain things on your tax return.

Some of the higher risk items and areas include:

	Claiming tax shelter write-offs.
	Reporting passive income or losses.
	Making tax protest statements on your return.
	Working in occupations that produce cash income (such as taxi drivers or waiters).
	Being self-employed.
	Reporting related party transactions (such as paying wages to children or claiming a bad debt deduction for money lent to relatives).
	Earning a high income.
	Having a complex return and preparing it yourself instead of using a professional preparer.
	Using a return preparer who is on the IRS's problem preparer list.
	Taking deductions where the IRS feels taxpayers tend to stretch the truth (such as home office, travel, and entertainment deductions).

In auditing returns, the IRS isn't necessarily limited to a single year's return. The Service uses computers and "economic reality" procedures to help identify cases of underreported income. When reported income is inconsistent with a taxpayer's lifestyle (type of automobile the taxpayer lives in, college expenses paid for children, etc.), the IRS will ask the taxpayer to explain the discrepancies.

Requesting an audit

While most taxpayers dread an audit, there are times when an audit should be requested. For example, large estates can't be closed until an IRS clearance letter is obtained. The sooner the IRS examines the estate tax return, the sooner the estate beneficiaries receive their inheritance. Another situation for which you may want an audit is when a business closes. Key personnel who can explain the records may move. An audit two years later may prove costly if you must compensate former personnel for their time and travel to answer IRS inquiries.

No need for alarm

It's wise to contact your accountant when you receive an audit notice. Experienced accountants know how to respond to audit requests. Many IRS audit notices are incorrect. Yet, taxpayers often meekly pay additional taxes being assessed, assuming the IRS is right or fearing a full-blown audit if they question a notice. Your accountant can review an IRS notice for propriety and decide if his or her services are required, or if you can easily handle the situation yourself. Don't let the fear of an audit keep you from taking legitimate deductions on your return. Just remember, as long as you have written documentation to support items on your return, you will be well prepared to face any IRS challenge.

Contact our office if you'd like details or assistance with any tax concerns. We're here to help.