Minimize your IRS audit risk

Bankrate.com

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.
The number of audits in 2005 was the highest since 1998, just before
the agency's operational structure was realigned. The trend is
continuing. During fiscal year 2006 (from Oct. 1, 2005, through Sept.
30, 2006) IRS figures show that the agency completed more than 1.28
million audits of individuals, up slightly from the 1.25 million
scrutinized the year before.
That sounds like a lot and the IRS is pleased that its agents are
catching more incorrect returns. But overall, the examination rate of
individual returns in 2006 was just under 1 percent, statistically the
same as in fiscal year 2005.
Don't breathe easy just yet. If your tax return included a Schedule C
detailing any self-employment income, you are three times more likely
to face IRS questioning. And the IRS says it will be stepping up
audits of filers who run their own unincorporated businesses.
Since this type of income 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 self-employed
individuals underreport their income. The IRS also is keeping an eye
out for potential scams that show up on returns.
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 prospect of raising
taxes.
In March, IRS Commissioner Mark Everson reassured Congress about
enforcement efforts. He told the Ways and Means Oversight
Subcommittee, during its annual look into IRS operations, that the
agency is committed to continued audits. In particular, Everson said,
the IRS will continue to look closely at returns from wealthier
taxpayers, particularly filers with incomes of more than $1 million.
Viewed against the total number of returns filed each year (the IRS is
expecting around 136 million individual returns this filing season),
the nominal increase in recent audits still means that most of us will
likely escape extra IRS scrutiny.
You can make sure your examination chances are even more statistically
remote by ensuring that, in your zeal to cut your tax bill, your 1040
doesn't send 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."
Most returns chosen for audit are flagged by an IRS computer program
known as the Discriminant Function System, or DIF, in 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, 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 2004 return statistics
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 $6,229 $5,324 $6,125 $9,811 $31,332
Taxes paid $2,761 $3,592 $5,808 $10,528 $38,143
Interest paid $6,664 $6,933 $8,310 $10,949 $19,721
Charitable contributions $1,969 $2,132 $2,663 $4,130 $19,014

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 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.
* 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 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 says, "at every level of the
process."

Regardless of what kind of audit you might face, the key is to be
prepared.
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