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
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.

Crackdown to continue
You can count on the tax-cheat 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 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 examined 2004 return statistics and came up with the following itemized deduction averages. These are for illustrative purposes only. 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

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.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. That's easy when you have good records to support your tax return entries.

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, 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. 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, the IRS is not necessarily putting your return under a lot of scrutiny. They just want questions answered, some clarity. 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 at every level of the process.

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

S. Raines, Sr. Financial Advisor/Tax Preparer

www.effectur.com