5 Things to Know About Getting Audited

Getting audited is not fun for anyone, but being aware of new trends can help taxpayers avoid a potential audit. CNNMoney.com recently put together a helpful list of five things you know about getting audited, check out a section of their article below or find the full text here.

1. Audits are on the rise

Now that your 1040 is out the door, you may be second-guessing yourself: Will the IRS come a-calling?

Well, the number of audits has risen every year over the past 10. And experts expect that trend to continue, what with the ballooning federal deficit and the additional $400 million earmarked for tax enforcement in 2010.

Even so, your audit risk in any one year is slim -- about 1% if your income is under $200,000, 2% from there to $1 million, and 6% for the über-rich, based on 2009 data. Those selected tend to be self-employed or have unusually large write-offs, says Trudy Moore, an enrolled agent in Stevensville, Montana. If you do get hit this year, it's likely to be for 2008 taxes: Audit letters typically go out 18 months after the filing date.

2. Delaying can cost you the right to fight

If you are one of the unlucky few to get the dreaded letter from the IRS, be sure to take the action required within the time frame allotted, usually 30 days. Otherwise the dispute becomes a final assessment and moves on to the collections department, with no grace period.

Ruling in Tax-Auditing Case Puts Corporations on Edge

According to the Wall Street Journal, a recent tax federal appeals court ruling is causing stress for corporate lawyers across the country. The decision gives the IRS authority to look through documents that have been complied by independent businesses. However, legal experts assert this is a violation of the “word-product doctrine” which shields an individual or business from having to turn over documents created "in anticipation" of litigation.” Check out the WJS story below.

Last week, in a widely anticipated ruling, a federal appeals court in Boston said the IRS could gain access to documents created by a defense-contracting firm to determine whether the company's calculation of its tax liabilities would pass muster during a possible IRS audit. The decision in U.S. v. Textron Inc. reversed a January ruling by a smaller panel of judges on the same court.

To some lawyers who represent corporations, the decision signaled an attack by the courts on the "work-product doctrine," the legal rule that shields an individual or business from having to turn over documents created "in anticipation" of litigation. In its ruling, the First Circuit Court of Appeals said the documents at Textron weren't protected under the doctrine because they weren't prepared specifically "for use" in litigation.

The ruling "eviscerates the work-product doctrine," says Frederick Krebs, president of the Association of Corporate Counsel, an organization for in-house corporate lawyers. He says the ruling, which is binding in federal courts in the Northeast where the First Circuit is based but could influence other courts, will embolden the IRS -- as well as plaintiffs' lawyers who bring shareholder lawsuits -- to seek more such documents from public companies. "If the IRS gets access, [it] can immediately figure out where the client thinks it's weak, what it's willing to pay," he says. The IRS praised the ruling in a statement last week but declined further comment.

Prepare Audit-Ready Tax Returns

Last week a new article I penned for WomenEntrepreneur.com titled “Prepare Audit-Ready Tax Returns: Getting audited is unlikely, and you can reduce the chances further by steering clear of IRS 'red flags' was published in their Money and Finance section. In the column I explain the three different types of audits the IRS conduct, and how you can prepare returns that will stand up to an audit. Check out the introduction of the article below, or read the full version here.

"Audit."

It just might be the most terrifying word in the English language. It can strike fear in the heart of even the most diligent taxpayer. But listen up, ladies. Audits are not the life-shattering events everyone thinks they are. The more you know about the audit process, the less you have to fear.

An audit is simply the process of the IRS closely reviewing your tax return and backup documentation as part of the agency's compliance checking. Think of it as a government quality-control tool, much like the quality-assurance checking you do in your own business.

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The Audacity of the Audit

Audit.

Is there a more frightening word in the English language? Probably not, for most taxpayers. In the most recently completed tax year, the IRS used the audit to collect more than $23.5 billion, a 37% increase over the previous year. High-income earners and small business owners are especially suspect when it comes to audits.

But first things first. What is a tax audit? Well, it is basically a thorough examination into the background and substantiation of income, expenses, deductions, and credits claimed on an individual or business tax return. It is conducted to ensure that items claimed on the return are correct and can be proven through documentation (e.g. receipts, etc.).

There are a couple of types of audits, each with its own rules.

By far the most common type of audit is called a Correspondence Audit. Generally, the IRS will send you a letter, requesting more documentation from you. You provide the documentation, and can go on with your life. Though it can easily result in an increased tax liability.

The IRS also conducts Office Audits, where you are asked to bring documentation to the nearest IRS office for a review and interview. The IRS agent will request specific documentation. This is where deductions will be challenged, and if fail to back it up, you can end up with a much higher tax bill. Be sure you only bring what is asked, otherwise, you’re opening yourself up for an expanded audit. If you have it with you, the IRS agent will want to see it.

The Field Audit will strike fear in the hearts of even the most conscientious taxpayer. This usually occurs in more complex tax situations, such as with a business entity. In this case, the IRS agent will want to fully review your return and verify each and every deduction and income source. This can be a lengthy, involved process and can end up costing you thousands in increased tax liabilities. I guess the one piece of good news is that you are allowed to decide when and where to schedule the meeting. I recommend picking a neutral location — preferably in your tax professional’s office, since they probably know more about tax laws than you do.

Tempting the Tax Auditor

BankRate.com posted a wonderful article on tax auditing, and the way the IRS is re-thinking them in the struggling economy. You can find a snippet of the post below, but the full story can be found here.

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.

IRS to Begin Increasing Amount of Audits

Because of increasing pressure from Congress and the Executive Branch, the IRS has began an effort the drastically increase the number of audits they perform to help lower the ever growing tax gap. Eliminating the tax gap – estimated to be $312 billion to $353 per year – would provide enough money for the federal government to pay for Medicaid’s entire 2007 budget. Montana Senator Max Baucus, the top tax writer in Congress, has publicly demanded the IRS conduct more audits in order to continue to help lower the tax gap.

As a result, the IRS has announced that it plans to do more random audits in the next few years than it has in the past. In addition, the IRS announced plans to conduct more audits of high-risk groups. The Government Accountability Office recently concluded a detailed study on the tax gap and informed the IRS on which high-risk groups have the highest percent of misreporting on their tax returns.

With help from congress, The Government Accountability Office has identified the following groups of taxpayers to have the highest rates of misreporting on their tax returns:

• Sole proprietors reporting on Schedule C forms
• S corporations where owners aren’t taking enough wages in an effort to minimize payroll taxes
• Taxpayers who gamble and underreport their winnings
• Taxpayers who own a farm or are involved in farming
• Taxpayers who take advantage of the Earned Income Tax Credit when they don’t qualify
• Taxpayers who incorrectly report capital gains from sales of investments
• Taxpayers who take itemized deductions on Schedule A for medical expenses, charitable contributions, and non-reimbursed job expenses

However, being in one of these groups does not mean a taxpayer will necessarily be audited. Based on 2005 statistics, a taxpayer’s average likelihood of being audited was around 1%. But if a taxpayer falls into one of the groups listed above their likely hood of being audited increases to above 5%.

The IRS had discontinued its random audit process five years ago in an effort to be seen as a kinder and gentler agency of the government. However, under pressure to increase revenue to offset the tax gap, the IRS has decided to once again target not only returns that raise red flags, but to also select taxpayers to audit at random. Beginning in October, it’s expected that the IRS will target approximately 50,000 income tax returns from 2006. The IRS is warning that not all taxpayers audited will be subject to a scrupulous line by line audit though. Out of the 50,000 returns the IRS aims to audit, they estimate that 8,000 will just be examined by the IRS requiring no action on the part of the taxpayer, and 9,000 of the taxpayers audited will be able to respond to audit inquiries via mail. The remaining 30,000 taxpayers will be required to make face-to-face meetings though. Many of these audits are to be conducted even if the IRS doesn’t suspect a problem, but the IRS is claiming they hope to use the audits to gather information about taxpayer norms.

Shortly after the IRS’s announcement of their plan to increase audits, National Taxpayer Advocate Nina E. Olson delivered a report to Congress identifying the priority issues the Office of the Taxpayer Advocate will address in the coming year. One important aspect of the report was the battle the IRS is facing because of all the pressure being placed on them to lower the tax gap quickly.

"For fiscal year 2008, both the IRS and the Taxpayer Advocate Service (TAS) face similar challenges," Olson claimed. "The IRS is under scrutiny for its efforts to close the tax gap, while TAS is struggling to address taxpayer difficulties that arise as a result of these very efforts."

In multiple prior reports to Congress, Olson has identified the tax gap as one of the most serious challenges in tax administration. She has put together numerous proposals to try and help address it, but nothing has come from her proposals. She has expressed concern that the pressure on the IRS to reduce the tax gap could result in the IRS excessively cutting corners in it’s treatment of taxpayers. She emphasized that Congress needs to play an important role in helping to achieve an appropriate balance.

"IRS oversight should not just be limited to urging the IRS to collect more tax revenue," Olson continued. "Even as Congress directs the IRS to address specific areas of noncompliance, Congress should require the IRS to adopt a long-term research strategy that focuses not only on "closing the tax gap" but also on understanding what it takes to encourage taxpayers to be voluntarily compliant and how to change taxpayer behavior."

Sources
IRS to start auditing more tax returns?
Congress Instructs IRS to Conduct More Audits
More Audits Are Coming; How Can You Cope?
IRS targeting certain deductions in effort to close tax gap
They're back! IRS resurrects random audits