Are you afraid of a tax audit?

January 25, 2011

Abdul Haji (R), a volunteer from AARP for the Internal Revenue Service's Volunteer Income Tax Assistance Program, helps Ahmad Haleem (C) fill out his income tax return at the Southwest Neighborhood Library in Washington, April 15, 2010.    REUTERS/Jonathan Ernst   Mark Berg did a very smart thing when the Internal Revenue Service (IRS) told him that he was about to be audited last year — he didn’t panic. “It strikes the fear of God in your heart when you get the [IRS audit] letter, though there is nothing to fear when you haven’t done anything wrong,” says Berg, president of Timothy Financial Counsel, Inc. and a national board member of National Association of Personal Financial Advisors (NAPFA).

He was flagged because of the high amount he gave to charity. But instead of just waiting for the audit to begin, he gathered together all of his receipts, put together a summary letter, and called the IRS prior to starting his information collection. “They were originally going to audit my whole Schedule A, but after speaking with the agent they narrowed it to just charity,” he says.

Berg’s lessons on how to manage an audit are likely to have widespread appeal as the Obama administration roles out its 2011 tax enforcements initiative. In an effort to close the budget deficit, the IRS plans to increase the number of audits by an estimated 10 percent over last year.

While the IRS doesn’t reveal the formula it uses to determine who to investigate, there are a number of red flags that may trigger IRS interest in your tax returns.

In general, the more complex the return and the more income from non-withholding, non-reporting sources, the higher the probability of an audit, says Stephen Bankler, a CPA in San Antonio, Texas. There are two categories that generate the highest probability of IRS interest: those who are self-employed, file a Schedule C and claim high deductions, and those who earn over a million dollars, he says. Both cases will arouse the suspicion of the IRS.

To avoid an audit, tax experts suggest staying within the industry standards. “The IRS has a table of national standards for every deduction based on income,” says Bonnie Lee, owner of Taxpertise, in Sonoma, California. She also recommends avoiding rounding numbers when taking deductions. Finally, don’t over inflate red flag deductions like automobile expense, meals, entertainment, travel and charitable contributions. “Take your valid deduction and make sure you have plenty of substantiation in case of audit,” she says.

Another strategy that might help avoid an audit is to essentially become “audit proof.” Consider having your tax counsel conduct a “friendly audit” — that is, a review of your financial activities, bookkeeping and record keeping procedures, and accounting practices to uncover and correct sensitive areas before they are discovered in an IRS audit,  says Asher Rubinstein, a Manhattan tax attorney with Rubinstein & Rubinstein LLP.

Say you’re flagged for an audit — what should you do? It is important to note that while many people dread the audit aspect, about 75 percent of all audits are correspondence audits, says Bob Meighan, a vice president with TurboTax. That means, when you receive a letter from the IRS you just need to send in a closing statement or a broker’s statement and that can be the end of it. Only about 25 percent of the audits are field audits when an agent comes to your home or office.

Whether the IRS interest is for a correspondence audit or a field audit, realize that just because they have contacted you does not mean you have done anything wrong. “Audit selections are generally made according to a computer model that selects returns based on how dissimilar they are from a national norm,” says Rubinstein.  “Quite often, after supplying information or documentation to the IRS (for example, receipts to substantiate a tax deduction), the IRS is satisfied and the file is then closed,” he says.

If it turns out that more information is needed, make sure you inquire about and understand the nature of the IRS inquiry and take notes during this process. Then immediately tell the agent that you’d like time to seek the advice from a tax representative, says Rubinstein.
 “Once you make this request, you are under no obligation to answer any further questions,” he says.

There is no foolproof way to avoid the eye of the IRS, but with these simple strategies maybe you can minimize the chance they’ll come knocking at your door.

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I’ve wrestled with them periodically, usually about capital gains distributions. I’ve won two out of three, and would have won all of them if I’d known what I was doing the first time.

Best tip: Make written notes during every phone call, or record the phone conversation. Especially record the name and employee ID number. Tell them upfront if you are recording them. You will seldom deal with the same person twice and they will take all the time they want to respond. Having notes forces them to adhere to their own standards.

Overall, chill. Unless you have been seriously involved in major tax evasion, you will probably face a penalty and some interest.

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