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Understanding Audits: What Taxpayers Need to Know About Triggers, Procedures & Penalties

Understanding Audits

For accountants nationwide, Tax Day represents a long-awaited finish line, as hours of overtime and countless weekends spent in the office make way to deep exhales and stereotype-defying parties.  But for those consumers who rushed through their returns or, even worse, tried to pull a fast one on Uncle Sam, April 15 might very well mark the beginning of a nerve-wracking waiting game.

“Will I get audited?” they wonder.  “And if so, what’s the IRS going to do to me?”

Whether you’re irrationally concerned or in real danger of IRS scrutiny, there’s certainly nothing fun about that.

So, what are the odds that a given individual will be audited?

Before we answer that question, let’s first nail down exactly what an audit is.  The IRS, according to its 2012 data book, “accepts most Federal tax returns as filed. However, it examines (or audits) some returns to determine if income, expenses, and credits are being reported accurately. Some examinations are handled entirely by mail, while others are conducted in a taxpayer’s home, place of business, IRS office, or office of an attorney, accountant, or enrolled agent.”

Audits don’t have to be done immediately either.  The statute of limitations for initiating an examination is generally three years from the time the return in question was filed or April 15 of that year, whichever is later.  The IRS can also go back as many as six years if a substantial error is discovered.

That said, only about 1.03% of all returns filed in 2011 were examined.  And approximately 70% of those audits were done via correspondence, meaning most people received a letter about unreported income, unfiled forms, or additional liability rather than a house call from an actual examiner.  That, as well as the following statistics for last year’s audits, should calm your nerves a bit:

  • In 2012, 10% of the individual returns examined in the field and 15% of those examined via correspondence were unchanged (i.e. no additional tax liability was found).
  • Nearly 54,000 returns examined in 2012 actually resulted in refunds, with the average payout being about $18,191.
  • For cases that resulted in additional taxes being assessed, the average amount was $16,851 for field examinations and $8,241 for correspondence examinations.

Those figures merely speak to averages, though.  Certain “triggers” could increase your odds of falling under IRS scrutiny.

What factors increase your audit odds?

In a way, the tax system is a lot like middle school.  While being unique is an asset in subsequent grades and other aspects of life, it could get you picked on by bullies and audited by the IRS.  Middle school students are operating from a place of insecurity and are looking for easy targets, and the IRS must use automated systems to identify outliers given the sheer number of taxpayers they oversee as well as the complexity of the modern tax process.

More specifically, “the audit selection process is usually done via a DIF score,” says Caroline Chen, director of the Low Income Taxpayer Clinic at the Santa Clara University School of Law.  “The Discriminant Function System (DIF) score rates the potential for change based on past IRS experience with similar returns.”

In short, things tend to be easier if you don’t stand out.  Some of the most common factors that can trigger an audit are:

  • Clerical Mistakes:  Errors on your return don’t necessarily indicate that you’re trying to pull a fast one on the IRS, but they will attract attention to your paperwork, which could unearth other issues.
  • Filing a Paper Return:  Dovetailing on the above, paper returns are more susceptible to audits because they boast a higher incidence of errors.  According to the IRS, the error rate for paper returns is about 21%, compared to just 0.5% for returns filed electronically.
  • Using Suspiciously Round Numbers:  This is rather obvious advice, but you really don’t want to create the impression that you’ve made up the figures on your forms.
  • Failing to Report Traceable Income:  You need to report any income for which you receive a 1099 or W-2 form because the IRS will compare what you report to the records it receives from other sources.
  • Claiming Abnormal Charitable Deductions for Your Income:  The IRS is able to use the considerable information at its disposal to determine “normal ranges” for various types of deductions given an individual’s reported income.  That doesn’t mean you should avoid reporting what you actually donate, but rather that you should be ready to answer some questions with the proper documentation.  For example, you’ll need evidence of an appraisal if you donate a physical item instead of cash, and you must fill out Form 8283 for any charitable donation totaling more than $500.  “If either of those items are not included, the return will definitely be audited … through a letter saying we disallow the deduction,” Frank Doti, director of the Juris Doctor Tax Law Emphasis in the Chapman University School of Law, said.  “The law is clear that if you don’t put what you’re required to put in the return as filed, you don’t have a second chance. … It’s unique to charitable deductions.”
  • Taking a Deduction for a Home Office:  In order to deduct a home “office,” the space in question must be used exclusively for business and be your principal workplace.
  • Deducting for a Rental Property:  You’re generally prohibited from deducting rental property losses unless you actively manage said property and have less than $150,000 in adjusted gross income or are a real estate professional.
  • Being Self-Employed:  The number of self-employed filers has skyrocketed in recent years, as the traditional job market has dried up.  The IRS wants to make sure that people who are new to the process do things correctly, especially given the myriad different deductions that are possible and the historical tendency self-employed folks have to over-claim.“You are much more likely to be audited if you have a significant Schedule C (self-employment) or Schedule E (rental activity) because typically the IRS has not received significant information on these activities from third parties,” Joseph Newpol, a professor of law, taxation, and financial planning at Bentley University, said.  “Think about it this way—if you take a standard deduction and show just wages, dividends, interest and capital gain, there is nothing to audit.  They are supposed to have received all of the backup information from third parties.  Even if you itemize your interest paid and taxes, they receive that information.”
  • High Income Levels:  Audit rates are considerably higher for people who report significant earnings not only because that raises suspicions, but also since the payoff potential is greater.  For example, 2012 statistics show that one in about every eight people who reported making $1 million or more were audited, while fewer than one in 100 people reporting earnings of less than $200,000 came under scrutiny.

It’s obviously important to keep the aforementioned triggers in mind during tax season, but the best protection against an audit will always be honesty and doing things by the book.  You can account for human error and a lack of tax knowledge by consulting an accountant, visiting a local tax clinic, or even simply using an electronic preparation program.  “They would give you as the taxpayer an idea of whether what you’re claiming is outside the norm,” Ronald Blasi, director of the Low Income Taxpayer Clinic at the Georgia State University College of Law, said.  “Presumably, if it’s outside the norm, that’s one indicator that you’re more likely to be audited.  That’s all it can really be – just more likely.”

What happens if you get audited?

IRS audit penalties can range anywhere from 20-70% of the amount by which you understate amounts owed to $100,000 in fines and up to five years’ jail time, depending on severity and intent.  With that said, there are a few ways to limit the damage:

  • Keep Detailed Records:  If you disagree with the IRS about how much you owe, you’ll need to make a case for why you’re right, using the proper documentation.“There are positions that are correct which might not be acceptable to the IRS but that doesn’t mean you shouldn’t take them,” Newpol advises.  “If you do, you might be required to defend your position in audit.  I always tell my clients that if they can support a deduction or proposed tax treatment with facts, you should not be afraid to take that position even if it triggers an audit.  Playing the ‘audit lottery’ is never a good idea.”
  • Use Records to Support Your Case, Not As Your Case:  You can’t just send a packet of files and expect the IRS to interpret the information.  You’ll need to do the legwork, explaining the rationale behind your payment and using hard data for evidence.  This will also enable you to control the narrative because while numbers never lie, they can be used to tell different stories.“If you just send in some data … without a clear explanation of how this will justify the deduction you’re claiming, you’re wasting your time,” Blasi warns.  “The IRS is not going to take the time to parse through raw data and try to figure out your case.  So, it’s up to the taxpayer to pull that data together.  And, of course, never ever send in the originals.  The chances of data getting lost is very high.”
  • Don’t Ignore Notices:  The IRS will first send you a 30-day notice.  You’ll have a number of options at this point – some more attractive than others – including paying up, filing for an extension, and presenting a case for why you don’t owe the extra money.  If you aren’t proactive during that time, you’ll receive a subsequent 90-day notice.  At that point, your only options are to pay, file a petition in tax court, or default and accept the punishment.  You don’t want to get boxed into that corner.
  • Seek Professional Help:  Given the amount of money that’s likely at stake, you’ll probably want to hire an accountant/tax attorney or, if you can’t afford one, head to your local tax clinic for free advice.

At the end of the day, the one thing you really shouldn’t do is nothing.  Taxpayers “should find no solace in doing nothing because the Revenue Service is not going to forget about them,” Blasi says.  “The IRS just grinds ahead in a very deliberate fashion if they do not get a satisfactory response from the taxpayer.”
Image: Andrey_Popov/Shutterstock

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