IRS scandal may reduce audit risk

IRS sign with magnifying glass Internal revenue Service tax taxes CBS/iStockphoto

(MoneyWatch) Recent congressional hearings, changes in leadership and the impact on resources resulting from budget cuts mark a low point for the IRS. They may also mark a reduction in the number of tax returns they'll audit.

IRS officials say that not since the Tax Reform and Restructuring Act of 1998 has the IRS been under this much scrutiny. During that period, IRS employees feared disciplinary action resulting from enforcement actions, causing a measurable reduction in audits. According to IRS data, following the 1998 act, audits fell by as much as 50%. The percentage of individuals audited also fell from 1 percent to 0.5 percent.

Currently, the IRS audits slightly more than 1 percent of all individual tax returns filed, so the chances of being selected for audit are low. But if you know what the IRS looks for, you can reduce your risk.

The red flags

The IRS runs a check on every tax return for errors in math and tax calculations, and for clerical errors such as incorrect Social Security numbers and incorrect addresses. If a mistake is detected, a notice of the error and a recalculation of the tax due is sent to the taxpayer. If you avoid these simple mistakes, you are halfway to reducing your risk.

Next is the agency's document-matching program, which compares reported information with the information supplied by your bank, your employer and others on forms W-2, 1099 and assorted forms and documents.

If you omit an item from your tax return that is picked up by IRS computers, the agency sends a computer-generated notice that includes a recalculation of the tax and the additional interest and penalties you owe. Typically, these notices are sent two to three years after the return in question is filed, so when you receive them, you must retrieve your returns and records to verify if the IRS is correct in its assertions.

These omissions are usually honest mistakes by the taxpayer, and although the IRS maintains the position that it may assess a negligence penalty, the law does not allow the agency to presume negligence and automatically penalize the individual in question. So collect your tax forms and correctly enter the required information. That is about all you can do to reasonably reduce the risk of an audit.

The IRS may also deploy a computer program assigning a numeric value or score of selected items on tax returns. When the total score of all selected items exceeds a minimum set by the agency, its computers will single out the return for a possible audit. The exact items and scoring convention are closely guarded secrets, but some of the items believed to be on the list include:

1. Large amounts of income not subject to tax withholding.
2. More unusually large deduction amounts claimed than seem reasonable given your income.
3. A large number of dependent exemptions claimed in conflict with reported SSNs, tax withholding allowances and so on.
4. Indicating a change of address when not reporting a sale of your residence and not changing your home-related deductions.

Finally, the IRS also runs special audit programs in which it uses its computers and specially assigned and highly trained agents to scrutinize returns that report income from a selected list of business categories, especially those with income from self-employment reported on Schedule C, that are categorized in one of several business market segments on an list maintained by the agency. If you are the proprietor of a business that is the subject of this audit program, take extra care to document and substantiate your income and deductions.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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