If The IRS Gets Tough, Don't Fret

It's enough to cause a momentary panic, to make your heart race and blood pressure rise. A letter from the Internal Revenue Service just can't be good.

The government has been examining more tax returns, doing more audits and independently verifying more information. Large corporations and wealthy individuals, in particular, have been in its sights.

Yet the chance of an audit remains small. Last year, the IRS looked at about 1 in 129 returns filed by individuals and families. The rate increased to 1 in 68 when incomes rose above $100,000.

That still lags the pace set in the mid-1990s, when the agency looked at about 1 in 60 individual tax returns.

But the IRS doesn't always need to conduct a full audit to catch mistakes and missing information. It increasingly relies on computers to verify what's reported, making it harder for taxpayers to hide some types of information.

That doesn't always mean the IRS is right and the taxpayer is wrong. One thing is certain, experts say, and that's the importance of answering any letter sent from the IRS.

"Taxpayers have to respond to the IRS. They can't be ostriches," said National Taxpayer Advocate Nina Olson, who helps taxpayers resolve problems with the IRS. "You have to pick up the phone, even if you just want to just go hide. It won't go away."

Just ask Richard Hatch, who failed to include on his tax return the $1.01 million he won on the first "Survivor" reality television show. Survivor Entertainment Group reported the payments to the IRS, and the tax collectors caught up with him.

The IRS gets more than a trillion such documents each year from employers, banks, brokerages and other institutions, reporting the payments they made to taxpayers.

"That allows us to come in each year and look at the tax return that individuals are filing and run a match," said Linda Stiff, deputy commissioner for the IRS division that conducts most audits.

It also helps the IRS find people who earned income but didn't file a return.

The IRS last year reached out to more than 2 million taxpayers after comparing such documents to tax returns, Stiff said.

The agency also recently started checking information reported on Schedule K-1 documents, which cover income, deductions and credits from partnerships, trusts and S-corporations.

IRS document matching programs mean taxpayers should act quickly to correct any errors in the statements they get from their financial institutions, said Bob Sharin, editor of RIA's Practical Tax Strategies.

Even if you report the correct information on your tax return, the IRS will only know that the information you provide differs from the information the third party provided.

"That's going to be a red flag," Sharin said.

Some of the most common problems that generate letters can be avoided by filing electronically and letting the computer check for valid Social Security numbers and math errors. If you fill out the forms by hand, make sure to double- and triple-check your work.

The IRS has no single formula that determines which tax returns will be audited. The agency audits some taxpayers by mail and others in face-to-face meetings, depending on the complexity of the return.

It screens returns for potential irregularities and uses information gleaned from other taxpayer audits to find areas with frequent problems, caused either because the rules are too complex or because practitioners and taxpayers "play in the gray areas," Stiff said.

Among deductions and credits, the IRS gives special attention to areas known to be complicated or known to inspire taxpayers' creativity, such as the home office deduction and the earned income tax credit.

That shouldn't discourage taxpayers from taking advantage of deductions or credits if they qualify, said Brenda Schafer, manager of tax analysis and advice support at H&R Block.

"They should never be afraid to claim a legitimate deduction or credit, even if the IRS questions it," Schafer said. "There is no point paying any more tax than you have to."

Taxpayers who worry that something might trigger an audit should first make sure they understand the law and have followed it correctly. Enlisting professional advice can be useful.

Backing up claimed deductions and credits with proper documentation also is important. That means collecting receipts for business expenses and charitable donations, keeping mileage logs and tracking home improvements — dull but necessary tasks for maximizing tax reductions.

Those records should be retained in case the IRS does ask questions.

If you do run into a difference of opinion with the IRS, the records will be critical to supporting your case. Often a question can be resolved quickly with a telephone call and a photocopy of the appropriate documents, Sharin said.

Whatever you do, don't ignore the problem, experts say. Interest and penalties could be mounting as time passes.

"Putting it in a drawer is not going to make it go away," Schafer said.

The IRS can work out payment plans for those who owe unpaid taxes, interest or penalties. The Taxpayer Advocate, an independent office inside the IRS, can help people resolve problems that haven't been remedied through normal channels.
By Mary Dalrymple