Insider Tips From An IRS Auditor
Nationally, little more than 1 percent of individual tax returns are audited. As your earnings rise and your tax return becomes more complex, your odds increase.
Why are they auditing you? Are you audit bait? We asked an IRS auditor to confess the inner secrets of how its examination division operates and what to expect. His only request was that we don't use his name.
Types of audits
Why it's important to keep records
Home offices and small businesses
There are three basic forms of audit: by mail, through an interview and in the field.
By mail, a letter may ask only for additional information to explain a confusing situation on your return. For an interview, you'll be asked to drop by the IRS office and bring your shoebox full of receipts. The field audit typically involves a small business and involves an IRS auditor arriving at the business door, usually with advance notice. If you have a business in your home, this may include you.
Our auditor says the mail and interview audits are considered limited in scope. There'll be specific expenses that are called into question. You may be asked to bring verification documents to back up deductions for such things as unusually high medical expenses, employee business expenses or charitable contributions.
Even if you're asked to visit the office, if you think there is a simple misunderstanding that you can clear up by mailing copies of the documents to the auditor, offer to do that. It may be enough to clarify the problem.
Keeping accurate records is extremely important, and if you get an audit letter you'll understand why. For example, if you sell stock you've held for many years and don't have documents to show the original purchase price our auditor says, "In the worst case you could be taxed on the entire sales price," without being able to deduct the original cost.
"It's up to the taxpayer to be able to demonstrate what was used to claim the item deducted," the auditor said.
Years after the stock or bond purchase "the brokerage information may have been sent to microfilm and be hard to get or it may have been destroyed. If all you can muster is a cancelled check to show you bought from a broker, we have to have some idea of what the stock was worth at the time," the auditor said.
If you can get stock tables from an old newspaper or an online archive that has the data that may work. "We just need information that makes sense," he said.
Recent controversy over what was termed "lifestyle audits," has caused the agency to re-evaluate the practice. The lifestyle audit simply meant looking at the living standard of the taxpayer alongside the tax return to see if the two seemed realistic. If you drive a new Mercedes and send your kids to private school but routinely claim $25,000 a year income, they'll ask how you manage to do that.
The entire process is under scrutiny and auditors should be getting new guidance in coming months. If you believe you are being asked questions that seem unfairly outside the area of the audit, you may always ask for a manager to review the questions or seek help from a professional tax representative or tax association listed on the Internet.
Home offices and small businesses
Home offices have also been under stringent scrutiny in recent years but some new legislation relaxed the rules to favor taxpayers. "We're not giving away the farm, but people will have new rules to look forward to," the auditor said.
The field audit may be much wider and will not be limited to a specific category of deductions. Our auditor says they come in to verify expenses claimed on a return. They want to see books and usually look for the most common problem areas. Those include high travel and entertainment expenses for a small business or high advertising costs.
He also says if there appears to be a related corporation or closely held business they will look at that as well.
"One important issue, if you have your own small business, is dealing with other consultants (to whom) you pay over $600," the auditor said.
Anyone paid more than $600 a year by you must be issued a Form 1099, he said. If you claim the payment as an expense, you better have issued to Form 1099 so the IRS will know who to credit with the income.
The IRS has begun using industry-specific characteristics to track undeclared income. This has expanded to nearly two-dozen industries with more being added all the time.
The IRS releases audit guides telling businesses just what its auditors use for at least 17 industries and professions including taxi drivers, architects, the wine industry and the entertainment industry.
At the end of an audit you will be given a report that outlines any proposed changes to your return. If you disagree you may meet with the auditor's supervisor. Or you may take your argument to the appeals office. Most disputes can be settled at that stage, but you can also take your case to the tax court.
By Pam MacLean
©1998 MarketWatch.com, L.L.C