Let’s get one thing clear; if you’re an average taxpayer, the chance of being audited by the IRS is less than being struck by lightning while standing in the middle of a building covered in rubber. The IRS is underfunded and understaffed. They don’t WANT to audit you. It takes too much time and too many resources. Tax returns are a complicated mess and there are simply bigger fish to fry. A full compliance audit on a guy who earns $50,000 takes as much time as a guy who reports $500,000. Who do you think they’re going after? If you’re a wage earner (meaning no self employment schedule C) and you itemize your deductions, the only way you’re getting an audit notice is if you transpose an obvious number, say calling interest expense $30,000 instead of $10,000.
This is just a personal theory. At one time I owned an accounting and tax practice and prepared approximately 700 returns a year for several years. Most clients were simple mom and pops, average deductions, small businesses; two kids and an IRA… you know the type. In ten years, seven of my clients were audited! SEVEN!
You’ve probably heard all the war stories, how tough the IRS is, and how grueling an audit can be. Let me set the record straight, on an average audit, the IRS wants to get you in and out in about an hour. In other words, they don’t want to spend days verifying every receipt and every exaggerated church donation you’ve claimed. If you’re representing yourself, which is not a good idea, be prepared to lose a few battles. If your records are somewhat in order, (most aren’t) understand that if the auditor can walk away with a slap on your wrist, say deny the use of your dog Sparky as an outside contractor, let them have it. On small returns, they simply want a notch in the win column.
Most of the Time
Most of the time, if you’ve made a glaring error on your tax return you’ll receive automated letter from the IRS pointing out a discrepancy in your return on an item where they’ve already received an information return such as reported mortgage interest, a 1099, or W-2. For example, your mortgage company reports total interest paid by you in a form 1099 which they send to you and the IRS. If the number you claim differs from the number reported by them to the IRS it will trigger a letter. If the mortgage company screwed up (which they often do) simply send your response and a copy of your documentation to the IRS. For example, you might have made your January payment at the end of December and included it on your current year’s interest and the mortgage company might not have included it.
The most common automated letters result from W-2 discrepancies and reported interest expense. If you want to avoid an IRS letter, you might want to just claim the interest your mortgage company reports instead of arguing over a measly month or two.
If Hell Freezes Over
Shit happens. Like I mentioned earlier, you’re probably just an errant statistic, one in a million and they still don’t really care that much about you (with the exception of a TCMP audit which we’ll discus in a minute or two.
If you are audited, it’s probably a correspondence audit and you’ll be sent a letter asking you to clarify certain specific deductions such as a business expense or that charitable deduction you took on your vacation in Cancun. In most cases, your tax return triggered a red flag because it exceeded a score which the IRS uses on tax returns.
When income tax returns are filed in the IRS Service Center, the information on the return is put into the computer. Each return is assigned a numerical score that is arrived at by determining how far above or below the average each of your deductions are. Each deduction that you have taken that varies from the norm is added together and the total amount determines your numerical score. This is top secret stuff and if CPA’s and tax preparers had access to this information, there’d be much less audits.
Experience tells us what makes the score go up:
- Low gross profit margin: You showed a $2,000 net profit on $300,000 in sales.
- High auto expenses: Corvettes are expensive.
- High business use of autos: 50,000 business miles for an in home craft store
- Number of autos used in business: You can’t deduct your daughters Mustang or your Harley.
- High travel and entertainment: Your total sales are $15,000 with $50,000 in trip expenses.
- Little or no profit from business operations: Stock trading has been a bitch.
Preparing for the Battle
- Be organized. Duh, really?
- Only provide the documents needed to support the specific deductions that are being questioned.
- Never give the IRS more or less information than is requested Answer questions honestly but briefly (DO NOT OVERSELL!).
- Never give the IRS your only copy.
- Do not leave original documents with the IRS.
- Don’t chatter or try to be friends Never be argumentative or belligerent.
- Get copies of information they have in their files or of anything you sign.
- If you’re unsure about signing something tell the agent you’ll need your CPA or attorney to review the document first.
The Dreaded TCMP Audit
TCMP stands for Taxpayer Compliance Measurement Program. It is a program instituted to measure the average taxpayer’s compliance with the tax code. It is literally a line by line audit. Every number and check mark on the return will be examined. If you claim two dependent children, they’ll want copies of the birth certificates. If you claim $5 in interest income they want a copy of the bank statements. The best advice I can offer here is “bend over and pretend it’s not happening;” picture lilies in the field and a steak and lobster dinner when it’s over. For your information these audits almost always turn up a bunch of errors. You’re no different than anyone else, maybe a tad less lucky.