Surviving an IRS Tax Audit
by Scott Gordon, Attorney-at-Law

At this time of year, many thoughts may enter your mind during the annual ritual of preparing and submitting tax returns to the Internal Revenue Service: "Are we getting a big refund?" "I can't believe that we owe money this year!" "Is the deadline really next Wednesday?" But what flashes in your mind when you open an official envelope from the IRS and inside is a letter informing you that your tax return has been selected for audit? Panic, fear, and dread immediately take hold, leaving you light-headed and just a bit nauseous. What should you do? How do you prepare? And, how could you have avoided this audit in the first place?

An audit is typically defined as an official examination and verification of financial accounts and records. Businesses regularly conduct audits on themselves to provide shareholders with numbers that are reliable beyond fault or error. If you look at the fact that each of us is, in effect, a shareholder of our country, then it is in our best interest to conduct some audits on the process of collecting tax dollars. Audits are a necessary fact of life.

IRS audits take a number of different forms. The most common IRS audit is triggered by an inconsistency between the information reported to the IRS by payers/employers and information reported by the taxpayer. This type of audit is part of an IRS compliance program and usually has the letter code "CP 2000." Most often it focuses on income that the IRS suggests is missing from tax returns, commonly from a Form 1099 that has been omitted from the tax return by mistake.

The CP 2000 letter never states that the IRS is auditing you because, in effect, they have already conducted the audit through their research. If you receive such a letter, you should compare the tax forms you have received to those the IRS claims are missing from the tax return. It's possible that you never received the tax form in question (wrong address, negligence of the payer, etc.) or you included the income on the wrong line of the tax return, or simply forgot to include the income. Don't ignore this notice, since interest and penalty will continue to accrue if you do owe the money. Maintain an open and ongoing line of contact, since the IRS tends to exercise the most patience with recipients of a CP 2000 letter.

More frightening are IRS field audits and random audits conducted under the IRS National Research Program. IRS field audits are triggered by any one of a number of factors including informants (angry ex-spouse, disgruntled employee), poor return presentation (incorrect calculations, missing forms), significant deviation from national averages in various categories (e.g. $15,000 charitable contributions for someone with only $25,000 of gross income), and suspicion of unreported or underreported income. IRS random audits begin with random computer selection of tax returns, which are then screened by agents to determine if there are enough issues to warrant examination (and to provide enough research data and potential revenue to the IRS). For the first time in a number of years, the IRS is conducting a three-year random audit program covering the 2006 08 filing years and using a total sample of 40,000 returns.

Should you receive a notice from the IRS for either type of audit, don't panic. The audit notice contains information specifying the scope of the audit, so make sure to read it carefully. Most of these audits focus on specific areas where the IRS can collect revenue. This usually means they scrutinize the following items: charitable contributions, medical expenses, capital gains and losses, business expenses, self-employment income, and distributions from corporations, partnerships and trusts. These audits usually require a taxpayer to present all bank accounts and investment accounts, which are then examined for evidence of undeclared income. Often, the IRS will want to set up an appointment quickly; make it clear to the examining agent that you need adequate time to prepare and that the IRS must be reasonable when it comes to scheduling the actual audit. Should you need additional time to prepare all of the documentation, don't hesitate to ask for a temporary postponement. However, the IRS is not too happy when you make multiple postponements or cancellations with little notice—and the last thing that you want is to compromise the attitude of the agent towards you.

When it comes to preparation for the actual audit, be thorough. Dazzle them with data. If the IRS wants to see documentation for all of your charitable contributions and business expenses, try to make sure that you can prove every item. In reality, you should not declare any expense or deduction on your tax return without proof of its existence. Some rogue tax preparers or friends might encourage you to take a deduction for which you have no backup documentation. Never follow such bad advice. The IRS does not look too kindly upon individuals who simply make things up. It is one thing to have claimed a deduction for which you have substantiation that is ruled to be not deductible under the law; it is a whole different matter when such expenses were never incurred in the first place. A perceived lack of veracity may very well trigger an even more aggressive examination of your records.

The first set of questions at an audit usually involves the reporting of all income. If you reply that you did not have any other income and the IRS discovers that you were intentionally misleading them, the matter could mushroom from a civil audit to a criminal examination. Do not lie about income. This is one of the reasons it might make sense to hire a tax professional to represent you at an audit. Such a representative can usually answer the series of income questions with "not to the best of my knowledge." Whether you represent yourself or hire somebody to represent you, remember to approach the audit in a serious and thorough manner. If you take the time to accurately report all of your income in the first place and make sure that you take all of the expenses and deductions to which you are entitled and can comfortably defend your position through documentation, then any audit will be just more of a hassle than a truly dreadful (and costly) experience. And, the end result might very well be the magic two words: No Change.

Scott Gordon has been practicing as a tax attorney for almost 25 years. He can be contacted at 43 Blackberry Hill Rd, Red Hook NY 12571, (845) 756-3400 or scottg@mhcable.com.