The taxman cometh

February 7, 2001: 10:56 a.m. ET

Yes, you can survive an IRS audit. Tax pros explain how to tackle Uncle Sam
By Staff Writer Alex Frew McMillan

NEW YORK (CNNfn) - They're words to strike fear in the heart of mortals: IRS audit. But tax pros say there are ways to handle a nasty surprise from Uncle Sam.

Let's start with the good news. The Internal Revenue Service has come calling much less often in recent years.

The IRS used to audit randomly. But it stopped its Taxpayer Compliance Measurement Program in 1988. Congress has quashed moves to revive random audits, and some tax preparers think they won't ever be back.

DIF system makes the audit difference
But the agency used TCMP audits to develop a computer program. Its Discriminant Function, or DIF, software compares each return against a norm. The higher your DIF score, the more likely the taxman cometh.



	Nobody knows what the DIF score is -- if they did, I guess they'd be rich.



	Frank Degen National Association of Enrolled Agents

The chances of having your return pulled are slim. For the fiscal year through September, the most-recent statistics available, around 0.5 percent of individual returns ended in audits, according to the IRS.

Who gets called? The IRS keeps the scoring system close to its chest, to discourage attempts to skirt it.

"Nobody really knows what the DIF score is – if they did, I guess they'd be rich," said Frank Degen, spokesman for the National Association of Enrolled Agents and an enrolled agent.

But the odder your return, the more common an audit. The IRS searches for the returns likely to produce extra tax when they're examined.

A disproportionate level of deductions
The IRS begins the audit process by seeking out returns with disproportionately high deductions compared with income.

For instance, people who earn less than $25,000 are more likely – slightly – to get audited than people who earn more than $100,000, according to Martin Nissenbaum, national director of personal-income tax planning for Ernst & Young.

Nissenbaum attributes that to abuse of the earned-income tax credit. At low levels of income, you can get a refund from the government even though you've paid very little in.

The IRS is clearly scouting for abuses of the earned-income credit, Nissenbaum said.

Sections to take care with
The home-office deduction is another area for caution. "You're basically asking for it," Nissenbaum said.

The deduction is perfectly legal. But any rent or mortgage expense deducted has to be for a room used purely for business. If you're an employee, the reason you're working at home has to be the convenience of your employer – not you.

A high rate of miscellaneous deductions on Schedule A also may prompt scrutiny. Degen, the enrolled agent, attaches an explanation for clients who are more-generous than normal -- if they give 10 percent of their income to charity each year, for instance.

Click here for CNNfn.com's special report on taxes.

Schedule E forms, for rental properties, partnership carryovers and estates, also can prompt an audit, Degen said. A very high level of rental-property expense is cause for concern.

Also tread carefully with Schedule C forms, for self-employed people. If you are employed but free-lancing, deducting lots of expenses for free-lance work could kick the agency into action, Degen said.

But if you're entitled to a deduction, it's yours to take. Then again, "If you're making stuff up out of holed cloth, you should be worried," IRS spokesman Don Roberts said.

Correcting mistakes
Obviously, the easiest way to avoid an audit is to file correctly.

"The No. 1 way to beat an audit is to have good records," said Fred Daily, a tax lawyer and author of the book "Stand Up to the IRS". "That sounds simple, but most people don't keep good records."

Pros say you should prepare your taxes as if you will get audited. Make sure that your 1099 and W2 forms correspond to your 1040. Make sure you include them all. If possible, get any errors on the forms corrected by the company that issued them.

But mistakes happen. Time was, a person filing with the wrong Social Security number would have had to settle the matter with a "correspondence audit," writing to the IRS. Filers now can sort out simple errors like that over the phone.



	The No. 1 way to beat an audit is to have good records.



	Fred Daily

As of this year, the IRS is including a new feature that preparers call "Check the Box."

If someone prepares your taxes for you, there is a box just above where you sign the 1040 income-tax return, asking whether the IRS can discuss the form with your preparer. Checking it will allow the preparer to clear up simple "processing errors" without involving you.

A visit to the IRS office
For individuals, anything beyond a simple processing error likely will require a trip to the local IRS office. IRS agents may make a "field audit" to businesses, because they have more paperwork. But field audits are rare for regular Joes.

The IRS letter will identify the questionable part or parts of the return. Make sure you take documents to support that area of the return.

"Have your records tied up as neatly as possible, so you're not shuffling through records," Nissenbaum recommends.

The letter also will set a date for an appointment. If you or your tax preparer can't make it, call the local IRS office to reschedule. The IRS typically will work around scheduling conflicts, as long as they aren't excessive.

Do you need a lawyer?
In many instances – particularly if you're sure your return is right – individual filers can represent themselves.

If you decide to represent yourself, don't discuss anything beyond the areas the auditor asks you about, Nissenbaum suggests. And don't volunteer information.

"Everything you say can give the agent an idea about something," Nissenbaum said. You may have nothing to hide, but why give the agent food for thought?

If you start to get uncomfortable or confused, it is your right to say you want representation. In most cases, the agent has to stop the audit and reschedule so you can hire an accountant or enrolled agent to tell your side.

Audits sold separately, normally
Some tax preparers include representing clients for an audit in their initial fee. But most don't. Check when you hire the preparer.

Your tax agent, accountant, or a lawyer will still normally represent you, though, for an hourly rate. Tax pros say it's best to stick with the person who prepared your report.

But switch preparers if you feel unhappy. Tax preparation can also be seasonal, and you may have to hire another expert.

Representation isn't a suspicious sign. "The IRS suspects there's something wrong, or they wouldn't have picked you to start with," Daily said. And auditors often prefer dealing with tax professionals. "Taxpayers just prolong the process," he added.

Leave it to the experts
You may want to attend the audit. But many preparers prefer to go alone. They feel there's less risk of their client complicating the audit or saying something inadvertent.

If you do go, keep quiet. "When we have clients come with us, we say 'Don't say anything'," Nissenbaum explained.

In 5 percent to 7 percent of audits, the IRS finds that it owes the taxpayer money, according to Roberts, the spokesman. But it's much more likely the audit goes against you.

For small discrepancies, the IRS may simply require you to pay the extra tax, plus interest. The interest alone can be substantial if it's old, because it gets compounded.

For negligence, the IRS tacks on a 20 percent penalty, on top of the tax and interest. The penalty for fraud is 75 percent of the value of the missing tax – which you still have to pay, too. In extreme cases, there's the possibility of criminal action.

But it's normally a much simpler, mundane process. It's basically a receipt recount. "It's kind of like watching the ballot-counting in Palm Beach," Daily joked.

For further information, the IRS provides a guide to audits, Publication 556, that is available free on its Web site and runs down the basic reasons for an audit and the procedures.