Viewpoints

Chances You'll Be Audited and What To Do If You Are

Bruce Zicari

Originally Published:
April 2007
Author: Bruce Zicari, CPA

Last year, the IRS assessed about 26 million civil penalties against individual taxpayers. Of these, about 60% were for failure to pay, followed by about 7 million – nearly 25% - for underpayment of estimated tax. Close to 300,000 returns were tagged for “accuracy penalties”—matters that include negligence, substantial understatement of income tax, substantial valuation misstatement, substantial overstatement of pension liabilities, and substantial estate or gift tax valuation understatement.

So, what are the chances that you will be audited this year?

In 2006, the Internal Revenue Service IRS collected more than $2.2 trillion in tax and processed over 228 million returns. Over 108 million individual income tax return filers received tax refunds totaling $243 billion. From W-2s to 1099s to mortgage interest statements, the IRS received a total of 1.5 billion information forms in Fiscal 2006. Of this total, less than 4 percent were submitted on paper.

This information, and a significant amount more, can be found in the IRS’ annual data book (Internal Revenue Service: 2006 Data Book, Pub 55B, March 2007; IR 2007-63) that provides valuable information about how many tax returns IRS examines (audits), and what categories of returns IRS is focusing its resources on, as well as data on other enforcement activities such as collections.

There are some interesting statistics in the data book that I would like to share with you that can help reduce your chances that you will be audited in the future. Since you have or are getting ready to file your return, I also will address the issue of what you should do when you receive an audit notification.

Last year, a total of nearly 1.3 million individual income tax returns were audited out of a total of 132 million individual returns that were filed.  This works out to a little less than one percent. Here’s an interesting note – that’s more than double the number examined in 2000.

Of the total number of returns audited, about half a million were selected on the basis of an earned income tax credit (EITC) claim.

Revenue agents, tax compliance officers, and tax examiners conducted less than one out of four audits. That means that the bulk of the audits - about 76% - were correspondence audits.

The no-change rate – those are returns accepted as filed after examination - was 14% for returns examined by revenue agents, tax compliance officers, or tax examiners, and 17% for compliance centers.

The IRS initiated about 4,000 criminal investigations in fiscal 2006 and got about 2,000 convictions. Of those sentenced, over 80% were incarcerated.

On the business side, examinations of business tax returns grew for the second year in a row, reaching over 52,000 in 2006. Based on assets, chances of corporations under $10 million getting audited were less than 1 out of a hundred, but for those over $10 million, chances rose to nearly one out of five. And, about 1 out of every 200 S corporations and partnerships were audited.

Because the IRS does not have sufficient personnel and resources to examine every tax return, the odds are low that your tax return will be picked for an IRS audit. The IRS employs formulas and red flags to select those tax returns that have high audit potential. Note, however, that your chances of being audited increase if your return shows:

• Large amounts of itemized deductions that exceed IRS targets.
  
• Tax shelter investment losses.
  
• Complex investment or business expenses. 
  
• You own or work in a business that receives cash and/or tips in the ordinary course of business.
  
• Business expenses that are large in relation to your income.
  
• Rental expenses.
  
• Complex tax transactions without explanations.
  
• You are a shareholder or partner in an audited partnership or corporation.
  
• Large cash contributions to charities in relation to your income.

If you are one of the unlucky ones to receive notification of an audit, don’t panic – unless you have good reason. Don’t ignore the notice. You will have about 30 days to respond, but if you don’t the IRS can and will take action. Read the letter carefully to determine the nature and scope of the issue, for example, are they questioning your entire return, or just a portion?  In most cases the IRS tax notice will indicate which area of your tax return is being questioned. Be aware, however, that the best way to prepare for an IRS audit is thorough and consistent record keeping in the tax year of the audit.

While the traditional view of an audit is a face-to-face interview with an auditor, about a third of all audits are actually in the form of a letter from the IRS asking for explanations or documentation.

It’s generally a very good idea to get your tax advisor engaged before responding to the IRS. They can help you determine the appropriate response; types of documentation you need, and even may help with support for your tax deductions and positions. A satisfactory explanation in a well-reasoned letter can bring whatever issues the IRS has to a swift conclusion.

If you are subject to a face-to-face IRS tax audit, here are a few things to consider:

1. Get your tax advisor involved, and if you don’t have one, get one.
   
2. Bring documentation to support your tax case, but only for tax items specified in the IRS tax audit notice.
   
3. Organize your papers according to the tax items in question, and make copies.
   
4. Bring relevant worksheets to show how the tax figures in question were calculated.
   
5. At the IRS tax audit, do not volunteer information.  Be cordial, stay on point and remember, "Loose lips sink ships".
   
6. Don’t bring in a chip on your shoulder, and in particular, avoid making arguments about the constitutionality of the income tax, or other extreme viewpoints that will surely move you from what may be a simple matter to a full-blown compliance review.
   
7. When concluded, the IRS will indicate problems or issues and advise you of any tax adjustments needed – whether in your or their favor.

Last but not least, it's important that you know your rights, the audit process, and the law behind the deductions you are claiming. It's generally best to settle any difference at the audit level, but if you can't come to an agreement, you have rights that allow you to request a conference with the IRS Appeals Division.

My fervent hope is that you will be one of the 99% of taxpayers that are not audited. If you are, however, take a deep breath, organize your paperwork, get the resources you need, and defend your position. Who knows … you may even be one of the very select few that actually end up with the IRS owing money to you!

Disclaimer: The Bonadio Group provides the information in Viewpoints for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in Viewpoints are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.