Question: I file my federal income tax return every year with the IRS, but I'm terrified of being audited. What's the inside scoop on IRS audits, and how can I reduce my apprehension about it?
Answer: Yes, you have "audit anxiety." It's an important part of our voluntary compliance system. The IRS uses audit anxiety to help keep taxpayers honest. But, of course, there's more to the story. Let's talk about this.
First, we need to dial the stress level down a little. Here's the deal. If you've heard horror stories about the "audit from hell," you can relax a bit.
Years ago, the IRS had an ugly program called "Taxpayer Compliance Management." The program selected about 50,000 returns each year for "comprehensive" audit, and demanded that the taxpayer prove literally every detail of every line on their tax return. The TCMP audits were so intrusive and hated that Congress demanded a kinder and gentler approach. The National Research Program is the replacement.
There are two main reasons for all of this analysis. One is that the IRS wants to know where people fudge their numbers. Also, the feds want to be able to estimate what they call the "tax gap."
The concept describes the difference between what taxpayers report and pay, and what the IRS thinks they actually owe. The most recent estimate of the tax gap is about $300 billion annually. Over 80 percent of the gap is from the under-reporting of income and the over-reporting of expenses.
Today we'll take a quick look at several types of audits. Then we'll review examples of common "audit triggers." These are the red flags the IRS computers spot while processing your forms.
There are three common types of audits. Recent technology developments are changing this, but here are the basics: A correspondence audit typically involves a letter from the IRS asking for clarification or additional documentation in support of something in your return. An office audit asks that you come into the IRS office and bring certain documents or other information. A field audit is more suitable for larger companies; the auditor arranges for a visit to the business, seeking additional or clarifying information.
In 2011, the overall audit rate for all individual returns was 1.1 percent. Of course, more scrutiny is given to higher-income filers. For example, returns showing income of $1 million or more were audited at a 12.5 percent rate.
In general, the IRS can audit back for three years and, under certain circumstances, for longer, or even indefinitely. Get professional help with any audit issue you're unsure of.
As each tax return is processed, it is assigned a score. This is sort of a sniff test that compares the information entered on the return with the database of similar returns. You may hear this called a "DIF score." Returns with high DIF scores are pulled for further examination. The exact factors and formulas the IRS uses for audit selection are top-secret.
Here are eight common reasons for additional scrutiny.
Under-reporting income. The IRS matches essentially all W-2s and 1099s with the taxpayer's return. If you don't report documented income, the Document Matching Program will flag the error.
Operating a cash business. Firms that handle cash get extra analysis. Examples: beauty shops, restaurants and bars, and taxicabs.
Claiming large charitable contributions. The IRS has imposed restrictions on what used to be a free-for-all. Most recently, the crackdown was on donations of used cars at inflated values.
Using many round numbers. If you file a business Schedule C and a lot of the expense amounts are in round thousands, your DIF score will light up.
Reporting very low income in an expensive zip code. This may be a valid situation, but there's a flag here. The IRS will ask you this question: "What is the source of the money on which you live?"
Claiming recurrent business losses. This may flag your business as a hobby. This means no loss deductions, unless you can refute it.
Overstating business expenses for meals and entertainment. A partial deduction is allowed for legitimate business expenses. This means a reasonable meal with a current or prospective customer.
Using a "problem preparer." The IRS has a list of tax return preparers who have been problematic. Recent laws require preparers to undergo certification.
I hope this eases your anxiety. For further info: the Bellingham IRS office is at 114 W. Magnolia St. Also check irs.gov for downloadable forms and publications.
To learn more about managing cash flow, and other small business matters, contact SCORE, "Counselors to America's Small Business." SCORE is a nonprofit nationwide organization with more than 13,000 volunteer business counselors who provide free, confidential business counseling and low-cost training workshops to small business owners. Call the local SCORE chapter at 360-685-4259 to schedule an appointment. For details about the organization,visit SCORE.org.
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Ask SCORE is prepared for The Bellingham Herald by Bob Dahms, a business counselor with the Bellingham chapter of SCORE. Submit questions for this column to firstname.lastname@example.org.