Tax issues

Are You a Candidate for an IRS Audit?

Benjamin Franklin is credited with observing, “In this world, nothing is certain but death and taxes.” To whom taxpayers answer in death is a question of debate, but there is no question that U.S. taxpayers must answer to the Internal Revenue Service.

However, the actual odds of an individual income tax return being selected for examination are quite low. Less than 1 percent of individual income tax returns are audited, according to recent U.S. Treasury Department reports.

But a generally complex return may increase the odds of being audited. High-income taxpayers who are involved in intricate real estate transactions or who run their own real estate or construction businesses may run a higher risk of being selected for an audit. Similarly, industry practitioners who report their business activities on schedule C of their 1040 form also may have a greater chance of being selected.

An IRS examination should not be feared, but on the other hand, it should not be taken lightly. In addition to filing an accurate return and keeping complete records, taxpayers should know their rights and engage an attorney, certified public accountant, or other qualified professional when appropriate.

Who Gets Audited?
The IRS selects which individual tax returns to examine in several different ways. These include random selection; examination of refund or credit claims by matching documents such as W-2 and 1099 forms against income tax returns; and the computerized discriminant function system, referred to as DIF.

One of the more common methods of return selection, DIF essentially assigns a numerical weight to specific items on tax returns. If the total score exceeds a certain predetermined threshold, the tax return is flagged for potential audit. However, if a return is selected, usually only specific items are examined rather than the entire return.

However, the IRS is secretive about the specific weighting and scoring that DIF assigns so that unscrupulous taxpayers cannot fly under the radar undetected. Some of the items that a DIF may flag include:

  • large amounts of income not subject to withholding;
  • more deductions than seem reasonable for a taxpayer's income level;
  • claims for an unusual amount of dependency deductions in relation to withholding and other items;
  • discrepancies such as an address change combined with deductions claimed for owning a residence when a taxpayer has not reported a sale of an old residence;
  • items that may trigger alternative minimum tax such as significant miscellaneous itemized deductions and state, local, and property taxes; and
  • complex investment or business transactions without clear explanations.

Examination and Appeals Basics
The examination process generally begins when the IRS sends written notification to a taxpayer that a return has been selected for an audit. 

The notice indicates which items are being questioned and what records the taxpayer needs to resolve the questioned items.

Examinations handled by mail are known as correspondence audits. A taxpayer may be able to resolve disputed tax return items by providing documents to substantiate a tax return position by mail. Other taxpayers may meet with a local IRS agent for an office audit.

Although a correspondence audit may be settled more quickly than an office audit, no general rule suggests that either is more beneficial to the taxpayer. However, switching from a correspondence audit to an office audit could widen the scope of an investigation.

At the conclusion of an examination, the IRS agent either proposes an adjustment or accepts the tax return as originally filed.

If an adjustment is proposed, the taxpayer either can pay the additional tax or appeal it. The appeals process is handled by the IRS Appeals Office, where the taxpayer is entitled to an appeals conference.

If the taxpayer remains unsatisfied with the result of the appeals process, relief may be sought through the U.S. Tax Court, District Court, or Court of Federal Claims.

However, the taxpayer's case must include certain requirements before it can enter the court system. The Tax Court (which hears cases before taxpayers make payments) only will consider a case after the IRS has issued a notice of deficiency, often referred to as a 90-day letter. Further, the District Court and Court of Federal Claims will hear cases only after a taxpayer has paid any additional tax due and has filed a claim for refund.

Taxpayers' Rights One way that taxpayers can prepare for an examination is to know their rights. The IRS publishes Your Rights as a Taxpayer. This document includes several rights: privacy and confidentiality; professional and courteous service; representation; payment of only the correct amount of tax; an appeal and judicial review; and help with unresolved tax problems.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or steve.friedman@ey.com and samuel.hoppe@ey.com.

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