It is the most dreaded letter a taxpayer can receive.
Continue Reading Below
Some of the information that you provided to us does not agree with the information we received from other sources.
-- The Internal Revenue Service
You've just joined an elite club, one whose initiation ritual is an IRS audit. Unfortunately, you can't refuse membership -- and the dues could be astronomical.
When the IRS Restructuring and Reform Act was enacted in 1998, lawmakers ordered the agency to focus more on taxpayer rights instead of collection activities. Not surprisingly, the number of audits -- or examinations, as the agency prefers to call them -- dropped dramatically.
The first year of the kinder, gentler IRS, about 1 in 79 tax returns was audited. By 2003, it was even easier for tax scofflaws; that year, according to IRS data, only 1 in 150 individual taxpayers was audited.
But the tax times, they are a-changing.
Continue Reading Below
More Audit Attention
IRS Commissioner Doug Shulman says he wants to balance his agency's enforcement and service responsibilities. To that end, he has announced programs designed to take into consideration the financial struggles that many taxpayers are encountering in today's economy.
But balance doesn't mean taxpayers are off the hook. Facing pressure from a Congress dealing with a growing federal deficit, the IRS has made it clear it takes the enforcement portion of its job seriously.
Audits have been increasing, although the pace was slow in fiscal year 2010. According to the IRS' 2010 annual data book (the latest edition available), individual taxpayer audits last year were up slightly, just more than 1%. Of that number, says the IRS, individual income tax returns reporting higher adjusted gross incomes were more likely to be examined.
But the rich aren't the only targets. Recent tax law changes, particularly when it comes to confusing tax breaks such as the first-time homebuyer credit, always prompt closer looks at returns. And if you're a small-business person, either as a partnership or a Schedule C filer reporting self-employment income on your personal tax return, make sure you take extra care with your returns.
And those with lower incomes that make them eligible for the complicated earned income tax credit also face added scrutiny. Nearly 30% of audited returns claimed this tax credit.
What's the DIF?
When it comes to avoiding prying IRS eyes, it's best to be just one of the crowd. "Don't draw any more attention to your return than you need to," says Robert G. Nath, author of "The Unofficial Guide to Dealing with the IRS." "Simple, plain-vanilla returns are fairly safe."
The IRS says there are several ways a return can be selected for audit and the first is via the agency's computer-scoring system known as Discriminant Information Function, or DIF. The IRS evaluates tax returns based on IRS formulas, and DIF is based on deductions, credits and exemptions with norms for taxpayers in each of the income brackets.
The actual scoring formula to determine which tax returns are most likely to be in error is a closely guarded secret. But Nath, a tax attorney in the Washington, D.C., area, says it's no mystery the system is designed to screen for returns that could put more money in the government Treasury.
How do Your Deductions Compare?
Tax experts believe one discriminant information function component looks at average deduction amounts. This allows IRS examiners to spot inconsistencies, such as a high mortgage interest deduction and low income.
Tax specialists at CCH Inc. examined 2009 return statistics, the latest complete data, and came up with the following itemized deduction averages. These are for illustrative purposes only. CCH experts note that the IRS takes a dim view of taxpayers who base their claimed deductions on these figures. The numbers can be useful, however, in giving you a general idea as to whether certain deductions on your return might seem out of line.
Allison Einbinder, owner of Dollars & Sense, a tax and accounting firm in Oakland, Calif., recommends that all filers review the differential comparisons. How you stack up against a national standard, she says, will give you an idea of whether the IRS might take a closer look at your return.
So what is likely to trigger a discriminant information function red flag?
- Higher incomes.
- Income other than basic wages; for example, contract payments.
- Unreported income, such as investment returns.
- Home-based businesses, especially when in addition to salary income, and home-office deductions.
- Noncash charitable deductions.
- Large business meal and entertainment deductions.
- Excessive business auto usage.
- Losses from an activity that could be viewed as a hobby rather than a business.
- Large casualty losses.
Returns claiming the earned income tax credit, designed as a tax break for lower-income wage earners, also catch IRS eyes. The credit's complexity often results in legitimate mistakes on returns. Some filers, however, have been caught making false claims to increase the payment the credit provides.
Schedule C filers who report a business loss also are likely to face more questions from the IRS. The agency wants to be sure that it was indeed the economy, and not an effort to trim taxes, that produced the bad business results.
Don't Cheat Yourself
But don't let fear of a potential audit discourage you from filing for tax credits or taking legitimate tax deductions.
Although some tax return actions are likely to flag your return, Nath says that doesn't necessarily mean you'll be audited.
Even if your return is questioned, it's not a foregone conclusion that you'll end up owing the IRS. As long as your deductions and expenses are legitimate and you have documentation, Nath says, they will be allowed.
The groundwork you put into preparing your return will pay off in an audit situation. "Be confident in what you entered," says Einbinder. "That's easy when you have good records to support your tax return entries."
And even if an audit doesn't go your way, don't despair. "You have rights to contest audits," Nath says, "at every level of the process." Read Bankrate's story on how to prepare for an audit in case you get summoned.