In our country, we have a voluntary compliance system of taxation. This means we report to the government our income and deductions and compute the tax due ourselves. To insure that the tax laws are followed and the deductions on a return are legitimate, the IRS has the authority to audit our tax returns. If you receive a letter from the IRS, before you call them, call your tax preparer!

Types of Audits

Correspondence Audit

The IRS sends a letter asking you to verify certain items of income and deductions on your tax return. Generally, you can respond by mailing copies of your documentation. Never mail the original documents back to the IRS! If the IRS finds that you owe tax and you don't agree, you may request an office audit.

Office Audit

You receive a letter from a local IRS office requesting that you call for an appointment. The items in question will be listed in the letter. After making your appointment, you and/or your representative will take the records into the IRS office, and there you will verify your deductions and discuss with the agent any points of law on which you may not agree. If an agreement is reached with the auditor, your case will be closed. If you don't reach an agreement, you may appeal.

Field Audit

This type of audit is normally used for business. The auditor will come to your home or place of business. A field audit may also be conducted in your paid preparer's office, an especially good idea. You will need to have all your records there, but your home of place of business will not be disrupted.

How a Return is Selected for Audit

The IRS uses a computer generated program that compares your return to others in your income bracket and compares the differences in deductions you are taking against the average in your group. This highly secretive program which products the DIF (discriminate function) score is used to select returns that will general the highest probability of additional audit revenue.

The program takes into consideration your income, the size of your family, where you live and how your money is earned. Your DIF score is driven up by deviations from the norm. For example, if your total income is only $45,000 and you live in an exclusive residential area with four children, your return would have a higher probability of being audited. Furthermore, under the same circumstances, if you claimed $10,000 in charitable deductions, your DIF score would rise. Quite simply, the IRS program is looking for the likelihood that you are under-reporting income or over-reporting deductions.

What should you do if you know your circumstances will throw your return into the "deviant" group? Nothing, so long as the income and deductions are legitimate and can be proven. Simply be aware that you may have to sit through an IRS audit and provide proof of your expenses and receipts. If you know that your return has what we refer to as "red flags," you need to be extraordinarily careful to keep accurate records and receipts.

It is usually advisable to take a "proactive" approach with the IRS if you know you have a red flag deduction on your return. For example, if you have an unusually large charitable contribution in one particular year, you may want to attach a copy of the receipt and possibly an explanation as well. That will not prevent your return from being tagged by the DIF score, but before you are called in for an audit, a "human" examiner with the IRS will review your return and use his or her own judgement as to whether your return warrants a desk or field audit (a field audit occurs when the IRS actually visits your place of business and requests records on the premises).

High-Risk Areas

The risk of being audited is not spread evenly across the population as you have probably guessed. The IRS uses the same cost-benefit ratio used by business when considering a potential audit. Put quite simply, if you are in a low income bracket, it may not be worth the agent's time to bring you in for an audit that will yield only a few dollars in disallowed deductions.

Obviously, if having a low income decreases your chance of being audited, being a high-income taxpayer will definitely increase your risk. Being self-employed will increase it even further. The IRS is aware that the potential tax deductions available to self-employed individuals is tremendously greater than those available to wage-earners. Statistics show that deductions for travel, auto and entertainment are the top of the IRS' target list. Why? Because all too many people either fail to keep the required documentation or they take deductions that have dubious business purposes (such as taking a spouse to a conference in Hawaii).

Professions that deal heavily in cash transactions have also faced a greater degree of audit risk. Employees in the food service and entertainment industries are typically audited for under-reporting of tips and other cash income.

What To Do In The Event Of An Audit

What should you do if you're called in for an audit? First of all, find your records and get them in order. The more organized and professional you appear to be, the more likely it is that your records will be taken seriously. Secondly, if a paid-preparer prepared your return, call them. They can sit down with you and review your return and your records in order to determine where your potential risks may lie. It may actually be better to have them represent you before the IRS. They are far more likely to know where the agent is going with this or her questions and, more importantly, they will have a better understanding of when to not volunteer more information than is necessary. All to often, clients will begin speaking and volunteer much more information to the agent than was necessary to respond to the inquiries. If you choose to have someone else represent you, you will have to complete a Form 2848 (Power of Attorney) and have it on file with the IRS.

Overall, your risk of being audited is less than 2 percent. Of course, if your return has one of the red flags mentioned above, that risk increases dramatically. Legally, under the statute of limitations, the IRS has three years to pull your return for an audit (unless they can prove fraud). In real practice, however, since the audit process takes time, most returns are audited within one to two years after filing.

Finally, if your return was filed incorrectly and the likelihood of an audit is high, it may be better to file an amended return now and avoid the high penalties that could be involved with an audit.

What if I Don't Agree with the IRS?

If you don't agree with the auditor, you may appeal your case using the following procedures. First, you may appeal to the auditor's supervisor. Next you may appeal your case to the Appeals Division of the IRS. The appeals officer, although an IRS employee, is often more knowledgeable of the law. Consequently, it is common to reach an agreement at this level.

If you still don't agree with the appeals officer, you may appeal to Tax Court. This may be done without paying the tax due if you file within the time allowed. The IRS will issue you a Statutory Notice of Deficiency if there is no agreement. You have 90 days from the date this notice is issued to file a Tax Court petition and have your cases heard without paying the tax.

Depending upon the amount owed, you may elect to file your case in Small Case Tax Court where an attorney is not needed. Otherwise, you would file your case in regular Tax Court. As an alternative to Tax Court, you may pay the amount of tax due and file a suit for refund in either U.S. District Court or U.S. Claims Court.