Receiving an envelope from the IRS would make any taxpayer’s heart skip a beat. It can lead to sleepless nights if the letter is questioning your reported income or deductions on a tax return, or worse yet, requesting your personal appearance at an IRS office to discuss your return.

Greater IRS Use of Computers to Catch Discrepancies

For years, the IRS has focused its enforcement activities primarily on computer programs that match unreported or overstated deductions, allowing its face-to-face tax audits to decline to historically low levels. Unfortunately for taxpayers, the IRS is now enforcing the law with new energy, so there is a higher statistical chance of being audited.

Being selected for an office audit does not automatically mean you are going to be liable for additional taxes. If you have the necessary records to back up your reported income and deductions, the audit should result in a “no change.” What generally causes returns to be selected for an office audit are deductions that are excessively outside of statistical norms. Other frequently selected returns are those of self-employed individuals whose net income does not support living expenses. High-income taxpayers are also frequent targets of an audit.

Special Programs to Catch Income Reporting Abusers

The IRS often comes up with special programs to nab abusers who are habitually slipping through the cracks without paying their fair share. Here is a summary of some current programs:

• Identify and catch taxpayers with offshore bank accounts who do not report the income from the accounts and access the funds via credit card to avoid detection.
• Identify and audit returns most likely to have underreported income using a newly developed computer program.
• Match “pass-through” income and deductions for K-1s of partnerships and S corporations to returns filed by owners of these entities. No serious attempts were previously made by the IRS to match the more than 20 million annual K-1s to the owner’s returns. It is believed that many are underreporting income and overstating deductions.
• Shut down tax avoidance schemes such as the “Section 861 argument” which wrongfully attempts to dodge taxes on any income that is not from foreign sources or abusive trusts and whose promoters claim you can contribute certain assets to the trust and avoid taxes.

Tactics to Lower Chances of an Audit

Nothing can be done to avoid a random audit. However, you can reduce the chances of being picked up by one of several matching programs that compares income and deductions on your filed return to documents issued by your banks, investments, lenders employers, etc. These IRS programs flag missing income. For example, money is withdrawn from one pension plan and moved to another within 60 days allowed for rollovers. As far as the IRS knows, the funds were withdrawn. Unless the withdrawal and subsequent redeposit is shown on the return, one can expect to hear from the IRS.

How to Win an Audit

Report all of your income and document all your deductions. Don’t mix personal and business expenses, and when an expense is partly personal and partly business, allocate those expenses accordingly. Above all, maintain adequate records. When it comes to an audit, those with records prevail whereas those without are at the mercy of the auditor.