Income Tax Audits

What to do when the IRS knocks on your door.

Few occurrences strike as much terror in the human heart as an audit notice from the Internal Revenue Service. Although only about 1 percent of all tax returns are audited in any one year, the chance still remains that one day you may be faced with an audit of your income taxes. Over time, about half of all taxpayers will be audited at least once, and the odds increase along with the amount of income you report.

If you do receive correspondence from the IRS in the mail, don't panic. In some cases, what you receive may not be an audit notice at all, but an "automated adjustment notice," telling you that you owe additional tax. You're most likely to receive one of these because of an error you made in computing your income or taxes, or because you failed to report some income to the IRS which was reported to it on a 1099 form, such as dividends or interest.

Just because you receive an automated adjustment notice (also called a CP2000) doesn't mean that you must pay the amount assessed without question. In many cases, the IRS itself has made a miscalculation of the taxes you owe, or entered data about your income incorrectly. Under federal law, you have the right to appeal an automated adjustment notice in writing within 60 days.

Even when an actual audit is conducted, you may not need to actually meet in person with an IRS agent. Some audits (called "correspondence audits") are conducted entirely by mail. In a correspondence audit, you're asked to justify some part of your return by providing additional documents through the mail.

If you are asked to send supporting documents to the IRS through the mail, never send originals, since they may go astray. Always send photocopies, and mail any correspondence by certified mail, return receipt requested, so you will have proof that you mailed your response by the deadline the IRS gave you for responding to its inquiry.

While the correspondence audit notice you receive will often include a telephone number for you to call, doing so is generally a waste of time. The IRS employee who takes your call will not have your file available, and that means you will end up having to handle the matter by mail anyway. If you do call, however, be sure to keep a detailed log of the date and time of your call, as well as the name and title of any IRS employee with whom you speak.

No matter what, never ignore a letter or other inquiry from the IRS about your taxes. Doing so may subject you to additional negligence penalties, and could lead to a full-blown audit that might otherwise have been unnecessary.

When the IRS first contacts you about an audit, it will send you a copy of its publication entitled "Your Rights as a Taxpayer." In this booklet, you will find an explanation of the Taxpayers' Bill of Rights enacted by Congress, as well as a description of how the IRS conducts audits and collects unpaid taxes.

If an audit must be conducted in person, it will either take the form of an office audit where you visit the auditor at his or her office, or a field audit (the auditor comes to your home or business). Most IRS audits are office audits, and an office audit is always preferable, since it prevents the auditor from going on a fishing expedition in the records at your place of business.

Even if the IRS requests a field audit, you can keep the auditor away from your business or home by providing all of your financial records to your tax adviser and asking that the audit be conducted at his place of business. While this should be enough by itself to stop an audit from being conducted in your home, you may also have to show that a field audit would be disruptive to your business to keep the auditor away from your office.

Generally, you will have at least several weeks to prepare for an IRS audit, so you should have plenty of time to put together the documents you will need to support your return, such as canceled checks, receipts, brokerage statements and bank records. If you need extra time, however, you may request a change from the original appointment time set by the IRS.

Since the IRS generally has three years from the date you filed your return or its due date (whichever is later) to begin an audit, you need to keep your tax records and supporting documents for at least that long. This three-year limit doesn't apply, however, if you understated your income by more than 25 percent. The IRS then has six years in which to assess additional taxes. And if you filed a fraudulent return, there is no time limit at all. As a result, it's best to keep your tax records on file for at least six years. And some records, such as those relating to your IRA or other retirement benefit plans, should be kept indefinitely.

In some cases, the IRS may not be able to complete an audit within the three year time limit expires, and may ask you to agree to a voluntary extension of this time limit. While you don't have to agree to such an extension, the usual IRS response to a refusal is to disallow every questionable item on the return being audited. A better strategy is to negotiate an extension with a definite expiration date, and to limit the extension to only those items which are in question at the time the extension is granted. In this way, you can keep the IRS from expanding its inquiry into other areas of your return during the extension period.

Most experts recommend that you have the person who prepared your taxes appear at the audit with you to explain how your return was done. In fact, if your tax return was prepared by an attorney, a CPA, or an "enrolled agent," he or she can appear in your place, and you don't even have to attend the audit. (Any other kind of tax preparer may accompany you to an audit, but can't represent you.) Many tax advisers even suggest that it's better for the taxpayer to stay away, since the professional representing you doesn't have the same emotional involvement in the outcome of the audit, and so isn't as likely to say or do something that raises the suspicion or the ire of the auditor.

In the event that you decide to appear at the audit, it may be tempting to take a tough attitude with an IRS auditor, but it's always a bad idea to give in to the temptation. Being rude to the auditor won't help your case any, and may actually prompt a more penetrating examination of your records than would have occurred otherwise.

The most important tip we can give you if you are ever called for an audit by the IRS is this: Never give an IRS auditor any more information than what was requested. Unless you are one of the 50,000 unlucky souls called in for what's called a Tax Compliance Measurement Audit, which looks at every single item on your tax return, your audit will be limited to certain areas of your return, which you will know about in advance. Limit your responses to any questions the auditor asks to these areas. If the auditor starts off on a fishing expedition into other areas of your return, tell him that you do not wish to discuss them until he makes a formal request to audit that portion of the return.

Never respond to an auditor's rejection of a deduction or tax credit by saying something like "Well, we've always taken that deduction in the past." The auditor doesn't care, except to use that information to question previous returns you have filed. And remember that if the auditor is rude or unpleasant, you are legally entitled to request the assignment of another auditor.

When the audit is concluded, you will receive a copy of the auditor's report. If you disagree with the auditor's conclusion that extra tax is due, you can make an immediate appeal to the auditor's supervisor. If the auditor's supervisor agrees with the report's conclusion that you owe more money to the IRS, you have the right to file an additional appeal within 30 days to the IRS Appeals Division.

If you pursue your appeal to this step, chances are you may be able to settle your case for an amount that's less than what the auditor originally imposed as an additional tax. That's because Appeals Division officers can consider the cost of litigation and the risk that the IRS might lose a court appeal in evaluating your claim. According to statistics, approximately 9 out of 10 cases heard by the Appeals Division are settled.

If you still aren't satisfied, you can take your appeal to Tax Court. And if the amount in question is less than $10,000, you can use the Tax Court's Small Claims Division, which uses simplified procedures, although you may want to have an attorney or other tax professional's assistance in presenting your appeal. Eventually, you can even appeal to the U.S. Supreme Court, but remember that the Supreme Court hears only a handful of the many petitions brought before it in any session. Unless your tax issue is one that will have a far-reaching effect, it's unlikely that the Supreme Court will hear your case.

Of course, the best way to avoid trouble with the IRS is to minimize the possibility that your income tax return will raise a question when you send it to the IRS. That means you should be sure to file all the required forms and answer all the questions asked on your return, even if they don't seem to apply to your situation. You will also want to be sure to double check the accuracy of your W-2 and any 1099 forms you receive, and be careful to report all the income on these forms to the IRS.