Selection of returns for audits

Higher wages. As you may guess, when your income increases, so do the chances of being audited. There are a couple of reasons for this. First, many individuals and businesses that earn large amounts of money have a tendency to inflate their deductions to reduce their income. Second, because the taxpayer makes more money, his or her tax bill is higher and the government feels it has a better chance of collecting more tax from a high-income producer.

Reported income not in agreement with information forms (Forms 1099). The IRS will match the information you have provided on the forms with information provided from banks, brokerage firms, schedule K-1, etc., and verify that the information is correct. If an error is found, the IRS will typically call or send a letter to inform you it has found an entry that appears incorrect. Generally, a situation like this can be taken care of quickly over the phone or by sending a letter to the IRS with the correct information.

Excessive deductions. This is one of the most common "red flags" that triggers an audit. The IRS has a standard range of income as to where a deduction should fall according to other financial information you have provided on your return. If the deduction falls outside of this spectrum, the chance increases greatly that you will be contacted by an IRS agent to explain the deduction. This is why it is very important to retain all of the receipts for the deductions you claim. If you cannot prove to the IRS agent that the expense is legitimate, the deduction will be disallowed and a tax will be assessed on the amount of the deduction not allowed.

Random sampling. This is also known as a "lottery" audit. Under this type of selection, you or your business return will be chosen at random through a computer-selection process. If chosen, the IRS agent will go through your return line by line and not just look at a specific area on the return. The IRS has taken a great deal of criticism for conducting "lottery" audits because of the length and detail of the audit for the business or individual. Therefore, this type of audit is becoming less frequent than in the past.

Cash business operations. Many small businesses run on a cash basis, such as cafes and gas stations, which makes it easier to conceal income. These types of businesses are often the target of IRS audits to determine the accuracy of reporting.

Self-employed or cash employee. These individuals are self-employed or receive cash from their jobs, such as bartenders. The government reasons that if you are self-employed, you have a greater chance of underreporting income and taking excessive deductions.

Prior tax deficiencies. Once a taxpayer has been determined to owe a deficiency to the IRS, that person is often "marked" for a future audit. This is especially true if the deficiency was discovered through an audit procedure. This is not a guarantee the taxpayer will be audited and if he or she is, the IRS is primarily concerned that the taxpayer is in conformance with the law and has not repeated prior violations.

Tips from third parties. It is surprising the number of audits that are conducted due to information provided to the IRS from third parties, such as disgruntled employees or employers, ex-spouses or significant others, neighbors, news media, etc. Many people think it is a good idea to tell everyone how they are beating the tax system. Little do they know that all it takes is one phone call from someone to have the IRS knocking at the door.

Types of audits

1. Correspondence audit. This type of audit is commonly used to correct minor mistakes. The IRS will send a letter to the taxpayer reporting its findings. The taxpayer can usually fix the problem by correcting the documentation or sending additional documentation. The letter will specify exactly what the taxpayer needs to do. If the taxpayer responds to the satisfaction of the IRS, the case is closed.

2. Office audit. The taxpayer is required to meet an IRS agent at an IRS facility. An office audit is usually restricted in scope (the IRS will only look at one part of the return) and the letter will indicate what documents to bring. Bring only what the letter indicates to bring. Otherwise, you will subject yourself to a broader audit than what was intended.

3. Field audit. This type of audit is conducted at the taxpayer's place of business. The audit will generally involve several parts of the return or will involve a complicated matter that requires a great deal of records and documentation. It is generally advised that the business owner obtain legal and accounting services to help him or her through this type of complicated audit.

After the audit is conducted, the IRS will send a letter to the taxpayer summarizing the findings. There are three possible results that can be concluded from the findings: a refund, a notice of tax due or no change at all. The outcome will determine the taxpayer's next move.

Settlement procedures

Accept the findings. You can always accept the IRS findings. The important thing to remember is to look closely at the findings and determine if you truly agree. The IRS may be correct on its findings and you may be better off accepting them. If you agree, the case will be closed upon some filing of paper work and payment of the tax.

Negotiate a settlement. The IRS is willing to settle tax deficiencies more often than people realize. There are two main ways the IRS will negotiate the amount owed:

• The IRS will lower the amount owed depending on the probability of success on an appeal of the findings. If the IRS determines that it is unlikely to win, it will be willing to lower the amount due. Of course, the opposite is true if it believes it has a strong case.

• The second way to lower the tax liability is through what is known as an "offer-in-compromise." This procedure is used when the taxpayer is suffering financial difficulty. This is a separate negotiation procedure and will only focus on the taxpayer's ability to pay the tax due. Under an offer-in-compromise, you fill out forms demonstrating your income and asset status and submit a proposal for what you feel you can pay and still maintain a livable lifestyle. The IRS will then review the offer. The end result is that the taxpayer and the IRS agree to a payment plan. Typically, the IRS has been reasonable in negotiating this type of procedure.

Appeal. The third form of action a taxpayer can take is to appeal the decision.

The appeals process

The field auditor. At the IRS field level, there is limited flexibility as to what the field auditor can do once a notice of deficiency has been filed. However, the field auditor can change any mistakes that were made during the audit. Therefore, it is very important to fully understand the auditor's findings. It is not uncommon to see mistakes in the auditor's findings. If the findings are not considered a mistake, they must be accepted or appealed through the processes below.

Appeal to the regional appeals office. After a notice of deficiency has been sent to the business or business owner, the business owner may wish to make an administrative appeal within the IRS; this is done by requesting a conference with an appeals officer. The appeals officer is independent from the local office that conducted the audit. A request should be submitted by written or oral statement depending on the type of audit procedure conducted and amount of liabilities. Consult your business's CPA or tax attorney for assistance in requesting an appeal.

The appeals office has the authority to change the decisions made by the auditor. There is a good chance that the appeals officer will settle the issue based on the "hazards of litigation," meaning he or she will weigh the probability of success if litigation occurs against the amount of the deficiency.

Take the case to court. If you do not reach an agreement with the appeals officer, you may take your case to the U.S. Tax Court, U.S. Claims Court or the U.S. District Court. You do not have to appeal to the IRS Appeals Office first; you may appeal the deficiency of notice directly to the court system.

U.S. Tax Court. Once the business owner receives a notice of deficiency, he or she has 90 days to file a petition with the Tax Court. The instructions for petitioning to the Court are included in the letter of deficiency.

The advantage of the Tax Court to the business owner is that it is considered an informal setting as compared to other legal proceedings, and the business owner can use the court without first paying the tax. It is considered informal because legal representation is not required (although highly recommended). Also, the decisions are made by a judge rather than a jury. The judges are very knowledgeable in tax law and IRS procedures. Another advantage is that if the controversy is less than $50,000, the business owner may elect a "small tax case process." A small tax case process is beneficial to the taxpayer in that it is even less formal and more expedient than the regular proceedings of the Tax Court.

Once a decision is handed down in the Tax Court, it is final. The business owner cannot appeal the decision to a higher court.

U.S. District Court. Another option for the business owner is to take the case to the District Court. One difficulty in using this system is that the tax deficiency must be paid first before a claim can be filed. This court system uses the trial-by-jury approach. There is more uncertainty in the decision because the jury is less knowledgeable of the tax laws and IRS procedures. One advantage is that the decision can be appealed to the U.S. Court of Appeals and then petitioned to the U.S. Supreme Court if necessary. Another benefit is that you have other taxpayers making a decision regarding your tax liability.

U.S. Court of Claims. This court is similar to the District Court in that the tax deficiency must be paid before the court will hear the case. It also follows the same appeals process. The main difference is that there is no trial by jury; a judge rules on both facts and law. The judge, however, is not a tax expert as are the judges sitting on the bench in the Tax Court.

Statute of limitations

Assessment of additional taxes by the IRS. The IRS has three periods of limitations that it must adhere to:

1. Three-year statute of limitation -- Applies within three years of the date of filing the return. This means that the IRS has three years to assess additional tax to the business or individual owner.

2. Six-year statute of limitation -- Applies if an omission of income on the return is 25% or more. For example, $100,000 gross income was reported on the 1999 return and $26,000 of interest income was inadvertently omitted. Under the six-year statute of limitation, the IRS has six years from the date the return is filed to assess taxes on the income that was omitted.

3. No statute of limitation -- The statute of limitation does not apply if a return is not filed or if it can be proved that it was "fraudulently" filed.

Claim for a refund by the business or individual owner. A request for a refund must be made by the later of three years from the date the tax return was filed (due date if later), or two years from the date the tax was paid.

An IRS audit does not have to be as dreadful as you might assume. Understanding the system and taking a few steps should help the process move along quickly and as painlessly as possible.

SIDEBAR: Audit advice

Don't panic. Many business owners are audited every year. Stressing out will not help the outcome. If the audit becomes too much to handle, call a professional who can help you.

Be cooperative. A positive attitude can go a long way. Although you may think so, the IRS agent is not the enemy. He is merely conducting his job. The more cooperative you are the less likely he will feel the need to keep looking for errors.

Educate yourself. Become familiar with the process and your rights. This can be done by reading IRS Publication 1, Your Rights as a Taxpayer. You can order this and other publications by calling the IRS at 800/829-3676 or visiting its Web site at www.irs.go. There is no cost for the publication.

Be prepared. You should begin by understanding what the auditor will be looking for and then begin collecting and organizing your records accordingly. As a business owner, you should keep a log of mileage and business travel and all relevant receipts for all of your business's expenses.

Meet all deadlines. If the IRS says you have 30 days to respond, respond in 30 days! If you need more time to fill out a return or complete paperwork, call and ask for an extension. The IRS is usually good about granting extensions.

Don't wait to seek professional help. It's not uncommon to see someone contact a tax lawyer after a heavy tax has been assessed as a result of an audit. A great deal of time and money will have to be spent in the appeals process to lower the tax burden, when the problem could have been resolved at the audit level. As a general rule, you will not save any money going to an audit alone. In many cases, individuals who attempt to deal with the IRS alone will owe a substantially greater amount on taxes and will more than likely seek professional help at a later date.