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The art of the IRS audit
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March 17, 2000: 10:09 a.m. ET
Don't panic, dig up your receipts, and don't forget to appeal
By Staff Writer Shelly K. Schwartz
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NEW YORK (CNNfn) - "I have decided to examine your 1998 tax return and I would like to meet with you at the time, place and date noted above."
Makes your blood run cold, doesn't it?
That simple sentence, on Internal Revenue Service letterhead, is enough to strike fear in the hearts of taxpayers everywhere. And it's the type of letter that lands in thousands of mailboxes every year.
"The audit letter scares a lot of people," said Cindy Hockenberry, an enrolled agent and information coordinator for the National Association of Tax Practitioners. "They open it up and immediately think, 'Oh, man. I'm in trouble!'"
She said knowing what to do after you open the letter - - and more specifically what not to do -- can make all the difference between a painless tax review and an audit process that claims a space in your repertoire of recurring nightmares.
"The first thing you should do is to not panic," Hockenberry said. "Sometimes they are just looking for a very specific thing, and if you give them what they are looking for it's no big deal. Just give the IRS what it wants and do it as fast as you can. That way it'll be over fast."
At the same time, she noted, you should never take the out-of-sight, out-of-mind approach.
"You'd be surprised: Many people think that if they throw their audit letter away it's gone," Hockenberry said. "But it's not. The IRS isn't going to leave you alone. They'll keep at you until they get their audit."
The numbers
According to reports, less than one percent of U.S. taxpayers each year are audited.
The fractional percentage, which has dropped substantially from a decade ago, is due largely to the IRS Restructuring and Reform Act of 1998, which "prohibits the use of Financial Status Audit Techniques to determine the existence of unreported income unless a reasonable indication that there is a likelihood of unreported income has been established."
In essence, it has become an innocent-until-proven-guilty approach.
Of the tax return reviews that are conducted, experts in the industry say 25 percent of them are categorized as field audits. That means an IRS agent comes out to conduct the tax review at your home -- or, in the case of a small business owner, your office.
"Normally the IRS is only going to want to look at one specific year and they're usually a few years behind," said Frederick Daily, a tax attorney and author of "Surviving an IRS Tax Audit." "This year, you're most likely to be audited for the 1998 tax year."
In most cases, the IRS can only audit you for the last three years. If the government suspects you underreported your taxes by 25 percent or more, they can audit you for the past six years. And if they suspect fraud, the statute of limitations on an audit is unlimited, Daily said.
If it's determined that you owe the IRS money, the IRS can and usually does assess a 20 percent accuracy penalty on the amount of underreported income.
For more serious cases involving fraud, the government can impose penalties of 75 percent on the underpaid taxes. If you failed to report $100,000 of income, for example, your additional taxes would have $36,000 in back taxes, plus another $27,000 in penalties. Plus interest.
In addition to back taxes and penalties, you'll also owe on the interest since the taxes should have been collected. That can really add up.
Daily said the average bill from a field audit, where the taxpayer is found to have underreported their income, is about $18,000 in taxes and penalties. For those who earn more than $100,000, field audit bills typically exceed $35,000.
Step by step
Once you receive your audit letter, the first thing you'll want to do is pull together all the information you have on the tax year or years under review. That means digging up the tax form itself, along with all supporting documents.
Re-acquaint yourself with what deductions you claimed that year and why. And pull together, in an organized system, all the information the IRS requested of you in its audit letter. The more you've got to back up your claims, the better.
"They are looking for canceled checks, receipts - anything to show that this was not just something you dreamed up," Daily said.
If you had a professional prepare your return that year, now would be a good time to give him or her a call.
"Many tax professionals, as part of their fee, agree in advance to handle your audit for you free of charge if you get audited," said Hockenberry, of the NATP.
Keep in mind, though, that getting a tax professional to face the IRS on your behalf may make you feel more comfortable, but it won't necessarily do you any good.
"The taxpayer is required to substantiate on their own both legally and through documentation that they actually incurred the expenses they claimed they did," Daily said. "If you told your tax preparer you took a large charitable donation and just pulled that number out of the air, the tax preparer isn't going to be able to help you. You have to be responsible for your claims."
Red flags
Knowing how to avoid an audit in the first place, of course, is the best strategy for staying out of hot water.
That means reporting accurately and fairly all of your taxable income and write-offs. In other words, don't claim any charitable contributions if you don't have the receipts to back it up.
Also, before your file your tax return each year, always double-check your math to ensure the income and deductions you've claimed match the accompanying documentation you filed. Your reported income, for example, must match the figures on your W-2. 
As most tax professionals will tell you, however, keeping the IRS off your back also means knowing where to draw the line.
To each tax return, the IRS assigns a computerized score, using numerous factors and red flags. A high score means your return has a high probability of being audited.
Daily said tax returns from the self-employed are frequent targets for IRS audits, since those who work for themselves have "more room to cheat, if you will."
Your audit score card also racks up the points if you've claimed a large loss against your income, due to investment losses or a real estate sale. And lastly, you're more likely to have a talk with Uncle Sam if you amended a prior-year return or were audited in the past.
"Lightning really does strike twice for some people, especially if you were found to owe large adjustments in the past," Daily said.
Click here for a chart of other audit red flags, provided by nolo.com, a self-help legal resource.
The appeal
If it's determined that you owe back taxes, don't despair. You've lost the battle. But you might still win the war.
The audit system is set up to allow taxpayers to file for an appeal, or protest the findings. It may seem like a case of prolonging the pain, but Daily said in most cases there's actually good reason to appeal.
"It's simple and it's free unless you hire a tax professional to appeal for you," he said. "And it delays your audit tax bill, buying you time to raise the cash."
More important, Daily noted, the typical appeal results in a 40 percent decrease in taxes, penalties and interest proposed by the auditor.
"There's a joke within the IRS that the appeals officers work in the 'gift shop,'" he said. "They say they work on the 50 percent rule; they cut auditors adjustments by half."
If your bill is less than $2,500, Daily said, you can protest the audit over the phone. If it's more, you'll have to send in a written protest, instructions for which are usually included in the audit Examination Report.
(Click here for IRS instructions on how to appeal an audit.)
It's always good advice to mail your protest letter by certified mail, return receipt requested, to the local IRS District Director.
Lastly, Daily said, you should keep in mind that appeals aren't always the best option.
"Only you know what shape your tax returns are in," he said. "If you know you didn't report everything you should have and you know you are going to owe, it's best just to pay the bill and get it over with. Otherwise those interest and penalty fees will just keep adding up." 
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