Just in case, be prepared for an IRS audit

Hundreds of millions of Americans are sighing with relief after getting taxes filed. But not everyone should be so relaxed.

A small group of unlucky taxpayers is in for more work. They are the filers who will receive a notice telling them that they are being audited.

The latest statistics from the Internal Revenue Service reflect that the agency is ramping up its audits, particularly for high-income taxpayers, who are defined as earning $100,000 or more. In 2003, the IRS audited 139,379 high-income taxpayers, an increase of 24% from 2002 and up 52% from 2001.

Overall, the IRS audited 849,296 taxpayers in 2003, up 14% from the year before. The figure represents less than 1% of all tax returns filed, and the high-income taxpayers were audited at a rate of just more than 1% of their income bracket.

While the number of audits is small, it's clear that the IRS has its sights set on higher-income taxpayers. So experts say taxpayers should know the basic steps for surviving an audit in case their number gets called. They say physicians, whose incomes tend to be higher than average, should pay extra attention, because they have a greater risk of being audited.

A notice in the mail signals an audit. "Most people go into panic mode and get pretty alarmed," said Jerry Love, a CPA and certified financial planner who is president of the Abilene, Texas, accounting firm Davis, Kinard & Co. Taxpayers should put their panic on hold and concentrate.

"The first thing they need to do is very carefully read that letter and determine what it is asking for," Love said. It should let the taxpayer know in general what type of information or clarification is being sought as well as what type of audit has been ordered.

Next, Love and other experts recommend seeking help from an accountant or professional who specializes in tax audits. Though some audits can be handled by the taxpayer, tax professionals know how to deal with the IRS, prepare documents and avoid giving auditors too much information, which can cause more trouble.

"I think a lot of people are capable of doing it themselves. But with high earners, their time would probably be better spent doing what they do for a living. Also, a professional knows what they are looking for," said Fred Daily, a Lake Tahoe, Calif., tax attorney and author of the 1992 book, Stand up to the IRS.

If the IRS orders a correspondence audit, one that is conducted entirely by mail, the taxpayer might need only to provide a missing document or make a simple correction. Love said these audits, the most common of all types, are also sometimes called matching audits because the IRS is seeking to match something where there appears to be a discrepancy.

"A well-written letter explaining the information that they requested generally will take care of it," he said, though in some cases they can require several correspondences.

Perhaps more complex or time-consuming is the office audit, in which the IRS asks the taxpayer to come to its district office to clear up problems with a tax return. Love recommends sending an accountant and keeping the taxpayer out of the way.

Daily said office audits used to target more lower- and middle-income taxpayers. But he thinks the IRS is slowly backing off these to go after more lucrative audits at high-income taxpayers' homes and offices.

These audits are called field audits. They tend to be used for the most complicated cases, particularly for people who are self-employed or have much business activity.

An IRS agent will set aside at least a full day and sometimes more to spend at the taxpayer's office or home to go over business and personal records. "Sometimes if you have your office at home, they want to see that it's legitimately at home," Love said.

He recommends requesting that the audit be conducted instead at the office of the taxpayer's accountant. "You really don't want the IRS agent sitting there in the middle of your office disrupting the flow of your day-to-day operations. Secondly, you want to be cooperative and give them what they ask for but you don't want to give them more than they ask for," he said.

Taxpayers should be prepared to pay their accountants' fees as well as any tax assessment that might result from the audit. Love said it could cost anywhere from thousands of dollars in fees to get help for a field audit to just a few hundred dollars for help with a correspondence audit.

In most cases, the IRS assesses extra taxes or fines at an audit's end, though occasionally an audit will conclude with no change to the return.

Several factors make an audit more likely. Red flags include reporting a lot of gross income but not owing a lot of tax; engaging in high-profile tax schemes such as offshore transactions; reporting items that don't match; and showing a lot of losses from hobbies or side businesses.

Audits can be conducted for three years after a return is filed. Mary Wilson, an attorney and CPA for Rothstein, Kass & Co. in New York, said she tells her clients to keep their calendars so they have records of their activities to back up deductions such as business trips. She also recommends photographing any business equipment, home office furnishings or other items that might turn up as deductions on a tax return so there is proof in the event of an audit.