Tax Audits by the IRS — Should You Worry?
By: Patricia T. Henssler, C.P.A.
The Henssler Financial Group Position Paper

The latest data from the IRS confirms what the feds have been saying for the past year. The number of IRS audits has increased for virtually every taxpayer category. Overall, the IRS looked at more than 1.3 million returns in fiscal 2007, up 7% from 2006. What's more, the IRS vows to keep the pressure on.

During tax season, many of our clients tell us they do not want an audit — so if something is a "red flag," do not take the deduction. I think that is foolish. For instance, if you qualify for the home office deduction, you are entitled to the deduction and should take it. If you really gave a great deal more to charity this year than ever before, are you not going to take the deduction? If you had a devastating medical situation during the year and suddenly have expenses that exceed 7.5% of your AGI, are you not going to take the deduction?

On the other hand, if I ask people how much they gave to charity this year, many will say, "Take what I am allowed." It does not work that way. You are not "allowed" anything. You are allowed to take the amount of deduction that you made. These are the people that should be concerned about the IRS's new statistical study (read: audit program).

Enforcement Activities versus Statistical Studies (also called Calibration Audits)

Enforcement Activities

Virtually all enforcement activities use computers to identify potential compliance issues. Math errors and document matching generally beget a letter to the taxpayer. The "math error" letter indicates that you calculated the tax "this way," and the IRS calculates it "that way." If you agree, send the difference within 10 days.

If you reviewed your return before mailing it, and it was not electronically filed, I advise that you check your numbers again. The error rate on the IRS's side is quite high if the return was not electronically filed. They manually input your return numbers into their computers. It is easy for them to transpose numbers, leave numbers off, etc. I cannot tell you how many copies of Schedule A I have had to resubmit to the IRS or Georgia, over the last several years. They were left off the taxpayer's return at the IRS, and their computer generated a standard deduction. This generated a letter from the IRS, indicating that the taxpayer owed more money. I have also had Schedule C's submitted with losses that become profits, etc.

Document matching also generates a letter from the IRS. For every W-2, 1099, K-1, 1098, etc., that you receive, a copy is generated and sent to the IRS. They "match" theirs with yours. If they receive something that they do not see on your return, they send a letter indicating the amount is missing and that you owe more money. Again, review your return or have your tax preparer or C.P.A. review your return. In many cases, you have included the amount, but not where the IRS expects it to be. If indeed you forgot to include the amount, send the money. This DOES NOT put you on a suspect list.

If you disagree with the IRS, you must send an explanation, as well as the back-up documentation, as to why you disagree. At this point, the IRS matches the skill and judgment of IRS personnel engaged in enforcement against your explanation. If it is simple, you will receive another letter stating that they accept your explanation. If it is more complex, they may decide to refer the matter to their audit people who will require more information. Again, this does not necessarily mean the IRS will be camping on your doorstep. In many cases, "it is a good thing" to be referred up the ladder, as you will be dealing with personnel with some experience, and who are capable people with the authority to make a decision.

Calibration Audits or Statistical Studies

Random audits were designed to provide the IRS's computers with statistics about what people from certain income levels deduct. Therefore, if you earned $40,000 per year and they audited you and found that all of your deductions were legitimate, the computer knew that a $40,000 employee generally had X amount of mortgage interest, X amount of charity, X amount of medical, etc. They attempted to take a cross section of the public , e.g., teachers, doctors, self-employed plumbers, and arrive at some statistical information.

This statistical information could then be used to generate a "letter audit." I had a "letter audit" completed on my son. It was not painful. He had very large medical bills — obviously, larger than someone of his income level should have had according to the IRS computer. The first IRS letter insisted on an in person meeting. He was to bring all of his medical receipts. When he called me to tell me he had a letter from the IRS to appear at their office, he said he was worried. I have to admit, I laughed and then said, "you don't have to go to an IRS office — how ridiculous." He insisted that the letter said this and that he was worried. I told him to fax me the letter, and that the IRS wants people to be worried, but he had nothing on his return to be worried about.

Sure enough, the letter stated that he, or his representative, needed to appear. In this case, the audit was in Chicago, and I am in Atlanta. I contacted the representative, faxed them the four receipts totaling his medical expenses and asked for a change of venue to Atlanta. After six weeks, we finally heard that no audit would be conducted, and that the matter was cleared up. While I know that my son was not quaking in his boots since his mom, and C.P.A., told him that she would handle it, I am sure that this would generate a lot of anxiety for many taxpayers. Well folks, this is apparently what is coming from the IRS over the next few years. The IRS says that it is doing far too many audits generating "no change." This means that the taxpayer was truthful when filing and has all of the back-up to prove it. The IRS wants to spend their dollars fruitfully and needs new statistics.

Now that you have read the ugly part, remember the first part of this article. The IRS generates thousands of letters each year that really are painless and of little consequence. If you would like further information regarding this topic or any other tax related issue, please contact The Henssler Financial Group Tax & Accounting Division at 770-428-4025.