How to Survive a Tax Audit

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Jeff Schnepper

NEW YORK (TheStreet) -- Unfortunately, there's really no way to completely avoid an audit.

Most tax returns are selected either on the basis of a special target group (for example, waiters were targeted for unreported tips) or on the basis of a computer program that compares your income and deductions to those in similar circumstances (if you have a ghetto zip code on your return, a $10,000 charitable contribution would get you noticed). But, some returns are randomly selected.

The key is to minimize your exposure. Here are some examples of what to avoid if possible.

Math Mistakes

The biggest reason that people receive letters from the IRS is a goof in the addition and subtraction.

According to the General Accounting Office, at one point about half of the 10 million notices the IRS issued each year were "incorrect, unresponsive or incomplete."

Fortunately, math errors rarely lead to a full audit. So if you receive a letter from the IRS that says you owe them, check your numbers first.

Sometimes, the IRS misreads one of your numbers or the number is keyed incorrectly into the IRS computer. If it's wrong, send a letter with a printout of your calculations.

Mismatched Interest and Dividend Reporting

Mismatched interest and dividend reporting is the No. 2 cause for a letter from the IRS. If the amounts reported don't match the amounts on your return, you will get another letter from the IRS.

There are lots of errors here. Sometimes, the IRS will enter the Form 1099 information into its computer and erroneously keystroke the income amount or the Social Security number of the recipient. If the income isn't yours, you should get a letter from the bank or other payer and forward that letter to the IRS. If the amount is incorrect, send a copy of the Form 1099 mailed to you by the payer.

On the IRS Hit List

The IRS admittedly has audit priorities. Those who receive much of their income in cash are traditionally on the radar screen of IRS agents looking for unreported income. A few years ago, "offshore credit-card users" -- Americans with credit card accounts in tax-haven countries -- were the bulls-eye in the audit dart board.

Today, it's the self-employed and small businesses. If you are self-employed or have your own business, you have more opportunity to either "hide" your income or "create" deductions by converting personal expenses into business expenses. To close the estimated $385 billion in uncollected tax receipts, the IRS has pinpointed small businesses and the self-employed as major audit targets.

A Big Mouth

Never brag about how you put one over on the IRS! Informers to the IRS can earn a reward of as much as 30% of the additional tax collected, including fines, penalties and interest. Whistleblowers file Form 211 or call the IRS hotline at 1-800-829-0433.

Big Swings

An IRS computer program compares your deductions to others in your income bracket and weighs the differences. This secret IRS formula, called the DIF Score, is used to select returns with the highest probability of generating additional audit revenue.

For example, a taxpayer with a $50,000 salary would rarely have $10,000 in charitable contributions. This doesn't mean that, if you have only $50,000 in income and actually have $10,000 in charitable contributions, you shouldn't claim those deductions. It only means that if that is the case, be prepared to prove those deductions.

The DIF formula considers not only your income and deductions, but where you live, the size of your family and your profession as well. Rarely will a family of five living in the Hamptons have an income of $30,000 or less. It may happen, but if it does, the IRS will want to know how.

Your Number Popped Up

The IRS also computer-selects many returns for audit on a random basis. Your income, deductions or where you live are irrelevant. Your number just came up; you won the audit lottery.

A student making $3,000 a year is just as likely to be selected as an accountant making $300,000. You just got "lucky."

Don't Panic If Audited

An audit is merely a process where the IRS asks you to substantiate the numbers on your tax return. For example, if you claimed a charitable deduction of $750, the IRS would want to see canceled checks and receipts totaling $750. If you show up with $800 in substantiation, you get a refund; if your substantiation is less than $750, you owe money.

Some Survival Strategies

1. Call your tax professional. Never represent yourself at your own audit. You may know what to say, but you don't know what not to say. If the audit is simple -- to prove your charity and interest deductions, for example -- you can do it yourself by mailing in copies of your substantiation. Otherwise, for all in-person audits, I strongly suggest professional representation. In either case, if you have the records, you needn't worry.

2. Keep records for three years. The IRS can audit you for three years after you file your return. In reality, however, most returns are audited within 18 months of filing. This gives the IRS time to do the review and request the appropriate substantiation before the statute of limitations (usually the three-year period) ends. Once the statute has run out, the IRS normally cannot audit your return, and your expenses are insulated from examination.

3. Never file until the last minute, if you are concerned about a potential audit. It won't hurt and can only decrease your chances of being selected.

4. Plan your taxes to preempt an audit. If, say, you have a huge medical deduction for a year that you feel would increase your chances of being audited, attach copies of your medical bills to your return. Alternatively, if you made an unusually large charitable contribution, attach a copy of the check or receipts to your return. The IRS computer will still kick out your return, but when a real person looks at it, the reviewer will recognize that you know the rules. It may actually reduce your odds of a full audit.

The good news is, if you are audited one year with a refund or no change, it decreases your odds of being audited in subsequent years. In fact, if you are audited on the same items two years in a row with no additional taxes due, the IRS manual specifically recommends that they not audit you on the same items for the third year.

Jeff A. Schnepper, Esq., is the author of multiple books on finance and taxation, including How to Pay Zero Taxes in 2012, and all 28 previous editions of How to Pay Zero Taxes. He is a financial, tax, and legal advisor for Estate Planning of Delaware Valley and operates a tax, accounting, and legal practice in Cherry Hill, New Jersey. Mr. Schnepper is Microsoft's MSN MONEY tax expert, an economics editor for USA Today, and tax counsel for Haran, Watson & Company.

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