Publish date:

Don't Fear the Auditor

Most people would rather get a root canal than undergo an audit. But how likely is it?

Editor's note: As a special feature for March,

TheStreet.com

offers an ongoing series on everything you need to know about taxes. Today is part eight.

Anyone who has attended a dinner party or watched late-night talk shows during tax season has heard people joke about being audited. Everyone laughs politely, not because there's anything inherently amusing about tax fraud but because humor is an outlet through which a society contends with its anxieties.

TST Recommends

The good news is that individual taxpayers do not get audited as commonly as it is assumed, and, except in extraordinary situations, the audit is nothing more than a calculation error, a forgotten signature or innocent confusion about complex tax regulations.

Still, certain people are significantly more likely to attract the attention of the IRS.

The agency has always had an audit bias toward high-income individuals and business-related deductions, says CPA Mark H. Misselbeck, tax principal at Levine, Katz, Nannis & Solomon in Needham, Mass.

"The perception from their projection of 'the tax gap' is that these are the groups most involved in generating that gap, outside of outright criminal activities."

Closing the Tax Gap

The most recent figures from a comprehensive

four-year IRS study showed a tax gap -- the discrepancy between what taxpayers should pay and actually do pay on time -- of $345 billion in tax year 2001, a compliance rate of 83.7%.

Individual income tax accounted for more than 70% of the gap. Over four-fifths of that came from underreported income or inflated deductions and credits.

According to Misselbeck, the income threshold at which people become more likely for audit is likely to decrease to $100,000 from a much higher range. Audits are also more likely for people who are exposed to the alternative minimum tax (AMT) but who do not indicate that they took that tax into account while preparing their returns.

You Have to Like Those Odds

In any case, the odds of an IRS agent banging on the door are minuscule, with a growing percentage of audits conducted through the mail or over the phone.

In data prepared by Syracuse University's Transactional Records Access Clearinghouse, 1% of taxpayers with incomes of over $100,000 faced a correspondence audit in 2004, down from more than 2% in 1992. In 2004, around one-third of 1% of the same group faced an in-depth, face-to-face audit, compared with nearly 3% in 1992.

Taking all individuals into account further reflects the unlikelihood of being audited. In 2004, fewer than two returns out of 1,000 became involved in a face-to-face audit. The average taxpayer had fewer than eight chances in 1,000 of a correspondence audit.

There Goes the Neighborhood

In addition to your income, your address can help determine whether or not you are flagged for auditing. The digital age lets the IRS evaluate a much wider range of factors -- all income levels in a taxpayer's place of residence and the ability to afford living expenses in the neighborhood, for example -- to evaluate the validity of a claim.

State agencies, which lack the budget and therefore the manpower of the IRS, have been turning to technology to tackle the tax gap. Used in various areas of tax compliance, "data-mining" cross-matches databases to unearth instances of underreporting, non-filings and collection risk assessment.

Daniele Micci-Barreca, principal at Elite Analytics, an Austin-based analytics firm, works with state tax agencies to identify questionable returns through data-mining.

Data-mining allows Micci-Barreca's clients to more accurately and efficiently determine whom to audit on the basis of possible underreporting or overstated deductions. His system, Micci-Barreca says, finds "unusual returns, such as unusually high medical deductions for the age range of that taxpayer or recurrent patterns of losses on a Schedule C."

Using the Net to Catch Scofflaws

Other items that can catch an IRS agent's eye include charitable donations that are inconsistent with a taxpayer's income, information that doesn't correlate with forms submitted by employers and banks, and claiming deductions above IRS target ranges.

So a letter from the IRS glares at you from your mailbox months after you've submitted your return. Don't panic. Most investigatory correspondence from the IRS is prompted by a simple mathematical error or a forgotten signature.

In these cases, and in the majority of audit inquiries, the problem can be solved simply by providing requested documentation through the mail. Otherwise, you may be called to an IRS agency to meet with an examiner.

Upon receiving an audit, says Cindy Hockenberry, tax information analyst at the National Association of Tax Professionals, most taxpayers go directly their tax preparers. However, an audited individual can also use an enrolled agent, CPA or attorney. Unlike a tax preparer, who doesn't fall into one of those three categories, they don't need to have prepared the return to assist the taxpayer. The taxpayer can "just sign a power of attorney and can send them on their way alone," Hockenberry says. "You don't even have to go if you don't want to."

If the case remains unsettled, the next stop is the United States Tax Court, an independent entity from the IRS.

Next in the tax series: Don't Miss Out on Your Phone Credit