You've heard the oft-quoted statistic that more Americans fear public speaking than death. Well, I'm not sure where an Internal Revenue Service audit fits in, but I'd bet it's not too far from the top.
And with increased funding from Congress, the IRS is planning to reverse a decade-long decline in audit rates. This time around, the IRS will target high-income taxpayers (in the past, low-income taxpayers suffered the brunt of most audits); the IRS says audits of taxpayers with more than $100,000 in earned income will rise by 43%. Overall, audits are expected to rise 32%.
But those startlingly high increases are based on some mighty low numbers. In 2001, just 0.58% of tax returns were audited; the year before, 0.49% were audited. And those numbers reflect even the most benign of audits -- not all involve a smarmy IRS agent brazenly wandering around your home to assess how much you spent on furniture.
That doesn't mean you won't be hearing from the IRS, though -- millions of taxpayers routinely hear from the agency when they fail to report income or file a return. That's because one of the first tasks the IRS undergoes when it receives your return is to make sure that you've acknowledged all your income, be it wages, interest and dividend income or capital gains. (Employers and financial institutions send copies of all the forms they send to you to the IRS as well.) If something doesn't match up, you'll likely be sent a bill from the IRS simply stating there was a math or clerical error on your return and the amount you owe as a result. You can contest the assessment or simply pay the additional tax. (And yes, if you made an error that results in you owing
money, the IRS will refund your overpayment.)
In determining which returns are selected for closer scrutiny, the IRS also notes whether your deductions are in line with the average for your income. The IRS uses a computer scoring system to mark returns that may seem a bit out of line -- an unemployed person who donates a disproportionate amount of his income to charity, for instance.
The IRS (not surprisingly) won't release its scoring system, but the table below lists the average amount of the most common itemized deductions for various income groups as reported on their 2000 tax returns.
Now that doesn't mean that if you live in a high-tax state or are simply more generous of your income than the average person, you shouldn't claim the deduction that's rightfully yours. You should, though, make sure you have the proper documentation in case of an audit. And if you suspect that a legitimate deduction will look suspect, attach an explanation with your return.
Car donations, for instance, often raise an eyebrow at the IRS for two reasons. First, many people tend to inflate the value of the car they're donating. The proper amount is its resale value, which might be even less than the
Kelley Blue Book
value. Second, a few years ago there was a spate of illegitimate organizations claiming they would take your car and donate it to a charity on your behalf -- they'd do all the work and you'd get the deduction. Not so; you need to donate the car to the public charity itself -- the organization must be a 501(c)3 for you to claim the deduction. (The charity can, however, hire someone to pick up your car.)
Also, while running a side business allows for a good amount of legitimate deductions, the IRS also knows this is where some taxpayers stretch the truth a bit. So if you're claiming lots of deductions against income you've reported on a Schedule C -- particularly the strictly defined home office deduction -- your return may be pegged for a closer look.
Again, though, a closer look doesn't necessarily mean an invasive probe of your entire financial life. There are three types of audits, characterized by how and where they take place: by correspondence, in the IRS office or "field" audits, in which the agent comes to you.
Correspondence audits are simply letters from the IRS, asking for additional information regarding a specific item on your return. All you have to do is mail the supporting documentation -- such as a receipt or appraisal for a charitable contribution.
If the supporting documentation doesn't satisfy the IRS agent -- or if your return is complex and there's a question about more than one issue -- you might be called in for an office audit. These audits generally cover only a few specific issues that the IRS will notify you of in advance by letter. You won't need to answer any questions on additional subjects. You can go alone or bring along someone to represent you -- a CPA, enrolled agent or tax lawyer.
Field audits are generally reserved for business returns, and they require some preparation. It's strongly advisable to have a tax professional's help for these time-consuming audits.
In keeping with TSC's editorial policy, Beverly Goodman doesn't own or short individual stocks, nor does she invest in hedge funds or other private investment partnerships. Goodman welcomes your questions and comments, and invites you to send them to