Fear of the IRS and of the audit process is very high for most taxpayers. Recently several clients called me because they received the dreaded letter from the IRS. The letters vary in scope from a request for more information on mortgage interest deduction to a more detailed audit of a Schedule E (rental income and expense). Recently I assisted a taxpayer through an audit of tax years 2006 – 2008. The client had made several errors on these returns and the IRS caught them. The result was a long process of putting the puzzle back together and a large bill for underpaid tax.
All of these recent experiences got me thinking about the IRS and its desire to enforce tax compliance. Until recently Congress has been reluctant to increase IRS funding for enforcement. However, now that our federal government is spending money faster than ever before you can be sure that they will be looking for sources of revenue. The IRS estimates that the tax gap (the difference between what taxpayers should pay and what they actually pay on a timely basis) is about $345 billion. The IRS uses enforcement activities (ie: audits) to recover about $55 billion of the tax gap.
The IRS sends millions of letters each year. Most of these are the result of math errors or income items left off of the return. The letter reports a schedule showing items left off the return and bills the additional tax due. These assessment letters are often not completely accurate and it is very wise to have your tax professional review the tax amount due. This is a correspondence audit and usually can be resolved with a letter response to the IRS.
The other types of IRS audit are office and field audits. Both of these audits are more comprehensive and require the taxpayer to meet with an IRS agent and bring or provide documentation for specific income and/or deductions. As I was in the downtown Portland IRS office recently, I noticed several new IRS agents in training, which leads me to believe that the IRS is stepping up its enforcement activities.
The IRS does a computer review of all returns and assigns a score called a DIF score. A higher DIF score will make your return more likely to be audited. What items cause a higher DIF score? Two big triggers are:
• High ratio of deductions to income
• Self employment income reported on a Schedule C
How do you protect yourself? My first recommendation is if you file a Schedule C talk to your tax professional about options for creating a separate entity such as a corporation or LLC. Also keep good records, keep documentation for all of your deductions, separate business and personal finances and finally file your returns on time (or by the extension deadline).
Getting a letter from the IRS should not be as scary as we make it. The best way to handle this situation is to contact your tax preparer immediately. If you self prepared your return you may consider finding a good tax professional to assist you in your response. Never ignore a letter from the IRS. The best outcome will be to respond quickly and with as much information as possible. If you are prepared, you may be dismayed to see that letter in the mailbox, but you won’t be afraid.