The Letter arrives. ``Your return has been selected for examination,'' it says.
Seems the Internal Revenue Service has some questions on your tax return and wants to see some documentation.
Grown-ups have been known to weep openly. But it's only an audit, not the end of the world. Unless you have been engaging in tax fraud, the worst that can happen is that you have to pay what you owe, plus a penalty and interest. If you were called before your boss and asked about a cost overrun or a personnel dispute, you would have to account for yourself. This is the same thing, except the boss is the US government.
``You're never completely free of the possibility that you'll be audited,'' says Michael Borsuk, managing partner in the Long Island, N.Y., office of Coopers & Lybrand, the accounting firm. ``But you can do a lot of auditproofing.''
To begin auditproofing, he says, make sure your return is ``mechanically correct.'' Answer all questions on the correct lines. If you itemize, use the right tables and see that backup schedules correspond with the numbers they represent on the face of the 1040 form.
``Make sure you file a neat-looking return,'' Mr. Borsuk says. ``The returns that are technically inaccurate and those that are sloppy are going to get scrutinized more closely.''
Those are just the preliminaries. Consider what happens to your return next and you'll see what you need to do either to remain auditproof or to sail through an audit without a damp eye. The secret formula
Once the Internal Revenue Service, receives your return, says IRS spokesman Steven Pyrek, it goes through a multilayer screening process. First, it is checked for obvious things like signatures, missing schedules, and anything patently unallowable (a deduction for telephone excise tax, for example).
Then the return is entered into IRS computers and scored by a secret formula. The higher the score, the more likely an audit will be.
``Very few people know the formula,'' Mr. Pyrek says. ``We adjust it from time to time.''
In general, items like tax shelters, huge business deductions, losses for hobbies, big casualty losses and medical expenses, loans to and from relatives - all boost your audit score.
A return with a high score then goes to a ``classifier,'' who picks out the items that have to be audited. A math error or a simple mismatch of information (you reported $321 in interest income, but the 1099 form that went directly to the IRS has $391) is usually dealt with from an IRS service center in either a phone call or a letter. If you're wrong, you say so and pay up. If not, you tell the IRS where it's wrong.
Penalties are stiffer these days: up to 10 percent for negligence, 25 percent for substantial understatement of taxes, 75 percent for fraud. Nine percent interest accrues on the unpaid tax and penalty.
The next level of audit involves a more thorough examination of some claim on your return - for casualty loss, for instance. The IRS sends you a letter asking you to make an appointment to come in with your documentation.
``Don't panic,'' Pyrek says. ``Gather up your paper work and come in and show us where you got the numbers. It's not pleasant, but it's all done professionally. We know taxpayers make mistakes, misinterpret things.''
Keep a good attitude. ``Don't come in with shoeboxes stuffed with information and shove it on the lap of an auditor,'' says Pyrek. ``Approach it like a business meeting.''
The more complex your taxes, the more complex the audit. If a business or office in the home is being audited, an IRS agent might do a ``field audit,'' visiting you at home or work to look at all records for a particular year. And if you are deliberately avoiding the IRS, an agent will try to track you down.
If you and the agent are at loggerheads over a certain item, a meeting with the agent's manager often resolves the issue. If not, the IRS issues a letter explaining the points of contention and a proposed adjustment to your return. If you don't agree, you go to the Appeals Division of the IRS. If the dispute amounts to less than $2,500, you can request a hearing by phone; over that amount, you make a written protest.
You're getting into deep water, however, and probably need an accountant or tax lawyer. These professionals charge by the hour, so balance the amount in question with the cost of a challenge and the likelihood of success (the accountant or lawyer will know).
Most cases are settled at the Appeals Division. Beyond that, you go to the United States Tax Court or pay the assessed tax, file for a refund, and sue the government in federal court. In tax court, a judge decides the case; in district court, you can have a jury trial. You'll probably never go this far.
The main thing to keep in mind, IRS spokesman Pyrek says, is that the IRS does not have the staff or money simply to harass a taxpayer.
``We don't want to go through an audit only to find you did everything right. We want to audit returns that result in more taxes owed coming in.''
The odds of getting audited are low. Last year, the IRS audited only 1.1 percent of returns. It expects to audit 1.47 percent this tax year. But the higher the income, the more the odds increase. At $100,000 and over, 4.68 percent of the returns were audited. Enduring the `audit lottery'
Jack W. Wade Jr., a former IRS officer and author of ``Auditproofing Your Return'' (Macmillan, 1986, $22.50) calls this the ``audit lottery.'' If you know that your audit profile is high (because of extraordinary deductions, for instance), Mr. Wade suggests attaching a written statement or a copy of a bill to the return. That way the ``classifier'' at the IRS will see the explanation right away and might not pursue it further.
Mr. Pyrek at the IRS, however, does not think this is too good an idea and says a lot of extra paper work could get detached from the form and lost. He recommends instead making a note in the margin of the return.
There is a wild card in all this. It's called the Taxpayer Compliance Measurement Program, an entirely random selection of 50,000 returns each year. Every item is gone through. The IRS aim is to get information to adjust its screening formula. Fifty-thousand a year on a base of 100 million-plus taxpayers is a very low probability that you will ever be selected for the compliance program.
But by all accounts, if you get hit with one of these, it's a doozy. You have to produce everything from your birth certificate and marriage license to your receipt for having your teeth cleaned.
What is the most important thing to do? Accountant Borsuk, author Wade, and IRS official Pyrek all say the same thing: Keep good records and receipts. If you're being honest, these records will save you every time.