4 things you should know about tax audits

By Richard Barrington

4 things you should know about tax audits

The words "IRS audit" are enough to send a chill down the spine of even the most conscientious taxpayer. They evoke Kafka-esque images of a relentless bureaucratic inquisition, but are they really as bad as all that?

Since most people have never been through an IRS audit (after all, only about 1 percent of all individual returns are audited), much of the fear of a federal income tax audit is simply fear of the unknown. To ease that fear by removing some of the unknown, here are answers to four fundamental questions about tax audits:

1. What does it mean to be audited? An audit is not an accusation of any wrongdoing, but just a request to review the numbers and supporting documentation of your tax return. While a tax audit is popularly thought of as a face-to-face process, most of them take place through the mail. Of 1,425,888 audits of individual tax returns in 2009, 326,219 took place in the field, and 1,099,639 were handled via correspondence.

2. What triggers a federal income tax audit? Lest you feel unfairly singled out if you receive notice of an IRS audit, keep in mind that some returns are selected for audit randomly. Another trigger might be computer analysis that shows your return to be an outlier from the norm in terms of things like the level of tax deductions claimed. A real red flag is if amounts on your return don't correspond with the amounts on forms such as employer W-2s that are automatically filed with the IRS. Finally, if you are in one of the higher federal tax brackets, you are more likely to be audited. While only 1 percent of individual returns was audited in 2009, 6.4 percent of those for people making more than a million dollars were audited.

3. What are the consequences of an IRS audit? From good to bad, here are the possible outcomes of an IRS audit:

  • You could be awarded a refund or a lower tax liability than you had claimed on your return. After all, some mistakes cost the taxpayer rather than the IRS.
  • There may be no change in your return.
  • You may be ordered to pay additional tax. If there appears to be an honest mistake, you will probably be assessed interest but no penalty.
  • You may have to pay a penalty. If there was negligence or intentional wrongdoing, you may be assessed a penalty in addition to taxes and interest owed. More than half of the penalties assessed by the IRS are for failing to pay taxes; less than 2 percent are for honest errors in accuracy.
  • You may be subject to criminal prosecution. If you have committed a crime involving taxes, watch out: the IRS tends to get its man (or woman). 81.9 percent of cases referred by the IRS for criminal prosecution in 2009 resulted in a conviction, and 81.2 percent of sentences involved jail time.

4. What should you do if you receive an audit notice? Whether you do your own taxes diligently, or use the best tax software or preparer possible, you still might receive an audit notice. If so, don't panic. Assemble your records (the IRS requires that you keep these for at least three years after a return is filed), review your return for possible errors, and notify your tax preparer, if applicable. Most of all, be honest and forthcoming--attempts to deceive the IRS will only compound the consequences you may be facing.

Knowing more about federal income tax audits may ease your fear of them, but it's unlikely that anyone is going to learn to love them. Still, think of it this way: IRS audits are a way of making sure that everyone pays their fair share of taxes, and that eases the tax burden on the honest taxpayers. So if you are an honest taxpayer, you should at least learn to like the idea of IRS audits.

Richard Barrington has earned the CFA designation and is a 20-year veteran of the financial industry, including having previously served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc. Richard has written extensively on investment and personal finance topics.

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