Tax audits do not have to be feared. Find out the real deal when it comes to tax audits and why most tax audit concerns are unfounded.
An audit is arguably the most dreaded outcome of the tax filing process, and the situation carries with it some unsettling mystique. The standard nightmare has Internal Revenue Service agents with badges showing up on your doorstep, or the agency — seizing smorgasbord-style — the bulk of your personal assets. Experts in the field, however, say audits contrast greatly from their thriving myths.
“Audits are something most people should not be afraid of,” says Sandy Zinman, tax committee chairman for the National Conference of CPA Practitioners. “A lot of times the government just doesn’t want to do these audits.”
In fact, Zinman says, one of the most enduring tax audit myths holds that an audit is a common occurrence. He says audits are generally “a lose-lose situation” for the IRS because they require a lot of resources and because of the negative image audits project onto the IRS.
“Historically, only about 1 percent of filers get audited. That’s a real small percentage,” said financial adviser Thomas Jensen, owner and managing partner of Vaerdi LLC in Portland, Oregon. The IRS did not respond to questions regarding specific details of its auditing process, including its total number of audits.
Jensen said the IRS uses a system called the discriminate information function to determine what returns are worth an audit. The DIF is a scoring system that compares returns of peer groups, based on similar factors such as job and income. If a person’s financial data differs significantly from those established by his peers, the system gives that return a high DIF score. A high DIF score raises the chances that the filer will be audited, Jensen said.
Although the IRS audits only a small percentage of filed returns, there is a chance the agency will audit your own. The myths about who or who does not get audited — and why — run the gamut.
"There’s the myth that if a paper comes from the IRS you should break into a cold sweat. You shouldn’t."
Myth: Be very afraid of an audit
The looming myth out there suggests the audit process is something to be desperately feared. The truth, Zinman says, is that most people only need to respond to a few IRS questions.
“There’s the myth that if a paper comes from the IRS you should break into a cold sweat. You shouldn’t,” Zinman said. “More often than not it’s a situation of, ‘Our records show this. Is that right?’ A lot of times it’s a very simple problem to resolve. You send the information or a check for the additional money, no penalties, and the case is closed.”
This "correspondence audit" is the more common of the two IRS audits. Zinman said the correspondence audit is so subtle some people may not even realize it's an audit. The other is the in-person audit. An IRS agent will request an appointment with you to review certain financial information.
“A lot of times it’s a very simple problem to resolve,” Zinman said. “What we’ll see is someone sold some stock during the year and forgot about it (when filing taxes) or didn’t even know what the stock was worth. So they can get a letter asking for information and actually get a refund because they lost money on the sale.”
Myth: Professionally filed returns are audit-proof
Tim Clegg, a budget software developer and retired financial coach, says paying an income preparer will not shield you from an audit. Clegg, who provided tax filing guidance in Volunteer Income Tax Assistance programs for more than a decade, says he has encountered many people who thought that relying on a tax service guaranteed a solid, mistake-free return.
“The easiest way for these places to compete is to advertise they’re going to get you the biggest refund and that’s what it says in the window,” Clegg said. “The problem is, the lady down the street or the chain (preparer) — they get way too enthusiastic about getting you the most money back on your return and they screw up.”
In many neighborhoods, particularly in low-income areas, “fly-by-night” tax preparation operations engage in purposeful fraud, Clegg said. The taxpayers often do not understand what they are claiming on their returns.
“Among the less scrupulous preparers, they’ll do family splitting to optimize the Earned Income Tax Credit, like, ‘You take these kids and you take these kids, that way you’ll get $8,000 rather than the $6,000 you would have gotten,’” Clegg said.
Such steps can trigger an audit, interest and stiff penalties, he said.
Myth: Those with low to moderate incomes don't get audited
Jensen said the IRS has ramped up the number of audits it does in response to the country's economic woes. That means people should not think they're in the clear if they do not earn a lot of money.
“(The IRS) is doing audits across the board, for all incomes,” said Jensen, speaking in late 2011. “Over the last few years they’ve been hiring more people for that.”
Still, he reiterates that even though the IRS has increased its level of auditing, the number is a very small percentage of the returns filed.
Myth: Filing for certain deductions or credits increases the chance of an audit
Many people avoid taking certain credits and deductions — denying themselves tax advantages to which they are entitled — because they believe or have heard that taking them will make them more susceptible to an audit, says Clegg.
“I saw many thousands of people who said, ‘No, I don’t want to claim my daughter because she lived with my ex,’ or would not claim certain education credits out of fear," Clegg said. "Fear of an audit would cause people to just hand money over (to the government), money they were entitled to.”
Home office deductions are a big inspirer of audit fears, says Jensen.
“I hear a lot of people say, ‘If you take a home office deduction you’re going to get audited.’ These days, most or a lot of people have home offices,” Jensen said. “For years, I’ve had a home office, taken the deductions and I’ve never had an audit.”
Zinman said there are no automatic triggers for an audit. Only when the financial picture painted in the tax return stands out as atypical or beyond common sense should someone be concerned about an audit. He cited the example of a recent client. The individual had experienced financial hardship, dropping from a $350,000-salary job to a $7,000-a-year income and, subsequently, lost his home.
“He is worried about getting audited,” said Zinman. “I told him not to worry about it. There’s nothing to fear. The information is true, and it would come down to just explaining the situation to the IRS.”
Myth: Audits are done immediately
The IRS abides by a statute of limitations of three years after the due date of the return, says Clegg. For “substantial errors,” the IRS maintains it can go back six years and recommends you keep most records at least that long. The experts agree: If an audit is going to happen, it will occur in the latter half of the three-year time frame.
“Audits generally always happen two years after you file,” Zinman said. “You’ve got to understand all of the hundreds of millions of people who live in this country and (who) file returns, not to mention corporations. It takes a while for all of these filings to get done and the computer to get through this process.”
A deeper understanding
Although these are some of the most popular myths, experts say plenty of other misguided beliefs about audits run rampant, some even with their own regional flavor. The bottom line, says Zinman, is to understand what the process is all about.
“You know, the American way is to work hard and pay the least amount of taxes that you can. It’s the same even for the people who work at the IRS,” Zinman said. “With filing taxes, you’re making an assertion on your return. You’re basically telling a story. You’re putting forth your story and if you’re questioned, the IRS is saying, ‘We read your story and we want you to show us where you got this info.’
“But people shouldn’t worry,” he said. “They’re not going to just come take all your money. They have a long process to go through before that. You have a lot of rights. If you owe the money, they’ll eventually get it, but as long as you talk to them, you don’t have to fear that something is going to happen to you without your control.”
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So many of the myths about auditing are quite narrowly focused on the Internal Revenue Service, suggesting that the IRS is the only entity that matters. That's a big-time mistake says Tim Clegg, a budget software developer and retired financial coach. Many people, he says, get through the IRS only to get “tangled up” with their state returns.
“More of the heartaches I’ve seen have had to do with state returns,” Clegg said. “The IRS is a pussycat compared to a lot of these state (tax revenue) agencies. No one out there is hungrier for revenue than the states. They’re broke and working hard to get money. And they will not be as friendly, by and large.”
He recommends tax filers be at least as diligent and careful when filing their state returns as they are with their federal tax returns.
If you live in one state and work in another, Clegg noted, you must file returns for each state.
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