A few years ago, the Internal Revenue Service challenged the tax deductions a college professor took for losses he reported in his business as a book author.
"They came in and said, 'OK, prove to us it's a business,'" recalled Joseph Newpol, a certified public accountant and tax attorney who advised the professor on how to deal with the IRS's scrutiny.
"We showed them the history of his book writing activity and demonstrated that he didn't have income for several years," recalled Newpol, who is also a professor in the tax and personal financial planning department at Bentley College in Waltham, Mass.
But the IRS kept challenging the author's deductions, claiming his book-writing activities represented a hobby, not a business. Each time he faced an audit, Newpol pulled out the professor's receipts, logbooks and other evidence to prove the writing was a legitimate vocation.
"We won three years in a row," Newpol said proudly. "We haven't been audited since then."
But the experience took its toll. In addition to the aggravation and stress, each audit cost the author about $5,000 in Newpol's time and assistance.
"That's the painful part of it. Whether you win or lose, it's always a painful situation to go through an audit and it's always costly. So you want to avoid it," the accountant said.
Don't let it happen to you
As this April's tax filing deadline approaches, the question is, How can you avoid an IRS audit?
"The best advice is stay honest and make sure you have documentation for all your deductions," Newpol said. "We had backup - contemporaneous documentation such as receipts for meals, travel logs, the kind of things you can keep in a shoe box."
Experts generally agree there are a number of ways to trigger an IRS audit:
Mathematical or factual mistakes in your tax return.
Failure to declare self-employment income for which you received a 1099.
Passing off a hobby as a losing business.
Reporting a high amount of charitable contributions without supporting documentation.
Claiming your home as a business expense.
Sticking to the truth is the bottom line. In fact, a study done in 1994 by the University of Missouri found that Americans who played fast-and-loose with their returns were five times more likely to get called in for long, embarrassing audits than taxpayers who were straight with their filings.
To avoid an audit, or get through one relatively unscathed, experts suggest you:
Make sure your computations are correct.
Keep receipts and get appraisals for any charitable contribution of $250 or more.
Keep records of work-related entertainment and travel expenses.
Follow the directions on your tax return forms carefully.
Keep copies of all your returns for several years.
A gentler IRS does more computer cross-checking
"The IRS is a lot friendlier than it used to be," said Steven Elliott, an accountant with Ernst & Young in Boston. "They've received a lot of negative press and publicity. They've worked hard to shake the image. They're really trying to extend their hand."
However, as Rick Eckstein, a CPA with Walter & Shuffain in Norwood, Mass., pointed out, "The IRS is a business. Their job is to raise money."
And today, the Internal Revenue Service is doing that job with the assistance of sophisticated computers that automatically cross-check items on your tax return with all of the information they get from employers and other sources.
That gives the average person a one-in-200 chance of an audit, which is down from one-in-112 in 1999, and one-in-60 in 1996, according to new data from the IRS.
For taxpayers who make more than $100,000, slightly fewer than one in 100 were audited last year, down from one in 50 in 1998 and one in 9 in 1988.
Last year, the poor were more likely than the rich to have their tax returns audited, as the IRS followed orders from Congress to closely examine the working poor who apply for a special credit, known as the Earned Income Tax Credit.
In total, the IRS audited 617,765 tax returns last year, down a whopping two-thirds from the 1.94 million returns audited in 1996.
A shrinking IRS staff audits less often
IRS Commissioner Charles O. Rossotti has attributed the decline in audit rates to the downsizing of the agency's auditing staff to 12,550 last year from 13,061 in 1999 and nearly 16,000 in 1996.
But Rossotti has warned taxpayers against trying to take advantage of the decline in audits by cheating on their tax returns.
"If gambling is what you have a passion for," he said, "I would say you have better odds going to Las Vegas. Yes, these audit rates are down, but audits are not the only way we identify taxpayers.
"We get more than a billion pieces of information that come in from third parties and even though we are slow, our computers eventually do their job," he added.
While certain things might trigger an audit, the chances of being scrutinized remain extremely slim thanks, in part, to Congress.
It has slashed the revenue service's budget by about 30 percent since the 1980s. The result is that overall IRS employment has dropped from 116,000 nearly a decade ago to about 86,000 today.
But Congress is trying to reverse the trend. It has authorized the IRS to hire 2,000 new workers this year, and the agency is modernizing its tax processing system.
As a result, tax-law specialists have said, an individual may be more likely to get audited, especially if across-the-board tax cuts proposed by the Bush Administration force the IRS to scour ever more deeply for funds the government might be owed.
Don't panic if you're being audited
If you do get a letter from the IRS after filing your tax return, it's most likely because you forgot to sign it or include a specific form. So, it's probably nothing very serious.
But if you get word you're being audited, this is more serious, but usually not reason to flee the country. The IRS is unlikely to be auditing your latest returns. The statute of limitations for an audit of a particular year's tax return is three years.
(If you fail to report 25 percent of your income on a return, the IRS has six years to go after you. For the most serious cases of fraud or failure to file there's no time limit.)
In any case, most of the IRS's audit requests can be handled easily by providing it with the needed documents or forms. This doesn't usually require professional help.
But if there's a serious problem, such as indications of negligence, failure to pay, or fraud, experts suggest that you get a tax lawyer and an accountant to respond to IRS inquiries.
If the audit uncovers serious problems, most punishments involve monetary penalties, except for the most extreme cases, in which tax cheats are sent to jail. (Unless, of course, you're well enough connected to receive a presidential pardon, like Marc Rich, the fugitive financier.)
Even if you get audited, chances are you might prevail against the IRS.
In his 20 years of work as a certified public accountant and a tax lawyer, Newpol said his clients have made only minor adjustments to their tax returns.
"I haven't lost a cent," he said.
- Christopher A. Szechenyi, Salary.com contributor