Self-employed, big itemized deductions top list of IRS audit

Journal Record, The (Oklahoma City), Apr 8, 1999 by Curt Anderson Associated Press

WASHINGTON -- The computer formula used by the IRS to pick income tax returns for audit rivals a nuclear launch code in its secrecy. But some red flags are known: The self-employed and people claiming unusually high itemized deductions are among those more likely to face an audit.

The Internal Revenue Service audits less than 2 percent of the returns it receives and won't disclose precisely how it targets them.

"Basically, what you're going to see is people who have something out of the ordinary on the return," said Mike Szalkowski, senior manager at Ernst & Young accountants in Atlanta. "For instance, a high mortgage income deduction and low income. They look for things that don't make sense." From the IRS standpoint, the only people who should fear an audit are those who are trying to cheat or those who don't have documentation for their deductions or other claims. "If you're entitled to a deduction, and you have the records to back it up, by all means you should take it," said IRS spokesman Don Roberts. Two-thirds of audited tax returns are picked by IRS computers in Martinsburg, W.Va., using what is called the "discriminant function," or DIF. These are top secret formulas designed to screen for returns that have a higher potential for payment of more taxes. Other audits are selected through referrals from state and local governments, from criminal cases and by special enforcement programs such as those aimed at cutting down questionable tax shelters. New York accountant Nick Morrow said statistics show two broad categories of tax returns are frequently flagged by the computers: Schedule C returns filed by the self-employed where deductions exceed 63 percent of income and Schedule A itemized deductions that are over 44 percent of adjusted gross income. Because final audit decisions are made by humans at IRS and not machines, Morrow said people who fall into these categories should make sure their returns are not sloppy and that numbers are not too rounded, so they appear designed to just meet legal requirements. Other red flags include big deductions such as those for medical expenses, which must exceed 7.5 percent of a taxpayer's gross income, unusually large charitable contributions or casualty losses, large moving expenses or hobby losses and claims for business use of the home. The IRS has also occasionally targeted certain professions for extra scrutiny, such as lawyers and taxi drivers. Each year, 1 million to 2 million individual returns are audited. By far the most common is the correspondence audit, in which the taxpayer receives an IRS letter asking for more information about one or two relatively simple items. If the claims are documented, usually the case is closed. If not, the taxpayer gets another letter describing the additional taxes to be paid. A key reminder for taxpayers: Respond promptly in writing to every IRS letter. "They love to see paper," said Morrow, personal finance director at Martin Geller CPA. "Give them plenty of it, as long as it's relevant." More complex audits, often those involving business returns or investments, are handled in IRS district offices by revenue agents or tax auditors with greater training. Most professional preparers say taxpayers are better off if they have a lawyer or accountant on hand to help them. But taxpayers who meet with the IRS alone should remember to take only the documents the government wants. It's not wise to start volunteering information. "People start blabbing about stuff the IRS wasn't questioning," said Ernst & Young's Szalkowski. "They definitely won't lend a deaf ear if you start talking about what you've done." Two IRS documents, Publications 5 and 556, detail what happens in an audit, describe taxpayer rights and show how to appeal an audit. Both are available on the Internet at http://www.irs.ustreas.gov. Also, the IRS Taxpayer Advocate's Office has a Problem Resolution Program available toll-free at 1-877-777-4778 to help resolve thorny tax disputes.