Uh, oh!! You got a letter from the Internal Revenue Service that's says you are being audited. The average person's reaction is instant doom. That's it!!! I'm going to jail. Who will shovel the snow, who will cut the grass, who will play my numbers, who will feed the cat? This first reaction mellows a bit into, well at least I will get some peace and quiet, I wonder how many cable channels they have in a cell and what night do they serve spinach quiche?
Of course, all these reactions, although normal, are unwarranted. An audit letter can mean many different things. It runs the gamut from an invitation to come into the IRS office in Boston for a meeting to a request for clarification of a deduction on your return.
The worst, and most infrequent audit letters, are the ones that request you bring documentation for everything on your tax return. These can be referred to as compliance audits. If you get one of these letters, call a CPA who has experience in handling compliance audits. These can drag on for months. Most people are not aware of what the IRS can and cannot do during one of these examinations. As a result, innocent responses to seemingly innocent questions can prove to be disastrous. Either call a CPA, or hit the gym so you will look good in stripes. What the IRS is looking for in a full blown audit is usually more than one item. It could be that your deductions vary to a great degree from what is the norm for your income level. It could be that the IRS has a special project underway to look at self- employed individuals who are reporting losses. Or perhaps you just got unlucky, and your name was selected at random to see whether or not you are complying with IRS regulations. Believe it or not, examination agents are not looking to put honest people in jail. Mistakes are made either through ignorance of the law or a misconception of what the law really means. Honest mistakes will cost you money but not jail time. However, if you believe in taking deductions for things such as Fluff's neutering or for buying a snow blower as a medical expense, you better get your checkbook ready for a shock.
The more frequent types of audits are done through the mail. Generally the reason is that some items on your return do not jive with your income level and the IRS just wants to verify the validity of the deduction. Maybe your medical expenses as a ratio to your income, exceeds the average. Or perhaps your charitable donations appear high in relation to the earned income. For example, if you have exceptionally large unreimbursed employee business expenses, but have been unemployed for two years, it might raise a red flag. Why? Simple, individuals receiving unemployment do not have employers. Letter audits are usually satisfied by sending in copies of your support for the requested item. Think of this as a teacher checking your homework to see if you did everything correct. The difference is the IRS will fine you while your teacher may fail you.
Finally, a letter from the IRS proposing additional tax for a prior year return is not always correct. If you get a notice of a proposed increase in tax, don't jump to pay it, find out why the letter was sent. It may be that you omitted a 1099 for interest income from a bank in Maui. If it is clear that you forgot to include something, simply pay the man. But be sure you owe the money. I have had many letters assessing thousands of dollars that were incorrect because the IRS only saw part of the transaction. For example, say you have a $50,000 bond that matured. You paid $49,000 for it five years ago and have reported $1,000 of interest income associated with that bond over the years. As such, your cost basis is equal to the selling price, so when you receive a 1099 from the broker reporting gross proceeds of $50,000 you figure I have no gain so why bother to report it. Problem is the IRS sees a 1099 for $50,000 that it cannot find on your tax return, so they send a notice looking for tax to be paid on $50,000 of unreported income. In this case, a letter, with support, explaining that there is no gain and you didn't think it had to be reported should solve the problem.
Lastly, if you do receive an audit letter with an invitation to call a certain number try to be courteous during your call. IRS employees are regular people doing a job that can attract violent negative reactions to routine queries. They do not enjoy being called pin heads or buffoons. If you decide to handle this matter without a CPA should watch what you say, it may come back to haunt you.