Finis Cowan, Attorney - Retired CPA

1.  Identify who the notice is from. The IRS? Your state tax authority? Examine its authenticity and that it correctly spells your name and lists your taxpayer ID number.

2. THE IRS DOES NOT SEND UNSOLICITED EMAILS and never requests credit card information and pin numbers through email. Persons receiving emails that claim to be from the IRS should not attempt to visit any site contained within the email and should forward the suspicious e-mail to phishing@irs.gov.

3. Check to see if it is a form letter. For example, it may be a notice of changes or actions that affect everyone in your state or tax bracket. A personalized letter, on the other hand, may require specialized attention.

4. Is a specific IRS employee's name and title included?

5. Does it require action?

6. Is there a mandate or deadline that requires you to act within a particular time frame?

7. If the inquiry can be resolved by sending copies of the supporting documents, this is usually the most cost-effective solution and resolves the majority of examinations. However, the IRS is losing many of its experienced employees to retirement and is hiring hordes of inexperienced newcomers. In our experience, sending the IRS proof of our clients' tax position, while necessary, often fails to persuade the IRS and a meeting between the tax professional and IRS becomes necessary.

We strongly recommend professional representation at this point.

8. IRS examiners are trained and experienced at subtly using pressure and intimidation to increase their audit results. They frequently place biased interpretations of taxpayers' unprepared explanations and incriminating statements in their audit report that come back to haunt the taxpayers if the matter is appealed or taken to court.

• Cash businesses are easy targets for the IRS. Many people in these businesses don't declare all their income, and the IRS knows it. If, for example, your occupation is listed as a hairdresser, waiter or bartender, it may raise a red flag. If you regularly receive cash for your work, be sure to report all the money you earn, including tips.
• Self-employed professionals are also targeted. That's because they generally run their own businesses and do their own bookkeeping.
• Large, unusual deductions are easily picked up by IRS computers. Although these deductions may be justified, they may still raise a red flag.

Which Deductions Are Likely to Be Challenged?

The IRS mandates that certain deductions must exceed a minimum percentage of your income before you can claim them. For example, medical deductions must exceed 7.5% of your income, and casualty loss deductions must exceed 10% before you can claim them. Only a small number of taxpayers qualify, so if you claim these deductions, keep careful records.

The IRS is also likely to look at your contributions to charity. If you deduct more than the IRS's statistical norms, you may be audited. You must have a receipt (not just a canceled check) for any single donation of $250 or more. If you do not have a receipt, the IRS may disallow the deduction. A home office deduction may also be questioned. If you deduct expenses related to a home office, that office must be used solely for business-related activities. You must also perform the majority of your business in that office. A doctor who uses a room at home to do bookkeeping would not qualify for a deduction because it is not his or her main place of business.

The IRS may also audit if they receive a tip that you are cheating on your tax returns.

Income Document Matching

IRS computers match all pertinent forms, such as 1099s, W-2s, and K-1s relating to your name and social security number to what you report on your tax return. If the numbers do not match your tax return, you will be audited. The audit could begin with a phone call, an in-person meeting, or simply a bill itemizing the additional taxes, interest, and penalties.

DIF Scoring

The IRS scores every tax return with a discriminate function (DIF) number. It is based on secret calculations they use to identify income tax returns with the highest likelihood of tax change on audit. The DIF score increases for various items, such as Schedule C or auto expenses, and decreases for other items (such as using a paid preparer). IRS classifiers review high DIF score tax returns and select which ones and which items will be audited.

IRS Special Projects

The IRS annually identifies The Dirty Dozen - 12 of the most blatant tax scams. They use this list to identify income tax returns they will audit. Here is a recent list: http://www.irs.gov/newsroom/article/0,,id=180075,00.html

• Don't rush. Respond promptly to a notification of audit, but don't hesitate to ask for a postponement if you need time to gather records.
• Don't lie. Answer questions truthfully, but don't volunteer information that isn't asked for.
• Be friendly. A positive attitude will go a long way.
• Keep good records. The burden of proof is on you.
• Keep records for seven years.
• Educate yourself. Read IRS Publication 1, Your Rights as a Taxpayer. You can order this and other tax forms and publications by calling the IRS at 1-800-829-1040.
• Ask for help. Call or visit the IRS for help in preparation of your tax return. Refer to your 1040 instruction booklet for a directory of telephone numbers for recorded information or "live" help.
• Don't let the auditor keep your original documents. From http://www.pueblo.gsa.gov/cic_text/money/irsaudit/irsaudit.htm
• Take only the records related to the items in the IRS Notice of Audit - do not volunteer extra records, since you may end up subjecting yourself to a new investigation. If the examiner happens to question you on an item not mentioned in the IRS notice, you should refuse in a polite but firm manner until they file a formal request for this information.
• If the audit occurs in your place of business, all employees should be instructed not to talk about the business or the audit with the IRS agent. Inquiries from the IRS agent should be referred to you.
  
• 10 days prior to the interview, you should give the IRS written notice that you will be making an audio recording of the interview with the IRS agent. Video recordings are not allowed.