Why me?

Dear Bonnie: I got a letter from the IRS yesterday. They want to audit my 2009 income tax return. Why me? I just have a little business and barely get by. I’m a small fry. It scares me and I don’t even have anything to hide.  – Lydia, Sonoma

Hi Lydia: Thanks for writing. A letter from the IRS is scary stuff, especially if the letter is to advise you that you are about to be audited.

Audits are up. In 2009, the current administration approved an IRS budget increase of more than $600 million for enforcement – this included more auditors and more collection personnel. Existing personnel: receptionists, displaced by closing offices and keyboard artists who are no longer needed due to the advent of electronic filing, are being retrained as enforcement personnel. So beware, with so many newbies and the complexity of the tax code, audit determinations may not be accurate. If you choose to represent yourself, and you don’t like the results, don’t sign off on the audit until you have reviewed the case with a competent tax pro.

The good news is that many audits are only for a few line items on your tax return. It’s not necessarily the “strip search” that we have all come to fear. Maybe that’s the case with you Lydia. Check the letter to see what documents they want you to provide.

As far as the reason you were selected, know this: the IRS usually will not tell you the reason.  In fact, yours may have been a random selection. Otherwise, there could be many reasons:

Your numbers are a big departure from the National Standards.

One of the red flags slapped them awake: excessive automobile expense, travel, meals and entertainment, etc., Know this: home office, which was a raging red flag in the 90s is no longer a big issue with the IRS. With the loosening of the tax law and with so many free-lancers, self-employeds, and telecommuters taking the deduction these days, the IRS expects to see home office expense more often than not. If you have one and are being audited, they will likely want to check it out to make sure you are not abusing the law.

Big swing in income from one year to the next. If income plummeted, the IRS might think you’re hiding something. If it increased substantially, it might think you were previously hiding something and finally decided to come clean.

Targeted industry – every year the IRS selects its latest victim. One year it audited attorneys incorporated as Sub S. Another year, it audited cash businesses, another year trusts with offshore accounts, and so it goes.

You filed an amended income tax return for the year in question to take additional deductions, some of which may be red flags (see above).

Failure to include income that was reported to the IRS by a third party. Maybe you got a K-1 or a W2 showing income that you failed to include on the tax return. This normally results in a “mail audit”, a letter called a CP2000 which is about 12 pages of confusing rhetoric sandwiched around a description of the missing documents and a computation of the new tax liability. If the CP2000 pertains to a stock transaction, do not the pay the bill. They only have information regarding the sale price (cost basis will be provided by brokers to the IRS beginning with the 2011 tax year). You are allowed to deduct your cost and pay taxes on the remainder or enjoy the loss against your other taxable income. See your tax pro.

If the audit will take place at the IRS office, the auditor will likely allocate 3 hours. He will review the requested documentation and normally wrap things up within that time frame. If you failed to bring every requested item or cannot prove the validity of your deductions, the audit may run into overtime. This may require a second appointment or a mail-in of missing documentation.

If the auditor wants to hold the audit in your home, then she likely wants to verify a home office deduction. You don’t say if you have a home office or not. If there is no home office, she wants to go on a fishing expedition to compare your lifestyle with the financial story your tax return tells. If she wants to hold the audit at your place of business, the motive is to make sure you have a valid business with perhaps a little pulse taking as to your sales volume and likely deductions. Know this: you have the right to decline either location. And for good reason. It’s unsettling to you and your family or to you and your employees. You may require that the audit be held at the auditor’s office or at the office of your tax pro. The auditor may still want to do a tour of a home office or the business and she has the right. Although video footage may provide the information she seeks.

Good luck Lydia! You may want to get with your tax pro to review your tax return and decide if you want the tax pro to represent you or if you want to go it alone.