Avoiding an Audit

Getting audited by the Internal Revenue Service really isn't the end of the world, as columnist Dave Barry once calmly observed. "All that happens is, you take your financial records to the IRS office and they put you into a tank filled with giant, stinging leeches. Many taxpayers are pleasantly surprised to find that they die within hours."

Talk to a few people who've really been through the process and you'll realize Barry wasn't exaggerating all that much. If it wants to, the IRS can seriously mess up your life, in ways that often seem arbitrary and bizarre.

True, the chance that you'll actually suffer an audit this year is quite remote. Fewer than 2% of all the individual income-tax returns filed in each of the past several years were audited, IRS reports show -- 1.28% for the most recent year statistics are available. Still, the odds of being audited do rise sharply for people who fit certain profiles.

A lot of it depends on the secret IRS computer program that scans every return and then assigns it a score indicating the likelihood of questionable items. Despite the IRS's penchant for secrecy, some entries the computer searches for are fairly obvious, former IRS officials say. Among these are itemized deductions that represent an unusually large percentage of the taxpayer's income. Naturally, the IRS won't say how it defines "unusually large." But because of the intense interest in this subject, the Re search Institute of America, a tax-information publishing company, calculates averages each year for major categories of deductions, based on adjusted gross income.

WHAT'S ON AN "AVERAGE" RETURN
Yearly Income (in thousands)	Taxes Paid	Charitable Contri- butions	Deductible Interest	Percentage of Filers Itemizing
30-50	3,056	1,536	5,873	40
50-100	5,001	2,025	7,220	73
100-200	9,544	3,367	11,023	92
200+	35,386	17,993	22,258	93
Source: Treasury Dept. Statistics of Income Bulletin, Spring 1998

The table above shows the latest numbers, based on returns filed during 1997 for 1996. A word of caution: Remember that these are only averages, and not what the IRS officially considers acceptable. Even with that caveat, though, this table can be useful. If, for example, you find that some of the items you are claiming are particularly outsized for your category, consider attaching an explanation or copies of documents to support them. That could help calm suspicions.

Other ways of singling out returns are less sophisticated, such as the agency's "related examinations." These are what you get for, say, doing business with someone whose return is audited. There are also "chance" audits, triggered largely by, well, chance. Perhaps an agent saw something about you in your local newspaper or on television that piqued his curiosity. Or a disgruntled ex-spouse or former business partner turned you in to the IRS, hoping to collect a reward.

WHOSE RETURNS GET EXAMINED
Forms 1040, 1040A, 1040EZ*	% Audited in Fiscal 1997**
Income of $25,000 to less than $50,000	0.70
$50,000 to less than $100,000	0.77
$100,000 and over	2.27
Schedule C (Sole Proprietorships)	% Audited in Fiscal 1997
With gross receipts under $25,000	3.19
$25,000 to under $100,000	2.57
$100,000 and over	4.13
Estate-Tax Returns	% Audited in Fiscal 1997
Gross estates of less than $1 million	6.83
$1 million to less than $5 million	18.88
$5 million and over	47.43
*Total personal income before deductions, losses and other adjustments **Calendar 1996 returns Source: Internal Revenue Service, 1997 Data Book

Here are some of the other items that tend to raise examiners' eyebrows:

• Filing Schedule C. If you own your own business, deal in large amounts of cash and file Schedule C, your chances of being audited rise sharply. As you can see in the table above, in 1997 more than 4% of returns with a Schedule C showing income of $100,000 or more were audited.
• Taking a home-office deduction. The rules here are so complex and limiting that IRS agents figure they have a good chance of squeezing more revenue out of many taxpayers who claim a home office. The tax law enacted in 1997 will allow more consultants and other self-employed workers to qualify for the deduction, but not until 1999. And it won't remove many other ambiguities and limitations. So don't expect the IRS to ease up on its scrutiny.
• Writing off large amounts of travel and entertainment expenses. A classic example would be a businessman who deducts the cost of his daughter's wedding on the grounds that all the guests were customers. Yes, that really happened, says Cornelius J. Coleman, a former IRS official and now director of national tax services at Coopers & Lybrand in New York.
• Racking up large losses in a business each year for many years. That could prompt the IRS to conclude that there is no evidence you are in business to earn any money. An example would be people who say they are in the business of breeding horses or collecting antique cars, but have never once shown a profit.
• Taking large casualty-loss deductions. Very few people qualify for such deductions. Thus, says a former IRS official, those filers who take them tend to stand out and get asked questions, even if they are innocent.
• Being careless or lying. One easy way to get asked tough questions is to not report income you received that was reported to the IRS by whoever paid you. That's why it is so important to make sure whatever you write down matches exactly whatever is on an "information return" such as the W-2 form you receive from your employer.
• Living better than you seem able to afford. Even the IRS's ancient computers are smart enough to figure out that a Beverly Hills address is tough to maintain on Burger King wages. Sure, you may have an excellent explanation. You'd just better be prepared to share it with the IRS.
• Filing an estate-tax return. These returns draw unusually heavy scrutiny, reflecting the large amounts of money typically involved. The agency audited about 13% of all estate-tax returns received for 1996. That percentage rose to a startling 47% of all returns showing a gross estate of $5 million or more.
• Being in the wrong place at the wrong time. Unfortunately, where you live plays an important role in your chances of losing the audit lottery. Audit decisions aren't made by computers in Washington; they are made by local IRS officials, based on their own staffing levels and resources. According to IRS statistics, the Los Angeles region was the most active of all -- 1.55% of all returns were examined. Ohio's rates were lowest; residents there were audited only 0.31% of the time.

If that doesn't make you want to move to Ohio, we don't know what will.