Filing Your Tax Return: How Errors Lead to Audits

By Daniel Rinke, CCH Washington Staff Writer

What, exactly, does the IRS look for when processing tax returns and deciding on whether to audit a specific filing?

Essentially, all returns are examined, but as returns are processed, they go through a scoring methodology which will largely determine whether the return will ultimately be subject to a full audit, said Warren Simonsen, associate area chief counsel for the IRS's Small Business/Small Enterprise division, at the Washington D.C. Bar Tax Section luncheon held on March 9, 2004. Those returns with high scores are surveyed to determine if an audit would be proper.

At this stage, Simonsen observed that the IRS cannot contact the taxpayer, even if doing so could resolve the case. The reason cited was that the IRS is prohibited from opening a case twice, which would occur if the IRS contacted the taxpayer during the survey stage and then again at the later audit stage.

Thomas Cryan, of Deloitte and Touche, explained that there are a number of factors the IRS will use to select a return for audit. Some of the more routine infractions occur under simple math, or computational errors, which are often corrected through a simple correspondence audit. For this type of audit, the IRS will contact the taxpayer via telephone or by letter, seeking information to rectify the error. This process is generally only used if the return errors are very basic and are capable of a quick resolution without any legal maneuvering such as with certain credit claims or itemized deductions, said Simonsen.

Cryan added that the IRS also uses matching and related return exams to select returns for audit. Matching would most likely be used, noted Cryan, where a partner in a partnership has attached a Schedule K-1. In this situation, the IRS would simply review the return information to determine if the numbers "matched." Similarly, for related returns, the IRS could check a business entity return against the related employment tax return, for example, to make sure the information is reported consistently.

Recently, the IRS has been relying more on informant information, reported Cryan, particularly as a result of the IRS disclosure efforts over the past year regarding abusive tax shelters. The disclosures required under current tax law, for instance, have given the IRS lists of promoters and tax shelter participants, all of which have proven fertile ground for gathering information about tax shelter activities. In addition, the IRS has targeted high-income taxpayers, non-filers and participants in offshore credit-card schemes through the Offshore Voluntary Compliance Initiative (OVCI).

Where the exam is not capable of being resolved through the mail or via telephone, Simonsen said the case would be handled under either an office or field examination, depending on the complexity of the case and the number and nature of issues involved. These are much more lengthy and costly than simple correspondence audits and much more is at stake. As a result, Simonsen suggested that taxpayers might want to consider the Limited Issue Focused Exam (LIFE) process. This allows taxpayers to establish at the outset the number of issues as well as to create a set of time tables within which to work.

On the downside, however, given the more restrictive timelines of the LIFE process, taxpayers may have difficultly complying with complex document requests. Simonsen added that this can get cumbersome because, as an administrative matter, cases of this nature are very complicated and might involve significant amounts of material. As a result, agents have difficulty tracking all the material and may make duplicative requests which then take additional time to sort out.

If contacted by the IRS regarding a tax return, be sure to contact your tax advisor and respond promptly to the inquiry, in order to resolve the issue before it escalates into something much more problematic.

Related items:

$2.5 Billion In Unclaimed Refunds from 2000 Faces Looming Deadline

E-Filing Gains in Popularity

The Clock Is Ticking on Tax Savings

Tax Considerations Can Complicate Market Gains, Losses

FICA Taxes Will Barely Increase for High Earners in 2004

Tax Rate Projections for 2004

Third Largest Tax Cut Package Enacted

Congress Passes $350 Billion Tax Cut Bill

Retirement Planning in a Down Market

Who Really Pays Income Taxes?

States Face Growing Budget Gaps, Half Eyeing Tax Increases

Analysis of Bush's 2003 Tax Cut Proposal

New Year Rings in New Tax Laws

It's Not Too Late To Lower Your Taxes for This Year and Next

Posted February 20, 2004.