Caught in an IRS Audit

No one likes the idea of being audited. The good news is that the rate of Internal Revenue Service audits has declined steadily in recent years. The bad news is that the current IRS budget allocates more funds to "taxpayer compliance" — in other words, audits. However, many retailers have discovered that avoiding or emerging victorious from an audit has never been easier.

For many years, the IRS conducted a Taxpayer Compliance Measurement Program in conjunction with their routine audits. The program involved thorough, in-depth audits of a few taxpayers, and the results allowed the IRS to target the tax returns, and taxpayers, most likely to err or cheat.

But after many complaints, Congress abolished the program. Now, with more and more taxpayers successfully battling examiners, the IRS has come up with a replacement for TCMP, a research program that should increase the effectiveness of audits. In an effort to reduce the burden on taxpayers, many retailers may not even be aware that their returns are being examined.

The IRS's National Research Program (NRP) is already giving the agency a much-needed roadmap for selecting future audits — a crucial advantage because audits of compliant tax returns are unnecessary and burdensome costly for the IRS.

Beginning in September 2002, the NRP began working on less than 50,000 audits out of the 132 million individual tax returns filed. There were four categories of audits included in this sampling, ranging from no contact with taxpayers to scaled-back audits that require less taxpayer substantiation than previous studies. Of course, about 2,000 NRP audits involved checking every line of the tax return. In a major change from earlier studies, however, these will not require explicit line-by-line substantiation, so they won't be as burdensome for the taxpayer.

Of course, the best thing is to avoid being audited altogether. A few retailers have discovered one surefire way: Don't file them. But that's hardly recommended. At the other end of the spectrum, you can ensure that your return will be selected for an audit if you take big-time losses, operate your gift business on a cash basis, and keep sloppy records.

There are, however, some measures that can be taken to reduce the odds of being targeted for an audit, including: 1) Report all third-party income; 2) Use the proper forms; 3) Operate a non-cash business; 4) Use hired employees only, not independent contractors; 5) Operate as a corporation or partnership, not a proprietorship; 6) Keep an eye on your lifestyle (The question of how he or she "does it" is one that your competitors, enemies, and the IRS ask); 7) Hire a professional tax filer; and 8) Keep the evidence. (Good records can often stop an auditor from digging too deeply.)

Obviously, avoiding an audit shouldn't be the retailer's goal; saving money should be. Even the IRS encourages taxpayers to take any deduction to which they may be entitled. Still, if an audit cannot be avoided completely, it can often be won with the right strategy.

Because of the complexity of our tax laws, it's the rare IRS auditor who cannot find some point to contest. But even if the results of the audit are unfavorable, that doesn't necessarily mean additional taxes must be paid.

Until the business owner or manager agrees with the IRS, the appeals process remains open. The IRS is usually quite sympathetic to honest mistakes, and more than willing to discuss underpayment of taxes that may result from the many so-called "gray areas" of the tax code. They'll frequently negotiate the amount of tax due. But they don't like fraud.

Most retail businesses file truthful returns. Still, honest errors can occur. Should a gift retailer question any findings by the auditor, the first step toward redress is at the appellate level of the IRS. A disagreement over an auditor's findings is often referred to the appellate level, where representatives are more knowledgeable, and are empowered to be lenient. Of course, even at that level, the taxpayer doesn't have to agree. However, during your appeal, while the additional taxes demanded by the auditor go unpaid, interest and penalties accrue. Yet still further appeal is possible.

The purpose of the U.S. Tax Court is to review deficiencies asserted by the IRS for additional income, estate, gift, or self-employment taxes. The Tax Court is the only judicial body from which relief may be obtained without the payment of tax. The Tax Court maintains informal procedures for the filing and handling of tax cases where amounts do not exceed $50,000. Usually, business retailers represent themselves, although they may be represented by anyone authorized to practice before the IRS.

Decisions by the small tax case division of the U.S. Tax Court cannot be appealed by either the retailer or the IRS. Any taxpayer who loses in Tax Court may appeal the case to the proper circuit of the U.S. Court of Appeals, but the free ride ends with the U.S. Tax Court's ruling. If the Tax Court decides in the IRS's favor, further appeal requires an "appeal bond" guaranteeing payment of any tax deficiency finally determined.

The new National Research Program should allow the agency to better target those tax returns that will produce results for their budget dollars. So taxpayers who follow the rules have a good chance of avoiding an audit. Those already good odds are enhanced by retailers who take prudent steps to audit-proof their return.

And if all that fails, remember that many business owners have successfully battled the IRS.