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High income, deductions, credits raise odds of audit

Jan 22, 2006 | AP

Certain "red flags" on a tax return increase the odds of being audited: a six-figure income, home office expenses, unusually high deductions or credits, interest or dividend income that doesn't jibe with IRS records.

And if you're a high-profile celebrity, watch out: The IRS keeps tabs on you, too.

Last year, the Internal Revenue Service audited 1.2 million 2004 tax returns, up about 20 percent over the previous year. The overall odds of being audited are about 1 in 107, and 1 in 63 for those with incomes over $100,000.

Typically, the first inkling taxpayers have that all is not well is a computer-generated IRS notice, which is considered a "correspondence" audit.

"No one wants to get that envelope with 'Internal Revenue Service' in the upper left-hand corner," said Denise Sposato, spokeswoman for H&R Block. "No good can come of that, usually."

Not all problems are serious, though. Tax returns with an incorrect Social Security number or no signature can be corrected easily. Resolving other problems may only require sending the IRS copies of records or correcting a math error.

More serious tax issues involve underreporting income or overstating deductions, exemptions and credits. A tax return with a large number of deductions may be flagged.

That shouldn't discourage taxpayers from claiming legitimate deductions and credits, Sposato said, but records should be kept to back up those claims.

The IRS has no single formula that determines which tax returns will be audited, but certain situations increase the odds.

Deducting home office expenses, which has become more restrictive in recent years, may generate a flag. That's because people can claim only the part of the home used exclusively and regularly for business, and other restrictions may apply.

Trouble also can arise from the many 1099 forms people receive each January showing interest, dividend and other payments they received during the year. Though 1099s don't have to be attached to tax returns, the information on them has been sent to the IRS, which may check the taxpayer's return to make sure all income is reported.

The IRS also checks information reported on Schedule K-1 documents, which cover income, deductions and credits from partnerships, trusts and S-corporations.

Celebrities have been known to attract the IRS' attention: Richard Hatch, who won $1 million on the first season of the reality show "Survivor," was accused of failing to pay taxes on his winnings; former District of Columbia Mayor Marion Barry pleaded guilty to two misdemeanor counts stemming from failure to file tax returns in 2000.

Other high-profile figures with past tax woes include singer Willie Nelson, baseball's Darryl Strawberry, "Hollywood madam" Heidi Fleiss and hotel magnate Leona Helmsley, who, according to a witness at her 1989 tax fraud trial, once declared, "We don't pay taxes. Only the little people pay taxes."

Even the rich and famous may quake at the prospect of meeting face to face with an IRS agent, and the prospect of that kind of audit seems to bring out the worst in some people.

Richard Davis, an accounting professor at Susquehanna University's Sigmund Weis School of Business in Selinsgrove, Pa., said he saw some "very aggressive, very annoying, very rude" taxpayers during his tenure in the IRS' chief counsel office, which handled taxpayers' audit appeals.

"They somehow get the idea the IRS is out to get them, or maybe they think if they're really aggressive that will get a better result," Davis said. "They are so mistaken."

Go in with a respectful attitude, he advises, even if you are contesting the IRS' findings.

Taxpayers truly daunted by having to meet with an agent should hire a tax professional, an attorney or tax preparer, to go in their stead, Davis said.

And, he noted, it's always possible that the IRS is wrong. "A lot of people have the misimpression that IRS agents know all this stuff cold and they never make a mistake," Davis said. "That's not the case."

Taxpayers have the right to appeal IRS findings and, if the dispute can't be settled, take their case to the Taxpayer Advocate Service, which is part of the IRS but operates independently and will help taxpayers resolve problems.

The IRS also can work out payment plans for those who owe unpaid taxes, interest or penalties.

Congress set three years as the deadline, or statute of limitations, during which the IRS can go back and make additional tax assessments. But that time can be extended if the IRS suspects serious underreporting of income.

There is no statute of limitations for failure to file a return or when tax fraud is suspected.

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