So Your Taxes Are Being Audited By the State or IRS: Now What?

The below article was written by Jason Notte on March 18, 2015 and originally published on The Street.

NEW YORK (MainStreet) – If you’re being audited by the Internal Revenue Service this year, you’re either an unlucky or extremely unfortunate individual.

Budget cuts have steadily decreased the number of IRS audits from 1.4 million in 2013 to 1.2 million last year. IRS Commissioner John Koskinen told reporters in January that the number of audits would fall again this year after continued belt-tightening.

With the IRS budget falling 17% in the past five years, the number of audits this year is expected to hover around 1 million. Koskinen noted that his agency has left an estimated $6 billion to $8 billion on the table since 2010 because its enforcement division is understaffed by roughly 5,000 fewer employees than it needs. Further staff reductions should leave another $2 billion uncollected this year.

This isn’t exactly making life easier on the few folks who do get audited. In fact, it makes a certain few increasingly subject to scrutiny.

“There are only two reasons to get audited: One is if you’re randomly selected and the other is if you throw up some kind of red flag,” says Matthew M. Jehn, a certified financial planner with Royal Oak Financial in Worthington, Ohio. “Home office deductions are typically something that can throw up a red flag if they’re too egregious with what’s written down.”

If you were unlucky enough to fall into either of Jehn’s two categories, we’ve assembled a team of tax preparers and financial advisers to give you a step-by-step plan for how to handle your audit and how to avoid that unpleasant experience again:

1. Make sure it’s legit.

Paul Gevertzman, a certified public accountant and tax partner at Anchin, Block & Anchin, in New York City, notes that fraudulent tax examinations do happen and fake audit notices have only increased in frequency in recent years.

“You hear so many stories about people getting phone calls and emails, basically scams, from people pretending to be tax examiners,” he says. “These things are out there. If the first contact is something other than a written letter, there’s a very good chance that it’s not legitimate and you need to check it out before you provide any kind of information or make any kind of payment.”

2. If it’s the real deal, calm down.

“Breathe: It’s not cancer, it’s an examination by the IRS,” says Susan Lee, an enrolled agent and certified financial planner in New York City who specializes in tax preparation for freelancers. “It’s not to be taken likely, but it’s not the end of the world unless you’ve committed fraud intentionally.”

This is going to go a lot more smoothly if you actually read the letter and see exactly what the IRS or the state wants before heading into the audit. Larry M. Elkin, a certified public accountant, certified financial planner and president of Palisades Hudson Financial Group in Scarsdale, N.Y., notes that federal and state tax offices send out huge numbers of notices advising taxpayers that they owe money. He adds that most result from simple data or reporting errors the tax authorities believe you made. If you gathered your tax information carefully and had someone competent prepare your return, there is a good chance the notice is incorrect.

“Some people have this tremendous fear of being audited, but the important thing is not to panic and just deal with what you have to do,” says Gevertzman. “Most agents are public servants like police, firemen sanitation workers. We shouldn’t be prejudiced against tax examiners: Some of my closest friends are tax examiners and they’re all good, hard-working people who aren’t out to get you.”

3. Don’t go in alone.

Unless you’re especially deft at preparing your taxes and dealing with IRS or state auditors, you’re likely going to want someone to either coach you or — in the case of an in-person audit — be in the room to help out.

“If they are the one who signed off on your return, then they are required at a minimum to show that they used the information you gave them to put on your tax return,” Jehn says. “If they screwed up, they run the risk of having a claim filed against them, but usually something gets messed up and you didn’t give your CPA or tax preparer the right information.”

The problem, as Elkin points out, is that skilled professional representation is expensive, and only the auditor knows how many hours the process will take. They don’t care about your fees and, if they know what they might be in advance, they’ll offer to settle for that amount. Elkin suggests cash-strapped filers at least consider this option, but notes that everyone else should want as much help as possible and get out of a hired representative’s way.

“The audit process works best when it is limited to the issues the auditor raises,” he says. “Your presence invites incomplete or incorrect off-the-cuff answers to the auditor’s questions. An effective taxpayer representative (usually a CPA, attorney or IRS-authorized enrolled agent) will find out what the auditor wants to know, gather the information and present it clearly and concisely without triggering collateral issues.”

4. Don’t give the auditors more time than they need.

Elkin points out that you have a few months after the end of the year to file your tax return, but the authorities generally have three years thereafter to examine it and ask anything they want. Those with heavy caseloads who like to ease the burden by asking taxpayers to waive the three-year limit, however, are doing you no favors.

“Waiving the statute allows the agent to drag out the process, inflating the taxpayer’s cost for representation and increasing potential interest and penalty charges,” he says. “It lets the agent raise additional issues if new legislation, regulations or court decisions provide support. You get no benefit.”

5. Don’t underestimate auditors or get steamrolled by them.

There’s a big reason Gevertzman suggests handing power of attorney to a third party in the event of an audit: Because the IRS is after a specific sum but has no problem going for more if you put it on the table.

“In most cases, I prefer that my clients never deal directly with a tax agent,” he says. “Agents out there are trained to ask unrelated questions that seem innocuous, but they ask them in such a way that they get a taxpayer to say something that they don’t even realize they’re saying about a related business, a related company or their personal lives. That opens a Pandora’s box that, once it’s open, it’s open and you have to deal with that.”

That said, the agent’s word isn’t gospel. Many of our financial experts agreed that agents aren’t always experts in the law they’re enforcing. That leaves those representing themselves vulnerable to unnecessary penalties and payment, but offers tax professionals a chance to not only save their clients some grief, but to educate the agents themselves.

“Field agents often lack a detailed knowledge of applicable tax law, or may seem to make up rules that are not in the tax code or regulations,” Elkin says. “That’s because they are typically some of the least experienced and least trained personnel in the enforcement staff. Those with greater knowledge tend to be promoted to review-level positions.”

If you have a particularly surly or bullying agent — which our experts deemed rare — you have the right to speak to their supervisor, request a new agent or, in extenuating circumstances, even request a change of venue.

6. Get organized.

Having the evidence to back up your income and deductions is always helpful. Granted, it’s usually more helpful the first time around before you get audited, but the audit offers you a chance to not only refute the auditor if you feel they’ve made an error, but defend your own errors as accidental if that’s the case.

The state and IRS go a lot easier on folks who flat out didn’t get their 1099s or misplaced them than those who outright withheld them. Get copies of those documents, or get substitute documentation if they’ll allow it.

“When you respond, present as complete a package as possible.” Gevertzman says. “That doesn’t mean offering answers to questions that weren’t asked, but leading them to everything so they don’t have to ask additional questions.”

That’s the key to surviving an audit: Making it as easy on the auditor as possible. By being disorganized and antagonistic, you can make an audit a lot harder on yourself than it needs to be.

“It’s like being in a relationship with a partner where you expect them to mind-read: It may work, but I haven’t seen it,” Lee says. “You have to respect the point of view of the agent. They’re hard-working people who have to get through this and meet their metrics, and being disrespected by a person who may or may not understand isn’t high on their agenda.”

7: If you have to pay, settle up quickly.

While Gevertzman says taxpayers can ask auditors to waive penalties in the interest of getting them their money more quickly, he notes that they’ll never waive interest payments. Those add up quickly, which is why our advisors suggest paying the full sum as soon as your finances allow.

“Though tax enforcement is theoretically about collecting the correct tax rather than more tax, revenue agents do care about revenue,” Elkin says. “If they are not going to find a lot of money by auditing you, they will want to move on to a more productive assignment.”

Since the state and IRS aren’t going to offer you a great rate on an installment plan and will only put liens on your earnings if you skip payments, it’s best to let them know upfront that there’s no more cash coming their way. If you’ve made a mistake, concede it. If you owe something, pay it. If you can show the auditor authoritative proof that there’s nothing more to investigate, do so and let them move on to the next unfortunate taxpayer.

“A tax return is nothing more than a report card,” Jehn says. “It’s numbers in and numbers out … As citizens, it’s our duty to pay as little taxes as legally as possible.”