Confession, so they say, is good for the soul. It can also pay off for the pocketbook if you're admitting to the IRS that you made a mistake on your tax return. Although blowing the whistle on yourself might sound like unsound tax strategy, hundreds of thousands of taxpayers who do it each year are rewarded with refunds. Why? Because the errors they're correcting caused them to overpay their tax with the original return.
The amended tax return, filed on Form 1040X, can be a handy weapon in your tax arsenal. With it you can apply newly discovered tax-saving knowledge to returns filed in previous years. That means a once neglected tax advantage isn't irretrievably lost.
You might need to file a 1040X, for example, if you discover you failed to claim a dependency exemption you deserved or overlooked an itemized deduction or credit. Or, you might have to file one if Congress changes the law retroactively.
You generally have three years from the due date of a return to file an amended version, although the period can stretch to seven years if the revision involves a bad debt or worthless security. The three-year limit means, for example, that 2006 returns, due April 15, 2007, will be open for amendment until April 15, 2010. It also means you only have until April 15, 2007, to amend your 2003 return, if that's necessary.
Of course, the 1040X isn't a one-way street. You're supposed to use it to correct errors or oversights that resulted in paying less than you really owed in an earlier tax year. Each year, taxpayers file about 3.5 million amended returns.
Is it risky to file a 1040X? If you use one to ask for an extra refund, are you begging for an audit too? The IRS says the answer is no. Although that's what you might expect to hear from the tax collector, there's no reason to believe a 1040X marks your original return for audit.
If your amended return shows that you owe more tax for the year involved, send a check along with the form. The IRS will bill you for the interest due. If the mistake you correct results in the government owing you money, you can expect a refund check in two to three months—including interest back to the time the original return was due.
TaxCut will prepare a 1040X, and don't be intimidated: You don't have to re-do the entire return. Send the completed form to the IRS Service Center for the area where you now live, even if the return you are correcting was filed to a different center.
Even though the IRS has recently boosted the number of returns plucked for an audit, the vast majority (almost 99%) of individual returns go unchallenged. In 2004, the latest year for which figures are available, about 130 million individual returns were filed and just 1 million of them were audited — or about 1 out of every 130 returns. And, most of the recent increase in audits does not involve face-to-face confrontations with the IRS. Instead, most of the surge has been in the number of correspondence examinations handled by mail, with taxpayers receiving letters from the tax agency asking for verification of certain items on their returns. In the table below, we show both the overall odds of an audit and the reduced odds of a face to face audit. Of those 1 million audits in 2004, for example, 810,000 were handled by mail.
Don't think returns are chosen at random, though. The odds of being audited vary depending on the type of return filed and the amount of income you report. As you can see in the following table, the odds increase dramatically if you have a business and file a Schedule C with your return.
Here are the numbers from the IRS:
Even if your return survives the computer's scrutiny, you're not necessarily safe. You may have listed an investment in a tax shelter the IRS is particularly interested in, for example, or the agency might decide to take a closer look at your return because it is auditing the forms sent in by a business associate.
And there's always the chance that someone has fingered you as a tax cheat. (The IRS pays rewards for tips that pay off.) Or, you could fall victim to a random IRS research audit — line-by-line torture sessions designed to help the IRS figure out who cheats — and how — so the agency can better program its computers to single out future returns that really deserve to be audited. For years, the IRS was prevented from doing its research audits by a Congress that was concerned that putting unsuspecting taxpayers through the wringer was unfair. But, as the IRS computers became less adept at spotting returns that needed to be audited — a growing percentage of returns picked by based on out-of-date computer formulas turns out to have no errors — Congress gave IRS the go-ahead to collect fresh data. In 2002, 50,000 returns were picked for this project. Most of the taxpayers selected were expected to handle the whole matter by mail, but 2,000 got to sit down with an agent and explain where every number on their returns came from. Oh, joy! (Good news: The IRS's next random audit project isn't scheduled until 2008.)
Whatever the reason you're chosen for an audit, it's chilling to get the word that the IRS wants to examine your return. Still, it's important not to panic. There's a pretty good chance that you won't have to pay more tax. About one in five correspondence audits results in no change in the taxpayer's bill. And, between 8% and 15% of face-to-face examination wind up with the IRS accepting the original return as accurate. You might even get a refund. In a recent year, over 60,000 taxpayers walked out of audits with a total of almost $450 million in refunds. But, face it, most folks called in for an audit come out poorer. And even if you escape without owing an extra dime in tax, the time, hassle and stress involved are indisputably costly.
The simplest audit—a correspondence audit—requires only that you mail in the records needed to verify a specified claim on your return. In a field audit, an IRS agent comes to your home or place of business to go over your records. Most common, though, are office audits, which involve getting yourself to a local IRS office.
The written notice will identify the items on your return that are being questioned—usually such broad categories as employee business expenses or casualty losses—and outline the types of records you'll need to clear up the matter. Office audits are usually limited to two or three issues, so you won't be expected to haul in all your records.
What kind of evidence do you need? The answer to that question was put succinctly by a retired IRS official with thirty year's experience putting tax returns through the wringer. In an interview he said, "I expect to see the records you used when you prepared the tax return. You must have had some. Otherwise, how did you know you gave $5,000 to charity?"
You'll probably have at least a couple of weeks to prepare. If the appointment is set for an inconvenient time or you find that you'll need extra time to get your records together, call the IRS promptly to request that the audit be rescheduled.
In most cases, the statute of limitations—the deadline for the IRS to decide it wants to audit you—on your tax return expires three years after the due date of the return. Your return for 2005 is due April 15, 2006 so the auditing period ends April 15, 2009. If you haven't been alerted to an audit by then, you probably never will be, so it's probably safe to toss most of the records that back up your return.
In some cases, though, the IRS gets six years to come after you. The extended jeopardy applies if you fail to report income that is 25% or more of the amount of gross income you do report. And if you fail to file a return or the IRS can prove that you committed fraud, there's no limit.
The best way to begin preparing for your meeting is to pull out your copy of the return being audited. (If, as luck would have it, you can't find the return, call the IRS office that contacted you and ask for details on how to get a copy.) Before the IRS puts your forms through the wringer, do the job yourself. Pore over the items being questioned and pull together the documents that support your entries.
Of course there will be gaps, but don't automatically concede defeat. Try to reconstruct missing records. Get copies of canceled checks from the bank or duplicates of receipts or written statements from individuals who can back up your claims. Where you can't come up with written evidence, prepare your oral explanation.
Your records don't have to be perfect. If you have a reasonable explanation for how you came up with a figure that's not fully corroborated by the evidence, the IRS may well accept it.
The IRS likes to stress how reasonable audit personnel are. The agency's official manual for auditors notes, for example, that on some issues oral statements may be acceptable. "Adequate evidence," the manual says, "does not require complete documentation." However, when you're pulling together your records, remember this: The more thorough your documentation is in general, the more likely an auditor will cut you some slack on an occasional point.
You don't have to go to the audit at all. You can avoid it by hiring someone to go in your place. That's what Charles O. Rossotti, who retired as head of the IRS in late 2002, did every year he had the job. You see, a "perk" of being IRS Commissioner is that your return is automatically audited every year. Rossotti just sent his accountant in his stead. Such a representative must have written authorization to act for you, and the IRS provides a power-of-attorney form—Form 2848—for this purpose. (You can get a copy by calling 1-800-TAX-FORM or download it from the IRS website at http://www.irs.gov.)
Whether you go alone or hire a representative to go with you or in your place depends primarily on the issues involved. If they are relatively simple, cut-and-dried matters, you may be able to settle things without help. When matters are more technical or require interpretation of the law, however, it's more likely you'll need assistance. You have to make this judgment, and it will turn in part on how you feel about going head to head with the IRS. If you are scared, by all means get someone to go with you or in your place.
If someone else prepared your return, let him or her know about the audit and ask for tips on how to get ready for it. Whether or not you want this person to go along may depend on how much it will cost you. Although the IRS prefers to wrap up cases with a single meeting, if you don't agree with the auditor's conclusions or need time to round up extra evidence, a follow-up meeting can be scheduled. Unless you fear you might capitulate if you go to the audit alone, your best bet is probably to settle as many issues as you can by yourself.
If disagreements remain and the amount of money at stake justifies the expense, you can take an adviser along to the next session. That way you'll have help when you really need it but won't have to pay for hand-holding while you clear up routine matters.
The key to success is being well prepared. Forget the old slapstick routine of dumping a box of canceled checks and ratty receipts on the auditor's desk. That suggests your records are sloppy, and that's the last impression you want to give. Remember it's up to you to back up the information on your return.
The better organized your records, the more smoothly things will go. Try to develop credibility right from the start. Say, for example, that the audit notice announces that your interest deductions, charitable contributions and travel and entertainment write-offs will be reviewed. If you are solid on interest and contributions but a little shaky on T&E, try to steer the audit to your strongest suits first. If you establish credibility early on, there's a better chance a gap later may be overlooked.
Don't go into the session looking for a fight. But don't equate being cooperative with giving in whenever the auditor raises an eyebrow, either. If the agent tells you your records don't substantiate a deduction, for example, ask what might suffice. Perhaps you can mail it in later.
Be on your guard against chatting your way into a problem. Keep in mind that the agent is trained to zero in on tax issues. A comment you consider totally unrelated to your return might lead you into a thicket. Defending a deduction by saying you've taken it in the past, for example, could prompt a review of previously filed returns; discussing the family's cross-country driving vacation might lead the agent to recalculate the business/personal ratio of your car's use; or bemoaning the problems that led a child to drop out of college could cost you a dependency exception. (The opportunity to talk your way into trouble is why many tax pros say taxpayers should not go to the audit at all but instead pay someone to go for them.)
Above all, keep your wits about you. Don't be pressured into settling an issue just to bring the audit to an end. Although the IRS argues strenuously that agents aren't judged on how much extra money their audits produce, the fact is that one of the best guides to an agent's efficiency is the amount of additional tax he or she generates without going through all the formal assessment procedures or litigation.
There may be room for compromise on the issue at hand. It may save time and money all around to agree on some in-between point or even for one side to give up on one disputed item in order to win on another.
Most office audits take from two to four hours. You'll spend a lot of that time watching the agent crunch numbers. When it's over, you'll get the auditor's decision—which in most cases is that you owe more tax. Each proposed change to your return and the reason for it should be explained.
If you agree, fine. But remember that the auditor doesn't have the final say. Often, in fact, auditors make mistakes that cost taxpayers money. If you disagree with a finding, tell the auditor so and restate your position. He or she may be willing to compromise to close the case promptly.
If you and the auditor come to an agreement, you'll be asked to sign a form saying so. Within a few weeks you'll get a bill for the extra tax, plus interest and any penalty. Most audits end this way.
But if you can't come to a meeting of the minds, tell the agent so and go home. You'll receive a report explaining the proposed adjustments to your return. At this point, in the less-heated environment of your own home, you might decide it's not worth the time or trouble to carry on your dispute. If so, you can simply agree to pay the bill.
You have several options if you decide to fight on, and at this point you may want to seek professional help. You can ask for another meeting with the auditor to present additional evidence, for example, or you can make an informal appeal to the auditor's boss. If you're still unhappy, you can go to the IRS regional appeal level. At any point, you can take your case to court.
If you want to appeal within the IRS, you have 30 days after you receive the audit report to request a conference. After that, you'll probably have at least a couple of months to prepare. Regional appeals are handled informally, and IRS statistics indicate that taxpayers who appeal do very well. Don't assume that means an appeal guarantees a better deal. One important factor behind the favorable statistics is that generally only taxpayers with strong cases take their cases to this level.
If you are still dissatisfied after an appeal, your only choice is to go to court. Most tax disputes are settled in the U.S. Tax Court, although you can also take your case to the U.S. District Court for your area or the U.S. Claims Court in Washington, D.C. One important difference is that you can go to the Tax Court before paying the disputed amount of tax; otherwise you must pay the tax and go to court for a refund of what you think you were overcharged.
The Tax Court, which hears cases at sites around the country, has a special procedure for cases in which the disputed amount is $50,000 or less. With relatively informal procedures, you can represent yourself in a small tax case. However, unlike regular Tax Court cases and those heard by other courts, decisions by the small-claims division can't be appealed.
If you wind up going to court and winning, there's a slim chance—very slim—that the government will pay your legal fees. To be reimbursed for your costs, you must "substantially prevail" in court. In the past, you also had to show that the rejected IRS position was unreasonable. But in the late 1990s, Congress shifted the burden of proof to the IRS on this point. Once a taxpayer wins in court, it's up to the IRS to prove that it was justified in taking its position. If it can't do that, the taxpayer can win attorneys' fees and other costs.
In 1998, with great fanfare, Congress shifted the burden of proof in other tax matters. This change got lots of attention, probably too much, in fact, if it leads taxpayers to lower their guards when it comes to maintaining records needed to prove they deserve certain tax breaks.
The burden of proof shifts to the government ONLY when cases get to court—and that means only in a relative handful of cases, usually about 30,000 a year. Also, the burden shifts — so the IRS has to prove that you’re wrong, instead of you having to prove that you’re right—only if the taxpayer can show that he or she meets several relatively stringent requirements:
Some advisors fear that the possibility that the burden will shift when a case gets to court will lead the IRS to be even more aggressive and demanding in the earlier stages of a dispute.
The Taxpayer's Bill of Rights gives taxpayers a number of safeguards. First of all, if you arrange for a representative to go to the audit for you, the IRS can't demand that you appear, too. In addition, if you go to the audit, you can make a tape recording of the proceedings, as long as you advise the IRS ahead of time. Also, if you can show that an error on your return resulted from your having followed written advice from the IRS—a response to a specific request—you can't be penalized for the mistake. (You'll still have to pay any extra tax, though.)
The Bill of Rights also puts new restraints on the IRS when it comes to seizing a taxpayer's property to satisfy a tax bill. If you are notified of an IRS levy, promptly seek legal advice to protect your rights. Taxpayers also now can sue the IRS for damages if an IRS employee "recklessly or intentionally" disregards the law in collecting a tax liability.
What if the IRS computer decides that you should be audited year after year for the same item? Believe it or not, there's a procedure to short-circuit repetitive audits on the same issues. If you receive an audit notice that targets the same items that were examined in either of the two previous years—and that audit resulted in little or no change in your tax liability—call the IRS office that sent you the notice. There's no guarantee that you'll escape the new audit. But it will be suspended while the IRS considers whether there's any reason to believe the audit results are likely to be different this time around. If not, you may be spared.