Most of us manage to get through every tax season relatively unscathed, but others are not so lucky. Nothing strikes fear and panic in a taxpayer\'s heart like the prospect of a tax audit. What would you do if the IRS picked your tax return for an audit? Here we look at what you can do to prepare for an audit and what kind of penalties you can expect if you\'ve underpaid on your taxes. We also answer the question every taxpayer ponders at least once in his or her lifetime: what are the odds that you\'ll get singled out for an audit?

SEE: Personal Income Tax Guide

Maintain Accurate Records Now, Avoid Trouble Later
While the Internal Revenue Service (IRS) allows taxpayers numerous opportunities to save on taxes, it is ultimately your responsibility to keep accurate records to prove your deductions in the event of an audit. Collecting and organizing your records throughout the year will make it easier to prepare your return and reduce the likelihood of errors. It will also allow you to build your defense if the IRS chooses to dispute your return. To stay on top of tax matters, you should make it a habit to do all of these things throughout the year:

  • Maintain at least three years\' worth of tax returns and records
  • Keep your checkbook stubs
  • Retain and categorize your receipts from all purchases throughout the year
  • Track cost basis for property and taxable investments
  • File all your bills in organized folders
  • Journal your deductible items as they occur

The Odds of Getting Picked
When it comes to being selected for an audit, there\'s good news and bad news here. While the IRS has been ramping up the number of audits it conducts, the focus is on high-income taxpayers, abusive tax shelters and corporations. J.K. Lasser, the premier publisher of consumer tax guides since 1939, reports in its 2006 tax guide that the number of taxpayer audits in the U.S. has increased 37% since 2001, with more than 1 million taxpayers facing some sort of return examination in 2004. Audits of taxpayers earning more than $100,000 have more than doubled since 2001. Despite this, the odds that your return will be picked for a tax audit are actually quite low.

Certain factors may contribute to the likelihood that you\'ll be audited - for example, your income, your profession, the type of return you file, the types of transactions reported and where you live. Here are 10 specific items that will trigger a red flag for the IRS and increase your chances of being audited:

  • Large Charitable Deductions
  • Large Business Expenses
  • Inaccurate W-2 or 1099 Reporting
  • Excessive Itemized Deductions
  • Concealment of Cash Receipts
  • Tax-Shelter Losses
  • Informant
  • Prior Tax Problems or Audits
  • Complex Business Transactions
  • Complex Investment Transactions

Preparing for the Audit
If you are one of the unlucky few who are chosen for a tax audit, you\'ll need to be prepared. Your first step should be to take a good look at the details of your return to refresh your memory. Once you have a thorough understanding of the contents of your tax return, you\'ll need to organize your records to support the items questioned by the IRS. Prior to the actual examination, you should establish a range of settlements that you are comfortable accepting. This will prepare you for possible settlement terms that might be discussed later by the examiner.

If you feel that the matters being questioned or disputed by the IRS are over your head, you should seek the assistance of a professional such as a certified public accountant (CPA) or an attorney. If you decide to attend the examination, take only the records related to the items in the IRS Notice of Audit - do not volunteer extra records, since you may end up subjecting yourself to a new investigation. If the examiner happens to question you on an item not mentioned in the IRS notice, you should refuse in a polite but firm manner until they file a formal request for this information.

If the audit occurs in your place of business, all employees should be instructed not to talk about the business or the audit with the IRS agent. Inquiries from the IRS agent should be referred to you. Finally, 10 days prior to the interview, you should give the IRS written notice that you will be making an audio recording of the interview with the IRS agent. Video recordings are not allowed.

Depending on the nature of the tax underpayment, you may face one of the following penalties:

20% Penalty - This generally applies to the portion of any tax underpayment associated with overvaluation or undervaluation of property, negligence, disregard of IRS rules and regulations, and substantial understatement of tax liability.

75% Penalty - This typically applies to more serious tax underpayments that are due to fraud. If the IRS determines that any portion of the underpayment is fraud related, it will be your responsibility to prove otherwise. Otherwise, the entire underpayment will be treated as fraudulent and subject to a 75% penalty.

Interest Due - For violations such as fraud, negligence, failure to file on time and over or undervaluation of property, interest will accumulate from the due date of your return (including extensions) until the date the penalty is paid. For other penalties, interest is not charged if the imposed penalty is paid within 21 days (for penalties under $100,000).

Prison - In the most serious cases of tax evasion and other tax crimes, a conviction can result in much more significant fines, the forfeiture of assets/property and possibly incarceration.

The Bottom Line
Usually, the IRS will conduct an audit of a tax return only if it sees some invalid deductions or other expenses and it is confident that the audit will result in a tax bill. In other words, if you are audited, it is very likely that you will have to pay additional money for taxes, so don\'t be disappointed if you don\'t "beat the IRS" when all the smoke clears.

Although audits are unpleasant, you don\'t need to dread them if you\'ve kept your financial records organized, up to date and above board. If you are chosen for an audit, make sure the examination is scheduled far enough in advance for you to get ready. Solid preparation should enable you to get through the audit with a minimal amount of stress.

For more information, see Avoiding An Audit, Common Tax Questions Answered and Tax Tips For The Individual Investor and check out the official IRS website.

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