As you thumb through the mail one day, an unassuming letter catches your eye. Return address: The IRS. You nervously tear open the envelope and your worst fears are confirmed: The IRS has chosen your return for a correspondence audit.
Don’t panic. You don’t need to go into hiding or start stuffing money under your mattress. A correspondence audit is the least threatening of the three types of audits you could face. As the name implies, the audit is generally handled through the mail, so you’ll likely never see an IRS agent face to face. In contrast, the office audit and field audit are generally more cause for concern.
Correspondence audits are typically limited to just a few items on your return that you can usually clear up by mailing copies of receipts, checks or other records. Plus, the only way the IRS auditor can obtain information from you is to send a letter requesting additional documents. Since you’re not dealing with an IRS representative across a table, you can’t blurt out any damaging information or give embarrassing or inflammatory responses, and the IRS can’t expand the audit based on your problematic comments.
Example: If your charitable deductions exceed the average amount claimed by taxpayers in the same tax bracket, the IRS may ask you to substantiate your donations. Of course, things aren’t always so simple, so let’s look at making your way through the audit with the minimum hassle and expense.
Create and audit-proof return
Obviously, the best way to beat an IRS audit is to avoid one in the first place. A few smart moves when you prepare your return can save you a boatload of trouble later. Of all returns audited, IRS computers select about 75% using mathematical formulas that predict which returns have the highest probability for unpaid taxes. If the IRS flags your return, it goes to an IRS “classifier” who checks for reasons why your return doesn’t conform with averages. Here are a few tips to help prevent your return from waving red flags!
• Make sure your reported income seems sufficient to support the deductions and exemptions you’re claiming. Simply put, you must have enough money coming in to cover the amount going out. If you don’t appear to pass this test, it could be an indicator of unreported taxable income.
• Watch out for large refunds that raise eyebrows. Taxpayers typically don’t prepay a lot more taxes than they owe. So, be prepared to back up your claims if you’re in line for an unusually large refund.
• Don’t round off deductions to the nearest hundred or thousand. Round numbers make it appear that you’re “guesstimating” the figures. Provide the actual figures. Provide the actual figures from your records.
• Itemize deductions on Schedule A, if you’re self-employed. Small business owners who report a high income, show a small profit and take the standard deduction-instead of itemizing-on their personal return are practically waving a red flag in front of the IRS. The suspicion is that you’re burying personal expenses in the purported business write-offs listed in Schedule C.
• Beware of other red flags that could raise eyebrows at the IRS, including large travel and entertainment (T&E) expense deductions, any amount of under-reported income, unusually high itemized deductions, losses from a sideline business and early retirement plan distributions.
Key point: Never pass up a bona fide tax deductions or credit just because you fear it may ring audit bells at the IRS. Just make sure you’ll have the records to prove it. Does filing an amended return draw extra IRS attention? The tax experts are split on this issue. But it’s not worth filing an amended return if you will gain an insignificant amount of money. If you legitimately missed a big-ticket deduction, go ahead and file an amended return as long as you have the proof.
4 rules for handling “the letter”
Despite your best efforts, you still may face a correspondence audit. The opening salvo comes as a “contract letter” informing you that the IRS has selected your return and explaining why. It will also specify the documents needed to resolve the matter. Finally, the letter will give you a window of opportunity to respond-usually 30 days-before it adjusts the contested tax liability in its favor.
Copies of IRS Publication 1, Your Rights as a Taxpayer, and Publication 5, Your Appeal Rights should accompany the contract letter.
Just because you’re being audited doesn’t mean that you will automatically have to pay more tax. Many audited returns result in no change once you explain things to the IRS. In fact, you might even get money back if the IRS determines that you’ve overlooked a deduction or made an incorrect calculation.
Keeping that in mind, here are four ways to emerge unscathed, or at least unbowed, from a correspondence audit:
1. Don’t go it alone. Since this type of audit simply involves an exchange of letters, you may be tempted to handle the matter all by yourself. In a word: don’t. Talk to your tax pro. The issue may involve intricacies that are beyond your understanding. At the very least, it will be helpful to get a tax pro’s take as to whether you can handle the audit yourself. More often than not, the tax savings will be worth it.
2. Keep neatness and organization in mind. For starters, send a copy of the IRS’s contact letter when you respond to the mail audit. That way, the IRS can forward the documents to the right IRS staffer. The worst thing you can do is cram a bunch of papers in an envelope and mail them to the IRS without any references. You want the least amount of “eye time” on your return as possible.
3. Respond as quickly as possible. Even though the IRS typically allows 30 days to respond, don’t wait until the last minute. By returning the documentation promptly, within 10 days is recommended, you can demonstrate your complete cooperation. Tip: Send your letter via certified mail, return receipt requested as proof that you have complied with the deadline.
4. Don’t automatically pay the negligence penalty. If it turns out the IRS is correct, the agency will usually assess you the penalty dating back to the due date. In addition, the IRS may hit you with a 20% negligence penalty based on the tax underpayment.
Strategy: Request a penalty waiver if you believe that you have a good cause for the discrepancy. The IRS can’t waive back taxes and interest, but it does have discretionary power over the negligence penalty. It may cut you some slack if you provide a reasonable explanation for the error. Finally, although a correspondence audit is handled exclusively through the mail, all of the usual taxpayers rights apply. Furthermore, if you don’t agree with the audit results, you can appeal the assessments. Refer to Publications 1 and 5 sent to you by the IRS.

Know your rights before an IRS audit
Congress provides taxpayers with various protections against unruly and unreasonable IRS behavior. Here are a few highlights:
• You can appoint someone to represent you at IRS proceedings. Generally, you can’t be forced to attend yourself.
• An IRS agent must explain your rights before starting the audit process.
• The IRS must abate any part of a penalty or extra tax that is caused by inaccurate written advice it gives. (That’s why its smart to obtain significant answers from the IRS in writing. Don’t count on its telephone hotline responses).
• If you are assessed additional tax after an audit, you have 10 business days to pay before you can be charged additional interest.
• If your refund is disallowed, the IRS must give you an explanation.
• If you win a tax dispute, you can bill the government for legal fees unless the IRS can prove its actions were justified.
• If you go to court to resolve a tax conflict, the burden of proof shifts to the IRS on factual questions. That’s a significant change from the dark days when IRS completely ruled the roost.
• Online Resource: Your taxpayer rights are spelled out in IRS Publication 1, available at www.irs.gov/publications/p1

Source: Research Recommendations

 Caution  Do not adopt any of our recommendations without consulting a tax professional

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