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How to prepare for a tax audit

It's no secret that the IRS is ramping up the number of audits in an attempt to close the "tax gap." That's the term the IRS is using to account for the difference between the taxes it believes it should have collected and what it actually managed to collect. For 2001 (the last year for which data is available), the tax gap was $345 billion.

Audits can be divided into two general categories: paper audits and people audits.

Paper Audits.
If the IRS thinks you made a minor mistake, it will send you a notice advising you it has recalculated your tax. It may even ask you to send additional documentation to back up claims that you may have made. Generally, this involves simple human error on your part: bad math, not properly reporting dividend and interest income or transposed Social Security numbers.

If you receive a letter from the IRS, don't panic. Open the letter. See what it's asking for. In most cases, you can straighten it out without much difficulty; if you're not sure, you're better off consulting with a tax attorney.

Paper requests or requests for more information rarely lead to full blown audits. Your best bet is to simply respond to the notice and send the requested documentation.

People Audits.
Sometimes, however, the IRS will conduct an in person audit at your home or place of business. Audits are rarely random and are generally triggered by something out of the ordinary on your return.

In most cases, the IRS will send you a notice saying it needs you to call and set up an appointment for the agency to come to your home or place of business. Once the appointment is set, the agent handling your case will send you a letter advising you what documents they will need at review. You should be aware that this list is not exhaustive and more information may be requested at the time of audit, or afterward.

Don't ignore the IRS. It makes them irritated, it makes you look uncooperative, and it doesn't make anything go away. I can't stress that last bit enough: Ignoring phone calls and letters isn't going to make the IRS turn and walk away. In fact, usually just the opposite will happen.

If, at any time, you don't understand what the agent is asking for, or if you're concerned about the potential consequences, call your tax professional or tax attorney.

Prior to the audit, you'll want to assemble all the information the agent is requesting. I highly suggest organizing the documents by year and by type of record (meaning, all your receipts for charity in one folder, etc.).

In math class, you learned to "show your work." I highly recommend doing this in advance of the audit. Have your tax professional put together tables showing total deposits, checks written, etc., which should correspond to entries on your tax return. Being organized ahead of time makes responding to questions much easier.

If you notice that you're missing documents, such as a bank statement or credit card receipt, take the time to find them. If you can't find them, call your bank or credit card company and order extra copies. There may be a charge for this -- but it's worth it. You don't want to show up at an audit with half of your documentation.

On the day of audit, be prepared for the idea that this could take awhile. Don't plan any other meetings or appointments on that day. Shut off the phone. Make yourself available to the agent to answer questions, or better yet, make your tax professional available to the agent. While it's true that you might know what to say, you might not know what not to say -- sometimes, too much information isn't a good thing. A tax professional will likely be able to handle your in-person audit much better than you can because they've done this sort of thing before (hopefully, you haven't).

So, if you get a notice from the IRS about a potential audit, take deep breaths and pick up the phone. You can survive an audit. I did.

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