Red flags that tempt the tax auditor

By Kay Bell

It is the most dreaded letter a taxpayer can receive.

"Dear Taxpayer,

Some of the information that you provided to us does not agree with the information we received from other sources.

-- The Internal Revenue Service"

You've just joined an elite club, one whose initiation ritual is an IRS audit. Unfortunately, you can't refuse membership -- and the dues could be astronomical.

When the IRS Restructuring and Reform Act was enacted in 1998, lawmakers ordered the agency to focus more on taxpayer rights instead of collection activities. Not surprisingly, the number of audits -- or examinations, as the agency prefers to call them -- dropped dramatically.

The first year of the kinder, gentler IRS, about one of every 79 tax returns was audited. By 2003, it was even easier for tax scofflaws; that year, according to IRS data, only one of every 150 individual taxpayers was audited.

But the tax times, they are a-changing.

More audit attention

IRS Commissioner Doug Shulman says he wants to balance his agency's enforcement and service responsibilities. To that end, he has announced programs designed to take into consideration the financial struggles that many taxpayers are encountering in today's economy.

But balance doesn't mean taxpayers are off the hook. Facing pressure from a Congress dealing with a growing federal deficit, the IRS has made it clear it takes the enforcement portion of its job seriously.

Audits have been increasing, although the pace was slow in fiscal year 2010. According to the IRS' 2010 annual data book, individual taxpayer audits last year were up slightly, just more than 1 percent. Of that number, says the IRS, individual income tax returns reporting higher adjusted gross incomes were more likely to be examined.

But the rich aren't the only targets. Recent tax law changes, particularly when it comes to confusing tax breaks such as the first-time homebuyer credit, always prompt closer looks at returns. And if you're a small-business person, either as a partnership or a Schedule C filer reporting self-employment income on your personal tax return, make sure you take extra care with your returns.

And those with lower incomes that make them eligible for the complicated earned income tax credit also face added scrutiny. Last year, nearly 30 percent of audited returns claimed this tax credit.