In 1994, the Internal Revenue Service examined about 1 percent of all individual income tax returns filed, down from about 5 percent in the mid-1960s. Notwithstanding this downward trend and the resulting small percentage of returns examined, one of the most often-asked questions by taxpayers throughout the United States remains, "What do I do if I’m audited by the IRS?"

    For starters, don’t panic. In most instances, an IRS examination is nothing to fear, provided all income has been reported and accurate records have been kept to support deductions. In most cases, IRS audits are rather routine. About 25 percent of the time, either no charges are assessed or a refund is issued.

    On the other hand, an IRS examination is nothing to take lightly. As with all examinations, you should be well prepared, and, in this case, that preparation begins with keeping receipts and records, followed by careful preparation of your tax return.

    Just as each taxpayer must "play by the rules," so must the IRS and its examiner in conducting an examination. In 1988, Congress, for the first time, codified a "Taxpayer Bill of Rights." Most of these provisions either restate the law as found elsewhere or make into law some of the IRS's administrative practices. These rules and rights are spelled out in IRS Publication 1, "Your Rights as a Taxpayer." (For a free copy, call 800 829-3676.)

    The Taxpayer Bill of Rights addresses the following topics:

1. Declaration of taxpayer rights;
2. Protection of your rights;
3. Privacy and confidentiality;
4. Professional and courteous service;
5. Representation;
6. Payment of only the correct amount of tax;
7. Help from the problem resolution office;
8. Appeals and judicial review; and
9. Relief from certain penalties.

    Examinations And Appeals

    When the IRS examines returns, it is looking for correctness of income, exemptions, credits and deductions. While the odds that your return will be scrutinized are quite low, they can shift substantially upward, depending on your income level and types of income.

    In general, the lower your income, the less likely you are to be subject to an audit. For example, taxpayers reporting less than $25,000 on their 1994 returns faced a less than 1 percent chance of being audited, while the audit rate for self-employed individuals reporting total gross receipts of $100,000 or more that tax year jumped to 3.6 percent. Some of the items or circumstances that can draw the IRS's attention include:

• Reported income in disagreement with information received by the IRS on 1099 and W-2 forms.
• Married taxpayers filing separately. (Many taxpayers do not report items consistently between returns.)
• Returns with significant items that may trigger alternative minimum tax (e.g., high miscellaneous itemized deductions and state/local income and property taxes).
• Taxpayers receiving substantial cash payments in the normal course of business, such as doctors, lawyers, retail establishments and waiters.
• Business expenses or deductions that seem unusually large compared to income level.
• Complex investment or business transactions without clear explanations.
• Total "Schedule C" (business income) gross receipts of $100,000 or more. (A recent study reports the IRS has concluded that individuals filing Schedule C are the most likely group to under-report income.)

    Fairness If You’re Examined

    Most taxpayers' returns are accepted as filed. But if your return is selected for examination, it does not suggest that you are dishonest. No matter what the result — more taxes, a refund or the case simply closed — you are entitled to fair, courteous and considerate treatment at all times. If you ever feel you are not being treated correctly by an IRS employee, you should speak with the employee's supervisor. Really.

    An examination usually begins when you receive notification from the IRS. The IRS will tell you which records it seeks. If you gather the documents before the examination, it can be completed with the least amount of effort.

    The IRS selects returns for examination by several methods. Most audits are initiated by a computer program called the Discriminant Function System, whereby a computer uses historical data to score parts of the return. IRS personnel then screen these scored returns for possible audits.

    Some returns are selected at random. The IRS uses this method to update and improve its selection process.

    Another method of selection involves examining claims for credit or refund and matching information documents, such as forms W-2 and the 1099 series, with information a taxpayer reported.

    A newer selection method involves the concept of Economic Reality Audits in which the IRS gathers information about a taxpayer that is a reflection of the individual's financial status. This method is designed to ascertain whether the taxpayer's reported income is sufficient to support the individual's lifestyle. Areas of inquiry may include standard of living, accumulated wealth, economic history, business environment and potential nontaxable income. The intent is to audit the taxpayer and not just the tax return.

    Arranging The Examination

    Many examinations are handled by mail. These are often referred to as "Correspondence Audits." If the IRS requests a personal interview, you have the right to ask that the examination take place at a reasonable time and at a place that is convenient for both you and the IRS. These types of audits are commonly referred to as "Office Audits."

    If the examination is conducted at an IRS office, its scope may be expanded to cover all questionable items. Although correspondence audits may be resolved more quickly than office audits, there is no rule of thumb for which type is more beneficial to you. However, it is generally to your disadvantage to request that a correspondence audit be changed to an office audit or field audit. (A field audit is one where the examination is held at the taxpayer's place of business.) Inasmuch as correspondence audits are generally limited in scope, you may, during an interview audit, open the opportunity for the examiner to question other items.

    When To Seek Help

    Throughout the examination, you may represent yourself, have someone else accompany you, or, with proper written authorization, have someone represent you in your absence. If you want to consult an attorney, Certified Public Accountant or enrolled agent, the IRS will stop and reschedule the interview.

    Whether you need professional help depends on the issues involved and your ability to represent yourself. If the amounts involved are small, it may not be worth it to pay for an advisor's time. If your return was prepared by a CPA or lawyer, ask if his or her fee included representing you at an audit. If it did not, but you want that representation, you should agree on a fee at the beginning of the process.

    You will certainly want the representation of an accountant or lawyer if (1) the law involved in the audit is unclear or complicated, (2) highly technical supporting information may be required, (3) you think other issues may come up, or (4) you are too nervous or emotionally involved to handle the matter yourself.

    How To Appeal

    IRS examiners are under considerable pressure to close cases by reaching an agreement at the initial examination. An agent is given high marks for explaining the IRS position in a convincing manner. Contrary to popular belief, examiners are not rated by the amount of money they bring in or by the number of cases they close. If you do not agree with the examiner's report, you can meet with the examiner's supervisor to discuss your case further. If you still disagree with the examiner's findings, you have the right to appeal. Information about that option is available in IRS Publication 5, "Appeal Rights and Preparation of Protest for Unagreed Cases."

    In summary, it is very important to understand the audit examination process, rules and your rights when your return is selected for examination. You should know these rights since they affect you and your pocketbook.

    Whatever you do and decide, don’t panic. Like most things in life, the unknown is scary because it is just that, unknown. Take the time to become familiar with the rules and your rights, and, if desired, seek out and select competent professional counsel.

    Clifford Schechter is a personal financial counseling manager in the San Diego office of Ernst & Young LLP.