MONEY CAVEAT TAXPAYER

Back in October, I got the longest, newsiest letter I had ever re- ceived. Unfortunate- lv. it was from the Internal Revenue Service Eight sin- gle-spaced pages no- tified my husband and me that we were being audited for 1986. The tone of the letter was an unsettling combination of federal clout and folksy reassurance:

We find that the vast majority of taxpayers are honest and have nothing to fear from an examination of their lax returns. An examination of such a taxpayer’s return does not suggest a suspicion of dishonesty or criminal liability. In many cases, no change is made to the tax liability reported, or the taxpayer receives a refund.

Yeah. okay. But it should be noted hen that in 88 percent of the audits, there is some change to the taxpayers’ liability, which usually means they are levied additional taxes and penalties. In 1987, for instance. the IRS audited 1.3 million returns, which resulted in an additional haul of $19.6 billion for the government. Makes you feel downright patriotic, doesn’t it?

While it is true that many income tax forms are selected at random for audits, there are a number of “red flags” that pique federal curiosity. People with incomes above $50,000 are more likely to be audited than those with more modest salaries. If you claim deductions for an office in your home, or deduct your car mileage for business use, you’re also an audit target. High-dollar amounts of business deductions for meals are typically scrutinized, since these are the items taxpayers are least likely to document. Tax shelters and unusual investments are immediately suspect: in 1987, IRS investigators examined more than 150,000 returns :hat included tax shelter issues, and recom-nended additional taxes and penalties of $3.3 billion.

We also found out-the hard way-that a ax return can be “kicked out” of the system if the taxpayers’ deductions indicate they night be living beyond their means. That was definitely our situation in 1986. I had quit a fairly lucrative fulltime job to start my own business as a freelance writer/producer. Our income had taken quite a nosedive that -year, and Uncle Sam probably wanted an explanation.

Robert (the man with whom I file jointly) has long teased me for keeping such meticulous records, and after the initial shock wore off, I was honestly excited at the prospect of finally showing them to someone. “Look at this mileage log!” 1 exclaimed as we tore through the garage piecing together our 1986 files. “I dare them to challenge this! It’s beautiful! It’s perfect!”

We were both convinced the audit would be a breeze. We’d go in with our mountain of paperwork, convincing the auditor immediately of our sincerity and honesty. We’d whip out a few files, explain our 1986 employment changes, and leave unscathed. After all, we hadn’t done anything wrong. Had we?

Alas, we emerged from our first full day in the auditor’s office frustrated and confused. Dolores was a pleasant young woman in her thirties, chatty and even somewhat sympathetic. But our patience and optimism had been worn thin by hours of questions: do you hide any money in your house? How much money do you spend each month on groceries? Where did you go to college, and for how long?”

“What does all of this have to do with our income taxes?” I asked. “Level with us-why are we here?”

“Well.” said Dolores, “our records show that you seem to have spent more than you made in 1986.” (She later denied making the statement, but it will stick in my memory forever, primarily because of my abrupt response: “Welcome to America, lady. It’s called living on credit.”)

Together, we pored over our paperwork for hours. We had a couple of small victories-the auditor declared my car mileage log “the best she had ever seen.” But for the most part, the documentation Dolores required was more exhaustive than anything we could have imagined. She not only wanted to see credit card receipts, she wanted the corresponding check stubs from restaurants and vouchers from hotels. We had totaled our business phone calls each month, but she wanted to know who we called and why. (The Tax Code says you are required to produce “adequate documentation” to support your deductions; apparently, the definition of “adequate” is subject to the whims of the individual auditor)

In our case, the explanations we had assumed were logical and reasonable seemed woefully inadequate. We were on the defensive. At the end of the second day of the audit, we lurched out of the office and hired an accountant.

We liked Mike Moore right away, It’s probably much the same feeling that condemned convicts have for the chaplains who visit them in their lonely cells. The license plate on Mike’s car reads “MBA-CPA.’ He calls taxpayers “TPs” and refers to the IRS as “The Service.’” At any other time we might have thought him a bit cocky, but under the circumstances we found him comforting.

“Your first mistake,” he declared, “was going in without me.” Mike explained that most people’s taxes are surprisingly complicated when it comes to actually justifying every item. For instance, we have rental property, Robert’s expenses as a salesman, interest deductions, stock sales, and my self-employment to account for.

“Think of it this way,” he said. “Your deductions are probably more than the auditor’s annual salary. So she’s likely to go after you. There are a lot of gray areas in reporting and documenting those kinds of expenses, and it’s almost impossible to defend yourselves without some knowledge of the Tax Code.”

Indeed, Dolores had already asked for all of our canceled checks, bank statements, and savings account summaries for 1986. We spent many hours locating them, and additional hours going over the same points we thought we had already covered.

We were vocal about our impatience. We had three bank accounts that year, and after much digging and photocopying and squinting at old bank microfilms, I located thirty-four of the thirty-six months of bank statements and canceled checks. “Where are the other two?” asked Dolores.

“You’re the IRS,” I snapped. “If you need ’em that badly, go find ’em yourself.” My husband grimaced.

Soon, it was Robert on the hot seat, Dolores pulled out a copy of his 1986 W-2 form and informed us that the box labeled “Wages, Tips, and Other Compensation” did not include a $3,300 car allowance he had been paid by his company. Sure enough, the figure was written in another, smaller box on the form. We just didn’t realize it had not been added into the grand total.

“Is that our fault?” I asked. “Why don’t you penalize the company for not filling out the form correctly?”

“On your pay stubs each month, you should have been able to keep track of how much you made,” Dolores countered.

“Yes, but I don’t know anyone who adds up all his pay stubs at the end of the year to see if the amount exactly agrees with the figure on his W-2 form,” said Robert.

Luckily, the IRS distinguishes between simple miscalculation (charging penalty and interest) and outright income tax evasion (penalty, interest, and prison sentence!). Still, there was no way around it. We had made $3,300 more than we declared in 1986. And there was more trouble ahead.

As a sales manager, Robert declared thousands of dollars in expenses and had written off 95 percent of his car mileage. He did not keep a mileage log, but he did have several months of daily sales records showing where he went and who he called on.

It was time to try negotiating. “What if,” Robert ventured, “I drop the figure to 75 percent and give you three months of daily records? Can the three months be representative of what happened the rest of the year?”

Dolores did not budge. “If you give me three months’ worth of records, you can only deduct three months’ worth of expenses,” she said. Actually, this kind of negotiation goes on in many audits. While the auditor has limited negotiating power, a supervisor can approve a compromise. We simply got stuck with an auditor who refused to do it. In retrospect, we should have asked for a supervisor to sit in on the audit sessions.

It was Mike’s first chance to see our tense interaction with the woman. He was not pleased, but also not surprised. He suggested that we fight back with figures instead of arguments.

“You talk too much,” he told me. “The more you explain things and try to prove your honesty, me more ammo you arc giving her to question other items on your return.

“You have already given her way too much documentation. For instance, you should never have handed over all your bank statements. You should have demanded a better explanation of why she needed them.”

It had never occurred to us that we were in a position to make demands. Like people who defend themselves in court, we were victims of our own unfamiliarity with the rules and protocol. If we had options, we didn’t know enough to exercise them.

Mike looked at our 1986 tax return and found several areas in which we had not taken deductions. He prepared an amended return, hoping that any additional refund might cancel out a penally that we now assumed would be levied, sooner or later. Mike also suggested we try changing auditors, under the guise of moving our audit site to another IRS location more convenient to his office.

Then we got another friendly letter in the mail. It said we were also being audited for our 1987 return.

I was furious. ” Why are they doing this to us?” I shouted into the phone at Mike.

“Because they’re The Service,” he said. “Because they can.”

It is important to note here that another good reason to hire an accountant is that it gives you, the TP, someone to rage at instead of the auditor. As Mike put it, “My feelings can’t be hurt. You can’t insult me. You can’t intimidate me.” In short, he brought a certain calm objectivity to the table in addition to tax expertise.

Not surprisingly, Mike fared better with the auditor than we did. I wish I could report the outcome, but at this writing, our audit isn’t over yet.

In the meantime, I gave Robert a mileage log book for Christmas, which he fills out dutifully. We also bought a telephone log book, in which we jot down every business call. Our kitchen drawers are no longer littered with receipts-instead, all of our receipts are tucked into envelopes and totaled every month.

We still have no inkling what our additional taxes and penalties will be. but whatever the “mystery amount,” it has been accruing interest for some time now. The IRS interest rate is tied, more or less, to the Treasury Bill rates in the years in question. It is reevaluated every quarter, and has fluctuated in the past five years from a high of 13 percent (in early 1985) to a low of 9 percent (in late 1986). In addition, there is a penalty for underpayment plus charged interest based on the unpaid taxes: currently, it is 10 percent. (Ironically, if you overpaid the IRS and are due a refund, you only receive 9 percent interest!) And the interest is compounded daily, even during your audit.

If you’re socked with a sizable penalty, it is probably to your advantage to pay it all at once, even if you have to take out a loan. In fact, you are expected to pay your tax bill on the spot, unless you can prove that you cannot afford to do so and must have more time. This requires filling out forms, not unlike home mortgage applications, that give the IRS even more information about your life, debts, income, etc. It’s less taxing (pardon the pun) to deal with a bank or finance company. The IRS is evaluating the possibility of allowing taxpayers to use credit cards to pay their taxes, but the plan has not yet been approved by Congress.

One of these days, we will be asked to sign a form that says we agree with the findings of the auditor. We won’t have to sign it on the spot.. .we can take it home, think it over, and decide whether to appeal the decision. Instead of looking forward to that day, we are really dreading it.

If we don’t agree, the next step is Problem Resolution. It is the IRS’s in-house mediation service, where special circumstances and exceptions are weighed on a case-by-case basis. Most taxpayers’ problems can be cleared up in Problem Resolution, but if yours is a real stickler, you can petition to be heard in Tax Court. A CPA cannot represent you in Tax Court, but you can represent yourself, with a CPA serving as your “assistant.” At this point, you can also hire a tax attorney, which would be most helpful if you are try ing to challenge the IRS interpretation of particular tax laws. I can’t imagine it will go that far in our case, but by now, nothing surprises me.

I suppose we are wiser now. and we probably know a lot more about ourselves as well as our taxes since the audit. But somehow it is a sad feeling. I know that every time I write that quarterly self-employment tax check, or read something about the IRS in the newspaper, the resentment will knot in my stomach. In a way, the system has beaten a little of the citizenship out of me. Maybe this disillusionment is just part of growing up. But I think it is something far worse.