About audits
There are several circumstances that precipitate audits. The most common is a CP2000 letter. Of all possible audits, this is the simplest and easiest to deal with... Read the letter yourself before running to an accountant; all it may be asking is about a computer mismatch between what you have reported and what has been reported to IRS on a Form 1099 issued by banks, credit unions, brokerages, and other institutions that report to the IRS for dividends, and/or interest, that are paid to you. On this letter IRS kindly computes how much you owe, the interest, and maybe penalties for failure to report income.

Several things could have happened to cause the letter to be generated, either you missed something and owe, or the IRS reviewer didn’t read it right or the reporting on the Form 1099 was wrong. Let's say that you combined the totals from several sources on Sch. B, where these things are reported, and the IRS didn’t see a $100 reported on a form 1099 from one of your accounts. Leaping to conclusions, the computer sent out the letter not noticing that the total reported is right.

Anyway, first check it out yourself, and then if you are stumped, call for help. I have been retired from the IRS for more than 15 years and I still get calls from CPA's asking how I think they should handle a particular circumstance on a CP2000 letter. Their calls are mostly about penalties. On this topic you write a whiny letter about how you shouldn’t be penalized, and it wasn't really your fault. It may work.

The CP2000 letter is being used more and more by the IRS as it produces the highest level of revenue for the least cost. That is good business sense but can cause the IRS to miss larger technical errors. This can be to your advantage, while your return sits in a file waiting for your response, it is not in the normal audit review track. But, if your return has enough red flags, you may still be selected for a regular audit. If you filed only an individual return, a basic Form 1040 with attachments, you will be required to take your records to the local IRS office and sit down with an office auditor. This person will have selected certain items to be reviewed.

Here are our suggestions for this situation.

• Schedule your audit for late in the day. Your notice letter will have a time and place but you can call and explain why your meeting is not possible until later.
• Stories I have been told by professional preparers:
  "Try to get a male auditor, they aren't as picky."
  " I like for my clients to pay just a little bit of tax on an audit, that way they know I am getting all I can for them."
  " If it is a female auditor with an Asian name, I automatically ask for another auditor."

Do not go with a bushel basket of records and say "here it is". The last thing you want is to stress the auditor. He/she is just trying to do the job and go home. The office auditor's responsibility is to determine the correct tax, which could mean a refund to you, along with being paid interest. That is taxable and you will get a Form 1099. So be helpful, but do not volunteer any additional information. This means no visiting! That auditor is listening for clues from you for other possible problems with your return. If you have four items selected for audit, get each one organized to present efficiently. If you know that 3 of the 4 are going to be okay, ask to start with them, by the time you get to one that maybe a little sticky, the auditor may decide to let it slide.

If you have a business return or an extraordinarily complex personal return, you will be visited at your place of business by a Revenue Agent. This person is more experienced and assumes that your records will be too voluminous to carry to the IRS office. This type of audit may take days or weeks as the auditor will examine virtually all your records. As an agent, I spent a lot of time at CPA offices, because they preferred that I have as little contact with their client as possible.

Basics of an audit

Know that your return would not be looked at if the IRS didn’t think there was a problem. They do studies to look for patterns of error and compare numbers on your return to that norm. This does not mean that the return is wrong, just that it looks suspicious. Remember, their job is to ensure that the correct tax is paid, whichever way it comes out. But, also remember that they are there to collect tax.

You may have problems with the auditor because some personalities just plain clash. In that case, it is okay to ask for the supervisor, explain the circumstance without emotion and perhaps you can get your audit transferred to another person. If you do not agree with the findings of the auditor, again ask to see the supervisor. In my roll as a supervisor, I spent quite a bit of time interceding between accountant and auditor. That is how the system works. If you still feel strongly about an un-agreed upon issue, resolve the others and ask that an appeals office review the particular issue. This person is independent and has the authority to settle the case. Be sure the dollars are significant enough to justify your protests. You can go all the way to the US Supreme Court if you feel the need and have the bucks to do it.

If there is an auditor or agent actually looking at your return, remember he or she twill be focused on what is wrong from the IRS point of view, but not on what you might have missed. If you find something you have missed, bring it to their attention. If you are right, it will be credited. But that CP2000 letter doesn’t spot such things for you.

I once had a couple come into the office because of a CP2000 letter. I explained the problem, but also noticed they had made a glaring error by significantly over paying just two lines above the questioned item. It would never have been caught if the taxpayers hadn't come in to ask a question. They left the office being owed a substantial refund. The lesson here is, "Know enough to ask a question."

Other tools that allow for tax free exchanges come under Internal Revenue Code Sections 1031 and 1035. In general, they allow you to swap ownership of one like kind of asset for another with out creating a taxable event. A 1035 exchange allows you to exchange one annuity for another tax free, but your basis, essentially what you paid for something with after tax dollars follows the new product. The reason for a change could be that the product you now own may be under performing or you would now like one that pays out a better stream of income. The 1035 exchange could be something you want to investigate, but remember: buyer beware. Someone will get a commission and you may be facing another required holding period. It may or may not be worth it, and it is up to you to know and understand the details.

A 1031 exchange allows for this kind of exchange with real property. It could be equipment for equipment or rental for rental. If you should have a highly appreciated piece of property and you would like to get rid of it, you could exchange it for another that requires less effort and pays better. There are certain limited partnerships that offer ownership in rental complexes that require nothing of you except to deposit your monthly check. These are complex but can work if structured properly. How 1031s can work is best illustrated with an example:

Mom and Dad are getting older and the old homestead, bought by grandpa 100 years ago has a cost basis of almost nothing, or it could be an apartment building that has been depreciated to almost nothing and now is the time to capture a large capital gain. What ever the asset is, if it is too much work, concern or risk, and the family wants to dispose of it, they should do a 1031 exchange. Since it is now highly appreciated in value, selling would be tax expensive, the capital gains and AMT could cut the benefit to the family in half. The solution, if you don't want to hold the property until Mom or Dad dies and the family can benefit from the "stepped up basis", is to look for another like kind investment that would suit family needs and exchange it.

This new property requires less effort, and will eventually be inherited and receive the benefit of the stepped up basis, meaning that the old ranch or apartment building that cost almost nothing years ago and is no longer wanted by any family member, can be 1031ed to a passive investment that can then go to the heirs, not with an original basis, but rather what it is worth on the day the owner died. The heirs could then sell the new property after the death of the owner at the new stepped up value and there would be no tax due. Don't forget Estate Taxes which become another game to plan. See Asset Protection.