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When a Tax Audit Isn't an Audit, and Why You Should Care

Sandra Block

You've probably heard that the odds of being audited by the IRS are about the same as being struck by lightning. While holding a winning Powerball ticket. On your birthday.

Internal Revenue Service building in Washington, DC
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Technically, that may be true. In 2010, the IRS audited 1.0 percent of taxpayers. For middle-income taxpayers, the percentage was even lower. Only 0.6 percent with adjusted gross income of $25,000 to $75,000 were audited, according to the IRS.

But traditional audits are just one way the IRS enforces the tax laws. Increasingly, the IRS is relying on what IRS Taxpayer Advocate Nina Olson calls "unreal" audits. These typically come in the form of a letter alerting you to errors or omissions on your return. While these audits are less intrusive than full-scale audits, they can still cost you real money.

In 2010, more than 9.2 million individual taxpayers were subjected to "unreal" audits, according to an analysis by the Taxpayer Advocate Service. When combined with full-scale examinations, that boosts the percentage of individual taxpayers audited to 7.4 percent.

Moreover, while real audits tend to target the wealthy, the majority of individuals who are subject to unreal audits are low- or middle-income taxpayers, Olson says.

Unreal audits fall into three categories:

Automated Underreporter (AUR). Income on a taxpayer's return doesn't match income reported to the IRS by third parties, such as financial institutions and employers.

Math error notices. These inform the taxpayer that the IRS has corrected mathematical or inconsistent entries on his or her tax return.

Automated Substitute for Returns. These are typically sent to taxpayers who didn't file a return. The IRS uses information from third parties to create a return and calculate how much the taxpayer owes.

What to do

Typically, these IRS notices include a bill for unpaid taxes, which means you should never ignore them, says Edward Karl, vice president-taxation for the American Institute of Certified Public Accountants. But you shouldn't automatically assume the IRS is right, either, he says.

For example, incorrect information provided to the IRS by your bank or other financial institution could trigger an AUR, says Benson Goldstein, senior technical manager for the AICPA.

Likewise, a substitute return may not include all of the deductions and credits you're entitled to receive, Karl says. For example, a substitute return will typically use the standard deduction, even if the taxpayer has a mortgage.

You should file a return even if it won't give you a better outcome than the one provided by the IRS, Goldstein says. Once you file, the IRS has 10 years to collect unpaid taxes, he says. If you don't file your return, the IRS will be able to pursue you indefinitely, even if it files a return on your behalf.

Fighting an unreal audit requires perseverance, Olson says. Be prepared to provide documents supporting your case, and plan to spend a lot of time on the phone, she says. If you're unable to resolve the issue, contact the IRS Taxpayer Advocate Service at www.taxpayeradvocate.irs.gov.

Avoiding trouble

How to avoid a notice from the IRS:

Check Social Security numbers. If you provide an incorrect Social Security number for a dependent — or fail to provide one at all — the IRS will disallow the exemption.

In tax year 2009, nearly 300,000 tax returns contained incorrect identification numbers for dependents, according to the Taxpayer Advocate's Office.

Don't ignore third-party errors. If you receive a tax form with incorrect information from a financial institution or other third party, try to get it fixed before you file your taxes. If that's not possible, report the amount on your tax return and make an adjustment to correct the error. Most tax software programs provide a way to explain the discrepancy.

This story first appeared in USA Today.