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GETTING PERSONAL: Audit Red Flags As IRS Pursues Rich

The bottom line is that "if you're a millionaire, you're a lot more likely to hear from the IRS than taxpayers in any other income bracket," says agency spokesman Terry Lemons.

Taxpayers who make more than $10 million a year or more have nearly a 10% chance of being audited, he adds.

People with $1 million and up are "clearly are getting more scrutiny," says Benson Goldstein, technical manager at the American Institute of Certified Public Accountants.

TRAC, a research group affiliated with Syracuse University, interpreted agency data to show that the IRS audit rate dropped by at least 19% on the 300,000-plus returns reporting income of more than $1 million between fiscal 2007 and fiscal 2008. The decline reflects IRS "failure to keep its eyes on the ball," TRAC co-director Susan B. Long, also associate professor of managerial statistics at the Martin J. Whitman School of Management at Syracuse University, told Dow Jones Newswires.

That debate aside, a hot audit item now is the mortgage-interest deduction, especially in California and metro areas where houses carry high price tags, according to Claudia Hill, the president of Tax Mam in Cupertino, Calif. Many people refinanced their homes, milking the equity out of them and yet continue to fully deduct the mortgage interest - even when they're not qualified to, she says.

Jimmy Averitt, tax partner in the Dallas office of BDO Seidman LLP, warns that for taxpayers who lost a job last year, a major change in income can trigger a review of the return.

As for all of the new tax legislation, Lemons says those changes won't show up in audits until at least next year.

Otherwise, the standard audit red flags remain. Big business expenses, numerous gifts to charity and reported income that doesn't match numbers shown by employers and brokers on 1099 and W-2 forms are items that invite scrutiny. Schedule C, for business owners, tends to attract attention, as do big write-offs for hobbies like owning horses or Picassos, or, as in the case of Todd Palin, racing snowmobiles.

Generally, there are four main routes to an audit, according to Bryan Camp, a former IRS docket attorney, now a professor at Texas Tech University School of Law and an expert on the taxation of individuals and families.

First, returns are screened by a computer programmed with algorithms known as the Unreported Income Discriminant Function System. It compares deductions, credits and exemptions with a standard for taxpayers in each income bracket. A return with a high DIF score gets picked out and reviewed.

Second, an audit can result if a tipster calls into an IRS service center to report the taxpayer is up to something suspicious. Third, the IRS may decide to audit a return it is already examining for some other reason. And fourth, the agency audits some returns as part of special projects it conducts to drill down on certain tax return issues.

Despite all that, Camp dismisses the idea of a formula for avoiding an audit.

The IRS isn't a person or a thing, he says. Instead, it's a system of processes, a bunch of different departments that all have their own agendas.

"There isn't a genius superbrain who is pulling all the levers of government," says Camp. "That's why conspiracy theorists are out to lunch - they think there's a single person who knows what is going on at the IRS."

(Arden Dale is a Getting Personal columnist who writes about personal finance; she covers topics including tax and estate planning, retirement, investment strategies, and financial needs of small businesses. She can be reached at 201-938-2052 or by email at arden.dale@dowjones.com.)

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