The arrival of a letter from the Internal Revenue Service generally incites one of three reactions.

The first is the one that the IRS hopes for. The recipient reads it calmly, understands it, discusses it with his or her tax adviser if necessary, and makes a timely, appropriate response.

The second reaction is, really, no reaction at all. The recipient may be deeply in financial denial, so the letter simply sits unanswered, probably along with other tax notices and unpaid bills. Or the recipient may have been in battle with the tax authorities for so long that he becomes blasé and loses his fear of authority.

The third, and probably most common, is to go wobbly in the knees and become mildly (or severely) paranoid. No matter how carefully worded the letter, no matter how trivial the issue, these folks start to believe this notice is just the beginning—that someone at the IRS has looked at their entire tax and financial history, and will be auditing every tax return they have ever filed.

The Jungian Anxiety Closet

I see two reasons why so few people have the first response, and so many the second and third ones. To start, IRS letters and notices are trying to explain technical matters of tax compliance to non-technical readers. They try to use plain, jargon-free language; however, their ability to simplify is limited by concerns of being misunderstood and legally-mandated disclosures. I struggle with the problem, too, and I have the advantage of dealing one-on-one both with people I know, and with people who are better educated and more articulate than the average American.

The other reason is that all purpose, all-American emotion: guilt. Even the most scrupulously honest taxpayer has a deep-seated fear that he has done something wrong, somewhere, some time, maybe even by accident, but that he will someday be punished for it nevertheless. Your first-grade teacher probably threatened you by saying, “That will go on your permanent record card.” And while they may intellectually know better, many people have a visceral feeling that someplace in the bowels of the IRS is a gigantic file full of taxpayers’ permanent record cards. It’s a great image, but just not true.

According to the IRS’s own statistics, they received just over 130 million individual income tax returns during 2003 (the most recent year for which full statistics have been published). At one card per taxpayer, those permanent record cards would literally stack to the stratosphere: about 73,000 feet.

The same quantity of metaphorical cards—computer data records—is equally unlikely. Supercomputers may exist that can digest all the lines of data on that many tax returns each year, and compare them line-by-line over an extended period of years. The Pentagon or CIA might have those supercomputers; the IRS does not. From talking with IRS personnel, I gather that they must still toggle among several different, non-integrated software systems to address different aspects of most problems. Wal-Mart’s systems are probably more sophisticated and better integrated.

So when that letter comes, it’s about one situation, not everything you’ve done in your lifetime.

It’s Nothing Personal

That said, something you innocently did (or failed to do) probably triggered that correspondence. The letters and notices the IRS sends out are almost all forms automatically spit out by computers when data match certain criteria. The only time a person gets involved is when you respond, and even then all he may do is open the envelope and deposit your check.

The most common notices arrive if you filed your return late, or paid your taxes late, or have not yet fully paid them. They set out the penalty and interest you owe. The only response required is a payment.

The next group involves differences between what’s on the forms you filed and what’s in the IRS’s records. One type compares the payments (withholding, quarterly estimates, carryover from the prior year) and rudely announces that you owe money or will be getting a smaller refund. The other typical one is more complex and is at least gracious enough to ask, “Is this correct?” It involves their comparing the W-2s, 1099s and other third-party documents the IRS receives with the data in your tax forms. Either one requires a bit of research on your part. Misposted tax payments are the most common error the IRS makes, and the matching program can suffer from inaccurate reporting by payers.

The Gut Clenchers

The only notices you might get from the IRS that are manually generated are those few announcing an audit of your tax return. Using a type of statistical analysis, the computers create a list of tax returns which are potentially worthwhile audit targets. The formulas are secret, and it is hard to infer what is involved. For example, self employed persons are audited at a higher-than-average rate. So are high-income taxpayers, and so are doctors. If a rich, self-employed doctor gets audited, there’s no way of knowing what is cause and what is coincidence.

An actual person, though, must review that list of potential audits and whittle it down. The IRS simply does not have the resources to do many audits. IRS Commissioner Mark Everson’s recent statement to the Senate Finance Committee appropriately highlighted an increase in audit and enforcement activity in the two years since he took office. But the audit rate is still way down from what it once was. In 2004, the IRS received 60 million more tax returns of all sorts (not just income taxes but also gift, estate, payroll and excise taxes) than in 1981, a 36 percent increase. The number of revenue agents available to do audits decreased 10 percent in that time, from 13,492 to 12,255.

Some people see these low audit rates as an open invitation to... er... get creative in their tax reporting; so much so that the IRS recently felt the need to amend its ethical rules. Tax practitioners are now expressly forbidden from citing the unlikelihood of being audited when recommending strategies. Of course, average rates are just that, averages. Fudging the data enough to make a significant tax difference should make a tax return stand out in that statistical analysis,

And if your visceral response is, “Oh my God, I’m going to prison!”—well, relax. You’ve got to be mighty bad, or highly visible, or both, for that to be a significant risk. Across the entire country, the IRS referred a whopping 3,037 cases for prosecution in 2003, and secured a mere 2,489 convictions.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.

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