Update on my audit

It's been over five weeks since I sent exactly what I was told to send to respond to the NYS Tax Audit challenging our right to claim our 20-year-old college student daughter on our 2006 tax return.

Here's the tracking information from the Post Office, showing it was delivered on February 4.

Service Type: First-Class Certified Mail

Shipment Activity Location Date & Time
----------------------------------------------------------------------------
Delivered BINGHAMTON NY 13902 02/04/10 12:33pm

Arrival at Unit BINGHAMTON NY 13902 02/04/10 8:48am

Acceptance SCHENECTADY NY 12309 02/02/10 10:12am

The ball has been in their court for five weeks.

No word yet.

To see the complete saga of posts on my audit thus far, click here.

Update on the audit

I went to the Post Office yesterday to mail off the documentation requested by NYS Tax Department "Audit Group 3" telephone representative.

Basically, she said that I all I needed to do was to explain that we'd declined to claim our older daughter on the federal form in order to allow her to get the education credit and to provide the name and Social Security number of our daughter, so the tax department could look up her tax return and see that she hadn't claimed her own exemption on her return. (Why the NY tax form didn't give any opportunity to provide this information right on the original tax return in the first place is not clear. The federal Form 1040 requires listing the names and SSNs of all dependents claimed on the return, but the NY tax return did not and still does not provide any place to do that.)

It's also unclear to me why the Audit Group 3 phone representative could not just take that minimal information directly over the phone from me, especially since the wording of the audit notice letter had suggested it was possible for taxpayers to resolve matters over the phone, and this matter does look extremely straightforward.

(It's possible that their idea of "resolving matters over the phone" means getting the taxpayer to agree that the NYS Tax and Finance Department is correct and pay the assessed amount by credit card over the phone! Perhaps the only people who need to respond by mail are those who don't agree with the bill enclosed with the audit notice. It's likely that they hope many taxpayers will take the path of least resistance and just surrender and concede the bill, even if it's not correct. The National Taxpayer Advocate's reports have pointed out that many low income taxpayers--who are far more likely to be audited than the average American--do exactly that.)

But...whatever....off I trotted to the Post Office to mail off the form with an attached letter of explanation providing the information required. I sent it Certified Mail ($3.24) and set up email notification, so I'll know when it arrived. There's a good chance it will arrive today (2/3/2010), which is somewhat strange to contemplate, since the audit notice letter itself was dated 2/4/2010.

More reflections on phone information

Although I'm not a big fan of phone calls, I did want to call to make sure I was sending exactly the right documents that would be required to resolve our correspondence audit. And I also wanted to get some insights into how much difficulty a low-income taxpayer might have in navigating the phone interface of the NYS Tax Department.

Upon further investigation and reflection after my experiences this morning, the phone information provided in the audit letter was definitely NOT as helpful as it could have been.

1) Page 7 of our audit letter stated that "If you prefer to resolve your disagreement by phone, call the toll free Personal Income Tax Customer Service Center number given on the enclosed Notice of Taxpayer Rights."

However, the only actual toll free number given on the "enclosed Notice of Taxpayer Rights" is 1-800-462-8100. A taxpayer who attempts to follow the advice given on page 7 will only waste more costly cell phone minutes (toll free doesn't mean free if you're calling from the kind of cell phone plan most of our low income clients have!) only to learn he's reached the number for ordering forms, certainly not the number for resolving an audit disagreement by phone.

2) There is also a NON toll free number given on the above-referenced page: 518-485-6800, but since the toll free version originally pointed out explicitly as the place to call to resolve problems hadn't worked, I assumed that the corresponding toll version wouldn't work either. (I later called the number and it appears that in fact the toll version WOULD have worked! So if only page 7 had pointed the taxpayer to the toll version initially, he might have reached someone who could help him.)

3) Anyway, instead I called the number given on page 8 of the tax audit notice enclosure, the one labelled "If you have questions regarding this notice, call 518-457-5434. That was a number that should have been answered starting at 8 a.m., according to the NY Tax Department website, but as I indicated earlier, when I called at 8:20 a.m., the recording just informed me that the office was closed and I should call back during "normal hours," without actually telling me what those hours were!

These may all seem like minor petty details, but the cost of calling several incorrect numbers or at several incorrect times adds up for the millions of New York taxpayers who have to deal with complying with our tax code.

In our case the audit issue was clear and straightforward, but for a taxpayer with a more complicated issue, and perhaps with only a limited number of minutes left on his phone plan and no money to buy more, these kinds of issues DO add additional stress!

And, the fact is that if our tax code (both federal and state) were simpler, taxpayers would not need to be wasting nearly as much of their time AND of government employee time AND running up phone bills on both ends dealing with all these bed buffaloes in our tax code.

It's not the fault of the NYS Tax Department that the tax code is so complicated, but the audit letter could at least avoid wasting taxpayer time and cell phone minutes by clearly directing taxpayers to the correct phone number to call and the correct time to call those phone numbers. Those misdirected phone calls that come in at the wrong time or to the wrong number run up the state's phone bill as well.

Phone log with the NYS tax department dealing with the audit

According to the NYS Tax website, taxpayers can call them weekdays between 8 a.m. and 5 p.m.

Here's my phone log.

8:20 a.m. Monday Feb 1

I called the phone number listed in my audit notice, which is the main number for billing, payments, and information, 518-457-5434.

I immediately connected to a voice menu, listened to the options, punched in 1 for "Personal income taxes," and then was invited to punch in my Social Security number, which I did. As soon as I punched in my SSN, a recorded voice message repeated my SSN back and asked me to press 1 to confirm it, which I did.

It then played the following message:

"The office is currently closed. Please call back during normal hours."

The message did not give any information as to what the supposedly "normal hours" are. The website says 8 to 5 on weekdays. It's 8:20 on a Monday.

Anyway, if I was calling outside the supposedly normal hours, why didn't the voice menu tell me that before inviting me to punch in information. If I'd been a low-income taxpayer worried about using up cell phone minutes, I would not be very pleased about this.

I'll keep trying.

8:32 a.m Called again. Went through the punching SSN, reading back and confirmation steps. This time I was quickly transferred to a very nice representative who gave his name as Steve, if I recall correctly. I explained that I wanted to explain the circumstances to disagree with the audit notice I had received. He asked again for my SSN, along with my name, address, home phone, and employer's names. I believe the reason for asking all this information was to confirm my identity before disclosing any sensitive information.

After I provided satisfactory answers to those inquiries, Steve politely but firmly stated that we owed New York State $84.08 and that we should pay that amount before February 25 to avoid additional interest and penalties.

When I reiterated that we wanted to explain the information we needed to provide to disagree with the bill, he said he would need to transfer my call to another department ("Audit Group 3") in order to get the information about the documents required to do that. He also helpfully gave me the direct number for Audit Group 3 in case I got disconnected and once again very politely but firmly advised that we should pay the bill by February 25 to avoid additional interest and penalty.

(This information repeatedly provided by Steve is very important for many taxpayers, who may be uncertain about whether their position is correct. If I were less than 100% confident that the position we took on our return was correct, I would consider following his advice to pay the amount in question before February 25 to stop the clock on the interest and penalties. If I later turned out to be correct, I could still file to get a refund of that amount, possibly with some interest. If I turned out to be incorrect, however, following Steve's admonition would have saved me interest, which is currently running at 7.5%, as well as possible penalties.)

8:38 a.m After Steve transferred me to the line for Audit Group 3, a recorded voice asked me to punch in my SSN yet another time, followed by a request to punch in my zip code. The recorded voice then informed me that all lines were busy, but predicted a wait time of approximately 7 minutes. So I waited on hold, listening to reasonably soothing if somewhat repetitive music, periodically interrupted by messages telling me that my call was important to them and encouraging me to consult the website for additional information.

8:54 a.m. After 14 minutes on hold, I reached a very helpful and efficient telephone rep who did not give her name. She again requested my SSN and my name and then told me we owed $84.08 on our 2006 New York taxes.

When I explained that we disagreed with the bill and explained our reasons, she listened and provided clear information about what we would need to do. We simply need to attach a letter to the audit notice disagreement form providing our daughter's name and SSN and stating that we had been entitled to claim her on our 2006 federal tax return but had chosen not to do so in order to allow her to get the education credit on her federal return. Once they get that information, they will be able to look up the information they have on our daughter's federal and state returns and confirm that our information is consistent with those returns.

I had hoped that perhaps she could just take the information about our daughter's name and SSN over the phone, but apparently not. I guess that it's understandable that they want to keep telephone calls short, to avoid making hold times even longer for other taxpayers, so I will go off to the Post Office later today and mail the letter via certified mail.

Although she did not tell me to do so, I will take special care to use the return envelope provided in the audit notice, since I understand that the window in the envelope will allow a barcode to show through to the outside that will expedite processing once it reaches the NYS Tax and Finance Department.

End of phone call: 8:56.

Total elapsed time for the phone call: 24 minutes, including 14 minutes on hold, four minutes talking to Steve, two minutes talking to the Audit Group 3 employee, and four minutes dealing with listening to voice menus and punching in numbers.

Plus an additional minute or so wasted on the 8:20 attempted phone call, where I was invited to punch in my SSN and confirm it before being told the office was closed and to call back during the unspecified "normal hours," and waiting another 10 minutes to call back after making the apparently correct guess that maybe 8:30 was the beginning of "normal hours."

It was a local call for me and we have unlimited local calling from our landline, so no phone charges for us. However, many low-income taxpayers have calling plans which might make those minutes a costly expense.

Still, all in all, it was not nearly as bad as I expected, especially since I imagine Monday morning right after W-2s come out must be a peak calling time for the tax department.

Bed buffaloes in our tax audit

Here are the bed buffaloes that led to our audit:



Bed buffalo #1: New York State tax law does not allow the same number of deductions for exemptions as federal tax law.

While taxpayers are allowed to claim deductions for both personal exemptions and dependent exemptions on their federal tax return, the State of New York now only permits taxpayers to claim deductions for dependent exemptions. (Apparently, there was some distant time in the past, prior to 1988, when New Yorkers could claim personal exemptions for themselves as well as dependent exemptions for their dependents, just as they do on their federal returns, but no more. I can't for the life of me understand why the NYS Legislature decided to create trouble and confusion for taxpayers by deciding to change the definition of allowed exemptions back in 1988 so that it no longer aligned with the federal definition, but I guess we are stuck with that bed buffalo. Changing it back to conform with the federal definition would likely only cause more confusion at a time when state tax administration resources are already stretched thin! And our state legislature is even more notoriously dysfunctional now than in the past. In any case, we only moved to New York in 1989, and so our family has always known we could only claim our dependents as exemptions on our NYS returns.)

The NYS Tax Department folk are very aware that this is confusing for some folks, and every year they highlight this distinction, both on the tax form and in the accompanying instructions.

This is understandably confusing for many New York taxpayers and errors are quite common, especially for taxpayers who do their returns by hand. It's quite understandable that many taxpayers might reason: "I claimed four exemptions on my federal return and so I get to claim four exemptions on my state return," even though the New York instructions say otherwise. (This is not too surprising--life is short and the tax instruction manuals are long, and only tax policy wonks like me actually think they make interesting reading! Actually, I don't find the instructions especially interesting reading, but I do feel compelled to read them, since I want to keep my family AND our VITA taxpayers out of tax trouble!)

Bottom line: So the maximum number of exemptions we were eligible to claim on our 2006 federal return was four (two personal exemptions for my husband and myself and two dependent exemptions for our daughters.) The maximum number of exemptions we could claim on our 2006 state return was only two (just for our two daughters--none were allowed for ourselves.

We did not exceed those limits. So why does New York think we made a mistake in claiming our two daughters on our New York return?

Read on more for more bed buffaloes.



Bed Buffalo #2: Federal tax law provides that parents may decline to claim a dependent child on their federal tax return in order to allow that child to claim education credits on their own federal return.

We had done exactly that. Our income was too high to claim the education credits on our federal return, so by declining to claim our older daughter on our federal return, we enabled her to claim the education credit on her federal return. We did lose the value of her dependency exemption on our return, but due to dependent exemption phaseout provisions in the tax code (another bed buffalo in the tax code I won't go into here), that exemption wasn't actually worth all that much money to us.

Discussing this strategy gives me an opportunity to comment on a tangentially related bed buffalo that can gore the unwary.



Bed Buffalo #3: Declining to claim dependents that you could have claimed on your return does NOT, under current tax law, allow those dependents to claim their own personal exemptions on their returns!

A taxpayer who CAN be claimed by another taxpayer as a dependent may NOT claim a personal exemption for herself, even if that taxpayer entitled to claim her declines to claim her.

I knew that, of course, so I made sure to keep my daughter from being gored by that particular bed buffalo, but many people do not realize this.

Okay, enough on that side note, our family successfully dodged that bed buffalo. Back to the consequences for our New York return.

Yet another bed buffalo!



Bed Buffalo #4: Even though we had chosen not to claim our daughter on our federal return, New York State still allowed us to claim her on our NYS tax return.

I remember discovering this particular bed buffalo back in 2006, finding it somewhat surprising at the time. I had initially assumed that choosing not to claim her on our federal return would preclude claiming her on our state return, but page 94 of the 2006 NY Income Tax Instructions reads:

If you were entitled to claim a dependent on your federal return but chose not to in order to allow your dependent to claim the federal education credit on his or her federal tax return, you may still claim him or her as a dependent on your New York return.

(Conveniently those 2006 instructions are still available available online. In fact for the obsessively curious or very delinquent late filers, instructions are still available on-line going all the way back to 1985!)

So, I followed the instructions and did exactly what the worksheet on page 94 told us we could do: claim dependency deductions for both daughters on our New York return even though we had only claimed one of them on our federal return.

As far as I can tell, we followed the tax instructions correctly to the letter, but we still got ensnared in an audit triggered precisely by the discrepancy between the one dependent claimed on our federal return and the two dependents claimed on our New York return.

Why? Because the New York State tax forms did not--and still do not--provide any place where the taxpayers can explain why the number of dependents they claim on their state return exceeds the number of dependents that they claimed on their federal return.

Since New York State tax authorities are understandably diving into the sofa cushions for much needed tax revenues, they recently obtained a datatape from the IRS allowing them to compare the total number of exemptions claimed on 2006 federal returns (in our case that number was 3, my husband, myself, and our younger daughter) with the total number of exemptions claimed on 2006 NYS returns (in our case that number was 2, just our two daughters.)

Most of the people swept up in that comparison net were people who had been gored by Bed Buffalo #1 above, people who wrongly claimed personal exemptions themselves and/or their spouses on their NY returns, due to confusion with the federal rules.

Some of the people who successfully navigated Bed Buffaloes #1, #2, and #4, may find that when they mail in their required explanation, that the tax authorities will realize their dependent child was actually gored by Bed Buffalo #3, which could result in additional money owed by the dependent child, on her federal and/or state returns, if s/he wrongly claimed a personal exemption for herself.

I believe our family has successfully navigated around all the Bed Buffaloes listed above, but I need to call the NYS tax department folks to find out exactly what documents we should provide to prove this to their satisfaction.

Stay tuned for more.

What does a tax audit look like?

The image that comes to most people's minds when they picture a tax audit is a taxpayer sitting across a desk from a government auditor.

Once upon a time, that was true, but nowadays the overwhelming majority of what the IRS and New York State authorities call "audits" of individual taxpayers are "correspondence" audits conducted through the mail.

This is true for taxpayers at all income levels. It's just a practical reality--the tax agencies are under pressure to do more and more with less and less, and correspondence audits enable scarce auditor resources to be stretched a lot farther.

There are still a few face-to-face audits. Apparently, Taxgirl Kelly Erb had a face-to-face audit, presumably in an office, and I recently read an email on the TaxProf list from a law school professor who was expecting a tax auditor to come to her home to conduct the audit there. The professor said the worst part was having to clean up her home for the auditor! (I can definitely relate to that!) Perhaps coincidentally, both Kelly and the law school professor used to work for the IRS. Kelly has noted that she herself had previously been on the other side of the table from the taxpayer.

But most audits are not face to face, so perhaps you'd like to take a look at what a correspondence audit looks like. Here is a PDF of the initial letter for our NYS correspondence audit, with sensitive personal data (like Social Security numbers and our total taxable income) deleted.

I must say that I was initially rather taken aback at the strong boldface heading of at outset of the letter: NOTICE AND DEMAND for Payment of Tax Due, given that this was the first thing we'd heard from the state about our 2006 return since we'd filed it almost three years ago.

It seemed that the New York State Tax Department was coming on awfully strong in its very first ever approach to inquiring about our tax return. (It's my impression that the first notice in a correspondence audit from the IRS is not worded quite so strongly, but then I've yet to see one, so I don't know for sure.)

But after reading a lot of Treasury Department and GAO reports on correspondence audits, I realize that a lot of taxpayers just ignore tax audit correspondence, so maybe the New York tax officials have a good case to make that they need to be somewhat alarmist to make sure they grab the taxpayer's attention quickly.

That boldface headline certainly got my attention! I will be taking care of this matter pronto!

Later on in the letter, there is a page with the comforting title of "Taxpayer Bill of Rights," but it's full of scary things that could happen if we don't pay up or at least respond with our version of the facts within 30 days. (Seizing assets, filing liens, garnishing wages--none of it very reassuring, and certainly none of it does any good for one's credit rating, reputation with the bank or one's employer.)

The audit letter also has another page that provides the possibly comforting information that if one spouse wants to blame it all on the other spouse, s/he has the right to try to prove to the satisfaction of the tax authorities that s/he knew nothing about the allegedly incorrect information provided on the tax return and that s/he did not benefit from the allegedly ill-gotten tax gains from the allegedly incorrect information provided by his/her spouse.

None of this was any comfort to me. As the spouse who is supposed to be the expert at dealing with taxes in our house, any error would be almost surely be attributable to me. (My daughters sometimes irreverently refer to me as the "tax goddess.")

So I read everything over very carefully--and then breathed a deep sigh of relief--I think!

When I got around to reading the smaller and somewhat fuzzier computer print on the back of the first page, it yielded the information that suggests we may not have too much difficulty setting things straight--I hope.

If you're not familiar with New York tax law, I need to explain a few bed buffaloes in the code to help clarify this matter.

UPDATE: An earlier version of this post was getting way too long. I have decided to break it up into pieces. A separate post explaining those bed buffaloes in our tax audit will be up soon.

Much ado about $68? For some taxpayers, it will be a lot more

I've already posted a fair amount about our New York State audit, and I'll be posting more.

I'm still working on redacting all the sensitive personal information such as SSNs, PINs, taxable income, and so on from our audit notice, but I'll be posting it soon, along with more comments.

It's reasonable for readers to wonder if I'm making too big a fuss over $68 plus $18 interest, but my guess is that notices like this have gone out to taxpayers all over the state.

All this posting is not really about me--it's about the insights into the audit process I hope to get for other taxpayers who may have far more at stake, and who may have far less resources to deal with tax challenges.

Many of those taxpayers are likely low-income taxpayers, for whom an audit notice like the one my husband and I received will present far more difficulties than it does for our family, for the following reasons:

1) Due to all the credits associated with dependent children for low-income taxpayers, they likely stand to lose a lot more than $68 if their right to claim a dependent is challenged. A low-income taxpayer who loses the right to claim a dependent on her federal and/or state return could lose hundreds or even thousands of dollars in credits, especially if multiple years or dependents are at issue on both federal and state returns. In the case of Rachel Porcaro in Seattle, the newspaper reports indicate that the IRS attempted to assess $16,000 in an audit challenging her right to claim her two sons in 2006 and 2007.

2) Even $68 (plus interest accumulating at 8%) is far more of a burden for low income families than it would be for ours.

3) Many low-income taxpayers might have a far more difficult time fighting off a tax department challenge to a dependent claimed on their 2006 return than we will likely have, for a variety of reasons:

a) We are your classic "Leave it to Beaver" sitcom family. My husband and I have been married for 30 years, our children have lived with us continuously since they were born, and there's absolutely nobody else in the world who could conceivably preempt our right to claim our two daughters on our 2006 tax return. Our dependent daughters' only absences from living with us have been clearcut cases such as college attendance, summer camps, etc. where the tax rules clearly and explicitly state that the absences are deemed to be "temporary" and therefore irrelevant for tax purposes.

b) We have continuously lived in the same home with the same mailing address for two decades. We have a great postal carrier and a secure mail slot. We live in a low-crime area with an excellent police force. We have a reasonable degree of confidence that mailings of tax notices will arrive promptly, and we don't worry about mailbox burglaries or vandalism.

c) We have plenty of secure filing space in our home in which to archive our tax records and other family documents which could be relevant to proving our right to claim our daughters on our return. We pay for most things that we buy by credit card or check, so it's straightforward to document who is providing support.

d) We are well educated, highly numerate and highly literate in our native language of English (and I consider myself to be bilingual with a fair degree of fluency in my second language of "tax-speak" as well!) I am exceptionally well-versed in the rules for claiming dependents on federal and New York returns, since that's a major issue that comes up hundreds of times each year at the VITA site I supervise. We have easy high-speed Internet access which makes it easy to retrieve archived copies of 2006 New York State tax instructions on our home computer to check whether the rules for claiming dependents might have been different a few years ago.

e) Our home phone is a landline with unlimited calling time each month. We don't have to worry about burning up expensive cellphone minutes if we are put on hold for long stretches trying to get through to tax department employees who can answer our questions.

f) If necessary, we have the funds to hire credentialed professionals with the expertise to deal with audits that threaten to become expensive, and we have the expertise to feel reasonably confident in our ability to select a competent professional who will do a good job for us at an affordable cost.

By contrast, many low-income families have far more complicated family structures where it can be much harder to document a bulletproof case as to which adult relative is entitled to claim a given dependent.

Low-income taxpayers and their children often need to move a lot, due to financial and other difficulties, which makes it hard to document a child's residence three years later. (If a tax authority claimed that our daughters didn't live with us in 2006, it would be easy for us to find neighbors who could serve as witnesses to that fact, because we live in a very stable neighborhood with little turnover and we ourselves have not moved.)

Low income taxpayers may find themselves squeezing into small spaces with relatives which may not have room for all their children, let alone room for storing great volumes of tax records. Due to space constraints or parental problems with health or other difficulties such as incarceration, substance abuse or domestic violence, some dependent children may bounce about a good deal from home to home of different relatives, and it may not always be clearcut whether a stay with a given relative is "temporary" or not.

The homes and mailboxes of low-income taxpayers are often less secure and subject to vandalism. Their mail may not reach them reliably or punctually.

Many low income taxpayers are "unbanked" or "underbanked," and therefore pay for most of their purchases in cash, which could make it very challenging to document support three years after the fact.

Some low income taxpayers do not have a lot of education, some have limited numeracy or literacy, some have cognitive disabilities (ranging from learning disabilities to mild dementia), some may not be native English-speakers, and indeed many taxpayers at all income levels are quite understandably not fluent in "tax-speak."

The tax code simply doesn't use the English language the way you or I do. Depending upon a variety of circumstances, your son or daughter may or may not be "your qualifying child," "your qualifying relative," or "your qualifying person" for a variety of different tax benefits, each of which may have slightly different definitions, despite the so-called "Uniform Definition of a Child." In the Alice-in-Wonderland world of tax-speak, "your child, in tax-speak doesn't mean the same as "your child" in everyday English. In tax-speak, "married" doesn't necessarily mean the same as "married" in everyday English.

It's no wonder that the National Taxpayer Advocate says that many low-income people just throw up their hands and don't even attempt to challenge the government's assertion that additional taxes are due.

Mysteries of the NYS Tax Department Audit Notice

The duplicate audit notices my husband and I received on Friday

A close reading of the New York State Audit Division's Notice and Demand for Payment yields some mysteries to ponder:

Mystery #1: Time is apparently not linear with the NYS Tax Department

The Notice and Demand for Payment is dated 02/04/10, but it was postage metered on 01/28/10 and it arrived 1/29/10.

However, the computer generated text of the notice helpfully points out that "The Tax Amount Assessed portion of this bill may be claimed as an itemized deduction on your 2009 federal return if payment is made during calendar year 2009."

How the taxpayer is supposed to travel back in time to 2009 in order to pay a bill the Tax Department did not issue until 2010 is among the mysteries not explained by the audit notice. As the math textbooks say, the solution to the time travel problem is "left as an exercise for the reader."

My guess is that the NYS tax department considered updating the computer-generated script to refer to 2010 tax law, but given the vicissitudes of Congress, there's no way to be entirely what 2010 federal tax law will look like, and perhaps the NYS tax department folks didn't want to go out on a limb making any predictions about the ultimate form that 2010 federal tax law may take.

Still, it's a bit annoying to be told in 2010 that you might have been able to deduct a payment on your 2009 tax return when they waited until 2010 to bother telling you that they believed you were required to make the payment. (However, this is doubly moot in our particular case, since (A) I don't believe we owe the money they are "demanding" and (B) I believe our 2009 return will once again put us among the 8% of New Yorkers subject to the Alternative Minimum Tax, which means that--at the margin--additional New York State income taxes paid in 2009 would not reduce our federal taxes.)

Mystery #2: Why did we receive two identical copies of the audit notice in two identically addressed separate envelopes?

The notice states: "A copy of this bill has been sent to you and your spouse." Well, yes, we did get two copies, but both copies were identically addressed to both of us in identical separate envelopes, and we live still live together at the same address.

It seems to me that programming the computer to send a single envelope with a single copy of the six-page audit notice to all joint return couples whose most recent address of record on file with the New York State tax authorities indicates they are still living together would save a good deal of money and trees. (For the record, my husband and I have filed New York joint returns from the same address for 20 years and hope for many more "happy returns" from our cozy upstate New York home in the future.)

I'm not at all sure what the tax department hoped to accomplish by sending two identically addressed envelopes, each of them addressed to both of us at the same address, at least from the outward appearance of the envelopes.

A careful scrutiny of the contents of the six pieces of paper in both envelopes reveals that--buried in the middle of one internal page--one copy was intended specifically for me and one copy was intended specifically for my husband, but there was nothing visible from the outside of the envelope to indicate who was intended to receive each letter.

If one of us had moved out and left a forwarding address with the PO, how would the postal carrier have known that one of the envelopes should be forwarded to the spouse who had moved away, since both names were listed in the identical order on both externally identical envelopes?

If the tax department really wanted to send each spouse their own personal copy of the notice, why not program the computer to address the envelopes so that each envelope would show the name of the particular spouse to whom it is intended to be delivered, rather than keeping that information buried on an internal page.

Sending two identically addressed envelopes to the same address each stuffed with six 8.5x11 pieces of paper plus a return envelope in each seems like a lot of wasted paper and postage for no good reason.

UPDATE: On closer scrutiny, the two envelopes aren't quite identically addressed. There's a subtle difference. Both envelopes are addressed to both of us, but one envelope lists my name on the first line and his name on the second line, while the other envelopes lists his name on the first line and mine on the second line. Still not clear why they are wasting all the paper and postage. Also, each envelope contained 8 pages of text on six pieces of paper. With better planning, they could easily have put the 8 pages of text on four pieces of paper.

Another tax blogger gets audited

First Taxgirl Kelly Erb, now me.

Two letters arrived at our house yesterday, each with an ominous return address:

New York State Department of Taxation and Finance
Audit Division-Income/Franchise Desk AG3
W A Harriman State Campus
Albany NY 12227-0001

Upon opening both envelopes up, I discovered two identical letters (even the document number was the same on each, as was the AUDIT ID number), each of them six pieces of paper long. I don't know why the NYS Tax Department chose to send us two copies of this letter in two separate envelopes, each of which bore 48.2 cents in metered postage. At least two of the pages were printed on both sides, so we are talking 8 pages of printed text in each envelope.

The boldface header that first caught my eye was intimidating:

NOTICE AND DEMAND for Payment of Tax Due

A quick glance showed that the audit concerned our 2006 New York State tax return, which we filed in April 2007, almost three years ago. This is the first we had heard about any issues on our 2006 return, so the title of the notice was a bit alarming.

Ancient history, I thought, wracking my memory to try to remember what possible tax issues could come up from that year. I knew we should have all the archived receipts from that year stored in our basement file cabinet, but I wasn't exactly looking forward to spending the weekend digging through them. (It's a very busy time at our VITA site, as you might imagine, since most people get their W-2's this week.)

As I read through the letter, I figured out exactly what the New York tax authorities were challenging on our 2006 return: it was not any sort of exotic tax shelter (not that we have any of those!)--it was the dependency deduction we had claimed for one of our two daughters!

We had claimed two dependents on our 2006 New York return, resulting in a tax savings of $68 per child in NYS taxes that year, but the New York audit division has apparently decided we were only entitled to claim one daughter and is demanding $68 in back taxes plus $16.08 in interest on the back taxes allegedly due for the unspecified daughter they assert we were not eligible to claim on our NY return.

(Interestingly, they are not attempting to assesss any penalty, since the penalty amount is listed as $0. Apparently they are trying to be understanding about the penalty since the rules for claiming dependents are so complex.)

Hmmm, but $16.08 in interest on a $68 tax liability allegedly overdue for almost three years, that's an APR of about 8%, a pretty good investment return for the state these days. Where else can you you get those kinds of interest rates on your investments these days?

So the state of New York is demanding $84.08 from us, unless we can justify the two dependents we claimed on our 2006 New York return to their satisfaction. The burden of proof is on us.

Our daughters were 16 and 20 in 2006. Our 20-year-old was a fulltime college student in 2006, and we have transcripts and tuition receipts to prove it. Neither daughter provided more than 50% of her own support. Both were US citizens. Both daughters lived with us, at least in the way that the tax authorities define "live with," since our older daughter was actually away at college most of the year. I remain completely confident that both of them met all the criteria to be our "Qualifying Children" dependents that year.

The notice didn't specify which daughter's exemption they were challenging, so I suppose we will have to respond to the audit by documenting that both of them met the criteria to be claimed as our dependents.

It is might very well cost more than $84 in time and trouble to straighten this out, but hopefully the process will be enlightening and educational for others.

I'll keep you posted on how this works out. I'll also post a PDF of the letter (with personal details redacted) which explains why the NYS Audit Division suddenly decided to challenge our claiming our two daughters on our tax return--apparently out of the blue--almost three years after we filed our return.

More thoughts on Rachel Porcaro

Ms. Porcaro, the Seattle hairdresser and single parent of two boys who spent a lot of money contesting an IRS audit, has been much on my mind.

By coming forward to share her story, Rachel Porcaro has put a face on the faceless millions of low-income taxpayers who have been audited in the past decade. As I noted before, the IRS feels obligated to audit so many low-income taxpayers with refundable credits because there are very high error rates on their returns, some due to deliberate fraud, and some due to honest errors caused by the complexity of the tax code (all those bed buffaloes in the tax code!)

Of course, when the IRS chooses a return for audit, they can't know for sure, in advance of the audit, whether there are errors on that particular tax return, so inevitably some perfectly compliant, innocent, honest taxpayers are going to be caught up in the audit process, which can cost a lot of time, trouble, anxiety, and money to straighten out.

According to National Taxpayer Advocate Nina Olson, many honest compliant taxpayers just give up and don't even try to defend their position.

Rachel Porcaro provides a glimpse into the burdens that low-income taxpayers determined to prove their compliance may face.

She hired a CPA/attorney tax pro, Dante Driver, to help her with the IRS audit. According to the press coverage, the IRS was initially demanding $16,000 in additional taxes, interest, and penalties for her 2006 and 2007 tax returns. After spending $8,000 in legal/accounting expenses, she managed to get the IRS to agree to a lesser figure of $1,600.

That's a lot of legal fees for a low-income single mom to be spending. Her attorney, Dante Driver, has stated that even the final $1,600 was contestable, but the legal cost of fighting any longer was just not worth it.

Did she have any alternatives?

I've been thinking a lot about the alternatives that face low-income taxpayers like Rachel Porcaro, who are audited at rates much higher than the general public. Her story makes a good case study.

What can a low-income taxpayer in her situation do when faced with an IRS audit and a demand to pay back a very large sum of money, almost as much as she makes in an entire year?

Alternative #1: Get help from her original tax preparer
The Seattle Times reported that H&R Block prepared Ms. Porcaro's original tax returns. The H&R Block website states that it will provide a substantial amount of free assistance and support to any of its customers who are audited. They will also pay for any penalties and interest that resulted from errors made by their preparers. Customers who pay the optional $30 "Peace of Mind" fee are entitled to even more support. An IRS-credentialed Enrolled Agent employed by Block will represent Peace of Mind taxpayers at their audits, and Block will also pay up to $5,000 of additional tax liability assessed by the IRS at such audits.

Hindsight is 20-20, as they say, but in retrospect, it seems that Rachel Porcaro might actually have been at least a little bit better off if she'd opted for the $30 Block "Peace of Mind" plan in 2006 and 2007. (Of course, there is a good deal of fine print on those Block guarantees, and in order to collect the penalties and interest and $5,000 per year in additional tax liability reimbursement, she would have needed to establish that it was Block's errors that created the problem, not her own errors. Arguing with a tax pro about whose error was actually responsible for the additional tax liability could be a tough challenge for typical taxpayers. Also, it should be noted that any amounts reimbursed by Block under their Peace of Mind guarantees would constitute taxable income on her next year's tax return! So, the bottom line for the Peace of Mind guarantee isn't so clear after all.)

In any case, it's understandable that Rachel Porcaro didn't pay the $30 for the Block Peace of Mind program. Back at the time she filed her 2006 and 2007 tax returns, she probably did not realize that low-income taxpayers are audited at rates much higher than the general population.

Alternative #2: Get free help from a Low Income Tax Clinic As a low-income taxpayer, Rachel Porcaro was also entitled to contact a Low Income Tax Clinic (LITC). There are 168 LITC programs located around the country, mostly at law schools. These are private non-profit programs that receive funding from the IRS to assist taxpayers in audits and other IRS legal matters. Taxpayers with incomes up to 250% of the poverty level are eligible for assistance, so Rachel Porcaro would certainly have qualified.

Fortunately, because Rachel Porcaro lives in Seattle, she is close to one of the largest LITC programs in the country, the University of Washington Low Income Tax Clinic. The clinic received a $91,000 IRS grant this year, the largest such grant awarded in the country. The University of Washington Low Income Tax Clinic has also benefited from the generosity of the Gates family as it is located in a modern and well-equipped building named after Bill Gates' father, William H. Gates II, someone who clearly cares a great deal about tax equity.

What are the odds that the University of Washington Low Income Tax Clinic will be able to help a taxpayer like Rachel Porcaro?

Not very good.

According to the Brookings Institution EITC database of IRS statistics, Rachel was just one of out of 154,000 low-income taxpayers in the greater Seattle-Tacoma-Bellingham area served by the clinic who filed a tax return claiming EITC in 2006. Using figures from Nina Olson's 2007 Congressional testimony, we can estimate that 2.5% of those EITC tax returns were selected for audit.

That means that there were 4,000 other low-income working taxpayers like Rachel Porcaro whose returns were audited in the Seattle area last year.

The University of Washington runs the only low-income tax clinic in the greater Seattle area (Seattle-Tacoma-Bellingham metropolitan area). According to their website, "During 2008, the clinic handled 132 cases through the IRS administrative process and 67 cases in the United States Tax Court."

So the University of Washington assisted less than 200 taxpayers in 2008, and surely not all were EITC taxpayers. The clinic director mentions, for example, assisting senior citizens, who also need tax help but who typically would not be included in the EITC statistics since they rarely claim it.

Even if all 200 University of Washington cases had been EITC cases, that means that about 5% of the low-income EITC taxpayers like Rachel Porcaro whose returns were selected for audit last year got free help from the only LITC in greater Seattle.

So where does that leave Rachel Porcaro and the overwhelming majority of the EITC audited taxpayers that the clinic can't serve? Unfortunately, their remaining options are not very good. According to a recent study published National Taxpayer Advocate Nina Olson, the vast majority of low-income taxpayers go to their audits without any legal representation.

Alternative #3: Do-it-yourself approachRachel Porcaro could have tried contesting the audit on her own, but she's a hairdresser, not a tax expert. A hairdresser going into an IRS audit probably feels very much like she's in a David vs. Goliath situation.

Even TaxGirl Kelly Erb, an experienced tax lawyer who used to work for the IRS as an auditor herself, felt "that it was a "completely different feeling"" when she was preparing for her own audit recently.

It is, I must say, a completely different feeling.

For those of you who have never been audited, let me advise that the experience isn’t fun. The requests for information can be somewhat overwhelming – especially for a small business. Our bookkeeper has spent days and days putting together charts and reports. We’ve been printing out ledgers and bank account statements and desperately looking for supporting documentation. It’s all part of the examination process.

If an experienced tax lawyer like Kelly was daunted by her audit, how do you think a hairdresser like Rachel Porcaro would feel? Especially if the IRS is demanding $16,000 in taxes and penalties from someone making $10 per hour cutting hair.

National Taxpayer Advocate Nina Olson recently published a study showing that low-income taxpayers who go to an audit without representation are twice as likely to come out of the audit with negative results (i.e., losing their EITC and/or owing additional tax) as those who have legal assistance.

As noted above, Rachel Porcaro wound up hiring a very expensive CPA/attorney and spending $8,000 in fees to contest the IRS audit.

Such professionals are very expensive--and few of them specialize in the kind of tax law that applies to low-income working taxpayers like Rachel Porcaro.

Billing rates for attorney/CPAs can run hundreds of dollars per hour.

According to the press coverage, Rachel Porcaro made $10 per hour cutting hair at SuperCuts.

At that rate, it would take her 800 hours of cutting hair to pay off the legal bills run up during her audit.

Why do low-income taxpayers have IRS targets painted on their backs?

The blogosphere has been reverberating with comments on an article by reporter Danny Westneat in the Seattle Times, $10 an hour with 2 kids, IRS pounces. (Tax Prof Paul Caron post here, TaxGirl Kelly Erb here, The Wandering Tax Pro Robert D Flach post here.)

Here are the relevant facts as the Seattle Times reported them in the article:

1) Taxpayer Rachel Porcaro was a 32-year-old single parent.
2) She made $18,992 cutting hair at Supercuts at $10 per hour in 2007.
3) She and her two children, ages 8 and 10, lived with her parents.
4) She paid her parents $400 per month in rent.
5) She claimed Earned Income Credit based on her children.
6) She also claimed her two children as dependents.
7) She was audited by the IRS.

First of all, it's important to note that all facts reported in the article come from Rachel Porcaro, her family, and her tax advisor. The Seattle Times contacted the IRS to get its side of the story, but confidentiality rules prohibit the IRS from commenting on individual taxpayers that it audits.

However, based on the facts reported in the article, I can say that situations like Rachel Porcaro's are very common, and very similar to many taxpayers whose situations are simple enough to qualify to use the free tax preparation services of a Volunteer Income Tax Assistance (VITA) site like the one we operate at Union College.

In fact, even the first level Basic VITA certification tests that my students will take in the first week of January will require them to demonstrate that they understand how to use the IRS-provided resources (Pub 4012 and Pub 17) to prepare an accurate tax return for taxpayers whose circumstances look very much like the article's description of Rachel Porcaro's situation.

The article reports that Rachel wondered why her return had been selected for audit:

"I asked the IRS lady straight upfront — 'I don't have anything, why are you auditing me?' " Porcaro recalled. "I said, 'Why me, when I don't own a home, a business, a car?' "The answer stunned both Porcaro and the private tax specialist her dad had gotten to help her. "They showed us a spreadsheet of incomes in the Seattle area," says Dante Driver, an accountant at Seattle's G.A. Michael and Co. "The auditor said, 'You made eighteen thousand, and our data show a family of three needs at least thirty-six thousand to get by in Seattle."

"They thought she must have unreported income. That she was hiding something. Basically they were auditing her for not making enough money."

Rachel Porcaro's curiosity is understandable, but the truth is that an individual taxpayer is not entitled to an answer to the question as to why her particular return was selected for audit. In fact, it's entirely possible that even the auditor did not even fully understand exactly why Rachel's particular return had been selected for audit.

Some of the IRS criteria for audit selection are classified, a closely guarded secret limited to a few high-level IRS employees. Rank and file auditors do not know all the details of the audit selection process. The IRS has considerable discretion in how it selects returns for audit. It is under no obligation to reveal why a particular individual's return was selected for audit, just as airport security is not obligated to reveal why it selected a particular airline passenger for a special inspection.

For research purposes, for example, the IRS may have good reason to select some returns entirely at random, in order to get information that will enable it to better target future audits. Alternatively, the IRS may want to select some tax returns entirely at random in order to discourage taxpayers from thinking that they can prevent detection simply by making their returns "look typical." That's the same reason that airport security occasionally chooses an innocent-looking 13-year-old girl or 90-year-old grandmother for a more extensive baggage inspection at the airport.

However, although the IRS won't reveal why it selected any particular individual's return for audit, it does release aggregate statistics showing the percentage of tax returns audited in various categories.

Those statistics show that the IRS audits a lot of taxpayers who look very much like Rachel Porcaro at rates much higher than the general public. The graph shown below demonstrates audit rates for EITC taxpayers at over double the rate of the average taxpayer.

TABLE 4. INDIVIDUAL INCOME AND EITC RETURN COVERAGE RATES (1997-2005)Source: Congressional Testimony National Taxpayer Advocate Nina Olson March 5, 2007


Rachel Porcaro's tax return was one of 25 million tax returns filed in 2007 claiming the Earned Income Tax Credit (EITC). Using the most recent statistics available on audit odds from the graph above suggests that about 625,000 EITC taxpayers like Rachel Porcaro had their 2007 tax returns selected for audit. Millions of EITC tax returns have been audited over the past decade. An IRS official has stated that only taxpayers with incomes above $200,000 have higher audit odds than EITC taxpayers.

Although we are not entitled to know specifically why Rachel Porcaro's return was selected for audit, American taxpayers are certainly entitled to inquire why EITC returns broadly similar to hers are selected for audit at such relatively high rates.

Rachel Porcaro's circumstances may sound straightforward, but the rules for figuring out whether she can claim her children on her tax return for a variety of benefits (dependent exemptions, child tax credits, additional child tax credits, child care tax credits, earned income tax credits, and Head of Household filing status) are surprisingly complex. I'll be talking about those rules in my posts over the next few days as I help my students prepare for the IRS VITA certification exam.

There is a good deal of evidence to show a very high error rate on simple tax returns that look very much like Rachel Porcaro's tax return. Some of that evidence comes from "Secret Shopper" visits to paid and volunteer tax preparers. Some of that evidence comes from studies of audited tax returns. Even highly credentialled tax preparers such as CPAs, attorneys, and enrolled agents have very high error rates on Earned Income Tax Credit returns. No matter who prepared the tax return, whether it was self-prepared, or prepared by a commercial preparer at a big chain like H&R Block, a volunteer at a VITA site, a small independent tax pro, credentialled or not, the error rates in studies are unacceptably high. I have previously posted about a recently released study that found the following EITC error rates on a random selection of EITC returns:


The error rates shown in the chart above range from 45% to 71%, depending on the type of preparer. The chart shown above is based on a random cross-section sample of 1999 tax returns, there are some methodological concerns, and the error rate has come down since then, but it is still too high. An IRS official recently quoted an estimate of 25% for the error rate on EITC returns.

Some of the errors on EITC are deliberate and intentional fraud, but many are honest mistakes due to the complexity in the tax law, especially the rules for what the IRS calls "Qualifying Children." Those rules are surprisingly complex for children who may live and/or be supported by multiple adults, and, to make matters even more confusing, the rules for claiming Qualifying Children changed significantly as a result of the Working Families Tax Relief Act of 2004. Ironically, that act was designed to simplify the tax rules by creating the so-called "Uniform Definition of a Qualifying Child (UDOC)." It turns out those rules aren't as "uniform" as the U in UDOC suggests, creating the potential for continuing confusion.

IRS audit statistics also show a good deal of underreporting of Adjusted Gross Income on EITC tax returns. Again, some of that underreporting may be deliberate fraud and some may be honest misunderstanding about the types of income that need to be reported on a tax return (e.g., Social Security benefits) and the types of income that do NOT need to be reported on a tax return (e.g., Supplemental Security benefits).

Whether it's fraud or honest error, the IRS is obligated to audit tax returns to enforce the tax laws. As Rachel Porcaro's situation demonstrates, enforcement actions can create a lot of confusion, stress, and expense for vulnerable taxpayers.

Congress could do a lot to simplify the tax code to reduce the burden of enforcement on taxpayers like Rachel Porcaro. Part of the reason that low-income taxpayers have targets painted on their backs is that Congress has made the tax law so complicated by putting so many bed buffaloes in the tax code.

I'll have more posts on this topic in the coming days.

Thanks to Ms. Porcaro for coming forward and putting a face on millions of taxpayers who have been audited for EITC returns in the past decade. She paid hundreds of dollars to H&R Block to prepare her tax return, but statistics show that there is still a significant likelihood of error on her tax return. She spent thousands of dollars and a lot of hours and anguish trying to establish her rights to claim her own children on her tax return.

The difficulties Rachel Porcaro faced are part of the reason why I so strongly stress the need for scrupulously careful tax return preparation at our VITA site. Every tax return prepared at our VITA site is prepared by an IRS certified volunteer, double-checked by a second IRS certified volunteer, reviewed again by the original volunteer who walks the taxpayer line by line through her tax return, and then triple-checked by me prior to submitting the e-file tax return for processing. All of this takes a good deal of time, but we feel strongly about preparing accurate tax returns for our taxpayers. We want to secure all tax benefits to which they are legally entitled, but we do not want to create any problems down the road if and when their returns are selected for audit.

Compensating audited taxpayers: an idea whose time has come?

Ian Ayres and Barry Nalebuff, two Yale economists who write for Forbes, have proposed that the government pay taxpayers whose returns are selected for audit, especially taxpayers subjected to random exhaustive audits the IRS may conduct purely for research purposes.

Peter Pappas doesn't think much of the idea:

I’ll research this more, but here’s my initial response to Ayres and Nalebuff: What the hell have you two been smoking?

First, the IRS can simply pass these audit compensation fees back to the taxpayer by more aggressively disallowing tax deductions. Second, because IRS auditors and their group managers have discretion as to whether or not to assess penalties against taxpayers it’s reasonable to assume that they they will be more aggressive in assessing those penalties and denying reasonable cause abatements so as to offset the cost of compensating the auditees.

I hope American taxpayers are not stupid enough to trust a program that purports to compensate them for being audited when the compensator, the IRS, is the entity responsible for determining the amount of their indebtedness to the government.

Am I missing something here?

Ahem, well Peter, it wouldn't be the first time you've been missing something.

Economists have been talking about the idea of compensating audited taxpayers who are found to be fully compliant for their time and trouble for decades, probably since before you were born. I first encountered the idea in the 1970s, and it was not a new idea even then. I will admit to some mixed feelings about the idea, but I don't think you have to be "smoking something" to think it's an idea that deserves some consideration.

I don't know Ian Ayres (who happens to be a lawyer as well as an economist), but I spent a fair amount of time talking to Barry Nalebuff back in the 1980s. He is not your typical ivory tower economist. He knows a lot of mathematical economics (game theory and that sort of thing--he was a Rhodes Scholar and a former Harvard Junior Fellow, both very big deals), but he also knows and cares a lot about the real world. He runs a sideline business, which he and a former student founded in 1998. I understand it's quite a successful business: ten years after startup, Coca Cola bought a 40% share of the business for $43 million. That kind of real-world savvy alone sets him apart from most academic economists. You should read his books--I'm not saying that I agree with every single one of his offbeat ideas, but there's a lot of food for thought in them.

Paying audited taxpayers is clearly a controversial idea, and I'm not saying I'm ready to jump on the bandwagon, but I do think it's an idea that merits serious consideration. Your arguments, based on your extensive experience dealing with IRS auditors, are certainly worth taking into consideration, as well.

I don't know if you are old enough to have been practicing back when the IRS had its old Taxpayer Compliance Monitoring Program (TCMP) audits, but they seemed like thoroughly unpleasant affairs. As I understand it, they constituted a very major imposition on the time and energies of a hapless group of taxpayers selected entirely at random, in a stratified sample selected for research purposes.

In other words, the TCMP audits were exhaustive audits conducted on a random group of taxpayers about whom the IRS had absolutely no reason to suspect were any more guilty of non-compliance than the next guy. Why? Because the IRS believed it needed baseline data for research purposes in order to construct statistical models that would allow it to target all the rest of its audits more effectively.

That meant auditing a random cross-section of taxpayers, including some who were fully compliant, indeed, those TCMP audits even turned up a significant number of taxpayers who had overpaid their taxes. The IRS believes its duty is to enforce the tax law and to collect the correct amount of taxes from taxpayers, but not more than the government's due, so such taxpayers received refunds.

So what was a TCMP audit like? As I understand it from IRS researchers with whom I spoke back in the 1980s when they were still conducting such audits, if your return was selected for a TCMP audit, you were required to substantiate every line on your tax return, producing your marriage certificate if you were filing jointly, birth certificates for your children if you claimed them, evidence that you met the support tests and other tests to claim those dependents, and so on, line by line through every item of your return.

TCMP audits were understandably very unpopular with most taxpayers, although I understand that the IRS Commissioner kept a drawerful of letters from a minority of grateful taxpayers who found out from their TCMP audits that the government actually owed them money. They were the minority, of course, and a political clamor arose to discontinue those research audits, even though the IRS insisted that it needed that information to construct and updated accurate models for selecting the lion's share of its audits through the so-called Discriminant Function (DIF) model.

Congress listened to the aggrieved taxpayers and ordered the IRS to abandon the TCMP audits, and it's been almost two decades since there have been any TCMP audits. Without those TCMP audits, some statisticians believe the current DIF model used by the IRS is seriously out of date.

I'm not privy to the details of the DIF, nor am I privy to the classified data which causes those statisticians to claim that the IRS needs new research audit data to update its statistical models.

But, for the sake of argument, let's say those statisticians are correct, that the IRS does need to collect some audit data from a stratified random cross-section of taxpayers about whom the IRS has no particular reason to suspect non-compliance.

It doesn't seem entirely unreasonable to me that such taxpayers ought to be compensated for their time and trouble, if they are found to be compliant. In many jurisdictions, taxpayers are paid if they are selected for jury duty, albeit not very generously. In some states, jurors receive no pay for short trials (less than three days), but they do receive pay for serving on a long and complicated case. When I was growing up, young men drafted into the armed services were still paid for their work, again, not all that generously.

Random selection for a research audit is a burden more onerous than most jury duty assignments, and less burdensome than most military duty. There is a case to be made that a taxpayer whose return was randomly selected for a research audit has been "conscripted" into an important civic duty, and deserves at least some compensation from the government for his time.

There are ways to structure the incentives for the auditors so that those who conduct the research audits are rewarded for audits that are as accurate as possible, rather than audits that significantly favor the government. The old TCMP auditors were told not to worry about the dollar totals their audits collected, but rather to worry about making the audits as accurate as possible so the IRS would have the best possible data on which to build its DIF model.

By similar reasoning, accounting for the funds the government uses to compensate taxpayers could be done in a way that does not create perverse short-term incentives to maximize direct revenue collection from these exhaustive research audits. Such funds could come from a separate budget outside the direct control of the IRS. To serve their intended purpose, research audits need to focus on collecting the most accurate possible data, not the most revenue from the particular taxpayer who is audited. In other words, you don't want the taxpayer just throwing up his hands and saying, "Just get out of my hair. I'll pay whatever you tell me to pay." For a genuinely useful research audit, you want the taxpayer providing all the information needed to assess his tax bill accurately.

One could also, for example, ask the National Taxpayer Advocate's office to be involved in "auditing the research auditors" to make sure that they are conducting those very burdensome audits in an even-handed manner.

That said, I'm not necessarily willing to jump on the Nalebuff-Ayres bandwagon.

I still have some reservations about the idea of paying audited taxpayers. Paying people for complying with civic duties can sometimes be a two-edged sword. It might encourage so much cynicism and negativity that it could undermine what voluntary compliance remains among American taxpayers.

But I don't think you have to be "smoking something" to propose the idea for public consideration.