Insurance coverage on IRS audits pays extra taxes, associated costs

Most taxpayers dread opening the mailbox and finding an audit notice from the Internal Revenue Service. Although only a relative handful of individual tax returns are audited, the cost of being selected is high. The average audit conducted at IRS offices results in the taxpayer's being asked to pay an additional $579, according to IRS data. And if an auditor visits the taxpayer's home or office, the average bill is $6,374.

But a Washington, D.C., company has just begun offering anxious taxpayers insurance designed to eliminate much of the financial burden, if not the sweaty palms, connected with a federal tax audit.

For an average annual premium of about $300, the audit insurance policy developed by V.O. Schinnerer & Co. will pay up to $100,000 of additional taxes assessed by the IRS. The policy, which will be marketed nationally, also provides up to $1,000 to cover the cost of hiring a lawyer or accountant to plead your case with the tax man.

Tax audit insurance has never been offered before, according to the Insurance Information Institute. But what Schinnerer calls its ''Tax Right'' policy is part of an industry trend of selling highly specialized coverage, according to institute vice-president Ronald Snider.

The tax insurance is designed to prevent the individual from being penalized by the tax code's complexity, says Paul L. Genecki, senior vice-president of Schinnerer. ''There are so many gray areas where an honest taxpayer can make a good-faith effort (to interpret the law), then takes a deduction. Then the IRS performs an audit and says no.''

With insurance, a taxpayer is free to take aggressive - but honest - positions on tax matters. And with their client insured, tax advisers would feel freer to ''decide on the correct positions, based on their knowledge, skill , and experience, and not place so much emphasis on what impact the next'' court decision will have on their client, according to Walter T. Coppinger, a certified public accountant with Arthur Young & Co. He spoke here Monday at a meeting of the American Institute of Certified Public Accountants.

So far the IRS has no objection to the insurance plan. There is ''nothing illegal as far as the IRS is concerned,'' says IRS spokesman Wilson Fadely. The act of getting tax insurance ''is of no consequnce to the IRS.''

And the insurance plan contains several provisions designed to discourage tax fraud. First, Tax Right will only insure a taxpayer who has his return reviewed and signed by a CPA or tax lawyer. ''So to some extent their professional ethics come into play,'' Mr. Genecki says.

In addition, the policy has a number of exclusions keyed to IRS findings. For example, it does not cover acts for which a penalty is provided under tax law, including fraud, negligence, or substantial underpayment. Also, policyholders are not reimbursed for mathematical errors, for failure to report gross income, or for penalties and interest.

The policy also does not cover transactions, like certain tax shelters, which have no real possibility of economic gain other than lowering an individual's tax bill.

Still, because of the tax law's complexity, there is a wide variety of areas where legitimate disagreements can exist between the IRS and the taxpayer. In these areas the policyholder would be insured against additional taxes arising from, among other things, disallowed deductions or good-faith exclusions of income.

''Most tax controversies arise out of arguments about the facts or the significance of events,'' notes Mr. Coppinger, the accountant. He served as a paid consultant to Schinnerer & Co.

Adding to taxpayers' confusion is the fact that various courts often take conflicting positions on tax issues. For example, some courts say an individual who borrows money from a company he owns thereby receives taxable income. Other courts say there is no income.

If an individual has tax audit insurance, he is covered for any additional tax the IRS seeks on such an issue.

The cost of the insurance varies with the individual's income and the complexity of his return. ''The average premium will be something around $300,'' Mr. Genecki says. ''Our typical customer is the taxpayer with a household income of between $30,000 to $75,000.''

While $300 may be an average premium, for those with simpler returns it is much less. For example, if a taxpayer does not file Schedule E for supplemental income, the fee is based on the amount of itemized deductions. For up to $10,000 in deductions, the premium is $100; for up to $25,000 in deductions, it is $125. For an executive with an adjusted gross income of $130,000 who has one partnership, the premium would be $150 to $200.

But don't the odds favor the insurance company when the IRS only plans to audit 1.4 million individual returns this year, out of a total of 95.6 million expected to be filed?

''I would think so,'' Mr. Genecki admits. ''But I would quickly point out that the odds against a house fire are even greater, and people buy [insurance against] that all the time.''