Who Are the Latest Audit Targets?  What Are the Red Flags?

The IRS audit machine made improvements last year in closing the "tax gap" between revenue collected and the amount the federal government believes it is owed.

Key data: For its fiscal 2006 year, the IRS reported that it audited 1,293,681 personal tax returns (approximately

*Preliminary

IRS Offer to Companies That Issued "Backdated" Stock Options     The IRS announced an initiative to provide relief for rank-and-file employees affected by their companies' issuance of backdated and other mispriced stock options. (IRS Announcement 2007-18)     If an employee exercised a backdated option in 2006, the employee may owe an additional 20 percent tax, plus an interest tax, under the federal laws governing deferred compensation. If the option was properly priced, the employee would normally only owe income tax on the difference between the value at the date of grant and exercise.     The initiative allows companies to pay the extra 20 percent tax and any interest tax that employees owe. The initiative doesn't permit the company to pay the additional tax for options exercised by its top executives or insiders.     "This shameful practice was widespread," said IRS Commissioner Mark Everson. "We are allowing employers to satisfy the tax obligations of employees who did not knowingly participate in these schemes. This initiative does not extend to the executives and insiders who were the principal beneficiaries of the backdating schemes. We continue to pursue these cases and work closely with the Securities and Exchange Commission and the Justice Department as appropriate."     Under this initiative, an employer must notify the IRS of its intent to participate by February 28, 2007. The employer will be required to contact affected employees by March 15, 2007 to inform them that it has applied to participate in the Compliance Resolution Program.

one out of every 102 returns or .98 percent). This is an increase from 1,215,000 examinations in 2005 (.93 percent).

Increasingly, auditors are turning their eyes toward certain taxpayers. For example:

• More audits aimed at the upper crust. Audits of individuals with income of $1 million and higher increased to 17,015 in fiscal year 2006 from 12,835 in 2005, a nearly 33 percent increase. About 1 in every 16 of these taxpayers faced an audit last year.
• Audits of individuals with incomes above $100,000 surpassed 257,000, an 18 percent increase from 2005. That's the highest figure in more than a decade. Taxpayers in this category had a 1.67 percent audit rate compared with a .89 rate for those with incomes below $100,000.
• Certain businesses were a larger target. "We have placed more emphasis in the growing area of flow-through returns involving S corporations and partnerships," according to IRS Commissioner Mark Everson. In 2006, audits of S corporation returns increased to 13,984 from 10,417, a 34 percent increase.
• For partnerships, audits increased to 9,777 from 8,489, a 15 percent increase. This category is at the highest level since 1998.
• Audits of small businesses organized as C corporations remained about the same. In 2006, 17,871 audits were completed, up slightly from 17,858 in 2005. However, both of these figures are more than double the 7,294 audits of small businesses done in 2004.
• Audits of larger corporations, with assets of more than $10 million, dipped by 2.2 percent, to 10,591 from 10,829 in 2005. While down slightly this year, audits remain up nearly 50 percent from 2003.
• The IRS audited 7,079 exempt organizations in 2006, an increase of 43 percent from the previous year.

Note: The higher audit rates for 2006 still don't approach those experienced in the mid-1990s. After that, audit rates dipped to an all time low as the tax agency struggled with budget cuts, personnel losses and the passage of the IRS Restructuring and Reform Act. But over the last few years, the number of examinations and enforcement dollars collected has risen. "There's a strong trend line going up," noted IRS Commissioner Everson.

The question many taxpayers ask is: "How can I avoid being chosen?"

There is no 100 percent guarantee that you won't be tapped for audit because some returns are picked randomly as part of a research program that helps detect items such as underreported income and overstated deductions.

However, completing your tax returns in a timely, orderly and accurate fashion with the help of your trusted tax adviser certainly works in your favor.

It is true that some groups tend to be audited more than others and some items on tax returns are likely to draw greater scrutiny. The IRS uses a secret computer scoring method which flags returns for audit. Although no one outside the agency knows the exact formula, here are eight audit red flags that have been known to catch the attention of the IRS in recent years:

1

Being involved in target industries. The IRS publishes various "audit technique guides" to assist examiners in audits of taxpayers in specific industries and professions. The IRS considers these particular businesses to be ripe for abuse. If you are active in one of these fields, be forewarned that the IRS might tap you for an audit.

That's the bad news. The good news is that the audit guides spell out what the IRS expects to uncover and the requirements for proper conduct of the business.

2

Not reporting all income from third-party payers, such as banks, brokerage firms, companies paying independent contractors, the Social Security Administration and others. The IRS matches information reported about taxpayers to the amounts listed on their returns.

3

Collecting valuable fringe benefits. The IRS can become suspicious when non-cash fringe benefits are granted to highly paid employees. Auditors often zero in on compensation packages loaded with tax-favored perks such as deferred compensation, stock options, split-dollar insurance and golden parachutes.

4

Taking an unreasonable salary. If you're a company owner or executive, you may think you can pay yourself any amount. But the IRS could decide your salary is "unreasonable" - either too high or too low - under the circumstances. For example, an S corporation owner could be deemed to take a salary that is too low as a way to avoid employment taxes.

5

Claiming losses from part-time activities the IRS considers a hobby, such as horse breeding or photography. However, taxpayers have successfully fought the IRS on this issue by keeping accurate records, following industry practices and operating at a profit in three out of five consecutive years (two out of seven for some horse businesses).

6

Operating a cash-based business or paying large cash amounts. The IRS knows that businesses that deal mostly in cash don't always report all income. Auditors have numerous ways to search every nook and cranny of a cash-based business to detect cheating.

However, this is not the only pitfall involving cash. Going into a business, such as an auto dealer or jeweler, and paying with a large amount of cash can draw unwanted attention. In fact, businesses that receive cash transactions exceeding $10,000 must report them to the IRS on Form 8300 even if payments are made in a series of seemingly unrelated transactions. Violations in this area can result in stiff fines and criminal penalties - or both.

You can find yourself an audit target if you are listed on a Form 8300 or if you operate a business that the IRS decides is not properly filing these forms.

7

Writing off sizeable travel and entertainment deductions. This is a prime target of IRS auditors who are looking for taxpayers writing off personal expenses as business costs. Since the recordkeeping requirements in this area are stringent, many taxpayers don't comply with all the rules. Plus, meal and entertainment expenses are only 50 percent deductible.

8

Deducting large non-cash charitable contributions. Auditors are looking for large charitable gifts of property, without the required records and qualified appraisals. The IRS has also been cracking down in recent years on charitable contributions of conservation easements that it believes are abusive

These are just a few audit red flags. If you have items on your tax return that involve possible audit triggers, don't hesitate to claim them with your tax adviser's help. With the proper supporting records, you can successfully respond to IRS inquiries.