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Who is Under the IRS Microscope? |
The IRS is continuing its quest to tighten the "tax gap," which is the difference between the income tax that is owed to the federal government, and the amount that actually is paid voluntarily and on time. During the 2007 fiscal year, individual audits increased to their highest rate in a decade and the tax agency expects to conduct even more examinations in the future.
Take a look at the audit results from last year, as well as who might be targeted next and how you can help reduce your chances of hearing from the IRS.
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IRS Enforcement Revenue |
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Total Individual Audits |
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Fiscal Year |
Other fiscal 2007 statistics: Enforcement revenue collected totaled $59.2 billion. The IRS filed nearly 3.8 million levies, 683,659 liens and 676 seizures, an increase from the previous year and a substantial increase from five years earlier. |
Key Facts about Individual Audits
- The largest increase was among those with income of $1 million or more. Between fiscal 2006 and fiscal 2007, audits for this group rose a whopping 84 percent, translating into 1 out of every 11 taxpayers facing an IRS examination.
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Audits of individuals with incomes of more than $200,000 were up 29.2 percent from the previous year. And the IRS increased examinations of taxpayers with incomes of $100,000 or more by 13.7 percent.
- Overall, personal audits rose seven percent in fiscal 2007 over the previous year. This included both correspondence audits, which involve the IRS sending out letters to taxpayers, and field exams, which involve traditional, face-to-face meetings with auditors. However, although the chances of being audited are greater than they were a few years ago, the odds are low. For all individual tax returns filed, only about 1 percent are audited and the majority of those are correspondence audits.
Business and Not-for-Profit Audit Facts
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The greatest emphasis in 2007 was on flow-through entities. S Corporation audits were up 26 percent from the previous year and partnership audits were up 25 percent.
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Audits of mid-market companies (with $10 to $50 million in assets) rose six percent. Larger corporations faced slightly fewer audits in 2007 than in the previous year, but the number was up 14 percent from 2002.
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Overall, audits of businesses increased by almost 14 percent from the prior year.
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In addition, audits of tax-exempt organizations were also up, with 7,580 returns examined in 2007, compared with 7,079 the prior year. Who Could be Chosen in the Future?
President Bush's proposed 2009 budget includes an increase of seven percent for IRS enforcement initiatives. According to the Treasury Department, the budget continues to focus on fiscal year 2008 targets including small businesses and self employed people, mainly because they have greater control over reporting income and deductions. The 2009 budget also aims to increase audits of large corporations and improve compliance of domestic taxpayers with offshore financial transactions.
In addition, investors may face increased scrutiny of the capital gains and losses they report on their tax returns. Currently, brokerage houses, mutual funds, and other institutions file information returns with the IRS that report proceeds from the sale of securities. However, they are not required to report the "cost basis," which is defined as the purchase price, including commissions and certain other expenses.
In other words, the IRS is informed about how much investors sell securities for, but the tax agency relies on investors to provide the purchase prices.
Tax officials suspect many taxpayers overstate their cost basis in order to pay less tax. In response, the Treasury Department and members of Congress have proposed legislation that would require cost basis reporting by investment firms.
How Can You Reduce the Odds?
All taxpayers are potential audit subjects, even if they aren't in one of the groups listed above. (Some returns are randomly selected as part of a research program that helps the IRS detect unreported income and improper deductions.) But you can increase your chances of flying under the IRS radar if you file accurately, on time, and with the help of a trusted adviser.
The IRS uses a secret computerized scoring method that identifies returns for audit. Although no one outside the agency knows the exact formula, be aware that the following red flags could draw IRS attention:
Being involved in target industries. The IRS publishes various "audit technique guides" to assist examiners in specific industries and professions. For example, there are guides for the construction, commercial banking and farm industries, along with tax return items like executive compensation and lawsuit awards.
Taxpayers whose returns include items detailed in the audit guides could be tapped for an examination. That's the bad news. The good news is that the guides spell out what the IRS expects to uncover and the requirements for compliance.
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.
Collecting valuable fringe benefits. Auditors zero in on non-cash fringe benefits given to highly paid employees. These tax-favored perks include deferred compensation, stock options, split-dollar insurance and golden parachutes.
Taking an unreasonable salary. The IRS sometimes decides that the salaries of company owners and executives are either too high or too low. For example, S corporation owners may take low salaries as a way to avoid employment tax. To prevail in an audit, shareholders must show that salary levels are reasonable for the work performed.
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 showing a profit in three of five consecutive years (two of seven for some horse businesses).
Dealing in cash. The IRS knows that businesses that operate mostly in cash don't always report all income. Auditors have many ways to ferret out cheating in these cases.
Here's another pitfall: Paying for big ticket items, such as cars or jewelry, with cash. 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.
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Business casualness leads to business casualties. | Violations can result in stiff fines and criminal penalties.
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 the forms.
Writing off sizeable travel and entertainment expenses. This is a favorite target of IRS auditors who are looking for personal expenses disguised as business costs. Since the record keeping 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.
Deducting large non-cash charitable contributions. Auditors are looking for large charitable gifts of property, that aren't accompanied by the required records and qualified appraisals. The rules for charitable donations have become stricter in recent years.
These are just a few audit red flags. If you have items on your 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.
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
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