Budget cuts at the Internal Revenue Service (IRS) have turned out to be a “good news, bad news” situation.
The good news is the number of individuals being audited has dropped. The number of IRS enforcement agents and officers is down 28% over the past five years. This has forced the service to resort to more mail notices that some refer to as “audit lite.” Experts advise taxpayers to respond to these notices promptly and thoroughly to substantiate the item being questioned. This will hopefully resolve the issue and end the inquiry.
The bad news is that with a smaller workforce, it pays to go after the big money more aggressively. The IRS has formed a group of agents specially trained to review the finances of the very rich. This group was formerly known as Global High Wealth Industry Group, which was originally formed to focus on overseas tax havens. Regulations enacted several years ago under the Foreign Account Tax Compliance Act (FATCA) required foreign financial institutions to register with the IRS. FATCA forced overseas banks to provide information on accounts held by U.S. citizens. This group at the IRS is now referred to as the Wealth Squad.
The Wealth Squad and being audited
The new focus of the Wealth Squad is to make the best use of their limited resources by focusing on tax returns that contain situations representing a risk of non-compliance. The IRS is launching 13 new “campaigns” focusing on areas where they may be able to bring in additional revenue. Taxpayers moving money back into the U.S. and energy tax credits are some of the situations being targeted.
Fortunately, most taxpayers do not engage in these riskier situations. IRS audits of individual tax returns were down 16% last year. The chance of being audited even for taxpayers with incomes over $1 million was less than 6%. Individual audit rates for taxpayers with income under $200,000 was less than 1%. Some of the audits were just taxpayers pulled at random. The rest of the returns are selected for examination in a variety of ways.
Lowering your audit profile and high-risk factors
Even though the chance of being audited has dropped, taxpayers may still want to review how they can lower their audit profile. It is no secret that one of the biggest fears people have is receiving an audit notice. This fear is one of the best tools the IRS has going for them. Fearful taxpayers are less likely to cheat on their taxes.
Tax returns with a higher probability of audit are usually the ones that stand out from the averages. A return with larger deductions than an average taxpayer with similar income, large swings in the amount of income from year to year, being self-employed, and claiming rental losses on a vacation home are some of the common situations that can draw closer scrutiny.
Some areas that are more likely to cause an audit:
- Large Itemized Deductions – The IRS has established ranges for the amount of itemized deductions based on a taxpayer’s income. Deductions that exceed the statistical “norm” for a given state and region may be red-flagged for a closer look. This does not mean that you can’t take legitimate deductions. Taxpayers should take all valid tax deductions and keep back-up documentation.
- Self-Employment Income – The IRS believes that the vast amount of underreported income occurs among the self-employed. Self-employed taxpayers are audited by the IRS far more frequently than employees who receive W2s for wages. Taxpayers who are employed by others and receive W2 income, and also run businesses that report losses, are especially high on the IRS radar screen.
- Automobile Expenses – The IRS commonly audits individuals who use their own cars for business purposes. It is very important to keep good records of expenses and mileage. Experts recommend maintaining a log to show business-related mileage or, at a minimum, write down the beginning and ending odometer readings in an appointment book.
- Home-Office Deduction – A taxpayer who operates a business from his/her home is entitled to deduct the portion of the home that is dedicated to operating the business. The IRS suspects many taxpayers use this deduction as a means of writing off personal expenses and carefully scrutinizes tax returns that claim the home-office deduction. Claiming this deduction greatly increases the chances of an audit.
Taxpayers with income over $200,000 are more likely to be audited just based on their income. These taxpayers who are also involved in high-risk areas should not be surprised if their return is looked at closely by the IRS. Engage a professional to prepare your tax return if you fall into this situation because self-prepared returns themselves are more likely to be audited. The IRS believes that a non-professional has limited knowledge of the 74,000 pages of existing tax code and regulations.
Tax law is complex. The fees charged by enrolled agents or CPAs can easily be justified by the peace of mind they bring if you get the dreaded notice that you’re being audited.
- The IRS is focusing on wealthy taxpayers to make the best use of their limited resources.
- Taxpayers with incomes of $1 million or more are the most likely to be audited.
- Tax returns are compared to others with similar incomes to identify unusually large deductions.
 Source: IRS.gov
 Source: Wolters Kluwer, CCH