In recent years, there have been significant changes in the way the IRS targets taxpayers for audits, as well as how it conducts the exams. Whether you have read statistics about the percentage of returns that are audited or heard about the recent cuts to the IRS’s budget, you might feel justified in playing the odds that you or your business won’t be among those selected by the IRS for examination. But the numbers are very misleading, as the IRS is getting a lot smarter about how it chooses returns for audit and how their examiners conduct their audits.
Over the past few years, the IRS has dramatically stepped up its efforts to study specific industries, and to educate its examiners about business practices, terminology, accounting methods, and common industry practices. It has also identified areas of inquiry that produce audit results. Examiners are told specifically to look out for certain red flags to get at what is really going on in a business or transaction. The IRS has also updated its tax gap figures (the estimated $450 billion difference between what taxpayers owe and what they pay). Several research studies are underway into various segments of the taxpayer population. That, in conjunction with Treasury reports on IRS audit performance, means that examinations are increasingly focused on business areas and issues that are likeliest to generate increased taxes, penalties, and interest.
In March 2012, the IRS released audit rates for fiscal year (FY) 2011, which shows a general uptick in audits, especially of higher income taxpayers. Individual taxpayers were collectively audited as a 1.1 percent rate over the FY 2011 period. The audit rate for individuals with adjusted gross incomes (AGI) between $200,000 and $500,000 was 2.66 percent in FY 2011 compared to 1.92 percent in FY 2010. The audit rate for individuals with AGI between $500,000 and $1 million was 5.38 percent in FY 2011 compared to 3.37 percent in FY 2010. For individuals with AGI between $1 million and $5 million, the audit rate increased from 6.67 percent in FY 2010 to 11.80 percent in FY 2011.
Within our practice we have definitely seen a rise in audits of individual returns, particularly ones of self-employed individuals reporting gross receipts in excess of $200,000. In discussing with colleagues around town, our anecdotal experiences have been echoed by our peers. One specific focus of auditors for these types of returns is an analysis of the total income being reported by taxpayers, as compared to deposits into their banking and investment accounts. In performing this analysis, auditors make an assumption that all deposits into these accounts are income unless evidence to the contrary can be provided. While they do allow for some margin of error (the percentage which they will not disclose), our experience has been that their tolerance for a discrepancy is lower than one would expect.
With the rise in these types of audits, it is important to remember that the Treasury has regulations dictating that sufficient records must be maintained to establish the amount of gross income, deductions, credits, or matters required to be shown on a return. For individuals, this would include not only reporting forms received from third parties, such as W-2’s, 1099’s, and acknowledgements for charitable deductions, but would also include bank statements and receipts for any deductions being claimed. Failure to maintain this required documentation will often result in disallowed deductions or additions to income. In addition, more stringent requirements are in place for deductions relating to travel, gifts, entertainment and listed property, which most notably includes automobiles.
Another IRS initiative is to improve compliance by fostering greater communication between the IRS and representatives of various industries. This interplay is intended to clarify treatment of specific tax problems far in advance of an audit. For example, the IRS and the food service industry have come to an understanding about properly determining and reporting employee tips. Employers that comply will face reduced IRS scrutiny on this issue. Additionally, the IRS has established the Voluntary Classification Settlement Program (VCSP), where employers who have misclassified their employees as independent contractors may come forward before the IRS initiates an audit and voluntarily reclassify the workers in exchange for reduced penalties.
With this renewed focus by the IRS on shrinking the tax gap, it is even more important today to be prepared should the IRS call your number. At Cassady Schiller, we not only represent taxpayers once they are under audit, but we can also help them understand before an audit commences how to be best prepared should they get the dreaded letter from the IRS.