Update on IRS Statistics and IRS Audit Red Flags

Update on IRS Statistics and IRS Audit Red Flags

The IRS has released preliminary data on returns filed for the 2005 tax year. Here's a synopsis:

Taxpayers filed 134.5 million U.S. individual income tax returns, an increase of 1.6 percent from the preliminary estimate of 132.4 million returns filed for tax year 2004.
Adjusted gross income (AGI) increased by 8.9 percent from the previous year to $7.4 trillion for 2005 and taxable income increased 9.5 percent to $5.1 trillion.
In FY 2006, IRS spent an average of 42 cents to collect each $100 of tax revenue.
The IRS examined nearly 1.3 million individual income tax returns in FY 2006, more than double the number examined in FY 2000.
Examinations of business tax returns grew for the second year in a row, reaching over 52,000 in 2006.
The government revenues generated by the Alternative Minimum Tax (AMT) rose 31.6% to $15.9 billion! For that reason, our lawmakers have been reluctant to embrace reform of the AMT or outright repeal; they use the AMT to help balance the budget. The AMT, in particular, stings large construction contractors who use the completed contract method of accounting.
Capital gains, the second largest component of adjusted gross income, rose by 36.7 percent to $604.4 billion.
Government revenue from audit adjustments increased 10.2%, up to $104.2 billion! The IRS has refocused its audit efforts upon the high income, high net worth taxpayer. They have also begun matching K-1 forms (from pass-through entities like partnerships and S corporations) to 1040’s.
The Top 1% of Individual Taxpayers for 2005 were those with over $328,049 of Adjusted Gross Income (AGI) – i.e., Taxable Income before Itemized Deductions and Exemptions. This Top 1% produced 19% of all AGI (an increase of 2.2 percentage points over 2004). This statistic may get cited in the 2008 elections as evidence that wealth has become concentrated into fewer people. What won’t get cited is that the Top 1% now fund 36.9% of total income tax reported (a whopping increase from the 2003 level of 34.3%)!

Audits of larger corporations – those with assets over $10 million – continue to increase, including more audits of flow-through entities (such as partnerships and S corporations). Audits of high income and high net worth individuals also continue to rise.

Realistically, there is no bulletproof way to guarantee you will never be audited. However, there are some things we can do to greatly reduce the risk of audit. These include the following techniques:

File Extensions Instead of Filing Returns by the First Due Date. Because of budget restrictions, only a certain number of returns are selected for audit each year. For example, the first batch of individual returns are chosen for audit by the IRS during the summer. In order to avoid getting included in Round 1 of the audit selection process, it may make sense to hold off filing by the initial due date of the return. This can be accomplished by filing an extension. You still run some risk of being audited, along with other returns that were not selected in Round 1 of the audit selection process, but at least you will have opted for a bye in that first round and therefore significantly reduced your audit exposure. Naturally, extending the time to file your return doesn't extend the time to pay any taxes you owe. A close estimate of the taxes you owe should be paid with the extension, or else you'll be subject to interest and penalties.

Avoid Classifying Large Amounts as "Miscellaneous" or "Other" in Your Accounting Records. Ideally, each and every item of income or expense should be placed in the category that best describes it. Most expenses that clients call "Miscellaneous" or "Other" are, in fact, office expenses or operating costs of one type or another. The IRS presumes that you will be unable to furnish substantiation to support large "Misc." and "Other" deductions, and that will tend to increase the likelihood of an audit.

Set up an Entity. If you or your spouse file a Schedule C for a business operated as a sole proprietorship, you are dramatically increasing your risk of audit. The best way to lessen IRS scrutiny is to either incorporate or form a Limited Liability Company (LLC). Small business corporations and LLCs continue to be audited far less frequently than individuals. Our lawmakers may have imposed numerous mathematical limitations on individual income tax deductions; however, many of these limitations are not relevant to corporations and LLCs.

Stay within IRS Parameters. The IRS uses a DIF (Discriminate Income Function) system to choose which tax returns to examine. The scoring for the DIF system is set up to identify those returns that, if audited, could result in added tax revenue. Other than IRS employees who are directly involved with the system, hardly anyone can know with certainty the actual DIF ratios. However, some research studies have suggested that if your itemized deductions are more than 45% of your Adjusted Gross Income, the probability of your individual return being audited goes up materially. It also appears that e-filing gives the IRS a lot more information than you are legally required to provide and makes it all the more likely that your DIF score will be calculated quickly, thereby increasing audit risk.

Avoid Amendments. Amendments should be avoided, especially if a refund is requested. The filing of an amended tax return which asks for money back tends to attract attention by an actual human being that works for the IRS. It increases the risk that both your original and amended return will be audited.

Include on your Return all Information Reported to the IRS. If your return reflects less income than has been reported to the IRS by third parties, such as banks and brokerage companies, you may receive a Notice that the IRS could not match this income with your return, and this in turn may trigger an audit. This can happen even with a nominal amount of bank interest for which you did not receive a 1099 form. It can also happen by claiming mortgage interest for which you did not receive a 1098 form. It can now also happen by inadvertently omitting a K-1 from an investment partnership.

We at Large & Gilbert, P.C. make every effort to ensure that your tax returns do not contain red flags that would invite an audit. We take great pride in our internal quality control processes, which focus on eliminating such flags in order to allow you to go about your business as free as possible from government intervention. Although an L&G client does occasionally get selected for audit, the chance of audit for tax returns prepared by L&G runs well below the national averages.

Large & Gilbert, P.C.
6849 Peachtree Dunwoody Road
Building A-2
Atlanta, Georgia 30328
Phone: (770) 671-1533 (contact Joe Skalski)
Fax: (770) 671-1347
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