Assessing Your Risks of an IRS Audit


	Scott Wrigley

October 2010

Assessing Your Risks of an IRS Audit

A growing number of new and recurring issues heightens the likelihood of an audit and the possibility of greater tax liability

In the back of many taxpayers’ minds is the haunting question, “How can I avoid being audited by the IRS?” Unfortunately, there’s no sure-fire guarantee that you will never be audited, because some tax returns are chosen at random. However, completing tax returns in a timely, orderly and accurate fashion with a trusted tax adviser certainly works in your favor, as does knowing the red flags that catch the IRS’s attention.

While the overall percentage of taxpayers who are audited is historically around 1%, certain categories of people and organizations are audited at much higher rates.

Before we tell you about some of the new and recurring audit targets, here are some of the latest collection statistics from the IRS Data Book for the fiscal year ending September 30, 2009.

Individual Returns. During that 12-month period, the IRS audited about 1% of the 138.8 million individual returns filed. Auditors focused heavily on high-income taxpayers. For example, 6.4% of returns with total positive income of more than $1 million were audited, a jump from 5.6% the year before.

Corporate Returns. The IRS audited 1.3% of returns from corporations. Specifically:

For corporations with assets from $1 million to $5 million, audits edged down, from 2% of returns to 1.8%.
For corporations with assets between $5 million and $10 million, audits fell from 3.1% to 2.7%.
Audits for corporations with $10 million or more in assets dropped from 15.3% to 14.5%.
The audit percentage for S corporations and partnerships remained unchanged at 0.4% of returns.

Red Flags

While, statistically, the chances of being audited are generally slim, a number of new and recurring issues raise red flags that combine to skew the odds.

Homebuyer Tax Credit. In a recent report from the Treasury Inspector General, the IRS was found to have paid more than $27 million in fraudulent homebuyer tax credit claims included in 2008 returns. Incredibly, approximately 1,300 prison inmates (some serving life sentences) received $9 million for homes they “bought” from behind bars.

In response, the IRS plans to scrutinize the returns of taxpayers claiming the homebuyer credit, and it will try to recover money paid erroneously on past claims. There are now special filing requirements that include sending sale-related documents with a tax return claiming the homebuyer credit.

Online Income. Starting in 2011, the IRS will take a closer look at transactions by sellers on eBay and other online auction sites. This heightened scrutiny is the result of a new law that requires any bank or other payment settlement company that processes credit cards, debit cards and electronic payments (such as PayPal) to report to the IRS any amounts that merchants receive. Not all online sales are taxable, as many involve used items sold at a loss.

Investment Income. The IRS often discovers unreported taxable income when its computers compare the income reported on tax returns with dividend and interest information obtained from financial institutions.

Be aware that the IRS will soon receive more information about investors’ activities. Right now, the IRS is informed about investor proceeds from the sale of securities, but the tax agency relies on investors to provide the purchase prices.

However, beginning with specified securities purchased in 2011, brokers will be required to calculate gains and losses and classify them as short- or long-term. This information will be reported to customers and the IRS.

The expanded requirements were implemented in response to tax officials’ suspicion that, in order to pay less tax, many sellers of securities have overstated the tax basis.

Other Risky Areas. Beyond the new red flags described above are some continuing audit triggers:

Self-Employment Income. The tax system makes it easier for self-employed individuals (rather than employees) to underreport income and fabricate or overstate deductions. The IRS traditionally expends extra effort to ensure that self-employed taxpayers filing Schedule C remain compliant. But there is a new focus after a recent report from the Treasury Inspector General found that, even when the IRS audited self-employed taxpayers, it failed to address significant potential misreporting of income.

Automobile Expenses. Traditionally, this is a high-risk area for business taxpayers. Auditors are suspicious of claims that a personal car is mostly or exclusively used for business. Taxpayers who plan to deduct auto expenses should maintain a daily log of business mileage with odometer readings, dates, locations and purposes of meetings, as well as the names of people with whom they met.

High Itemized Deductions. If taxpayers’ itemized tax deductions exceed IRS ranges for their income group, the odds of an audit jump significantly.

Home Office Tax Deductions. As a general rule, the office must be a taxpayer’s principal place of business or a place where he or she regularly meets with clients or patients.

Alimony. These payments have become an audit target after years of perceived abuses. The IRS matches deductions taken by one former spouse with the taxable alimony income reported by the other.

Hobby Losses. This is another ongoing favorite IRS target and includes activities such as horse breeding and photography. However, taxpayers have effectively fought the IRS by keeping accurate records, following industry practices, and operating at a profit in three out of five consecutive years (two out of seven for horse businesses).

Professional Assistance. If you have income and/or deductions such as those described above and wish to reduce your risk of an IRS audit, depending on the assistance of a tax professional—from tax planning to tax return preparation—is a virtual necessity. For more information on how to minimize your audit exposure, contact your Schmidt Westergard & Company tax professional.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.