Should Individuals and Corporations Fear an Internal Revenue Service (IRS) Audit?
For more information, contact Bob Webb.
When millions of individuals and corporations file their tax returns for the tax year, many will hope that their tax returns are not audited by the IRS.
In 1998, the IRS Restructuring and Reform Act dramatically changed the nature and function of the IRS. As a result, audit rates have steadily declined since the 1998 Act.
In the paragraphs below, I will briefly discuss:
(1) The methods used by the IRS to verify the information that is reported on federal income tax returns;
(2) The statistical probability of your specific tax return being audited;
(3) The IRS' new get tough attitude toward individuals whom the IRS believes are intentionally violating the tax laws; and
(4) Some practical pointers for reducing your audit risks.
1. The Methods Used by the IRS to Verify Information Reported on Federal Tax Returns.
The United States tax system is based on voluntary compliance by taxpayers. The IRS uses various enforcement programs to check the accuracy of tax returns that are filed each year. Four major enforcement programs are:
(a) The Math Error Program. While tax returns are being processed, this program uses IRS computers to identify and generate notices to contact taxpayers about obvious errors, such as mathematical errors, or data that is inconsistent with other information that has been reported to the IRS.
(b) Document Matching Program. This program matches information on selected income reported on tax returns by individual taxpayers and reported on information returns that are filed by employers, banks, and other entities.
(c) Non-Filer Program. This program identifies and contacts potential non-filers of tax returns by using data from information returns and previously filed income tax returns. The IRS then asks the taxpayer to file the delinquent return or the IRS prepares a computer-generated return to substitute for the missing tax return.
(d) Audit Program. The IRS audit program has IRS auditors review tax returns to verify reported income and deductions. Audit contacts can be made through the mail or in face-to-face meetings with the taxpayers at an IRS office. Since 1998, it has been widely reported that the IRS audit rates for income tax returns have substantially declined.
2. IRS Audit Rates Are Rising Slowly.
For the 2002 tax year, taxpayers earning $100,000 or more are 22% more likely to be audited by the IRS. According to data released by the IRS, the audit rate for high income taxpayers rose from 0.79% in 2001 to 0.86% in 2002. The data showed, however, that this rate is still less than one-half of the 2.01% audit rate of the same taxpayers in 1998.
According to the statistics released by the IRS, audits for corporations with less than $10,000,000 in assets increased slightly from 0.60% in fiscal year 2001, to 0.63% in fiscal year 2002. There is still a significant drop from the 1.67% audit rate for these companies in 1998. Audit rates for 2003 and 2004 will continue to increase, putting more taxpayers at risk for an IRS audit.
3. The IRS is Criminally Prosecuting More Taxpayers. The IRS is criminally prosecuting more taxpayers today than in recent years. The IRS' prosecution of tax fraud involving legally earned income rose nearly 20% in 2003 with 2,541 prosecutions launched. Federal Grand Jury indictments in income tax cases increased 11% in 2003.
4. Some Practical Pointers for Reducing Your Audit Risks. Many practitioners believe that extending the due date for filing your Federal income tax returns may lower your audit risks.
If you are audited, your best defense is to use the services of a certified public accountant and a qualified tax lawyer. Taxpayers must keep in mind that the IRS settles cases that result from IRS audits based on the "hazards of litigation" standard. In other words, an IRS appeals officer will review the entire IRS audit file and attempt to determine how a court would decide the issue. A tax lawyer can provide valuable assistance to your CPA in organizing the facts and the law in a manner that demonstrates a high likelihood of success if your case is actually litigated in court. This generally results in the IRS accepting less money to resolve your tax issue. In other words, it may be more difficult for a CPA to convince an IRS appeals officer that your case will be won in the United States Tax Court since, by law, CPA's are prohibited from litigating cases in the United States Tax Court.