The number of audits that the IRS conducts varies from year to year. It's been reported that in the mid-1990s, 1.2 million audits were conducted each year. Under pressure from Congress to improve customer service, the IRS reduced the number of annual audits for a while. Now, however, enforcement activity is on the rise again. While just under 850,000 audits were conducted in 2003, that number represented a 14% increase from the previous year - and an even higher number of audits is likely this year.
The IRS's current practice combines both random and non-random audits. Approximately 50,000 taxpayers a year are selected for random audits. Some won't face any questioning from the IRS, as their returns will be reviewed based only upon information in the IRS's possession. Another group will have to respond to a letter or telephone call from the IRS demanding clarification of items on their returns. The majority of random auditees will have to meet with the IRS face to face, but only to discuss one particular area of their return. And an unlucky few - approximately 3,000 - will be subjected to a "calibration" audit, in which an IRS agent meets with a taxpayer and reviews every line on the return.
As tough as a calibration audit sounds, it's still not intended to be as burdensome on the random auditee as the former Taxpayer Compliance Management Program was. In that audit program, taxpayers not only had their returns scrutinized line by line but were expected to provide documentation for every line, even being required to submit marriage certificates and birth certificates to prove their filing status and dependents. Those audits ended in 1988 after earning the nickname "audits from hell."
Besides the random audits, a significantly larger number of taxpayers will face non-random audits. Many of these audits are aimed at owners of small businesses who file Schedule C. Schedule C filers are responsible for declaring their own business income to the IRS and claiming their own deductions, which increases the possibility of deceptive tax returns being filed, compared to wage earners whose employers report their income on Form W-2.
Not surprisingly, the IRS also places an emphasis on auditing high-income taxpayers. While the average taxpayer had an 0.65% chance of being audited in 2003, taxpayers earning over $100,000 had a 1.1% chance of being audited. Taxpayers earning over $250,000 face an even greater likelihood of an audit. Such taxpayers tend to have more complex returns including income from partnerships, trusts, and corporations, which the IRS believes may be used to conceal income from the government.
In addition, the IRS has published a list of twelve tax scams and schemes which it calls the "Dirty Dozen." These schemes include a variety of abuses, including the following:
Abusive trust arrangements. Some promoters of abusive tax transactions advise taxpayers to transfer their assets into trusts, claiming a variety of tax benefits not authorized by law. The IRS has obtained injunctions against several of these promoters, some of whom are being criminally prosecuted - as are some of their clients.
Offshore transactions. Using an offshore bank or brokerage account to hide or underreport income is illegal, and the IRS has been actively pursuing taxpayers and promoters in this area. Last year the IRS collected over $170 million in taxes, interest, and penalties from its enforcement activity against abusive offshore transactions.
Sharing dependents for the Earned Income Tax Credit. Low-income taxpayers with earned income are entitled to claim the Earned Income Tax Credit ("EITC"), which not only reduces their taxes but is refundable to the extent that the credit exceeds their tax liability. Taxpayers with a child receive greater EITC credits than those with no children, and taxpayers with two children receive even more, but no additional credits accrue to taxpayers with more than two children. Consequently, some tax preparers have come up with the idea of having their clients with one child or no children claim as dependents the "surplus" children of other clients with three or more children, to enable all the participating clients to claim the maximum EITC. As part of this scam, the tax preparer normally splits a fee with the actual parent who gives permission to have children listed on the other taxpayer's return, which means that not only will the tax preparer be prosecuted, but the participating taxpayers will all be subject to civil penalties.
Other scams are based on misinterpretations, often intentional at least on the part of their promoters, of the Constitution and Federal laws, including the following:
The "claim of right" doctrine. Some promoters encourage people to claim a deduction equal to their entire salary on the grounds that the amount represents "a necessary expense for the production of income." Not surprisingly, the IRS takes a dim view of such deductions, which have no legal basis.
Slavery reparations tax refund claims. While it remains to be seen whether the United States government will grant reparations to the descendants of African-American slaves, some promoters have encouraged descendants of slaves to claim a credit or refund for slavery reparations on their tax returns anyway. The IRS is now watching out for such claims and will impose a $500 penalty on any taxpayer who claims such a credit or refund and refuses to withdraw the claim. Furthermore, taxpayers should stay away from promoters who charge them to prepare returns containing such unauthorized credits and refunds - some of those promoters have already gone to prison for filing illegal claims.
And in yet other scams, the primary victims are taxpayers themselves:
Return preparer fraud. Some unscrupulous return preparers have ripped off their clients by diverting portions of clients' refunds for their own benefit, charging inflated fees for return preparation, or advertising guaranteed larger refunds.
Identity theft. Having access to their clients' social security numbers, bank account numbers, and other personal information, some return preparers have been reported to open bank accounts in their clients' names or even file false tax returns without the clients' knowledge.
To avoid becoming involved with these or any other tax scams, taxpayers should make sure that only reputable tax professionals become involved with preparing their tax returns.
IRS Commissioner Mark Everson has stated that every dollar spent on enforcement yields from five to ten dollars in revenue to the government. Thus, we can expect that the IRS will continue to expand its enforcement activities for the time being. So stay informed, keep the possibility of an audit in mind, and watch out for scammers - and you'll be better off when April 15 rolls around.
Joshua S. Kreitzer (B.A., Harvard University; M.A., University of South Florida; and J.D., Northwestern University) is an Associate Attorney with The Law Offices of Marc J. Lane, a Professional Corporation.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright © 2007 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.