Tax Audtis and the IRS

The Taxman Cometh- NOT!

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One of the most common questions I receive this time of year (other than:  “Can I please do their taxes?”) is. “What are my chances for an audit?”

In a nutshell- pretty darned low.  Let’s start with basic facts.   The Republicans are ticked off at the IRS for their supposed block of (illegal) social welfare organizations.  You know, like the one Karl Rove just got approved, Crossroads GPS.  Most of these esorts of ntities are formed as LLCs, so you don’t know who or what is involved (other than the identity of the officers).  And, yo get approved as a 501(c)(4), the entity promises to donate 51% for a social good.  (Hmm. I’m not quite sure finding charter seats on private jets is a social welfare item.)  And, what we really do find (I am only going on what has happened in the past two elections) is that AFTER the election, long after anything can be done, the social welfare goals have not been met.  Instead, a higher portion (termed dark money) was spent on political shenanigans.  (We can only expect more and more of such criminal activity unless and until we declare business entities to NOT be people, or, short of that,  require monthly reporting of all political expenditures by any ‘fictional’ (corporate, LLC, etc.) entity.)

But, I’ve digressed.  (And, I almost feel good getting that off my chest.  Somewhat.) Anyway, the IRS has had its budget slashed.  (There is a small increase in this fiscal year’s budget- but that still leaves the funding below 2010 levels.) It now has fewer folks on hand to do a larger job.  Not just to track these fake social welfare organizations and find tax cheating, but (the other reason why their funding is cut) ensuring that our citizens have health insurance.  (By now, you’ve become familiar with Form 1095  your employers and/or insurance companies send out every year.)

How much has this hit the IRS?  They have 25% fewer enforcement agents now than they did in 2010, when the Republican party began slashing their budget. (This is true despite the fact that the IRS is the only federal agency that returns more money to the treasury than it is allocated- 11X more.  The collections group reaps 4X the amount of money spent- including salaries- for it’s efforts.)

So, the odds of being audited are about 25% lower than they were five years ago.  The audit rate for individual tax returns has dropped from about 1.2% of all returns (1.6 million) in 2010 to about 0.8% (1.2 million) in 2015.  [The total number of tax returns has increased over those years, too.)   Likewise, the number of audits for corporations, S entities, and partnerships has dropped at about the same rate.

But, that doesn’t tell the whole story, either.

There are three basic ‘tests’ that set up whether a return will be audited:  DIF scoring, examination referrals, and document matching.  The Discriminant Index Function (DIF) score is a complex series of tests that compare your tax return to those the IRS has seen before.  This is the score many of you rely upon if you do your own taxes, whether you realize it or not.  (The various tax preparation programs tells you the likelihood that your return will be audited.)  Like, you’re having meal expenses of $ 22K for your unincorporated business that only generated $ 75K in revenue.  You should also know that the IRS does not publish what DIF score will afford you that personal invitation for a discussion.  Because that would invite many to cheat on their taxes.

Another method that the IRS uses to determine who or what to audit is examination referrals.  An agent doing a return audit notices that a fair amount of money was transferred to another entity (supposedly for business services, contract work, or other activities).  And, the agent does a spot check of the other entity- if s/he doesn’t find the appropriate revenue on its form, bingo!  A referral examination ensues.

Another, less publicly discussed form of examination referral (unless you routinely read my blog) is the choice of tax preparer. The IRS has a list (it also publishes a list of those barred from “helping” you with taxes) of preparers that it knows are prone to invent facts not in evidence.  If you use such non-professional, you can bank on being audited.  The audit rate is close to 100% for those taxpayers who choose these clowns to help with their taxes. (I’ve written about some of those folks here.)

Some of the more ridiculous deductions proposed by these “preparers” were the Slavery Reparations Act credit (don’t search for it- there isn’t one), the dependent deduction for Fido or Sylvester (pets are not tax dependents, even if they depend on their owners for food and shelter), or highly inflated business deductions.

The third process the IRS uses is document matching.  If 1099’s are issued and the taxpayer (individual or business) doesn’t seem to reflect that revenue (or doesn’t include it on their tax return), an audit can be triggered. Or, if a W2 issued is not quite what was reported by an individual- or even a handwritten W-2- the audit potential increases dramatically.

Given those general statements above, what else do we know about the odds of being audited?

Let’s start with a simple fact.  One that has led to a rash of complaints from the 1%ers.  The odds of being audited if your adjusted gross income is $ 1 million of more is around 10%.  (Note please that the percentage has dropped over the past five years from 13%.  But, it is way up from last year’s 7.5%, an anomalous low number.)  Don’t cry too much- this census (those returns demonstrating such adjusted gross incomes) only accounts for 0.27% of all the tax returns filed.

For those taxpayers making between $ 200K and $ 1KK, the audit chances are about 2% (down from 3%); these returns account for some 3.35% of all tax returns filed.  For the rest of us-  those making less than 200K, the audit rate has been fairly steady at about 0.8%.  (Note that almost 11% of all tax returns depict the income strata of $ 100K to $ 200K, 21.5% cover the $ 55K to $ 99.99K income grouping.)

Tax Audtis and the IRS

Before you consider the fact that those making more money are more likely to be involved in a variety of “iffy” schemes to lower their taxes, it also is related to the fact that these folks tend to be small business owners, running what are called ‘pass-through’ entities.  (LLCs, S Corporations, and Partnerships don’t pay income taxes on their net profits; the net profits flow through to the owners, who pay income taxes based upon their personal tax rates.)

It’s easier for the IRS to audit the individuals than the entity from which the funds derive.  (And, you will see later in this piece that the audit rate for such businesses is significantly lower than for other types of business entities.)  It doesn’t hurt that some 2/3 to ¾ of all pass-through income is derived by the top 1% of income earners in the US.

It also doesn’t hurt that the IRS has managed- even in its reduced staffing state- to garner some $ 54.2 billion dollars from these audits. That’s not chicken feed.  And, that’s despite the fact that audits were far more comprehensive a decade or more ago than they are now.  Often now, it’s a demand for documents and explanations- not a visit to your home or office, where the IRS agent scours your records.  (These latter examinations are called field audits.}

(Way back in 1980, I had such an audit.  A Mr. William Nicely [no, I’m not making up his name] spent three days in one of my offices examining each and every document that was tax related.  For my personal taxes and our business entities. My partner was —-ing a brick; I was absolutely confident.  The net result?  The IRS owed me about $ 1K and one of the companies about $ 2 K.  [I, too, know about DIF scores.  Even though our deductions were legitimate, I held some back, should there ever be an audit.  But, once the audit was proceeding, everything was fair game.]

It’s not just individuals that the IRS targets; corporations get audited, too. Last year, almost 12% of the larger business entities were subject to audits.  That is significantly higher rate than for the 0.9% of corporations that were termed small (so deemed by the definitions of the Small Business Administration).  The pass-through S entities and partnerships experienced a 0.4% audit rate.

But, there still are other issues to consider.

Starting with the fact that businesses are supposed to make a profit.  That means you can’t keep losing money year after year, and deducting those losses on your tax return.  Because the IRS then considers your business to be a hobby- and hobbies are not tax deductible.

Along those same lines, if your business has cash transactions- a lot of them- you can bet you are audit potential. (It’s one of the reasons that our service businesses refuse to accept cash payments.)

Alimony payments also are a hot spot.  It’s not atypical for Frank to deduct $ 12K in alimony, while his ex, Sally, only lists 10K.  No aspersions here.  Many a ‘Frank’ considers all the money he provides to be alimony- even though a portion may be child support (neither deductible nor taxable income to either party) or timely property adjustments.

MTE- meals, travel, and entertainment- expenses that are out of the “norms” the IRS expects are hot ticket items.  It was one of the primary reasons that triggered our audit back in 1980.  Back then, almost ½ our staff traveled more than 100 days a year- which meant high expenses.  (We did carefully outline the “reimbursements” we received from clients as a line item under our income.  But, that must have flown right by the examiner that set us up as targets.)

Automobile expenses are another cause for concern.  Because many of these vehicles are only partially used for business, but the individual (or pass-through entity) declares 100% of the costs as deductions. And, that is separate and above the inability of most businesses to fully depreciate the vehicle before disposing of it (which is why there are so many leases- they are almost always fully deductible).

For those of you who rent out a home or a portion of your own residence, your chances of an audit escalate if those expenses yield a loss.  (Most of us can’t take the full depreciation of the rental property, because of the IRS requirements that we spend 750 hours a year managing those properties.  Less than that quantity means the IRS does not consider one to be a real estate professional, thereby limiting the ability to deduct losses on one’s tax returns.)

And, while home office deductions are scrutinized, they are now so commonplace that the audit potential has been mitigated.  (Unless you deduct more than about 20% of the costs of the home mortgage/rent, insurance, and utilities.)

Remember, most of you are NOT my clients.  I am not responsible for the actions you take based upon these facts.

 

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