Are You Being Secretly Targeted By the IRS?
While it has been widely publicized that the IRS has been targeting tax-exempt conservative groups for audit, the IRS has quietly expanded the selection of small business owners, successful entrepreneurs and upper income earners. Most troubling has been the expansion of the IRS workforce under the Obama administration and the impact this hiring has had on the audit rates of affluent and upper middle income Americans. Over the last several years, the IRS has added more than 5,000 revenue agents to its employment ranks. While it has been politically un-savy to raise marginal rates of taxation, our politicians have been able to boost total tax collections by both increasing enforcement through additional audits and by hiring additional revenue officers to collect unpaid taxes. Why not, it has been estimated that the IRS earns an 18 to 1 rate of return on every dollar that it invests in audit and collection activities.
The IRS also recently competed a study of 46,000 taxpayers to determine who’s cheating and where they cheat. This study identified a tax gap of approximately $345 billion dollars and determined that as much of two thirds of this gap comes from small business owners, entrepreneurs, investors and professionals. As a result, we now have a redirected IRS that is moving 30 percent of its workforce out of audits of large corporations and is now using these auditors to target the small business owner and self employed individual.
Here are some more troubling statistics. Each year, the IRS reports its audit rates in a book called the “IRS Data Book”. Here is what we have uncovered. Some businesspeople file individual returns, and those with incomes higher than $1 million have experienced a 94 percent increase in the number of audits as a percentage of total returns filed in this income category. The IRS now has a team, nicknamed “the wealth squad” dedicated to auditing this group of taxpayers. Millionaires now have a one in eight chance of being selected for audit. This trend is also trickling down to more moderate income businessmen. In fact, those with incomes $200,000 and higher have seen a 36 percent increase in their coverage rate since 2009.
Audit proofing ones tax return is now as important as annual tax planning. Field audits, where a revenue officer visits your place of business, on average cost $8,000 or more in professional fees to resolve not to mention the interest, penalties and back taxes that get assessed.
The Audit Selection Process
Before identifying the techniques to reduce your chances of being selected for an audit, it is important to have an understanding of the process the IRS uses to select individual returns for examination. While the IRS has developed many resources to select returns for audit, perhaps the best-known is the discriminant index function (DIF) system, which the IRS has relied on for decades. This system uses mathematical formulas, typically ratios of expenses to deductions, to score returns based on their audit potential. Here’s how the process works. Once your return is e-filed or transcribed by hand, the numbers are crunched by computers at the Martinsburg West Virginia National Computer Center. What results is something called a “DIF” score. The higher the DIF score, the greater the potential of bringing in additional taxes during an examination. Accordingly, the IRS strives to audit the higher-scored returns first because of the expectation of getting more revenue per dollar of audit time invested.
DIF scores are developed and updated periodically from an analysis of a series of intensive audits, conducted every few years, called the Taxpayer Compliance Measurement Program (TCMP). In a TCMP audit, the IRS will analyze every item on the tax return, including proof of income. IRS computers analyze two primary measures in determining DIF score: total positive income and total gross receipts. Total positive income is the sum of all income items on a return. With regard to personal income tax returns reporting business receipts (Schedule C and Schedule F) gross business income rather than net income is the primary focus in DIF scoring. The reason for this is that The IRS believes that business gross receipts are better indicators of audit dollars than net business income reported on the return. For non-business tax returns, other items on an individual’s return will act as red flags (i.e., high DIF Scores) alerting the IRS to consider sending the taxpayer a written inquiry or worse, conducting an examination of that taxpayer’s return.
Once the returns are scored in Martinsburg, they are sent back to the service centers and ultimately hand screened for audit selection. This selection process does not even begin until after the end of June, over two months past the end of the April 15 deadline. The first step occurs when computer-selected returns are arranged in batches of examination class, a method used to categorize returns by the amount of income reported. All returns are placed into one of 12 classes based on their total positive income (TPI) for individuals or total gross receipts (TGR) for businesses.
Throughout the year, district IRS offices place orders with the IRS service centers for returns to audit. The service center then pulls those returns that are above a specific DIF cutoff score and sends them to the district office. Districts are required to order returns numerous times over a twelve-month period so that all tax returns, regardless of their filing date, have an equal chance of being delivered to the district for classification, a manual selection procedure performed by revenue agents called classifiers.
The screeners in each district office manually pull the returns with the highest DIF scores within each examination class and then review them for audit potential. Typically, there is a DIF cutoff within each class that often changes throughout the course of the year based upon staffing and overall workload. The classifier relies on his or her experience, judgment, and instincts to analyze the returns to find the ones with the greatest likelihood of change. When the returns are analyzed, the screeners are not informed of the item on the return that contributed to the high DIF Score. Therefore, the classifier must decide what items on the tax return to question during the audit. More than any other non-DIF factor, the classifier’s decision is the most significant variable in the selection process. The IRS actually publishes guidelines to classifiers on how to identify significant issues when selecting returns for audit. We call these red flags. This means that you may be able to influence the classifier’s decision and reduce your chances of being audited by following some simple rules and avoiding those red flags (even though you have a high DIF Score).
Avoid Troublesome Ratios that Generate High DIF Scores
Back in the mid 1990’s, Amior Axzel who was a current professor at Boston University was selected for examination and afterwards he conducted a study to estimate the IRS’s DIF by using logistic regression and regression trees. Aczel examined 1,289 returns and developed a DIF that will show if the return has no, some, or a high risk of being audited by the IRS. Aczel found when Schedule A’s itemized deductions are less than 35 percent of adjusted gross income, the taxpayer has virtually no audit risk. When the deductions are between 35 and 44 percent, there is some risk and when they are greater than 44 percent, there is a very high risk of an audit. He also found that when filing a Schedule C, deductions of up to 52 percent of revenues will result in virtually no audit risk, however deductions of more than 63 percent of revenues result in a very high audit risk. Here is a summary of the ratios that contribute to high audit risk:
Itemized Deductions as a Percentage of AGI Audit Risk
Greater than 44% High
Between 35 & 44% Moderate
Below 35% Low
To calculate the ratio above, you simply need a copy of the first page of your 1040 and a copy of Schedule A. Divide Line 29 on Schedule A by Line 37 on the first page of your 1040 and the result is the ratio described above.
Schedule C Expenses as a Percentage of Gross Income Audit Risk
Greater than 63% High
Between 53 and 63% Moderate
Below 53% Low
It is important to manage these ratios as much as possible on a year to year basis. By timing the payment of deductible expenses carefully, taxpayers can greatly influence the ratios at year end. Individuals typically have the greatest control over charitable contributions, the payment of real and personal property taxes and medical expenses.
Avoid Red Flags that Contribute to High Dif Scores
There are other non business items an individual’s return that act as red flags alerting the IRS to consider sending the taxpayer a written inquiry or worse, conducting an examination of that taxpayer’s return. Some of the red flags are as follows:
• If the Service Center must write the taxpayer concerning missing schedules and that taxpayer fails to respond, that return will generate higher DIF scores.
• Omission of Form 8283 when required (Non-Cash Charitable Contribution) will raise the DIF score.
• Failure to file an Alternative Minimum Tax Schedule (Form 6251) on a Form 1040 will increase chances of audit.
• The presence of casualty losses will increase chances that a taxpayer will be audited.
• Having a foreign bank account is an audit magnet.
• Returns which claim tax credits will receive a higher DIF score.
• High itemized deductions (e.g., mortgage payments and real estate taxes) relative to total positive income reported on a return will create a higher DIF score.
• Multi-year Schedule C losses, without intervening years of net income, will increase DIF scores.
• Form 1099 income reported to the IRS but not appearing on a taxpayer’s income tax return will, at a minimum, invite correspondence from the Internal Revenue Service. This is called a matching issue. All income and expense items that generated some form of information reporting document like a 1099 or W-2 are automatically compared against a taxpayers return. When income items are missing from the return or deductions do not match up to the information reporting documents a correspondence audit is initiated. It is important to respond to these notices in a timely manner so the manner does not get either escalated or assigned to a local service center for further investigation
• A lack of federal income tax withholding on a taxpayer’s Form W-2 (Employer Statement of Earnings) may flag a taxpayer as non-compliant and perhaps a tax protester.
• High itemized deductions in comparison to other residents of the same geographical area, will raise DIF scores.
• Lifestyle audits are becoming more common. The appearances of availability of more funds than reported as income on the return wlll figure into the DIF score. High mortgage interest and real estate taxes relative to a taxpayer’s level of income is an indicator for possible audit selection
Entity Structures Used for Business and Investment Activities Lower Audit Risk
The use of entity structures for business and investment activities have a dramatic impact on your chances of being selected for audit. Certain schedules that are attached to your 1040 are audited more frequently than others. For example, small business owners with gross receipts above $100K who report their income and expense items on Schedule C have a more than 4 percent chance of being selected for audit. Likewise, real estate investors who report their property activities on Schedule E have a more than 1 percent chance of being selected for audit which is x times the national average.
When we move these high risk audit items to an entity structure like a corporation, partnership or LLC return, the audit rate drops dramatically, sometimes by as much as a tenfold factor. In our example above, when we move the small business owners activities to either an S Corporation or a regular C Corporation the chances of being selected for audit drop down from over 4 percent to 4 tenths of a percent. The real estate investor who moves his or her properties to a partnership limited liability company enjoys a reduction in audit exposure as well. Partnership tax returns are audited at about 4 tenths of a percent as well compared to the over 1 percent rate for taxpayers using Schedule E.
So which entities are best? When it comes to using entity structures we advise selecting those entities that offer the best fit from both a legal and a tax perspective. Each entity type has unique tax and legal attributes and we simply want to fit those attributes to each individual’s unique needs. There are a couple of general principals to follow when using entities. Small businesses, professionals and entrepreneurs should use one of two forms of corporate structuring for their activities. The first option is an S Corporation where the income and expense from the business activity flows through to the each shareholders personal tax return in accordance with their share of ownership in the company. The income from an S Corporation is taxed at each shareholders marginal rate of taxation. This type of corporation allows individuals to split their income between two components: 1) A draw and 2) A wage. The benefit of the income splitting technique is that only the wage component is subject to social security and medicare taxes. So S Corporations lower the cost of payroll taxation for most owners and are a good entity choice for professional practices and other small businesses.
Regular corporations, often called C Corporations file and pay taxes at corporate rates. The net income in a C Corporation is subject to corporate graduated taxes which rates starting at 15 percent. C Corporations are the only entity structure in which owners can use to deduct their fringe benefit costs such as health insurance, out of pocket medical expenses, tuition reimbursement, daycare costs, etc.
Investment activities such as rental real estate, royalty producing properties and other passive activities belong in partnership structures such as limited partnerships and limited liability companies taxed as partnerships. In most states, partners in a partnership structure benefit from the legal protection that comes from a charging order, which is a body of law that dates back to old English partnerships. Partnerships are flow through structures like S Corporations where the net income from the partnership activity gets reported on each partner’s tax return in proportion to their share of ownership.
Here’s the bottom line with entities: Number one is the use of business structures clearly lowers your chances of being selected for audit and number two, is these structures when used properly lower your taxes to both social security and medicate taxes as well as to ordinary income taxes.
Include Supporting Documentation With Your Return
If you want to reduce your chances of being selected for an audit, you should attach supporting and substantiating documentation to your return for items that either create an out of balance ratio or are otherwise questionable. White attaching supporting documentation to the tax return is not required and is often not done, a classifier may not select a return for audit if the items under question are supported with copies of cancelled checks, legal documents or other records. Again, you are not required to send in these records at the time of filing and the IRS actually frowns on this practice, but by doing so you can made a constructive contribution to reducing your chances of an audit.
Do not include supporting documentation on every item, just the ones that are questionable or those that contribute to high DIF scores. For example, including supporting documentation for casualty losses is recommended as this is a highly audited item when present with the 1040. Don’t worry how thick the tax return is as it is generally a safe bet to inundate the Service with additional paperwork and documentation.
When to File Your Tax Return
Never file your tax return late after the due date of the return including extensions. Returns filed after the October 15th filing deadline are subject to as much as a 25 fold increase in audit incidence. Although the Service Centers are supposed to draw returns for audit on a consistent basis throughout the course of the calendar year, the reality is that the IRS is still short staffed and the entire audit plan is built at the beginning of the fiscal year and it appears that most returns that get selected for audit are those filed early in the filing season. Moreover, with recent mandatory government spending cuts and furloughs, the IRS has found it difficult to meet its audit targets even with its expanded work force.
Avoid Electronic Filing
Although there is much conflicting advice on this subject, we believe that it’s better to file a paper return because the percentages are in your favor relative to audit risk. Think about it. All E-filed returns are analyzed instantly for a discrepancy and run through the Service’s DIF scoring system. It has been rumored that less than half of all paper filed returns are put into this algorithm the IRS has for red flags.
Targeting taxpayers for audit is a major factor behind the IRS’s push for e-filing. E-filed returns are available for audit several months sooner than paper returns, allowing more time before the three-year statute of limitations expires. The IRS has even boasted that its e-file database is “a rich and fertile field” for selecting audits and has estimated that if its “screeners could be reallocated to performing audits, they could bring an additional $175 million annually.” Moreover, the Congressional Joint Tax Committee stated, in a 2009 report, that the cost savings associated with e-filing would make the IRS “better able to make use of its computer infrastructure to target returns with audit potential.” In other words, fewer clerks culling and mulling over paper forms gives the IRS more money to hire additional auditors.
Although most tax preparers are required to electronically file the tax returns they prepare, individuals have the option to opt out of this program. To opt out of the e-filing program, taxpayers simply need to fill in IRS Form 8948 and attach it to the paper filed return. This return is downloadable from the IRS website.
When an amended return is received at the service center it is associated with the original return and reviewed for completeness, validity, timely filing, and a determination if the issues in the claim involve an audit matter.
The service center will process an adjustment without referral to the Examination Division if the claim involves a mathematical or processing error, the inclusion of a previously omitted item, or similar errors. An evaluation is made of all the documents in the case, and if enough information is available to reasonably accept the claim, or if the claim is not worthy of an audit, it will be accepted. The basic rule is that if the item on the claim would not have questioned on the original return, it won’t be questioned on the claim.
Exceptions involve large dollar claims for refund (based on district policy), previously audited issues, and redeterminations of tax based on an interpretation of the tax law inconsistent with Service policies; it is these situations that may mean an automatic audit of the issues presented on the amended return.
The basic rule of thumb regarding the inclusion of supporting documentation is ever more important with amended returns. If you are amending a return to claim a large deduction that was overlooked when the original return was submitted, be sure to include all documentation to substantiate the claim. The form to submit and amended return includes an area to explain the reason for the amendment. In this area, we recommend referring to all of the supporting documentation to support the item or deduction.
There is another strategy individuals can employ to avoid an audit when filing an amended return. If you file the amendment towards the end of the statutory 3-year period during which the IRS can examine your return, you preserve all deductions on the return other than the amended item once the statute expires.
The Big Three
Yes there are new red flags and they are Travel, Entertainment and Automobile Deductions. These items are being single handedly targeted by IRS enforcement agents. Many taxpayers are being audited just for these three items and unfortunately, when non-compliance is identified in any one of these three areas the return is often opened up for further exam and scrutiny. There are five tests you must meet to sustain the deductibility of an entertainment expense. Miss one and you lose the entire deduction. Here are the five tests:
Date the entertainment expense was incurred.
Amount of the expense
The place the entertainment took place
Business Purpose for the expense
Relationship of the person or group entertained
A copy of a receipt satisfies three of the five tests. A handwritten note on the back of the receipt explaining the business purpose and relationship satisfies the remainder of the two. And beware, a credit card statement is not considered a receipt by the IRS. If you just have a credit card statement documenting the entertainment expense, the IRS will deny the deductibility of these costs.
With respect to automobile expenses, you must have a mileage log that includes beginning mileage and ending mileage for each stop along with an explanation of whether the distance travelled was business, commuting or personal. Without a mileage log, you lose the entire deduction claimed.
About The Author
Charlie Dombek is a internationally-recognized CPA and is one of the foremost authorities on tax planning and mitigation. His clients include professional athletes, entertainers, healthcare professionals, internet marketers and other successful closely-held business owners. Unlike most CPAs who focus on compliance issues and have a historical emphasis, Charlie is best known for the tax savings he is able to achieve for his clients through constant planning, coaching and ongoing guidance. Charlie began his career in the late 80’s at Big Four national accounting firm Ernst and Young. He holds an MBA from the College of William and Mary, along with a Bachelor of Science in Accounting from Virginia Tech. He is a highly recognized author and a regular speaker at financial and investment workshops throughout the country.
Charlie is the founding member of the Optimal Financial Group and can be reached at 866-966-4923 for complimentary consultations.