IRS Audits, By The Numbers – Does your income exceed $1 million? How and why you might get audited this year.

Does your income exceed $1 million? How and why you might get audited this year.

Amid the IRS’ much-discussed focus on closing the so-called tax gap (now estimated at approximately $350 billion per year), a quick look at the increasing number of IRS audits over the past few years could give any high-income taxpayer, no matter how diligent, a pang of panic.

In 2004, the IRS conducted 9,576 audits of taxpayers with $1 million or more in income. In 2009, the agency conducted 28,349 audits for the same income group. That looks like an increase of nearly 300%.

However, the situation is not as bleak as it may seem. Over the same time period, the number of high-income filings increased to 441,715 from 190,372 . That’s not quite the same increase as in the number of audits (232%), but it does make the increase in audits appear to be far less dramatic, based on filings. Over the same five-year period, IRS audits of high-income individuals have only increased from 5.03% to 6.42%.

 

 

2004 

2005 

2006 

2007 

2008 

2009 

Field 

5,857 

7,166 

9,459 

12,259 

12,233 

15,730 

Correspondence 

3,719 

5,669 

4,728 

10,941 

9,641 

12,619 

Total 

9,576 

12,835 

14,187 

23,200 

21,874 

28,349 

Prior year returns 

Filed 

190,372 

210,280 

270,161 

339,138 

392,776 

441,715 

Coverage 

5.03% 

6.10% 

5.25% 

6.84% 

5.57% 

6.42% 

*Internal Revenue Service, Fiscal Year 2009 Enforcement Results;
Editor’s Note: The statistical data above does not incorporate IRS audits related to foreign financial accounts and voluntary disclosure of foreign financial accounts.
 

More reassuring, of the 28,349 audits conducted for taxpayers with $1 million or more of income in 2009, slightly less than half (45%) were carried out by correspondence–not in person. Indeed, a closer look at the numbers reveals that high-income taxpayers are not necessarily being singled out for increased scrutiny. The various types of tax audits are triggered by various factors, but for the vast majority of high-income taxpayers, income alone may not be not enough to warrant contact by an IRS examiner.

If the IRS is not more apt to audit based on income levels alone, what, then, triggers an audit?

Tax returns are selected for audits in several ways. The primary way that the IRS selects returns for audit is the Discriminate Function (DIF) system. The DIF system uses mathematical formulas to weigh the various characteristics of tax returns and score them accordingly, in an effort to find the returns that would most likely have a difference between taxes owed and reported. For example, if an individual earns $50,000 in a year and makes a charitable contribution of $5,000, that characteristic would more than likely carry a higher weight than it would for an individual who had $500,000 in income and made that same charitable contribution; the first return would receive a higher score. Generally, the higher the score, the higher the probability of a tax change; the highest scoring returns are then forwarded for further review.

While the DIF system is the primary vehicle for audit selection, there are several other ways that returns can be selected for further examination:

Corporate Officer Return Compliance Check
As a part of every corporate audit, the IRS will determine whether the corporate officers’ returns have been filed. This typically includes the top management team and others “in a decision-making role.” The IRS will review the return for items that appear large, unusual, or otherwise questionable and will then determine whether or not the return will be audited. This routine check does not constitute an audit, but as a result of it, corporate officers may be subject to a greater level of scrutiny than those who are not subject to this additional review.

Flow-through Examinations
If the IRS proposes a change to the filed return of a partnership, S-corporation or trust, the partners, shareholders or distributees of a trust may see their income changed as well. This may result in additional scrutiny of the individual’s return and a possible separate examination.

The National Research Program
In this program, the IRS conducts examinations to gather data for use throughout the IRS in an effort to improve the tax system. Returns are randomly selected to allow the IRS to collect statistically valid information about how taxpayers meet their taxpaying responsibilities. These audits are generally more thorough than the so-called regular types of audits because of their basis in research.

Matching Programs
Under this type of audit the IRS would match various reporting documents, such as Forms 1099 for dividends or interest, with the income reported on the tax return. If there is a mismatch or a missing amount, the IRS will contact the taxpayer for more information. The taxpayer must then respond to the IRS with an explanation of the difference or an agreement to pay the amount due.

 

Global High Wealth Industry (GHWI) Group
The IRS announced the GHWI group in November 2009 to examine the tax returns of wealthy individuals in the totality of their financial and business arrangements, rather than on an individual-filing basis. Since then examiners have been selected and some audits have been initiated; the IRS continues to staff the group and expects it to be fully operational within one to two years. IRS Commissioner Douglas Schulman has said the group will enable the IRS to “take a unified look at the entire web of business entities controlled by high-wealth individuals, which will enable us to better assess tax risk and compliance risk. Our goal is to better understand the entire economic picture controlled by individuals.” The group is expected to focus exclusively on taxpayers with tens of millions of dollars in annual income.

What is the difference between the different types of audits?

There are three types of tax examinations: the correspondence audit, the office examination and the field examination.

A correspondence audit is conducted via mail of items on a tax return that require additional verification, such as home interest deductions and charitable contributions. This type of audit is usually less intrusive than the others and is conducted by an IRS tax examiner.

Office exams are face-to-face interviews conducted in an IRS office. These tend to be more in-depth and require more documentation and verification. Office exams are conducted by tax compliance offers who generally have a higher level of technical tax training and experience. In each of these exams, some type of limited income probe is required to determine whether or not all of the taxpayer’s income is reflected on the tax return as filed.

Finally, field examinations are face-to-face exams generally conducted at the taxpayer’s place of business or their representative’s office. Field examinations are generally more in-depth and are conducted by revenue agents with an advanced level of technical tax training. Many of these agents are certified public accountants, and some have higher degrees in taxation or accounting. Field examinations can ultimately consist of audits of so-called related returns and may include an examination of Forms 1120, 1120S, 1065 or 1041. This type of audit will also include some type of minimum income probe including, potentially, a request for the taxpayer’s personal and business bank statements.

It is anticipated that the IRS focus on taxpayers with incomes exceeding $1 million will continue in the future. In fact, President Barack Obama’s fiscal 2011 budget request seeks an increase of $293 million for the IRS’ enforcement programs, a portion of which will be earmarked for high income taxpayers.

Michael Tonkovic, 02.16.10, 06:00 PM EST

Michael Tonkovic is a director of PricewaterhouseCoopers’ Washington National Tax Services group.

Contact sales@globalvalueadd.com OR Call 210-248-3397, India +91-80-41633973, if you are looking for professional advisory services. GVA is not an attorney or attorney firm. GVA has partnered with NAFEP for Estate Planning services. Unless we expressly state otherwise in this post any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or other matter addressed herein.

 

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