Red Flags: IRS Taking a Tougher Look at Tax Deductions
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The Fiscal Times
July 22, 2011

The Internal Revenue Service  added a couple of notches to its enforcement belt in the past week. First came the disclosure that international financial services giant Credit Suisse is under federal investigation for helping U.S. citizens avoid taxes using foreign accounts. Then came multi-platinum rapper Ja Rule’s conviction for failing to pay taxes on $3 million he earned from 2004 to 2006. He was sentenced to 28 months in prison.

Gulp.

These major league tax fraud cases  obviously are far removed from the experience  of  average taxpayers.  But  these high-profile examples of  stepped up IRS enforcement can’t help but   fuel worry, even among the most honest taxpayers: Will the IRS raise a question on your return? Was there a faulty calculation? Did you claim a deduction that will rise a red flag?

Here’s some unsettling  news. Depending on your occupation, income and the kinds of claims you’ve made, there may be reason for concern. With government revenue in short  supply, the  IRS has begun bearing down on specific groups of wealthier taxpayers, and is showing far less understanding or  sympathy than in years pastmany accountants say.

“Our firm has 21 offices up and down the West Coast, and in every office there’s been an increase in examinations,” says Gary Stirbis, who handles the IRS controversy practice at Moss Adams, the nation’s 11th largest accounting firm. “The IRS has been less flexible, and agents seem to be under internal pressure to collect more aggressively. This often creates quite a burden for individuals.”

After a sharp decline in enforcement activity in 1998, due to a directive from Congress to shift IRS resources to taxpayer service, enforcement levels still aren’t where they were, but they have gained significantly.  Before Congress stepped it, there were 25,215 key enforcement staff positions at the IRS, but that number dwindled to  below 20,000 in 2003 and 2004. But now they are up to 22,710 – not a big increase, but enough to turn up the heat a little more.

And new programs have been launched to help spot problem returns, according to  Steven Miller, deputy IRS commissioner for services and enforcement. For example, last year, the IRS created the Global High Wealth Industry Unit, in which agents with various specialties will work in teams to evaluate wealthy taxpayers’ profiles. “When you look at the 1040, it doesn’t tell the whole story,” Miller says.

And this year, in an effort to crack down on under reporting of income, agents will begin reviewing credit card statements and cross-checking data against tax returns, Miller says. Big spenders who claim little income, beware. 

While big returns on enforcement efforts come from wealthy taxpayers running afoul of the rules, don’t think you’re under the radar just because your income is a tiny fraction of Ja Rule’s millions.

The IRS likes small, inexpensive  audits, because they can influence  large numbers of  taxpayers to be compliant, says Bill Smith, managing director of CBIZ MHM in Bethesda, Md. People who see a coworker or friend get audited are likely to be more careful in filing an accurate and honest return, he says. “One audit may only bring in $500, but if you can increase compliance in that group of taxpayers by 20 percent because people hear about the audits, then for the IRS its worth it,” Smith says.

For the general population, while the audit rate has been climbing steadily, the chance of coming under IRS scrutiny is still slim. The audit rate last year was 1.11 percent  of all taxpayers, up from 1 percent  the previous year.

But among some groups the audit rate is significantly higher. Those who operate their own businesses and are required to file Schedule C Forms (estimated by the IRS to be underreporting income by some $68 billion a year) have an audit rate of just over 4 percent. The wealthy get far more attention. The audit rate was 3.1 percent  for taxpayers with income of more than $200,000 last year, and 8.1 percent  for those earning more than $1 million.

Other broad areas of interest by IRS enforcement agents align with the biggest areas of suspected fraud, such as returns claiming refundable tax credits, over reporting deductions, and offshore accounts. Within these broad areas, the IRS often homes in on specific types of taxpayers or circumstances.

Karen Hube

Karen Hube is a freelance writer covering taxes, investing and personal finance. In addition to her work for The Fiscal Times, she writes a tax column for The Washington Post and contributes to Barron’s. She began her career as a beat reporter at The