It’s every taxpayer’s worst nightmare—there’s a knock on the door one evening and you open the door. You see a figure in the shadowy night but can’t see his face. You notice a pocket protector and thick black glasses frames. As the light shines upon the figure, an extremely nerdy man comes into view, strikingly similar in appearance to some of the kids you used to beat up in high school. In his most screechy voice he lets you know that he is an agent for the Internal Revenue Service and he is auditing your tax return. You begin to panic. Your first thought is that maybe this is divine justice for beating up those kids in high school. You then start thinking about everything possible that you may have done wrong to be audited. This unimposing dweeb of a man suddenly seems scarier than a rabid grizzly bear on steroids chasing you while you are covered with honey. It’s what every taxpayer constantly has in the back of his or her head and a question I am often asked—what are the odds that my tax return will be audited?
If you haven’t seen in the news, things aren’t so peachy over at the IRS as of late. It turns out the IRS is a little bit on the broke side. Well, not exactly a little. That would be like saying the Incredible Hulk was a bit cranky. Things have gotten so bad at the agency, according to an article in Bloomberg’s Businessweek last month, that employees have had to resort to bringing in their own staplers, pens, and other supplies to work. So what does this mean for you? Well, last year because the IRS’s budget keeps on shrinking and therefore their workforce is shrinking, the IRS audited 1.2 million individual tax returns. That’s less than one percent of the returns that were filed, the lowest rate since 2004 (when about one in every 104 tax returns were audited). The IRS Commissioner already said that this year it expects that number to fall to one million audits due to budget constraints. While one million sounds like a lot, it’s a significant decrease from the 1.4 million tax audits performed just two years ago.
But before you start expensing that trip to Sesame Place as “business travel,” the declining audit rate doesn’t necessarily mean that your little visit to Snuffy and the gang will go unchallenged. There are still many red flags that can trigger a tax audit. Some of the red flags are really not in your control. For example, while most of us fall in that one percent audit rate, for taxpayers that reported income of $1 million this number rises above six percent, and for those with $10 million or more of income this number is more than 16 percent. The reason for this phenomenon is simple. It’s because you have money and the IRS doesn’t, so the IRS is going to look real hard at your tax return to see if it can find a way to get some money from you. It’s like the old saying about why the bank robber robbed the bank: “Because that’s where the money is.” If your income is very high, congratulations. But just realize you are the bank in the eyes of the IRS. Another group that is highly targeted by the IRS are US citizens living abroad. The IRS is extremely focused on taxpayers hiding income offshore, which is why in 2014 the IRS audited 4.8 percent of international returns.
However, there are some red flags that we do have control over that you can look out for. One obvious thing is to make sure you report all your income from your W-2s and 1099s. The IRS receives a copy of these statements, so if you failed to include income from one or two of these statements, whether it’s intentional or not, you can be assured you will hear from them. Another scrutinized area is when a taxpayer has unusually high charitable deductions in comparison to their income. This doesn’t mean you should stop giving to charity, but just make sure you have proper documentation, especially if it’s a rather large number. Another high-priority target is taxpayers that fail to disclose any foreign bank accounts they have. All US taxpayers must file a FinCEN Form 114 to report foreign accounts that total more than $10,000 at any time during the previous year. The penalties for failing to do so are extremely severe. Lastly, if you own a small business, make sure you report all your income and you can substantiate all your expenses. The IRS knows how easy it is for sole proprietors to exaggerate their expenses and is always on the lookout for something that may not look right. They pay special attention to businesses where cash changes hands mostly, such as taxis, car washes, bars, and restaurants. With all this being said, I always tell my clients that if they can substantiate an expense with proper documentation then who cares what the IRS may think. If you really gave $1 million in charity then take the deduction as long as you have the proper documentation.
While the declining audit rates seem like a great relief to most of us, it can actually be a missed opportunity for the law-abiding citizens. Believe it or not, there are times when the IRS takes a second look at your return resulting in you actually receiving money back. In 2014, the IRS realized 38,029 taxpayers had paid too much in taxes and unexpectedly took a play out of the Santa Claus playbook and sent them additional refunds. See, being audited can actually be fun sometimes. Too bad your chances of experiencing it are becoming increasingly low.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether its tax returns, bookkeeping, payroll services, or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
By Daniel Magence