Friday, April 1, 2016

How to Avoid an IRS Audit? Make Less Money!

The WSJ presents some wisdom on how to avoid an unpleasant IRS Audit. The cynics among us may be tempted to sum it up as "to avoid an audit make less money!" The less money you make, the less chance you'll be audited is the message that comes through.

Laura Sanders writes "With tax day nearing, you may be wondering what triggers an IRS audit.

The short answer: It often takes more than it has in the past. In fiscal 2015, which ended Sept. 30, the Internal Revenue Service audited less than 1% of nearly 147 million individual returns, the lowest rate in a decade.

The drop in the audit rate stems from budget cuts, according to IRS Commissioner John Koskinen. Last year, the agency had $900 million less in funding and 25% fewer enforcement officers and agents than it did in 2010. Revenue from audits and other enforcement also dropped last year, to $54.2 billion, from about $57 billion in 2014.

In a November speech, Mr. Koskinen cited an IRS estimate that every dollar invested in the agency produces $4 in revenue.

The overall numbers don’t tell the whole story. In recent years, the IRS has increased its focus on high earners, and in 2015 it audited nearly 10% of returns with $1 million or more of income. In 2006, just 5.3% of taxpayers reporting at least $1 million of income were audited.

To identify returns for exam, the agency often turns to its top-secret computer program known as DIF, for Discriminant Inventory Function system. Its formulas are closely guarded, but tax specialists said DIF seems to compare various numbers on the return with one another and with norms, looking for aberrations.

For example, the program could identify disproportionate charitable, medical or business-entertainment deductions and flag them for scrutiny, said Joe Walloch, a professor emeritus of advanced taxation at the University of California, Riverside.

The IRS also has ramped up enforcement through automated document matching and “correspondence” audits, which are conducted through the mail. Document-matching inquiries focus on discrepancies between a taxpayer’s return and income that a third party reports for that individual. Correspondence audits examine issue-prone areas, such as business expenses or rental properties.

Forewarned is forearmed, so here are areas known for attracting IRS attention:

Form 1099 mismatches. Taxpayers receive a flurry of income reports from banks, brokers and others who have paid them and are required to tell the IRS about it. Taxpayers who don’t account for this income on returns will probably get a letter from the IRS, sometimes within a few months of filing.

If there is a mistake on the form, try to have it corrected. If that isn’t possible, tax specialists said to claim the erroneous amount on your return and enter an adjustment correcting it, to avoid confusing the IRS’s computer matching the documents.

Charitable deductions. It can’t be stressed enough: Taxpayers must have appropriate proof of a donation in hand by the time they file the return to qualify for a deduction. The law has gotten stricter in recent years, and the IRS is enforcing it. Failure to comply with the letter of the law cost one taxpayer an $18.5 million deduction in 2012

For details of proof, see IRS Publication 526. For donations by check, taxpayers often need a letter saying the amount of the donation, its date and whether anything of value was received in return.

Small-business income. IRS research has shown that underreporting of income is high in cash businesses. To uncover it, the IRS may turn to analysis of bank deposits and other methods.

In recent years, the agency has gained another useful tool, Form 1099-K. It reports receipts from credit-card firms and other processors, such as PayPal, both to the owner and the IRS.

Auditors are using this data in the hunt for unreported income. In one example cited by Mr. Walloch, a tobacconist received Forms 1099-K totaling $80,000 and claimed $150,000 of income. The IRS wrote him saying that according to statistical data, a proprietor with $80,000 of 1099-K income should have total receipts of about $240,000 and proposed an assessment of $90,000.

Business travel, meals and entertainment. This is another perennial hot spot for scrutiny. In brief, taxpayers must have records detailing who, what, when, where and why to qualify for a deduction. Tax preparers said people often forget to record the why, the business purpose of the deduction. For more details, see IRS Publication 463.

Undeclared foreign accounts. U.S. law requires taxpayers to report foreign financial accounts, and there can be draconian penalties for both citizens and green-card holders who don’t.

U.S. authorities know much more about such accounts than in the past due to a provision requiring foreign financial firms to submit information to the IRS. In addition, banks and other financial firms in Switzerland, Israel, the Caribbean and elsewhere have been turning over account information following legal settlements...