This subject was hard to write about, not because of the topic, but because it was almost irresistible to add a comment on the economic stimulus package that President Bush and Speaker Pelosi crafted at mid-month. On that subject, let’s just say that the plan is appealing, but what really matters is the final version, so we will skip any analysis for this month.

Since the stimulus package is not law yet, let’s talk about something that is real – IRS audit statistics and what they mean to you. This month, we will discuss where the IRS is headed with its audit process. Next month, we will talk about audit protection strategies.

When you look at the statistics, you need to be aware of how the IRS defines an audit. You may think that an audit requires an IRS agent to come to your home or office and pour through your records, but the majority of IRS audit performed at the individual level are not this intrusive. Often, an audit is performed through correspondence where the taxpayer is requested to send information via mail to the IRS. In fact, 76% of 2006 audits were performed by correspondence - the rest of the audits were performed by field examiners.

Let’s take a look at the latest statistics. For fiscal year 2006, there were 132,275,830 individual income tax returns filed. The IRS “audited” 1,283,950, or .97% of those returns. This percentage is slightly higher than 2005 (.93%) and is the highest percentage in this century. You had the greatest opportunity to be audited if your return included a Schedule C with total gross receipts above $100,000 (3.90%). Though that may be no shocker, what might surprise you is the second highest risk category: those with a Schedule C showing total gross receipts less than $25,000 (3.78%). For those of you with farms, there was good news; as a category, individual business returns with a Schedule F were not hit harder than any other categories.

Historical trends are interesting, but they do not necessarily indicate where the IRS is headed. To find this out, let’s take a look at what the Internal Revenue Service has to say. In a 2002 release, the IRS adopted an audit strategy that included addressing the following areas of noncompliance:

1. Offshore credit card users.
2. High-risk, high-income taxpayers.
3. Abusive schemes and promoter investigations.
4. High-income non-filers.
5. Unreported income.
6. The National Research Program.

The use of offshore credit cards is not illegal, but from a taxation standpoint, they are considered high-risk because they can hide income not reported to federal authorities.

High-income taxpayers typically have more complex returns than middle and lower income filers. They have the ability to invest in pass-through entities like partnerships, trusts and corporations. Upper income taxpayers also have the ability to engage in sophisticated tax mitigation schemes. Because of the resources available to higher-income taxpayers, the potential for errors and outright fraud to occur in their returns exceeds the risks inherent in tax returns of lower-income filers.

The IRS continually updates it’s listing of transactions and schemes that it considers abusive and fraudulent. Using any of these schemes could signal your return for audit. For more information on such schemes, check out the IRS Compliance and Enforcement page.

High-income non-filers - and those who fail to report income - should be aware that the IRS has developed, and constantly improves upon, a sophisticated computer model to catch them. As time goes on and more data is collected through the National Research Program, the accuracy of these models will only increase. Even without the use of the model, the IRS’s 1099 matching program has greatly enhanced collections from returns that omit income.

As a final note on where the IRS is headed, be aware that certain returns are automatically screened by IRS personnel. From an individual standpoint, all returns with total positive income items that total $50,000 or more will be screened. This does not mean the returns will be audited, only that there is a higher chance for them to be chosen in the long run.

The strategy articulated in 2002 is still applicable today. As the IRS continues to develop its computer models, you can expect to see greater accuracy in the returns it chooses for audit. With greater accuracy comes the likelihood that the IRS will increase the numbers of returns it audits and finds additional taxes. For this reason, it is important for you to make certain that what you report to the IRS is accurate. With the complexity of our system, this is not always easy. Before you put your return in the mail to the IRS, make sure you have done everything you can to prepare an accurate return and, if you need help, give us a call.

Have a great February!