Are You Playing Audit Roulette?

Thomas R. Tartaglia, CPA (Jul, 2009)

The IRS has recently upped the odds of being audited, partly due to the downturn in the economy and partly due to a "tax gap" estimated to be in excess of $345 billion. The "tax gap" is the difference between what taxpayers should pay (i.e., what they owe) and what they actually pay on a timely basis. 

The recently released enforcement numbers for the fiscal year ended September 30, 2008 are among the highest in a decade. Although the tax dollars collected were down slightly from 2007, collections are up by over 58% from 1999 levels. In the coming years the IRS will focus their resources on "higher income" individuals (those with incomes in excess of $200,000), large corporations and international transactions. The IRS will increase their enforcement by using a combination of audits, more information reporting requirements (such as Form 1099, etc.), notice mailings and a greater emphasis on penalties. Another tool they use are "Audit Technique Guides." These guides contain examination techniques, common and unique industry issues and statistics, business practices, industry terminology and other pertinent information that an agent can use in performing examinations. The guides cover industries from Aerospace to Veterinary Medicine and are available to the public on the IRS website www.irs.gov.

The IRS estimates that for every dollar they spend on enforcement they receive four dollars in added tax revenues. The IRS actually audits a very small percentage of the population. However, its sophisticated computer selection process allows them to quickly identify, and then audit, only those returns with the highest likelihood of generating additional tax revenues. Locally we have seen increased audit activity in midsize corporations (revenues between 15 to 40 million dollars and assets greater than 10 million dollars).

Some areas that tend to be higher than average audit risks include, but are not limited to, the following:

Home Office deduction: If you use a portion of your home exclusively for business you are entitled to deduct the costs related to that portion as a home office deduction. The home office must be your principal place of business or a place where you regularly meet with clients. The "office" must also be used exclusively for business. For example, it cannot double as a guest bedroom or child's playroom. The "exclusivity" requirement is most often successfully challenged by the IRS.

  • Job Expenses: If you work for someone as an employee, you are entitled to take a deduction for expenditures you make in connection with performing your job duties. The expenditures must be "ordinary and necessary" and must not be reimbursed (or be eligible for reimbursement) by your employer. IRS looks for "double dipping" (expenses reimbursed by an employer and claimed on the individual's return), as well as expenses for which the employer will not reimburse the employee (an indication the expense is not a true job-related expense). 
  • Rental losses: The rental income/loss rules are very complex. The concepts of "passive activity", "active participation" and "material participation" are scrutinized by the IRS often resulting in rental losses being deferred rather than currently deductible. The IRS also looks to apply certain "re-characterization rules" in situations when you are renting your personally-owned building to the business that you also own.
  • Self employed individuals: If you are running a "business" there is an expectation that it will be profitable. The IRS will focus on self-employed activities with a history of losses, which may be indicative of a "hobby" rather than a "business". As a result, deductions are limited and losses are non-deductible.
  • Automobile expenses: In order to deduct the business portion of an automobile you must maintain a contemporaneous mileage log to properly document the "business use" portion of your automobile. Lack of contemporaneous documentation can lead to a total disallowance of otherwise valid automobile-related expenses.
  • Research credits: the IRS recently announced that it will be more aggressive in auditing business returns claiming research credits. Proper documentation for "qualified research expenses" as well as the projects to which the expenses relate are essential to claiming the credit.
  • "Offshore" transactions: The IRS will increase scrutiny of taxpayers that have used previously undisclosed foreign accounts and undisclosed foreign entities to avoid U.S. taxes. Increased penalties and voluntary disclosure reporting will help the IRS in developing strategies to inhibit illegal promoters and facilitators. Failure to report foreign activities and accounts could result in the imposition of substantial penalties (as much as $100,000 for noncompliance).

While the above activities may have a higher probability of facing an IRS audit, the maintenance of proper and contemporaneous documentation will greatly increase the chances of sustaining deductions in the event your "number comes up".

 

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.

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