Whole Ball of Tax 2003

AUDIT RATES HOLD STEADY, AS IRS LOOKS TO NEW PROGRAM TO CATCH TAX CHEATS

For Small Businesses, "Steady" Means Three Times as Likely to Get Audited

(RIVERWOODS, ILL., January 2003) – While there has been no significant change in audit rates recently, that doesn’t necessarily mean that there are more individuals accurately reporting their tax obligation. In fact, the government estimates there are quite a few less-than-forthcoming taxpayers – or altogether evaders – and it’s starting to take a closer look at how to bring these individuals to the honest side of the tax-paying equation, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software.

Based on IRS statistics for the 2000 filing year, the latest data available, the overall audit rate is just 0.58 percent, up from 0.49 percent a year earlier. That means that only 731,756 of the more than 127 million individual tax returns filed in 2000 were recommended for further review. While this is an increase of about 100,000 from the previous year, it still doesn’t measure up to the more than 1.2 million individual returns audited in the mid-1990s.

The lower audit rates are a result of the IRS’ reduced budget, not its belief that more taxpayers are fulfilling their tax obligation, notes Mark Luscombe, JD, LLM, CPA and principal tax analyst for the CCH Federal and State Tax Group.

In fact, the IRS is concerned that noncompliance is on the rise, partially due to its lack of audit resources and further fueled by the agency’s reliance on outdated compliance information, which is resulting in an increase of no-change audits. To help combat this, the IRS launched the National Research Program (NRP) late last year.

On the positive side, through information captured as part of the NRP, the IRS hopes to update its records so that the information it uses to flag individuals for audits is more accurate, meaning fewer law-abiding taxpayers will have to endure an audit. But, the idea of random audits conjures negative memories for many.

"The last time the IRS performed a random inspection of returns for tax compliance was on 1988 tax returns under its Taxpayer Compliance Measurement Program," said Luscombe. "For taxpayers randomly audited under that program, the ordeal was excruciating as they had to back up every number on every line of their return."

Under the NRP, the IRS randomly is auditing 50,000 individuals. About 8,000 of selected returns will be reviewed using information already provided to the IRS, so these individuals will not even be aware their returns are being reviewed.

Another 9,000 audits will be correspondence-based, with the IRS sending a letter or calling the taxpayer regarding some type of clarification. Focused audits are in store for another 30,000 people, meaning they will have to visit an IRS office for a face-to-face meeting, but just to go over a particular area of the return.

The remaining 2,000 taxpayers will undergo detailed in-person audits, where the IRS will check each line of the return, but it will not require the taxpayer to provide line-by-line substantiation.

While the initial focus of the NRP is reviewing returns filed by individuals, the IRS has indicated subsequent programs could include the review of other types of taxpayers, such as partnerships.

As for certain segments of the population, IRS attention is all but random. Specifically, the IRS has indicated some hot areas it plans to pay close attention to for the foreseeable future include: offshore credit card abuse; high-risk, high-income tax payers; abusive schemes, such as certain tax shelters; and non-payment of income taxes by high net-worth individuals.

Former Enron Corporation manager Lawrence M. Lawyer, for example, would fall into this last category. Late last year, Lawyer pleaded guilty to filing a false tax return, after having been indicted for failing to report as income payments that he received connected with a partnership.

Unfortunately for small business owners, they often are considered potential high-risk, high-income earners, so it’s unlikely they’ll see any near-term relief from the special attention they receive from the IRS.

In fact, small business owners who file a Schedule C return are still three times more likely overall to attract IRS attention than individuals filing 1040s. For 2000, the overall audit rate for small business filers was 1.61 percent, compared to 0.58 percent for all individual filers.

Those small business owners in the low-income range, with total gross receipts (TGR) of less than $25,000, were the most likely to be audited, with 2.72 percent of returns in this category being reviewed in 2000. Middle-income small business owners with TGR of at least $25,000 but less than $100,000 were the least likely Schedule C filers to be audited, with an audit rate of only 1.02 percent. Those with TGR of $100,000 or more had an audit rate of 1.20 percent.

"The IRS may view these individuals as high risk because so much of the information is self-reported by the small business owners themselves. Low-income reporting by a small business owners also could raise attention as it begs the question of why the owner is choosing to be self-employed at all," said Paul Gada, JD, CCH small business analyst and editor of CCH Business Owner’s Toolkit Tax Guide 2003.

One sure way to catch the attention of the IRS is reporting earnings or expenses that fall out of the "traditional" category for someone in your profession. To aid IRS agents in determining this, the agency now has more than 50 Market Segment Specialization Program (MSSP) guides – with professions ranging from Alaskan commercial fishing to veterinary medicine.

Available on the IRS site www.irs.gov these guides can help small business owners and the self-employed see what the IRS expects from their returns. You also may circumvent IRS inquiries about something that you know might look suspicious by attaching a short letter to the return explaining the circumstances surrounding the entry.

While there’s not much you can do if the IRS decides to audit your return as part of the NRP or because you fit a particular high-risk category, there are some steps you can take to reduce other audits.

"Every contact with the IRS can be considered an audit, even if it’s something as simple as the IRS requesting a written explanation about a mathematical calculation or for the taxpayer to furnish basic information omitted from the return," said Luscombe.

While these types of inquiries are common and generally no cause to lose sleep over, they’re still an inconvenience for you or your tax preparer.

A few simple steps you can take to help minimize the risk of a basic IRS inquiry include:

• List all required Social Security numbers on your return, including children claimed as dependents.
• Check your math twice. Numbers that don’t add up trigger audits.
• Accurately report all statements (W-2, 1099, 1098 forms, etc.).
• Include all of the necessary forms with your return.
• Make sure you have proof for your deductions; if you are audited and you can’t substantiate them, they will be disallowed.

Also, keep all receipts and tax records for at least three years. After this time, the chances of being audited are reduced.

CCH Business Owner’s Toolkit Tax Guide 2003 is available in bookstores nationwide, by phone at 800-248-3248 or online on the CCH Business Owner’s Toolkit site (www.toolkit.cch.com). The online site also offers additional information and software tools to help you start, run and grow your home office or small business, including instant access to federal and state information, calculators and forms.

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. The company annually produces more than 700 electronic and print products for the tax, legal, securities, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The CCH tax and accounting destination site can be accessed at tax.cchgroup.com.

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