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In the spring of 2002, the Internal Revenue Service began implementing plans to upgrade its audit efforts. These plans included increasing the number of audits, moving to a risk-based audit system using statistical data compiled from returns and other public information, and instituting the National Research Program, in which thousands of taxpayers selected at random would be subject to intense line-by-line audits.

Since then, the IRS has substantially increased its enforcement measures. According to testimony made in November 2004 by the IRS before Congress, over 1 million individual audits were conducted in 2004, and the IRS brought in a record $43.1 billion in enforcement revenue, representing an increase of $5.5 billion (or 15 percent) from 2003. Additionally, high-income audits have risen by 74 percent and criminal tax prosecutions have risen by 50 percent since 2002. However, most of the increase in individual audits is attributable to “correspondence audits,” according to the Transactional Records Access Clearinghouse (TRAC) at Syracuse University, which are substantially less intrusive than “face-to-face” audits.

The IRS, in News Release IR-2005-38, of March 29, reported that the United States sustained a “gross tax gap,” defined as the difference between what taxpayers should pay and what they actually pay on a timely basis, of between $312 billion and $353 billion for tax year 2001. Preliminary findings from the program indicate that the largest component of the tax gap is underreporting noncompliance and that individual income tax is the single largest source of the annual tax gap, accounting for approximately two-thirds of the total. The preliminary findings also reflect that, with regard to individual underreporting, more than 80 percent originates from understated income, rather than overstated deductions, and that most of the understated income results from business activities, as opposed to wages or investment income.

The National Research Program was a three-year study that audited 46,000 individual income tax returns for 2001, according to IRS Fact Sheet FS-2005-14, March 2005. The program introduced several innovations to the audit process that were designed to reduce the burden imposed on taxpayers whose returns were selected for the study. These innovations were described in testimony by IRS Commissioner Mark Everson before the House Committee on Small Business on April 27, 2005.

The first innovation was the compilation of a comprehensive set of data to supplement information reflected on the selected returns. This reduced the need to request information from taxpayers. The second major improvement of the program was to introduce a “classification” process, whereby the randomly selected returns and associated case-building data were initially reviewed by experienced auditors who identified the most efficient way to handle each return. These and other innovations were intended to reduce the burden that existed for taxpayers under the previous system, where every line of every return was examined. These innovations are now being expanded into the IRS’s regular operational audit programs.

As a result of the Program, preliminary findings, and in an effort to reduce the tax gap, the IRS has recently stated, again in News Release IR-2005-38, March 29, that they are ramping up their audits of high-income taxpayers and corporations, focusing more attention on abusive shelters and launching more criminal investigations. The IRS indicated in its Strategic Plan for 2005-2009 that its priority areas for discouraging noncompliance include:

Promotion and use of abusive tax schemes and avoidance transactions;

Misuse of offshore transactions;

Nonfiling and underreporting of income by higher income individuals; and

Flow-through income.

Additionally, the IRS has received modest budget increases over the past two years and has increased its spending on enforcement by almost 8 percent. In 2004, the audits of large businesses (those with assets of $10 million or more) increased and the IRS intends to do the same for small businesses in 2005, again based on the testimony made in November 2004 by the IRS before Congress.

Tax Implications

Taxpayers who have high income, are self-employed, receive flow-through income from a partnership, S corporation or limited liability company and/or claim business deductions, have an increased risk of audit as a result of the IRS’ focus.

The IRS uses two primary methods for identifying returns to be examined. The first, a computer program called the Discriminant Index Function, scores a return using mathematical formulas. The higher the “score,” the higher the chances of an audit. Some of the items that may increase a DIF score and therefore increase audit risk include:

Higher income, greater than $100,000;

Income other than basic wages (contract payments, etc.);

Large casualty losses;

Large meals and entertainment deductions;

Excessive business auto use;

Low gross profit margin from self-employment income;

Low income with large business deductions;

High noncash charitable deductions;

Hobby losses; and,

Little or no profit from a business operation.

The Market Segment Specialization Program is the second primary method used for selecting returns. The MSSP focuses not on the type of return a taxpayer files, the amount of gross income reported, or the ratio of deductions to income, but on the industry the taxpayer is in. Compliance activity is organized around market segments, where practical. A market segment can be a professional group, such as attorneys; an industry, such as manufacturing; or an issue, such as passive activity losses.

The IRS has released audit guides on 75 professions, industries and issues. Individual market segments are then assigned to examiners with auditing experience, training and research responsibilities in that area. The most recent of the 75 audit guides reflects the IRS’ guidance on payments and perks given to departing or retiring executives, including such compensation issues as the treatment of club memberships, qualified employee discounts, home improvements, personal use of a company’s aircraft and qualified retirement planning.

In addition, IRS officials recently announced the launch of a study to determine the reporting compliance of S corporations. The study, carried out under an expansion of the National Research Program described before, will examine 5,000 randomly selected S corporation returns from tax years 2003 and 2004.

Once a return is selected for examination using one of the methods described — above for example, revenue agents and group managers exercise professional judgment on whether the return should simply be surveyed or examined. Additionally, revenue agents utilize public information to assist them in determining the audit potential of a return. For example, an agent may check public records to determine the average price of homes in a taxpayer’s ZIP code. If the average price is $500,000 and the return selected shows inadequate income to sustain such a lifestyle, it is likely to be scrutinized further. Revenue agents also engage in pre-audit planning, including communicating with a taxpayer’s accountant, in an effort to reduce the number of issues under examination. Agents are also encouraged to consult with divisional counsel for guidance on tax law matters and on issue development, which helps to reduce or eliminate bad issues from moving forward as a result of an agent’s misunderstanding of the law.

A few years ago, as reflected in the IRS publication, IRS Strategic Plan 2005-2009, released in June 2004, the IRS reorganized into four separate compliance divisions: Wage and Investment, Small Business/Self-Employed, Tax-Exempt and Governmental Entities, and Large and Mid-Size Businesses. Each division has a compliance function. Wage and Investment taxpayers typically have no personal contact with the compliance division since the majority of the W&I audits are conducted by mail. However, issues that cannot be resolved by mail, phone or electronically are referred to the Small Business/Self-Employed division. Small Business/Self-Employed taxpayers can expect to see an increase in the number of audits in the next few years.

Changes to the IRS audit process as a result of the program are a work in progress. No one, including the IRS, knows exactly how the compliance function will work in the future. However, it is certain that the IRS is increasing its enforcement efforts, and it is important for taxpayers to bring their files up to date in an organized fashion, in order to avoid proposed tax return adjustments. Accordingly, taxpayers may wish to engage a professional to conduct a “simulated audit” for the purpose of reviewing record keeping policies, existing tax positions and obtaining advice on correcting problems or deficiencies that would be likely targets in the event of an actual IRS examination.

In the event you are contacted by the IRS and informed that your return is being audited or that an adjustment is being made to your return, talk to a tax professional. Even if the IRS is correct in making the adjustment they may have made an error in the recalculation of tax. For example, a taxpayer was recently audited in a case in which the IRS made an error in calculating an adjustment to their return and in computing the corresponding tax assessment. The taxpayer’s accountant did not discover the error.

Our firm was retained once the matter went to the Collections Group of the IRS. During our representation before the IRS Collections Group, we identified the error. While we were eventually successful in arranging for the IRS to correct the assessment and release the levies, resulting in a reduction of more than $400,000, it would have been much more efficient and less costly to have resolved the issues during the examination phase.

MICHAEL A. GILLEN is the director of the tax accounting group and a variety of ancillary businesses at the law firm Duane Morris. He is also the president of the Greater Philadelphia chapter of the Pennsylvania Institute of Certified Public Accountants, a chapter of the second-oldest and fifth-largest state CPA society in the country. Gillen devotes his consulting practice to criminal and civil tax and nontax controversies, damage assessment and measurement, class action matters and taxation.

BARBARA A. RUTH is a manager in the tax accounting group of Duane Morris, where she practices in the areas of federal, state and local taxation, with particular emphasis on income tax compliance and planning for estates and trusts, nonprofits and individuals. She also devotes her practice to litigation consulting services, including criminal and civil tax controversies, damage measurement and marital dissolution.

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