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Audit Bait

Is Your Return Audit Bait?

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.

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.

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. 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 people 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 and elsewhere have been turning over account information following legal settlements.

Manually prepared returns.  When the IRS enters data from such returns, it automatically checks for math errors and other mistakes. They can generate not only a letter but also further scrutiny, said Raymond Edwards, a CPA based in Los Angeles with wealth-management firm Aspiriant LLC.

(From the Walll Street Journal, April 2, 2016 by Laura Saunders)

Audit Bait - The Dirty Dozen: Moves that could trigger IRS scrutiny.
Some tax moves attract more scrutiny from the Internal Revenue Service than others.

One of the biggest is reporting high income. Audit rates start shooting up sharply for taxpayers who make more than $200,000 a year.

Here are 12 others.

Forget to claim reported income. The IRS automatically matches reports of different types of income against the numbers on tax returns. Omitted items raise red flags.

Take outsize deductions, especially for charitable gifts or travel and entertainment. IRS computers are geared to pick up anomalies from established norms. The agency is also aware that many people don't know about tough rules requiring taxpayers to have paperwork in hand before taking a large deduction.

Hide offshore accounts. U.S. officials have conducted an intense five-year campaign against undeclared offshore accounts and now have many ways to "out" U.S. taxpayers with such accounts. Penalties can be severe: up to half the value of the account or more.

Claim certain items on small-businesses returns. Declaring negative gross income can catch the IRS's eye, as can claiming to have paid independent contractors, deducting expenses related to bad debt or claiming large expenses for repairs.

Pretend a money-losing pastime is a business. The IRS is quick to disallow so-called hobby losses, and courts have often sided with the agency. To deduct expenses from a labor of love, it is best to show a profit in at least three out of five years.

Use suspiciously round numbers. Taxpayers are allowed to round amounts to the nearest dollar, but a return with many strings of zeros calls attention to itself.

File an amended return. Scrutiny is especially likely if a large refund is claimed on such returns, say experts.

Use a dubious tax preparer. Tax professionals are supposed to uphold the law. When the IRS finds one who hasn't, it may follow up by examining the clients' returns.

Be a tax protester. The IRS takes a dim view of people who it says "make unreasonable and outlandish claims to avoid paying the taxes they owe."

Provoke a whistleblower. The IRS has two programs that can pay rewards to people who provide conclusive evidence against tax cheats. Often the whistleblowers are former spouses or employees.

Fail to claim canceled debt as income. Some types of forgiven debt are taxable while others aren't, and experts say the IRS often is quick to challenge taxpayers.

Fail to file. If you don't file a tax return, the IRS may do it for you, using information from W-2 forms and other income reports. Don't expect the agency to assume you have deductions, and be prepared for further attention.

(From the Walll Street Journal, March 14, 2014 by Laura Saunders)

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