My son’s scariest Halloween costume was a T-shirt bearing the words “IRS Audit Agent.” An audit can be a terrifying experience. The prospect of defending everything that you have sworn was true on your income tax return and justifying everything you left off is not only disruptive but potentially expensive. So, what are the chances of being audited?
NUMBER OF AUDITS IN THE US
The rate of audit has been in decline for at least a decade. In 2022, the audit rate for all taxpayers was 0.38 percent, down from 0.9 percent in 2009. To be more specific, for Fiscal Year 2022 the total number of audits was 626,204 out of 164,545,167 filed individual returns. This represents a slight decline from the previous year of a 0.4 percent audit rate. However, the audits that do occur do not equally impact all taxpayers. Notably, the audit rate of 1.27 percent for individuals below the poverty line in 2022 was just over three times the overall average and more than five times the rate of 0.023 percent for all taxpayers above the poverty line. Only 0.3 percent of all corporations were audited in 2018, down from 1.45 percent in 2010.
One reason for the disparity of audit rates is that, presently, the IRS is hampered in auditing the returns of higher-net-worth individuals and corporations because of a lack of resources. Tax issues that generate audits for lower-income taxpayers are generally more straightforward, less complex, and involve eligibility for tax credits. On the other hand, wealthier taxpayers and corporations have more complex tax returns. According to IRS Commissioner Charles P. Rettig, “The number of examining revenue agents, who handle complex enforcement cases, fell by 35 percent, and field collection revenue officers, who manage difficult collections cases, dropped by 48 percent.”1 Testifying before the House Ways and Means Committee in March 2022, the Commissioner virtually waved a white flag of defeat in the face of corporate audits: “We do not have the resources to go after the bigs or the superbigs, as we refer to them, and we get outgunned routinely in that space.”2 This statement was followed by the May 6, 2022 report by the US Treasury Inspector General for Tax Administration (TIGTA) which also concluded that the decline in audits has been impacted by the reduction in audit examiners in all units: Large Business & International (LB&I) Division, Small Business and Self-Employed (SB/SE) Division, Tax Exempt and Government Entities (TE/GE) Division, and Wage and Investment (W&I) Division.
In recent years, the IRS has relied on correspondence audits (i.e., those conducted solely by mail) as they require fewer IRS resources. In 2022 (as in 2021), 85 percent of all tax audits were correspondence audits and nearly half of those were against taxpayers with less than $25,000 in income claiming the earned income tax credit (EITC). Simply put, auditing low-income taxpayers by correspondence audit is cheaper and easier for the IRS and can be performed in under five hours, without human intervention, and at a cost of just $150.
Additional agents hired in recent years have not addressed the imbalance in audits. Most new hires have been tax examiners rather than revenue agents. Tax examiners are generally less experienced and less capable of handling complex audits—the type of audits that apply to higher-net-worth taxpayers.
Today, the likelihood of being audited is not very great, but some taxpayers are more at risk of audit than others based upon income, geography, and issue reporting.
WHAT CAN INCREASE YOUR RISK FOR BEING AUDITED?
Selection for an audit does not always suggest there’s a problem. There are several reasons why your tax return may stand out and become one of the thousands open to audit scrutiny.
Random selection and DIF scores
Sometimes returns are selected based solely on a statistical formula. With an eye toward increased computerization, the IRS developed formulas, known as UI-DIF, short for Unreported Income Discriminant Function, to evaluate which returns should be selected for audit. The IRS does not have to disclose how it determines which cases to audit, and the actual criteria for generating a DIF score remains an IRS secret. Behind this seemingly random method of selection is the process of comparing certain “norms” or expectations to a random sample of returns.
In 2000, the IRS began the National Research Program (NRP) as a result of a directive from Congress requiring them, under the Reform & Restructuring Act of 1998, to conduct informational studies of taxpayer non-compliance to support tax policy and collection. The most recent highly visible NRP audits were conducted against former FBI director James B. Comey and former Deputy Director Andrew G. McCabe. This was a highly curious coincidence. The likelihood of an NRP audit is slim. Only 8,000 NRP audits were conducted in 2019 out of 154 million returns.
Taxpayer protection program and frivolous returns
IRS filters detect fraudulent and frivolous returns. A return that appears out of the ordinary compared with prior years may trigger investigation. A return taking a frivolous position can also trigger an audit. The IRS publishes an extensive list of frivolous positions, so if you claim that the tax system is unconstitutional and the government has no tax collecting authority, prepare to be audited and have penalties assessed.
You may get pulled into an audit if, for example, your business partner is undergoing one. The transactions that tie you to other taxpayers may suddenly involve you in a wider-scale investigation. For example, investors in tax shelters may wind up in an audit where the shelter itself is under review.
Income at the poverty level
Unfortunately, the odds of being audited increase five-fold for those with an annual income under $25,000. These taxpayers typically claim the EITC anti-poverty credit, which makes them more susceptible to review. For those with adjusted gross income between $1 and $24,999, the audit rate percentage has increased over the years, contrary to the general decline in audit rates. Fiscal Year 2022 showed a slight decline to 1.27 percent, down from 1.3 percent in 2021. The Congressional Research Service delved into the accusations of disproportionate auditing among lower income taxpayers and, in June 2022, issued a report (IN 11952) detailing their findings.3 Using 2017 statistics, they confirmed that one percent of all returns showing an EITC claim were audited and individual returns without EITC claims were audited at a lower rate of 0.3 percent.
CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Lawyer.