The IRS recently announced that a total of 1,391,581 individual income tax returns were audited during FY 2008 (October 1, 2007 through September 30, 2008) out of a total of 137.8 million individual returns that were filed in the previous year. This works out to 1.0% of all individual returns filed (about the same as the audit rate for the preceding year). Even the national average is about 1% that includes large numbers of returns where the income is easily verifiable and the deductions not complicated. However, once your return includes more complicated items, the odds quickly increase. The following are examples taken from the IRS report.

Returns with Earned Income Tax Credit

The earned income credit provides low-income taxpayers and taxpayers with children with a refundable credit that rewards them for working. Because the credit is refundable, it is treated like withholding and any amount that exceeds a taxpayer’s income is included in their refund for the year. Those that benefit the most from this credit are taxpayers with children who can receive a credit as high as $4,713 (2007 amount). Because of the dollar size of the credit, there has been a significant amount of abuse in claiming the credit, partly because it is complicated to understand and partly due to larceny among taxpayers. Since the IRS is able to track dependents and earnings (W-2 and 1099) by using their computer, they can quickly identify those suspected of claiming more EIC than they are entitled to and audits most of them by computer-generated correspondence.

Non-Business Returns without EIC

This group includes what most would describe as your average run-of-the-mill tax returns using standard or itemized deductions but without EIC or any business schedules attached. As you can see from the numbers, the IRS also relies heavily on their computer matching skills to target candidates to be audits. The IRS has become very efficient at this over the years by using their computer to identify unreported income, overstated deductions, unreported sales transactions, etc. For example, the IRS computer is able to track wages, other compensation, investment income, pension income, partnership and
S-corporation income, alimony, mortgage interest, tax refunds, security sales, dependents, and other items enabling them to easily identify unreported income. Also note that those most heavily audited are the returns with employee business expenses (Form 2106) and Schedule E, which includes K-1s from partnerships and
S-corporations.

Business Returns Without EIC

Once you attach a business schedule (self-employed businesses (Schedule C) and rental property (Schedule E)) to an individual return, the audit rates take a significant jump. These returns become more complicated, and small business owners are historically poor recordkeepers, which make them a high value target for audit. Notice also that the correspondence audit count drops significantly for these types of audits and most are face-to-face with IRS audit personnel, especially at the higher-income levels.

High-Income Taxpayer Returns

High-income taxpayers are also a more frequent target for audit, simply because they are in a much higher tax bracket and resulting adjustments yield a higher percentage of tax. Higher-income taxpayers are also the ones more likely to get involved with tax shelters. Notice that the higher the income, the greater the audit rate.

Non-Farm Corporations

Corporations are generally selected or audited based upon the total assets of the corporation and increase in frequency as the value of the assets increase. Notice also that correspondence audits represent a very small portion with the IRS relying mostly on office audits.

If you receive an audit notice or correspondence inquiry from the IRS or state tax agency, contact this office immediately. Experience and having an in-depth knowledge of taxes and IRS procedures is important when it comes to responding to IRS inquiries. Procrastination can also complicate matters that are generally easy to resolve, so please call as soon as possible.