IRS plans to revive its random-audit program
Random tax audits are coming back.Beginning this fall, the Internal Revenue Service plans to revive a once-controversial practice of randomly targeting thousands of taxpayers for audits, even when the agency has no reason to suspect them of wrongdoing. IRS officials expect the tax probes to provide fresh data to update the top-secret formulas the agency uses to help select which returns to audit and thus enable it to do a better job of combating tax-dodging.The first wave of random audits will start in October and target about 13,000 income-tax returns for the 2006 tax year, selected from various income categories. The IRS says it expects to conduct random audits on similar-size groups in subsequent years.Although the number of taxpayers affected represents a tiny share of the 136 million tax returns expected this year, many of the random audits “will probably cover more ground than a regular audit” as agency officials gather data for their tax research, says Mark Mazur, the IRS’s director of research, analysis and statistics. What’s more, many targeted taxpayers might want to hire an accountant or lawyer to represent them, which can end up costing hundreds or thousands of dollars.The audits come at a time when the IRS faces intense pressure from Congress, struggling with large budget deficits, to take bolder action to slash the nation’s “tax gap,” or the difference between what the government collects each year and what it should be collecting. The IRS estimates this gap at around $290 billion.”The new program will be a big step forward for tax research,” says Kevin M. Brown, the acting IRS Commissioner. “Our approach will reduce the burden on taxpayers, improve our audit selection techniques and give us more timely information to help reduce the tax gap.”Random IRS audits have a long and highly controversial history. IRS officials say the new wave of audits will be less burdensome than a program in the early 1990s that attracted intense criticism for being overly intrusive and time-consuming for many taxpayers. Accountants say the IRS often challenged nearly every item on a tax return and ordered taxpayers to produce large amounts of supporting documentation, even for minor items.Those audits “were pretty ugly,” recalls David Lifson, a partner at Hays & Co. and president of the New York State Society of Certified Public Accountants. Mr. Lifson says he had two clients who faced audits in that earlier program and each took “the equivalent of about 10 full working days over a four-month period.” They were asked for such things as birth certificates, Social Security cards and details of contracts specifying how they would be paid. Mr. Lifson doesn’t recall how much he charged the clients, but says both wound up owing no additional tax.In the mid-1990s, the IRS made plans for another round of random audits to gather fresh data. But the uproar from the previous project “was so fierce that the program was stopped cold,” recalls former IRS Commissioner Charles Rossotti in a book he wrote about his experience. That left the IRS “with nothing but its increasingly out-of-date information from the 1980s” on who was and wasn’t paying what was owed, he wrote.A few years ago the IRS took a new approach: a slimmed-down, gentler version of random audits that examined more than 45,000 returns for the 2001 tax year. That program has drawn relatively little criticism, and results already have enabled the IRS to update its system for identifying which returns to audit. The system relies in part on a computer program, known as the Discriminant Inventory Function System, which assigns a score to each individual return based on the likelihood that an audit will lead to a tax change. (The IRS won’t divulge details of its scoring system.)Among other things, IRS officials and congressional investigators say research has shown that tax “noncompliance” typically is highest among people who work for themselves, who deal in large amounts of cash, who don’t have taxes withheld from their pay and whose income isn’t reported separately to the IRS, such as by their employer.Another area the IRS has been focusing on for noncompliance is S corporations, which are the most common type of corporate entity. With a typical S corporation, profits or losses flow through to the individual owners, who in turn are supposed to report those items on their individual returns. The IRS is doing a separate study of S corporations.Now, the IRS says it needs to gather fresh data. Much has changed since the 2001 tax year, including stronger overall economic growth, surging executive compensation, soaring stock prices, a proliferation of hedge funds and business scandals such as options backdating.One area that could get attention in the latest research is capital gains taxes. The reason: IRS officials and lawyers suspect the government is losing billions of dollars in tax revenue because many investors inflate the cost basis, or the price they originally paid for stocks and other securities, in order to report lower capital gains when the securities are sold.Congress is considering legislative proposals that generally would require many brokers and other financial-services companies to report to the government what investors pay for stocks and other securities. President Bush has made a similar proposal, which Treasury officials say would improve compliance on capital-gains taxes. Currently, many brokers and fund companies already track cost data for customers, although they aren’t required by law to do so.If you are chosen for a random audit, how painful and expensive will it be? And what should you do to protect yourself?The answers are likely to vary widely. In some cases, Mr. Mazur of the IRS says some of the targeted taxpayers won’t even realize they’ve been picked. That’s because the IRS will be able to verify everything it needs simply by computerized comparing of what the taxpayer put down on the return against what was reported separately to the IRS by financial institutions, employers and others. And in some cases the IRS will be able to get most or all of what it needs from a taxpayer by mail.But “the majority” of tax returns selected for the new round of random audits will lead to in-person meetings with IRS examiners, and many people will face more-detailed questions than in regular audits, Mr. Mazur says. That’s because IRS researchers need the additional information for their studies. Agents may also pay more attention to smaller dollar amounts because even such small amounts can be important for research purposes.Some people comfortable with tax issues and who have long prepared their own returns may be able to handle one of these new audits on their own. But in view of the rapidly growing complexity of the nation’s tax laws, most who get detailed questions from the IRS should consider getting professional help, such as an accountant, lawyer or “enrolled agent” (a person specifically approved to practice before the IRS). That’s especially the case for someone subject to the alternative minimum tax, a complex parallel tax system that affected nearly four million people for 2006 and that disallows certain deductions.Some taxpayers with relatively simple returns may be able to get help with an audit from one of the tax-preparation firms for a few hundred dollars.But in other cases, help won’t come cheap. Asked how much his firm would typically charge a high-income client in the New York City area for help with a random audit, Mr. Lifson of Hays & Co. replies: “Anywhere from $2,500 to $25,000.” That’s based on his estimate that the audit could take anywhere from one day of work to two weeks.To protect yourself, make sure you have as much supporting documentation as possible. Also be sure it’s neatly organized so that your tax pro won’t have to spend many billable hours sorting through your papers.
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