IRS Audit Rates and the Audit of the Future

A few weeks ago the IRS Commissioner threw a very public fit over decreases in the IRS’s proposed enforcement budget.  He publicly announced that audit rates would decrease for the foreseeable future.  His announcement was like the FBI announcing that it won’t prosecute bank robberies for the next year.  The decrease in audit rates may seem like good news for taxpayers, but the audit rate is no longer a meaningful measurement of IRS enforcement.

The audit rate for personal tax returns is already effectively 100%.  When you file your return, electronically or otherwise, the IRS computer matches the amounts from your return against their electronic files of W-2 forms, 1099 forms, and any other data required to be reported annually to the IRS.  So if you forgot to include income from your brokerage account, you don’t need to be audited to be caught.  The IRS computer notes your omission and sends you a tax assessment – along with penalties and interest.

Over the past ten years the IRS spent millions and millions of dollars creating an electronic tax enforcement system.  The electronic system functions as an audit, even if not called an audit.  The IRS no longer needs human agents to catch your mistakes.  So I you consider that all personal tax returns go through the electronic enforcement system, the actual audit rate for personal tax returns is really 100%.  The system has blind spots and makes a lot of mistakes, but it assesses hundreds of millions of dollars annually, and every year the IRS enhances it to match more tax forms against your return.

This electronic audit is the audit of the future.  You could even consider it the audit of the present since the IRS relies on it so heavily. today  Here’s the bad news.  Since the IRS relies so heavily on automated enforcement, it no longer has the staff to deal with all of the errors and discrepancies created by the IRS computer.

For instance, what happens if someone sends you a 1099-MISC form for $4,000 when they only paid you $3,000?  First you get an assessment notice for taxes, penalties, and interest from the automated enforcement system.  The IRS computer considers all 1099 forms as handed down from God.  Those of us in the tax business know the error rate on 1099-MISC forms is probably 25%.  People suck at bookkeeping.

Next, you write a letter responding to the assessment stating that you only received $3,000 not the $4,000 reported on the form.  If you’re really smart, with the letter, you enclose proof that you only received $3,000.  The other way to resolve the problem is to threaten the issuer of the form into sending a corrected form to the IRS.  The result is the same either way.

Three to six months later, you will receive a response from the IRS.  Hopefully, they’ll remove the assessment after your first attempt, but maybe not.  Then you’re in for another three to six months of waiting.  In the meantime, the IRS computer considers your assessed tax balance outstanding and undertakes automated collection efforts against you.  They won’t just lose the assessment as they claim to have lost Lois Lerner’s e-mails about targeting conservative groups.   You might have your bank account drained by the IRS before they can correct their error.  This is why the decreased IRS enforcement budget shouldn’t please you.  It might cost you money.

Staying out of tax trouble in the world of electronic tax enforcement requires prevention not reaction.   First, you have to effectively retain all of the tax records you receive.  We frequently ask clients about income from a source that we had last year for which we don’t have a form in the current year.  You can’t just glibly answer, “I didn’t get a form from them this year.”  If the IRS has the form, you’ll enter the gates of electronic enforcement hell.

Second, you must understand how the IRS processes electronic tax forms and where they expect the income from the forms to appear on your tax return.  If you understand this, you can easily handle incorrect forms.  For instance in the situation above where you received an incorrect 1099-MISC form, you would report the $4,000 on the schedule C income line where the IRS computer expects to see it.  Then you deduct $1,000 as an expense titling it “incorrect 1099-MISC amount.”

You decide by your diligence whether the IRS audit of the future targets you.  You can spend hours trying to fix issues noted by the IRS computer.  Or you can be a little more diligent about tax record keeping and keep the IRS computer from bothering you.  Your choice.

As always, thanks for reading!  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also please like the How to Screw Up Your Small Business Facebook page.  I post tax and accounting hints there daily.

Until next time, let’s do it to them before they do it to us.