Since the spring of 2002, the Internal Revenue Service has been upgrading its audit efforts. According to IRS data released Jan. 17 (IRS Doc. 2008-1073), IRS enforcement efforts have increased in virtually every area. The IRS' annual data book, which provides statistical data on its fiscal year 2007 (12-month period ending Sept. 30, 2007) activities, reflects the increased scrutiny to which high-income individuals and pass-through entities are being subjected.

In fiscal year 2007, IRS enforcement revenues (from collection, document-matching and examination activities) increased to a record $59.2 billion. Since IRS enforcement revenues for fiscal year 2006 were $48.7 billion, this 22 percent increase – considering no increase in IRS staffing levels – is noteworthy. Out of a total of 135 million individual returns filed in 2006, about 1.39 million, or 1.03 percent, were audited, which, while low, is almost twice the number audited for tax year 2000. Audits of S corporations and partnerships also increased substantially since tax year 2000, by 42 percent and 140 percent, respectively.

More telling, however, is the change in the IRS' enforcement activities from fiscal year 2006 to fiscal year 2007, particularly with respect to the audits of individual tax returns with income of $1 million or more and also with respect to the audits of S corporation and partnership returns.

In 2006, 9.25 percent of individual tax returns with income of $1 million or more were audited, which is nine times higher than the overall individual tax return audit rate and 50 percent greater than the audit rate for 2005 individual tax returns.

With respect to audits of S corporation and partnership returns, the IRS audited 59,500 business returns in fiscal year 2007, a 14 percent increase over fiscal year 2006. However, the IRS audited 17,700 S corporation returns in fiscal year 2007, a 26 percent increase over fiscal year 2006, and it audited 12,200 partnership tax returns in fiscal year 2007, a 25 percent increase over fiscal year 2006. These increases are nearly double the overall business return audit increase of 14 percent.

Although, as noted above, IRS enforcement revenues for fiscal year 2007 increased by 22 percent, revenues from audit activities (document matching and collection activities are the other two components of total IRS enforcement revenues) increased by 37 percent from $17.2 billion to $23.5 billion, making revenues from audit activities the dominant driver in the revenue increase.

As the above figures indicate, it is clear that the IRS is focusing on high-income individuals, pass-through entities and the audit function.

Individuals

Most of the increase in individual audits is attributable to "correspondence audits," which are less intrusive than "face-to-face" audits and take little time to complete, making them very cost effective. In fiscal year 2007, almost four out of five audits were correspondence audits. When the IRS reorganized six years ago, it eliminated face-to-face audits for most taxpayers because the wage and investment division had and continues to have no field auditors. Taxpayers who report business-type transactions on Schedules C, E, F or Form 2106 still face the risk of a potential face-to-face audit, since these audits are handled by the Small Business/Self-Employed Division (SB/SE).

Business Taxpayers

As noted above, the IRS is placing more emphasis on the growing area of pass-through entities. Audits of S corporation returns are at their highest level since 1998 and, as previously noted, have increased by 26 percent since fiscal year 2006. Audits of partnership returns have also increased significantly (as noted previously, 25 percent since fiscal year 2006) and are at their highest level since 1997. Perhaps because of the increase in S corporation and partnership audits, audits of large C corporations are down from fiscal year 2006, and IRS revenue agents are spending substantially more of their time on corporate audits that produce no revenue for the government than they have in the past.

How the Above Affects Risk

The IRS uses a variety of methods to select returns for examination, including computer scoring, identification of potential participants in abusive tax avoidance transactions, information matching and random sampling. High-income taxpayers, self-employed individuals and those who receive flow-through income from a partnership, S corporation or limited liability company and/or claim business deductions have an increased risk of audit as a result of the IRS' increased enforcement efforts and its methods for selecting returns.

One of the IRS' primary methods used in selecting returns is the Market Segment Specialization Program. The MSSP focuses on the industry the taxpayer is in rather than on the type of return the taxpayer files, the amount of gross income reported or the ratio of deductions to income. Compliance activity is organized around market segments, where practical. A market segment can be an industry like construction, a professional group like attorneys or an issue like tax shelter transactions. The IRS currently has released audit guides on 87 industries, professions and issues. Individual market segments are then assigned to examiners with auditing experience, training and research responsibilities in that area.

Interestingly, lawyers and law firms have been subject to heightened scrutiny longer than most of the other targeted groups.

Another primary method used in selecting returns is a computer program called the Discriminant Index Function, or DIF. Under the DIF, a return is scored by mathematical formulas. The chances of an audit increase as the DIF score increases. Some of the items that may increase a DIF score and, therefore, increase audit risk, include:

• Excessive business auto use;
• High noncash charitable contributions;
• Higher income, greater than $100,000;
• Hobby losses;
• Income from a flow-through entity, like a partnership, S corporation or limited liability company;
• Income other than basic wages (contract payments, etc.);
• Large business meals and entertainment deductions, or other business deductions;
• Large casualty losses;
• Little or no profit from a business operation;
• Low income with large business deductions; and,
• Self-employment income, or a low gross profit margin from self-employment income.

Additionally, returns may be selected because of information received from media sources, public records or individual informants (like an ex-spouse or disgruntled employee or vendor). However, since these sources may be unreliable, the IRS evaluates the reliability and accuracy of the source before using such information as the basis for an examination.

Once a return is selected for examination under a risk-based audit system, revenue agents and group managers exercise professional judgment on whether the return should simply be surveyed or examined. Furthermore, revenue agents may utilize public information to assist them in determining the audit potential of a return. For example, an agent may check public records to see the average price of homes in a taxpayer's ZIP code. If the average cost of a home is $750,000 and the return does not reflect adequate income to sustain such a lifestyle, it is likely to be scrutinized further. Revenue agents also engage in pre-audit planning, which includes communication with a taxpayer's accountant, which helps to reduce the number of issues under examination. Agents are also encouraged to consult with divisional counsel for guidance on tax law matters and on issue development, which helps to reduce or eliminate bad issues from moving forward because of an agent's misunderstanding of the law.

The Bottom Line

Based on the statistics discussed above, it is evident that the IRS is continuing the trend of its increased enforcement efforts, and it is important for taxpayers to bring their files up to date in an organized fashion. Additionally, taxpayers may wish to engage a tax professional to conduct a "simulated audit" for the purpose of reviewing record-keeping policies and existing tax positions and obtaining advice on correcting problems or deficiencies that would be likely targets in the event of an actual IRS examination. Consider having a tax professional conduct a "simulated audit" or simply discuss your risks and the benefits of a "simulated audit" in your specific situation.

In the event you are contacted by the IRS and informed that your return is being audited or that an adjustment is being made to your return, the guidance of a seasoned tax professional is invaluable. Even if the IRS is correct in making an adjustment, there may be an error in the recalculation of tax, an error that an experienced practitioner can find. For example, some new clients recently enjoyed the benefit of reduced multiple IRS assessments, including the reduction of a $2 million assessment to $110,000 and a $25,000 assessment to a $15,000 refund, plus interest. Although these results certainly benefited these clients, a more efficient and less costly solution is typically available in the initial examination phase.

Michael A. Gillen is the director of the tax accounting group of Duane Morris, a group of certified public accountants providing tax, accounting and consulting services as an ancillary business of the law firm, where he devotes his practice to federal, state and local income taxation. He is a former two-term president of the Greater Philadelphia Chapter of the Pennsylvania Institute of Certified Public Accountants and is a published author and speaker regarding tax and litigation consulting topics.

Bruce J. Rogers is a manager in the tax accounting group of Duane Morris, where he concentrates his practice in federal, state and local taxation, with particular emphasis on income tax compliance and planning for individuals and corporations. He is a published author of articles on tax matters and a speaker at seminars regarding tax and litigation consulting topics.

As required by United States Treasury Regulations, you should be aware that this communication is not intended by the sender to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.

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