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The Audits Are Coming!

Fewer than 1 in 200 taxpayers was the target of an audit in 2000, continuing a downward trend that accelerated after congressional hearings in 1997 and 1998 put a spotlight on alleged IRS abuses. The agency diverted enforcement personnel to customer service and backed away from some tough stands because of legislation that bolstered taxpayers' rights. From 1992 to 2000, the IRS's staff was reduced from 115,000 to 97,000 while the number of tax returns filed increased by 10%. During that period, the number of audits the agency performed fell by two-thirds.

But just when you were being lulled to sleep thinking that the IRS was getting warm and fuzzy, here come those random audits again! Sending shivers down the spines of taxpayers, the IRS says it will start randomly auditing individual tax returns. Also, IRS officials have received money to beef up their enforcement staff. Last year's budget allowed for adding 2,036 IRS employees for auditing and collection.

These moves represent a startling about-face from reforms the IRS made in recent years to become a friendlier agency. The IRS did its last random audits in 1988, and was stopped by Congress when it tried to start them up again in the mid-1990s. But they're back now, and are considered by many to be the financial equivalent of a root canal. The IRS claims that these new National Research Program (NPA) audits will be "no more costly and no more burdensome than it needs to be." That's great, unless you are one of the unlucky few who will be selected. So let's take a look at what may be in store for some of you.

Focus on noncompliance
Under a new strategy, the IRS will reallocate resources in order to focus on key areas of noncompliance with the tax laws. The IRS expects to focus first on promoters and then on participants in these various tax schemes and scams. You'll likely want to get more details on these programs from the IRS press release, but let's review some of the new priority areas.

Offshore credit card users: If you have an offshore credit card, does that make you a tax cheat? Nope. But there are many offshore tax scams involving these credit cards and tax dodges. Last year, the IRS requested and received 1.7 million records from American Express and MasterCard that involved more than 230,000 credit cards issued by banks in the Bahamas, the Cayman Islands, and Antigua. The IRS then went on to request that Visa turn over millions of confidential records with the names, addresses, Social Security numbers, and telephone numbers of American cardholders with accounts in 30 countries.

So if you have a foreign credit card, you may be hearing from Uncle Sam in the near future. Remember that, if you have an interest in a foreign bank account, that information must be disclosed on Schedule B with your annual tax return.

High-risk, high-income taxpayers: The IRS believes that high-income taxpayers may be involved in many more complicated tax transactions. A partnership here... a corporation there... a trust over there... and a bevy of accountants and attorneys to pull the loopholes a bit bigger.

Again, simply because you are a high-income individual with a complicated tax structure doesn't make you a tax cheat. But many times those multiple organizations are used to create transactions, passing from one organization to another, with little or no economic substance. And there is always the possibility of underreporting income with such a complicated tax structure.

Abusive schemes and promoter investigations: The IRS will be looking to round up and prosecute promoters of such popular tax schemes as slavery reparation claims, abusive tax shelters and trusts, and bogus claims such as income taxes that aren't authorized by the Constitution. So if you're involved in any of these schemes, it's possible that you and the IRS will become close before too long.

High-income non-filers: This one is a head-scratcher as far as I'm concerned. If the IRS knows (through the various computer reporting systems) that a taxpayer has high income, but yet is not filing, why not target these folks first and foremost? If they have the money and assets, they can be prime targets for IRS collection efforts. Nevertheless, if you've got money and assets, and have decided to simply not file your past returns, you might want to consider the error of your ways before the IRS comes to call.

Unreported income: This has long been a sore point with the IRS. And they are taking new steps to determine those taxpayers who have a great propensity for not reporting all of the income that they should.

National Research Program (NRP) audits
About 50,000 returns for the 2001 tax year will be randomly selected for an NRP audit. This program is designed to provide a statistical base for the IRS to be used to audit other tax returns in the future -- an attempt to find areas where taxpayers are not complying with the tax laws. But just because your return is selected for an NRP audit doesn't mean that you'll have to provide line-by-line documentation and substantiation.

About 8,000 audits will be undertaken by comparing documents that the IRS has at its disposal to the tax return itself. You might be part of the NRP program and never even know it. Another 9,000 will be correspondence audits, where the IRS will request the information to support your return via the mail. You won't have to meet with an IRS auditor.

About 31,000 audits will focus on limited and selected issues on your return. While you will have to meet with the IRS auditor on these issues, they will cover only certain parts of the tax return. And the IRS will already have accessed information from various databases in order to have many of the issues resolved or at least more focused before you meet.

Finally, about 2,000 of you will have the privilege of dropping your financial shorts in front of the IRS. These are called "calibration" audits, and you may not have to provide substantiation for each and every entry on your tax return, but every entry will be reviewed and considered by the auditor.

While this program has been in place for a little while now, it appears that the returns to be examined are now on the desks of the auditors at the local IRS offices, and notices are going out to those unfortunate taxpayers now. So open your mailbox carefully. (You can read more about the NRP Program at the CCH small business website.)

Increased audit activity
No matter how you slice it, there will be an increase in audit activity in the months and years to come if the IRS has its way. Because of the limited number of audits in the immediate past, coupled with many new enforcement employees at the service, getting through many of these audits could be difficult.

If you do find yourself in the clutches of the audit monster, you don't have to fight him off alone. You always have the right to representation (Enrolled Agents, Certified Public Accountants, and attorneys are all authorized to represent you before the IRS), and you should consider availing yourself of that right. It's not inexpensive. But a qualified tax pro with experience in IRS audits and techniques can possibly save you hours of grief and aggravation.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.


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