Audit Exposure -- There May Be Nothing You Can Do About It

With the tax season for 2011 returns now underway, I’ve been giving thought to audits. Much is made by many tax advisors about “audit-proofing” your return. The fact is that your actions may have very little to do with whether or not you are audited.

Of course, actions you take on the return can affect audit selection. For example, if you fail to report income that had been reported to the IRS on a 1099 return or on a Schedule K-1, the IRS computer-patching program will identify your return and generate a letter (“correspondence audit”) to you. But even if all the care that’s taken with your return, there are two arbitrary ways you may find yourself being an audit target:

National Research Program
This is a program under which the IRS selects certain returns at random for the purpose of gathering information that will be used to better audit other taxpayers in the future. Three audit projects of note:

  • S corporation returns — this audit project examined 5,000 randomly-selected 2003 and 2004 returns in a three-year program that begin in 2005.
  • Employment tax returns — this audit project examined 6,000 randomly-selected employment tax returns from companies of all sizes and industries; the project began in 2010 and should be completed by now or very soon.
  • Form 1120 (regular corporation) returns — this audit project is set to start this April. Details are not yet available (the project was mentioned by a panelist in passing in an IRS Webinar on January 11, 2012).

High income
The IRS has less money to spend on examinations, so it’s focusing more and more on higher income taxpayers. Most small business owners report their share of business income on their personal returns, so they may fall into the “high income” category without really being rich. Recent statistics revealed by the IRS show while the overall audit rate on taxpayers was just a bit over 1%, the audit rate for certain taxpayers was a lot higher in the government’s fiscal year ending September 30, 2011:

  • For taxpayers with income over $200,000, the rate was 3.9%, up from 3.1% in 2010.
  • For taxpayers with income over $1 million, the rate was 12.5%, up from 8.4% in 2010.

Bottom line
What can you do to protect yourself?

  • Make sure your return has been properly prepared and that you have the documentation to back up the positions taken on your return. This will probably avoid a correspondence audit and even if you are selected for a more detailed audit, likely you will survive with “no change.”
  • If you are selected for audit, consider using professional representation. This will cost you money in professional fees, but will probably save you taxes, interest, and penalties in the end.

In addition, you can keep your fingers crossed!


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