Potential trouble spots as IRS steps up enforcement

By Karen Hube,  

The Internal Revenue Service has added a couple of notches to its enforcement belt. First came the disclosure that international financial services giant Credit Suisse is under federal investigation for helping U.S. citizens avoid taxes using foreign accounts. Then came multi-platinum rapper Ja Rule’s conviction for failing to pay taxes on $3 million in earnings. He was sentenced to 28 months in prison.

Gulp.

These high-profile examples of stepped-up IRS enforcement can’t help but fuel worry even among the most honest taxpayers: Will the IRS raise a question on my return? Was there a faulty calculation? Did I claim a deduction that will raise a red flag?

Depending on your occupation, income and the kinds of claims you’ve made, there may be reason for concern. With government revenue in short supply, the IRS has begun bearing down on specific groups of wealthier taxpayers and is showing far less sympathy than in years past, accountants say.

“Our firm has 21 offices up and down the West Coast, and in every office there’s been an increase in examinations,” says Gary Stirbis, who handles the IRS controversy practice at Moss Adams. “The IRS has been less flexible, and agents seem to be under internal pressure to collect more aggressively.”

A directive from Congress in 1998 to shift IRS resources reduced enforcement activity, but it has recently climbed again. Before Congress stepped in, there were 25,215 key IRS enforcement staff positions. That number fell below 20,000 by 2003. It’s now 22,710 — not a big increase, but enough to turn up the heat a little.

And new programs have been launched to help spot problem returns, according to Steven Miller, deputy IRS commissioner for services and enforcement. Last year, the IRS created the Global High Wealth Industry Unit, in which agents work in teams to evaluate wealthy taxpayers’ profiles. “When you look at the 1040 [form], it doesn’t tell the whole story,” Miller says.

This year, in an effort to crack down on underreporting of income, agents will begin reviewing credit card statements and cross-checking data against tax returns, Miller says. Big spenders who claim little income, beware.

Don’t think you’re under the radar just because your income is a tiny fraction of Ja Rule’s millions.

The IRS likes small, inexpensive audits because they can influence other taxpayers to comply, says Bill Smith, managing director of CBIZ MHM in Bethesda. People who see a co-worker or friend get audited are likely to be more careful, he says.

“One audit may only bring in $500, but if you can increase compliance in that group of taxpayers by 20 percent because people hear about the audits, then for the IRS it’s worth it,” Smith says.

Still, for the general population the chance of coming under IRS scrutiny is slim. The audit rate last year was 1.11 percent of all taxpayers, up from 1 percent a year earlier.

Among certain groups the rate is significantly higher. Those who operate their own businesses and are required to file Schedule C forms (estimated by the IRS to be underreporting income by about $68 billion a year) have an audit rate of just over 4 percent. The wealthy get far more attention. The audit rate was 3.1 percent for taxpayers with income of more than $200,000 last year, and 8.1 percent for those earning more than $1 million.

Other broad areas of interest by IRS enforcement agents align with the biggest areas of suspected fraud, such as returns claiming refundable tax credits, over-reporting deductions and offshore accounts.

Some of the IRS’s latest areas of focus, according to the agency and tax lawyers:

Interest deductions for home loans

Taxpayers who claim big interest deductions on mortgages and equity loans have come under scrutiny “because a lot of people have been borrowing on their homes for college tuition or just to live,” says Ira Rubenstein, a principal in charge of the New York region for MBAF-ERE CPAs.

Homeowners are allowed to claim an interest deduction for up to $1 million of mortgage debt, and up to $100,000 of home equity debt. “We worked with one auditor who looked at the amount of the deduction and said, ‘That’s too high for the interest rate,’ ” says Phil London, a CPA and tax partner at Wiss & Co.

Adoption credit

After the adoption tax credit was raised to a maximum of $13,170 last year and it became refundable — meaning you can claim it and get a refund even if you owed no taxes — “the IRS is flagging anyone who took the adoption tax credit last year and asking for proof,” says Diane Michelsen, an adoption lawyer in Lafayette, Calif.

Gifts of property

The IRS has been scouring state property transfer records and comparing them with tax records to find taxpayers who haven’t disclosed real estate gifts, says Beth Shapiro Kaufman, a partner at Kaplin & Drysdale in Washington. With property values depressed, gifting real estate has become more popular, particularly among wealthy folks.

Under current law, you must file a tax return for gift values in excess of $13,000. Anyone whose undisclosed gift exceeds the $1 million unified credit (the maximum you can give away in a lifetime without paying the gift tax) will be subject to hefty penalties and interest, Kaufman says.

Large donations relative to income

The IRS is sizing up charitable deductions against income, looking for discrepancies. “Some innocent retired people with low income have the wherewithal to make contributions, and get targeted,” says Greg Margarit, a tax partner at Boulay, Heutmaker, Zibell & Co.

Ultra-rich

The audit rate for taxpayers with more than $10 million in income rose to 18 percent from 10 percent last year. And with the IRS’s new global wealth squad, these folks should expect a colonoscopy-style checkup rather than the old-style knee-knock exam.

Looking ahead, it’s unclear how long the IRS can keep flexing its muscles at its current level. The agency has requested that its $12.1 billion budget be ramped up to $13.3 billion next year, but cuts appear likely. This may force the IRS to trim enforcement — or it could mean taxpayer service will be scaled back first, making audits potentially more painful.

A note on my last column, which explained that taxpayers on vacation may be able to claim business deductions when a big chunk of time is spent working:

Chip Watkins, a reader and longtime tax attorney, raised questions about the ability of a taxpayer to ever deduct a portion of meals and lodging on a trip that is primarily personal. He cited this part of the tax law: “If the trip is primarily personal in nature, the traveling expenses to and from the destination are not deductible even though the taxpayer engages in business activities while at such destination. However, expenses while at the destination which are properly allocable to the taxpayer’s trade or business are deductible even though the traveling expenses to and from the destination are not deductible.”

Other tax advisers say the there is room for interpretation, especially for executives and managers who don’t punch a clock. “These rules are detailed, but there are still circumstances not addressed,” such as spending hours a day working on a supposed vacation day, says Stephen Kirkland, a tax adviser at Kirkland, Watson & Dyches. “That’s when you have to make a judgment call.”

Hube is a columnist for The Fiscal Times, an independent news organization that provides original reporting and analysis on fiscal and economic matters.

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