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The Tax Man Still Biteth


BusinessWeek Investor: Taxes

The Tax Man Still Biteth

The audit rate is down-but some deductions invite scrutiny

Under pressure from Congress, the Internal Revenue Service is trying to shake its tough-guy image. Indeed, look no further than today's tax audit rate. The average person today has a less than 0.5% chance of an in-person audit. Five years ago, the odds of being audited were 0.7%, and in 1981, they were 1.6%. Budget and staff cuts are partly behind the fall-off. But audit rates are also down because the IRS has turned its attention to beefing up customer service.

Don't be lulled into complacency, though. The IRS recently asked Congress for money to conduct more audits, starting in 2001, and indications are it will get more funding for this purpose. More important for now, the IRS continues to target certain categories of taxpayers for audits. If you take a deduction for a home office, own a cash-based business such as a restaurant, or even pull down a six-figure salary in Los Angeles, your odds of being audited rise well above the norm. "There is no assurance that the kinder, gentler IRS will be a pussycat with you," warns David Rhine, national director of family wealth planning at BDO Seidman in New York.

What triggers a tax audit? The most common way the IRS pulls returns for a closer look is by using a computer program called DIF, which stands for discriminate function. DIF scans every tax return and assigns it a score indicating the likelihood of questionable items. The IRS doesn't disclose what DIF might flag, but tax experts figure it searches for seemingly out-of-whack relationships, such as itemized deductions that are large compared with earnings.

There's evidence the DIF criteria, which were last updated in 1992 with data culled from 1988 returns, are not as relevant as they once were. Indeed, the IRS used DIF to select 29% of returns audited in 1998, down from 46% in 1992.

What also catches the IRS' eye are deductions most people don't qualify for--such as casualty losses or employee business expenses. Say a hurricane leaves your finished basement a soggy mess. Insurance should cover the damage, but if it doesn't, the IRS only lets you deduct unreimbursed casualty losses that exceed 10% of adjusted gross income, plus $100. If you claim this deduction, BDO Seidman's Rhine suggests trying to head off an audit by attaching supporting documents to your return such as newspaper clips on hurricane damage in your area. SMALL-BIZ TARGET. Small-business owners remain targets for audits as well. The IRS zeros in on entrepreneurs because of concerns about lumping personal expenses with business deductions. Home-office deductions are scrutinized for the same reason. In 1998, 2.85% of returns with a Schedule C (the IRS tax form used by many small-business owners) showing income of $100,000 or more were audited. That audit rate is six times higher than the national average. The IRS especially reviews cash-based businesses such as restaurants and dry cleaners, to unearth unreported income. The agency has developed detailed manuals for 57 businesses to help its auditors. Many of these industry-specific Audit Techniques Guides are available for free on the Net at www.irs.gov and can help small-business owners and their accountants determine what is likely to catch the IRS' attention.

For instance, in the guide on bed and breakfasts, the IRS lists several sources of cash income, such as referral fees from local businesses that the B&B recommends to its guests. B&B owners "should substantiate and verify that they either have or don't have these sources of income," says Mark Ely, national partner in charge of tax controversies at KPMG in Washington. The guides, he adds, can help business owners track income they might have overlooked.

Taking a deduction for donating a car to charity is another red flag. Marcus Owens, director of the IRS division that watches charitable contributions, says anecdotal evidence suggests a growing number of people are overstating the value of vehicles given to charity. Owens says some used car or scrap-metal dealers also buy the use of a charity's name to fool people into thinking they are dealing with a charity. But "you don't get a deduction for giving your car to a for-profit organization," he says. In November, Owens sent a memo to the IRS' 33 districts directing them to look out for this abuse.ADDRESS ALERT. Having your return pulled for an audit also depends on where you live. In 1998, individuals in Los Angeles reporting $100,000 or more in adjusted gross income were audited at a 2.56% rate, nearly six times greater than in Houston, which boasted a 0.45% audit rate, the lowest anywhere for the wealthy among the 33 IRS districts. Other areas with steep audit rates in 1998 were Brooklyn (1.78% rate) and northern California (1.61%). Meanwhile, New Jersey (0.66%), Michigan (0.81%), and Illinois (0.89%) enjoyed among the lowest audit rates. Why the discrepancy? "We tend to do more audits where our research shows higher instances of noncompliance," says IRS spokeswoman Jodi Patterson.

The IRS is taking other measures to ensure compliance. For instance, the agency compares income reported on returns to W2 forms from employers and 1099s from banks and brokerage firms. It is also installing state-of-the art data-mining technology that will make it easier to identify patterns of cheating and fraud. When it is up and running in four to five years, "we will be better able to look at pieces of information to understand the entire profile of a taxpayer and changes from year to year," says Paul Cosgrave, chief information officer at the IRS.

When you're doing your 1999 return this spring, you may be tempted to avoid taking certain deductions out of fear of triggering an audit. Such behavior is silly if the deductions are legit, tax experts say, because you shouldn't ever pay more in taxes than you owe. Just be sure to keep detailed records--whether Uncle Sam comes calling or not. By Susan ScherreikReturn to top


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