IRS defines audit targets

The IRS, intensifying its crackdown on tax dodgers, plans to increase the number of tax audits it conducts in 2006.

The agency will focus more of its resources investigating taxpayers with incomes of $100,000 and above. Agents will also examine more returns of high-income taxpayers in search of what they call abusive shelters, or transactions with no real economic purpose other than dodging taxes. The agency will devote particular attention to abusive transactions involving parking money in offshore accounts.

While IRS officials won’t discuss specifics of audit targets, they are expected to focus more on self-employed workers who deal largely in cash. Congress recently raised the IRS budget to $10.68 billion, which includes an increase in money earmarked for enforcement activities.

In an interview, IRS Commissioner Mark Everson says the assault on shelters includes more audits, litigation and settlement offers. The aim is to strengthen public confidence in the tax system and slash the “tax gap,” the difference between what the government collects and what it estimates it should collect. An IRS study this year estimated that tax evasion and other forms of noncompliance cost the government more than quarter of a trillion dollars in lost revenue each year.

“Combating abusive shelters remains the centerpiece of our enforcement efforts,” Everson said. “Average Americans don’t want to feel that the big guy gets away with something just because he’s rich.”

The IRS audited about 1.2 million individual income-tax returns in the fiscal year ended Sept. 30, up more than 20 percent from a year earlier. The government also has gone to court against numerous taxpayers involved in what it considers to be abusive shelters. The agency also recently announced plans to hire private debt-collection agencies next year to help recover billions of dollars of tax debts.

For those who may have used a questionable tax strategy, the IRS recently announced a settlement initiative for taxpayers to step up and settle, with reduced penalties. The offer, which expires Jan. 23, involves 21 transactions the IRS considers abusive.

Some wealthy individuals are turning to foreign entities, such as offshore trusts and insurance policies, as part of their tax-planning and asset-protection strategies. Although U.S. citizens generally must report any foreign accounts and entities with the U.S. government each year, going offshore could add extra roadblocks on an audit trail. Still, some advisers caution that using foreign entities could be a red flag to the IRS.

Despite the increased chance of an audit, some tax professionals still are devising aggressive plans designed to stay one step ahead of the IRS. Some cutting-edge tactics have many layers, involving convoluted combinations of trusts, partnerships, insurance policies, annuities or retirement plans, all of which can have special tax-savings advantages. The idea is to multiply the tax savings, but the arrangement also could make it tough for auditors to track.

Despite the tough talk, IRS statistics show the agency’s audit rates generally remain low by historical standards. In fiscal 2005, 1.58 percent of taxpayers with annual incomes of $100,000 and above were audited. That is up from 1.25 percent a year earlier, but down from 3.21 percent in 1996. Also, the IRS is doing a larger percentage of its audits by mail, rather than face-to-face interviews.

The IRS “has made great strides” in improving enforcement under Everson, “but it still has a long way to go in restoring compliance,” says Donald Alexander, a former IRS lawyer and now a Washington, D.C., lawyer.

IRS officials say they are auditing more intelligently these days, making better use of limited staff resources and trying to avoid burdening taxpayers with face-to-face audits on issues that could be resolved by mail. Audits done by mail are “very efficient ways” of handling many issues, says Kevin Brown, commissioner of the IRS’s small business/self-employed division.