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IRS publication gives clues as to who gets audited

It's Your Money

Posted: June 19, 2008 1:04 a.m.
Updated: August 20, 2008 5:03 a.m.
This is the first part in a two-part series about being audited by the IRS.

I have had several of my tax clients call me recently, with fear and trembling, to tell me that they have received that dreaded notice from the IRS that their income tax return was being audited. I tried to tell them that this wasn't the end of the world and that they should come out of this OK. Well, there were a couple of clients I didn't say that to, recalling my suspicions regarding some of the deductions they insisted on claiming. In any event we were well-prepared for their audits and came away relatively unscathed.

Yes, audits do seem to be more frequent than in the past. Just recently I came across information from an IRS publication called the 2007 Data Book (Pub 55B, March 2008) which provides statistical data on its fiscal year 2007 activities. The data book provides valuable information about how many tax returns IRS examines (audits), and what categories of returns IRS is focusing its resources on, as well as data on other enforcement activities, such as collections.

What are the chances of being examined? A total of 1,384,563 individual tax returns were audited during fiscal year 2007 (Oct. 1, 2006, through Sept. 30, 2007) out of a total of 134.5 million individual returns that were filed in the previous year. This works out to 1 percent of all individual returns filed (slightly higher than the 0.97 percent audit rate for the preceding year).

Of the total number of returns audited, 503,267 (36.5 percent) were selected on the basis of an earned income tax credit (EITC) claim (down slightly from the 40.3 percent rate for fiscal year 2006). That leaves some 881,294 (63.5 percent) returns that were audited for other reasons. Moral of the story here is be real sure that if you are claiming an earned income tax credit that it be correct.

Only 22.49 percent of the audits were conducted by revenue agents, tax compliance officers, and tax examiners; the bulk of the audits (about 77.5 percent) were correspondence audits. These percentages are about the same as they were in fiscal year 2006.

The no-change rate (returns accepted as filed after examination) was 12 percent for individual returns examined by revenue agents, tax compliance officers, or tax examiners and 16 percent for correspondence exams. Keep in mind that a small percentage of these adjusted returns were in the taxpayer's favor.

Here's a roundup of selected audit rates from IRS's latest databook. Because the audit categories aren't organized the same way for individual as they were for fiscal year 2006, comparisons to the rates for the previous fiscal year aren't possible.

Following are the audit rates for individual nonbusiness returns that didn't claim the earned income credit:
* For selected nonbusiness returns having no schedule C, E, or F: 0.4 percent
* For returns with Schedule E (rental properties): 1.2 percent
* For nonfarm business returns by size of total gross receipts: under $25,000: 1.3 percent; $25,000 under $100,000: 2 percent; $100,000 under $200,000: 6.2 percent; and $200,000 or more: 1.9 percent

The moral of the story here seems to be that if you have a schedule C business, be sure that you either have gross receipts under $100,000 or over $200,000 if you want to reduce your chance of being selected for audit.

For returns with total positive income (TPI) of at least $200,000 and under $1 million, the audit rate was 2 percent for nonbusiness returns and 2.9 percent for business returns. For returns with TPI of $1 million or more, the audit rate was 9.3 percent.

The audit rates for entities were as follows:
* Fiduciary (estate and trust income returns) - 0.1 percent (the same as for fiscal year 2006)
* Corporations with less than $10 million of assets - 0.9 percent (up from 0.8 percent for fiscal year 2006)
* Corporations with $10 million or more of assets - 16.8 percent (down from 18.6 percent for fiscal year 2006)
* S corporations - 0.5 percent (up from 0.38 percent for fiscal year 2006)
* Partnerships - 0.4 percent (up from 0.36 percent for fiscal year 2006)
* Estate tax returns - 7.7 percent (down from 9.66 percent for fiscal year 2006); and
* Gift tax returns - 0.6 percent (down from 0.77 percent for fiscal year 2006)

The bottom line here seems to be that if you are claiming an earned income credit, have Schedule C (proprietorship business) gross receipts of between $100,000 and $200,000 or have total positive income of more than $1 million, your chances of being audited are much higher.

Next week look for my follow up column on ways of reducing your chances of being audited.

D. Frank Norton CPA, MBA, CFP, is a money manager and financial planner in Santa Clarita. His column represents his own views, and not necessarily those of The Signal. "It's Your Money" appears Thursdays and rotates between a handful of the Santa Clarita Valley's financial professionals.


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