A Taxing Dilemma: To Audit or Not to Audit?

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Audits are expensive, and more often than not the IRS loses money by performing them. [5] Is this cost worth it? What would the agency actually lose by not performing audits?

To understand the answers to these questions, it is important to understand the auditing process, and look at the effects they have on both consumers and the Internal Revenue Service.

What is an audit really?

Typically an audit is a verification of financial information by the Internal Revenue Service, the agency is checking to make sure that the information provided on a tax return is correct, complete, and matches information gathered from third parties.

The statistical probability of being audited is extremely low. Only 1 percent of individuals or businesses are audited in any given year. The IRS reported in their 2015 Data Book that a little over 72 percent of audits are settled through correspondence. The remainder are conducted at the taxpayer’s place of business, a CPA’s office, or an IRS facility [1].

Increasingly, the IRS is moving toward settling as many audits as possible through correspondence, a much more cost effective method. Sometimes someone who is experiencing a correspondence audit has no idea they are actually being audited but rather think they may not have included some information the IRS needed, and that the letter or letters are simply a follow up.

The process begins with a letter from the IRS letting the taxpayer know their return is being examined and asking for clarification or supporting documentation of some line items. It often is resolved when documentation or clarification is provided through correspondence, and face to face meetings are even necessary.

What Triggers an Audit?

There are several things that can potentially trigger an audit. Even though audits are infrequent, there are still certain behaviors that will cause the IRS to take a second look at a return.

Underreported Income:

According to CNBC, this is probably the most common audit trigger, as the IRS uses an Automated Underreporter Program which flags a return if the income reported by the taxpayer does not match information obtained from third parties like employers and financial institutions [2].

Discriminate Information Function:

This is a function the IRS uses to compare the returns of peer groups based on factors like job title and income. If a return has variances that are significant compared to other returns in the same peer group, it returns with a high DIF score, which raises the chances of an audit [3].

Suspicious Activity:

Reporting costs that exceed income or seem excessive for your type of business can be classified as suspicious activity. Even math mistakes can trigger the IRS to take a second look at your returns. Omissions, lavish business expenses on meals and other items, and a sharp drop in reported income from year to year can also trigger an audit, as can large charitable contributions [4].

Random Selection:

Although not as common, there are times when the IRS randomly selects taxpayers to be audited. The IRS does not share information about how these returns are selected or why. [4]

What do Audits Cost?

Audits are costly, both for taxpayers and for the IRS. When added up, those costs have a significant economic impact. The fact that taxpayers spend between $67 and $387 billion annually just to have their taxes prepared is no small impact when taken by itself. [5]

However, it is estimated that the tax code results in a revenue gap of $452 billion in unreported taxes. [5] The audit system is designed to help close that gap by encouraging and ensuring compliance. This is in part because only 81.7 percent of people pay their taxes without the IRS forcing them to pay up, and even with the efforts of the collections and enforcement division, these numbers only go up to 83.7 percent.

Taxpayer Costs:

Most of the time if you are being audited by the IRS, both individual and business taxpayers choose to get help in the form of a tax attorney or by using an audit defense service. For defense of minor audits, this can cost between $700 to $1,500. Moderate cases can cost between $2,000 to $4,000, and extensive audits can potentially cost $5,000 to $15,000. Attorneys and tax relief services charge similar fees, but sometimes relief services charge fewer up front fees [6].

IRS Costs:

There are no readily available figures available regarding exactly how much it costs the IRS on average to perform audits. [7] While simple correspondence audits may be resolved quickly and require very little manpower, office and face to face audits are resource and personnel intensive.

Some audits can be resolved quickly, only requiring a few hours. Others can take months and even years, potentially costing the IRS hundreds of thousands of dollars. [7]

How Effective are Audits?

IRS records show the amount of unpaid taxes recovered from audits has dropped from $16.9 billion in 2010 to $9.93 billion last year, due in large part to $900 million in budget cuts during that time period, and the fact that the agency has cut the number of auditors by 25 percent from 13,888 to 10,159. With only one percent of taxpayers being audited, the IRS is counting on people to being honest [8].

Studies show that taxpayers who have been audited report more taxable income in future years, so it seems like the fear of audits works as a compliance tool. However, audits are one of the more costly things the IRS does. [8]

Currently the IRS must decide to audit or not to audit based largely on budget constraints, the number of auditors available, and the possible gains in revenue if a discrepancy is found or has even mistakenly misreported line items. Not auditing means not only lost revenue but lost incentive by some to be honest. [8]

To audit or not to audit will continue to be a question the IRS must ask itself, as Congress and taxpayers analyze the efficacy of the current system, and determine what it might look like going forward. A Graduate Degree in Taxation from Villanova University can prepare graduates to help people navigate through tax changes and audits as they happen. Villanova’s Graduate Tax Program offers both a Master in Laws in Taxation (LL.M.) and a Masters of Taxation (MT). In addition, a student or tax professional can pursue a Certificate in Tax Controversy, which addresses the practical and procedural issues that are involved in controversies and disputes with federal, state, or international tax authorities. It also explores specific litigation considerations and strategies with various tax controversy forums and venues. It is open to LLM and MT students, or on a stand-alone basis.

Sources:

[1] https://www.irs.gov/pub/irs-soi/15databk.pdf
[2] http://www.cnbc.com/id/100567579
[3] http://www.businessnewsdaily.com/4300-what-is-a-tax-audit.html
[4] https://www.nerdwallet.com/blog/taxes/7-reasons-irs-audit/
[5] https://www.mercatus.org/system/files/Fichtner-Hidden-Cost-ch1-web.pdf
[6] https://www.supermoney.com/2016/08/what-average-cost-hiring-tax-attorney/
[7] http://www.taxanalysts.org/content/overview-fatca
[8] http://www.joplinglobe.com/cnhi_network/irs-budget-cuts-mean-fewer-audits-more-tax-cheating-and/article_6402b83b-9959-5915-b964-0d66a0000859.html