It is common knowledge among tax practitioners and the informed public that the IRS is strapped for funds, and that this has made it very difficult to reach IRS personnel, reduced audits and slowed collection activities. But we have heard clients and others say that because of this they are taking little care in what they put down on tax returns. Unfortunately, this can be a costly practice despite the IRS’ problems. First, a few facts as to the IRS problems.
It is true that a combination of budget cuts (and proposals in Congress to further cut IRS funding for 2015), and new responsibilities (for example, those connected with Obamacare) are straining the IRS’ ability to answer the public’s questions, audit tax returns and collect taxes. The written testimony of IRS Commissioner John A. Koskinen of February 5, 2014, stated, for example, that “For FY 2013, as a result of the ongoing decline in agency funding, the telephone level of service for taxpayers trying to reach the IRS’ toll-free lines dropped to 60.5%, the lowest level since FY 2008.” We would add that it is also increasingly difficult for practitioners to get through to IRS personnel, which impairs our ability to help our clients.
Koskinen also noted the big decline in both audits and collection activities. He said that while revenue collection increased in 2013 compared with 2012, the total collections are still down by more than $4.2 billion from four years ago and that there has been a steady decline in revenue collection since the high point in FY 2007. The reason for this decline is primarily due to a decline in revenue from audits. In 2013 the IRS audited just .9 percent of individuals who earned less than $200,000 a year, the lowest rate since 2005. The odds of being audited were greater for high earners, but while 10.9 percent of individuals who earned $1 million or more were audited last year, that was the lowest proportion since 2010. The IRS also examined approximately 61,000 business returns in Fy 2013, down 13 percent from FY 2012.
But none of this means that it is less risky to file returns with certain types of understated income or overstated deductions. This is because because IRS tax return computer scanning capabilities are not likely to be affected by budget and personnel cuts. Moreover, “red flag” issues are still likely to bring a questionable tax return to the top of the pile for audit, budget cuts notwithstanding. For example, computerized information matching capabilities mean that if a return shows less income than the minimum due as shown on W-2s and 1099s, a deficiency letter is almost certain to be issued. This deficiency, if not explained or paid, will automatically march lockstep to a 90-day letter, assessment, billing and lien and possible automatic garnishment of bank accounts, wages and other income sources.
As far as we know, IRS also still employs DIF and UDIF computer scanning to detect returns whose income or deductions are scored as out of line with similar return populations. For example, if you report a loss on a Schedule C, whether as a sole proprietor or a sole member LLC, and the numbers or expenses are out of line with the numbers shown on DIF analysis, then the chances of an IRS audit increase. There are other “red flag” deductions which, despite plummeting audits, still increase the likelihood for audit in a particular case, such as, for example, high charitable deductions, large investment partnership losses which may raise issues of basis and passive loss restrictions or home office expenses.