Tax Audits Increase, Especially for the Wealthy

As you prepare your 2007 tax returns, you should be aware of the increased audit risk. This is particularly true of those with larger incomes. In the 2007 budget year, the IRS audited one out of every 11 individual tax returns with incomes greater than $1 million - an audit rate of 9.25%. In 2007, the number of audits of those with $1 million incomes increased 84 percent from the number audited in fiscal 2006. In contrast, if your income was $100,000 or less, your audit rate was only about 1%.

Audit rates have changed dramatically over the years. Ten years have elapsed since the Congress held much publicized hearings in which various purported IRS abuses and organizational shortcomings were exposed. These hearings ultimately resulted in the passage of the IRS Restructuring and Reform Act of 1998 (RRA 98) and the birth of a kinder, friendlier IRS.

IRS audit rates dramatically declined as a product of these efforts. For three consecutive years, audit rates declined across the board from 1998 levels, and then remained steady at these lower levels for two additional years. In 2001, the audit rates for many types of tax returns were under 50 percent of their 1998 levels, and in 2003, less than 60 percent.

But there have been marked increases in IRS audit rates since 2003. The reasons include complex political and policy considerations. However, one easily overlooked factor is the vision and leadership of the IRS Commissioner. IRS Commissioner Charles Rossotti completed his 5-year term in November 2002. His post was filled by Mark Everson, who the Senate confirmed in May 2003. While Rossotti’s tenure is noted most for his efforts to modernize the IRS’s antiquated systems and technology in addition to administering RRA 98, Everson was a champion of enforcement activities - both civil and criminal. Not surprisingly, with this focus, IRS audit rates rebounded drastically since 2003.

In 2006 (the most current year for which complete IRS data is presently available), all of the 10 broad taxpayer categories considered by Fulcrum had audit rates higher than 2003 levels. Individual income tax returns were audited at an overall rate of 149 percent of 2003 levels, while C-corporation tax returns had a rate of 143 percent. Nearly off the charts were nonfarm business returns with total gross receipts of $100,000 or more, which had an audit rate of 264 percent of 2003 levels.

However, even after several years under Everson’s leadership, the IRS audits taxpayers at rates generally still below 1998 levels. In 2006, only the aforementioned nonfarm business returns were audited at rates higher than in 1998. Audit rates for both small corporations and S corporations were still under 50 percent compared to 1998 levels, while the audit rates for partnerships and large corporations were 62 percent and 87 percent, respectively.

Everson’s tenure as Commissioner is now over. He resigned in May 2007 to become president and chief executive officer of the American Red Cross. If approved by the Senate, the new IRS Commissioner will be Douglas Shulman. Shulman is vice chairman of the Financial Industry Regulatory Authority, which was previously known as the National Association of Securities Dealers (NASD). There currently is not much information whether Shulman (a securities regulator) will continue with Everson’s increased enforcement activities. Stay tuned.