Step 3-3

Special IRS Audit Targets You Should Know About

The IRS Audit (or Examination) Division faces continuing increases in its workload each year as the number of returns filed grows, new and more difficult schemes are used to avoid taxes, and tax laws become more complex. IRS resources have not kept pace with the growing filing population and audit coverage has declined in the last 10 years from 2.4 percent to 1.31 percent of individual income tax returns. The audit activity is IRS's biggest tool for promoting voluntary compliance; it employs approximately one third of all of IRS's resources. Program priorities are provided for guidance in determining the application of resources and input of returns. These priorities represent national goals for the utilization of Examination resources and should be followed in the sequence followed below:

1. Returns involving Taxpayer Compliance Measurement Program (TCMP) audits and nationally directed compliance studies, such as unreported tips income study.
2. Returns identified as abusive tax shelters. (See Chapter 7.) Sufficient resources will be allocated so districts can timely investigate each abusive tax shelter package referred by the service centers.
3. Returns in need of examination which represent a national commitment to specific areas of abuse: tax protestors, tax havens, foreign tax credit manipulations, abusive W-4, unreported income projects, and returns with potential unreported income shown or foreign information documents.
4. Special Noncompliance Projects: to identify and examine U.S. persons who may be using foreign entities to evade U.S. taxes by concealing income and/or creating false deductions.
5. Schedule C and Revenue Initiatives: to identify noncompliant taxpayers by making in-depth probes for unreported income, and to audit corporate returns in asset class $100 million and over.
6. Information Returns Program cases. (See Chapter 6.)
7. Locally initiated projects, such as the Unreported Income Program, involving areas of high non-compliance.

Areas of Emphasis

The following programs represent areas that are to receive special emphasis from the IRS this year:

• Fraud: identify and develop cases with fraud potential by emphasizing efforts against organized crime and high-level drug traffickers, using multiple year examinations, and probing for unreported income.
• Payer compliance: ensure employers are submitting W-4s, identifying tax protestors, aggressively asserting civil penalties, ensuring informational returns such as W-2s and 1099s are provided to taxpayers.
• Computer-Assisted Audit Activity: emphasize the identification of all ADP records, especially those created and retained on data base systems- using specialists to emphasize proper recordkeeping- aggressively pursue civil penalties where taxpayers have failed to retain machine-sensible records- maximize use of computers in audits.
• Resolution of cases: to obtain a greater number of agreements to tax determinations.
• Identifying instances of misconduct by return preparers and aggressively asserting the appropriate penalties under the Return Preparers Program.
• Encouraging taxpayer compliance with the audit process.

Service Center Targets

• Abusive Tax Shelter Detection Teams are established in each service center to identify potentially abusive tax shelter schemes.
• Special emphasis to detection of fraud cases.
• Tax Protestors- to identify and examine protest scheme returns- the National Illegal Tax Protestor Data Base will be implemented to stop issuance of improper refunds and for identifying new schemes.
• Information Returns Program (IRP). (See Chapter 6.)

Examination Initiatives:

1. The Partnership/Investor Control System (PICS) implemented to control investor returns related to TEFRA partnership/S corporation examinations.
2. TIP Income Allocations- a matching program for tax year 1983 returns to discover employees who have underreported tip income.
3. Examination of investors who have received Pre-filing Notification and Pre-refund Letters due to potentially abusive tax shelter.

Future Examination Initiatives:

1. Individual Retirement Arrangements- a matching program similar to IRP is being developed to verify that an IRA exists, and that IRA deductions claimed by taxpayers are not overstated. Verification of rollover amounts and excess contributions will be built into the program.
2. Expansion of IRP matching to include bartering transactions, stock and securities sales, and tip reporting.
3. Matching state and local income tax refunds.

Special Projects

1. Direct Sellers of Home Products Study

Direct sellers of home products are individuals who sell consumer products to others on a person-to-person basis, usually working out of their own home. They may sell door to door, through a sales party plan, or by appointment in someone else's home. Or they may find their customers among their co-workers, friends, relatives, or neighbors.

Subject to certain limitations and substantiation requirements, ordinary and necessary expenses incurred by an individual in carrying on a trade or business are deductible for income tax purposes (Code Section 162). The determination of whether an expense is ordinary and necessary to the operation of a business is a factual question.

Except for certain expenses allowed as itemized deductions, an individual's personal, living, or family expenditures are not deductible (Code Section 262). Certain expenditures which otherwise would be treated as personal living expenses, such as expenditures for meals, lodging, travel, or entertainment, may be deductible when incurred in a business or investment activity.

If the expenses from a business exceed the taxpayer's income from the business for the year, the net business loss may be used to offset income from other sources, such as employee wages received by the taxpayer.

This study will address the issues of taxpayers who claim a business loss from direct selling activities on their Schedule C and use such loss to offset other types of income thereby reducing their tax liability. It will be determined if expenses claimed are ordinary and necessary for carrying on the business and if income is properly reported.

The objectives of this study are:

• To determine compliance levels of taxpayers claiming a loss from direct selling activities;
• To evaluate the feasibility, practicality, costs, and revenues of a continuing compliance program in this area;
• To develop a profile that can be used to supplement current selection methods if necessary;
• To determine the need for legislative proposals to enhance voluntary compliance.

Even though this study has been completed, it was designed to produce a "supplemental return selection system." That means that very soon that IRS will be targeting direct sellers on a nationwide basis.

Direct sellers should note that the line items on their return that will be scrutinized the closest are:

* Cost of goods sold. * Car and truck expenses. * Travel and Entertainment. * Other Expenses. * Office-in-the-home expense.

2. Unreported Income DIF Scoring.

A selection system has been implemented to score returns with a high potential for unreported income.

3. Lifetime Exclusion of Gain or Sale of Residence (LTEX)

This program identifies taxpayers who have claimed the lifetime exclusion of gain on sale of their personal residence, determines that the exclusion is properly claimed, and corrects returns claiming the exclusion which appears to be unallowable.

Code Section 121 now allows taxpayers age 55 and over to elect a lifetime exclusion up to $125,000 of the gain on the sale or exchange of their residence. ($62,500 if married filing separately.) The taxpayer must have owned and used the principal residence for a period of three or more years during the five years preceding the sale.

Because the law allows a taxpayer to make this election only once in a lifetime, the IRS will track these elections until the taxpayer's death. The law further stipulates that a taxpayer is not eligible for the election if the spouse previously elected the exclusion in another sale or exchange. In the case of a jointly filed return with an election present, the account will be tracked for the lifetime of both spouses regardless of taxpayers' subsequent marital status.

4. Questionable Form W-4 Program

Employers are required to submit to the IRS any W-4 submitted to them that claims more than 14 withholding allowances, or claims exemption from withholding even though the employee is earning more that $200 a week. The IRS reviews the W-4s for accuracy. If not accurate, the employee and the employer are notified and the employee is prohibited from claiming more allowances that the IRS allows.

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