It is the most dreaded letter a taxpayer can receive.
Some of the information that you provided to us does not agree with the information we received from other sources.
— The Internal Revenue Service
You’ve just joined an elite club, one whose initiation ritual is an IRS audit. Unfortunately, you can’t refuse membership – and the dues could be astronomical. When the IRS Restructuring and Reform Act was enacted in 1998, lawmakers ordered the agency to focus more on taxpayer rights instead of collection activities. Not surprisingly, the number of audits – or examinations, as the agency prefers to call them – dropped dramatically.
In the first year of the kinder, gentler IRS, about 1 in 79 tax returns was audited. By 2003, only 1 in 150 individual taxpayers was audited. But the tax times, they are a-changing.
During the recent recession, the IRS implemented programs designed to take into consideration the financial struggles that many taxpayers encountered. But balance doesn’t mean taxpayers are off the hook. Facing pressure from a Congress dealing with a growing federal deficit, the IRS has made it clear it takes the enforcement portion of its job seriously.
The IRS receives millions of tax returns every year from individuals, married couples, and businesses. So you would think that your chances of being audited are slim. Think again. The IRS has set up a filter system where certain items, also known as “flags,” on your tax return will trigger an alert that something may not be right with the information.
What flags might trigger an audit? Failing to report taxable income is at the top of the list. A close second is “breaking the rules on foreign bank accounts.” Hunting undisclosed offshore accounts remains an IRS priority, a fact supported by its staffing trends. For example, in 2001, the IRS had thirteen Special Agents in its international operations unit, and none in what it calls the “global high wealth” unit. But by 2011, there were seventy-one revenue agents assigned to global high wealth and 856 to international operations.
With respect to unreportable income, the IRS has taken great pains to know what the median average wage is for the job you have. If your income is out-of-proportion to how much other people in the same industry earn, the IRS will want to know why.
The IRS gets copies of 1099s and W-2s you receive. IRS computers are proficient at matching the numbers on the forms with the income shown on your return. A mismatch between your tax returns and your W-2 form or 1099 form sends up a red flag. At that point, it is no longer a matter of “if” the IRS will audit you, but “when.”
One question that you might be asking yourself is whether an audit could turn criminal. That possibility always exists. After the civil agent has worked on your case, it can take one of two directions. First, the agent may not perceive your case as having criminal potential. In that case, he will close the audit making such civil recommendations as he thinks appropriate.
To the extent that the agent proposes a change, you have two choices. First, you can agree, thereby paying more taxes, interest, and/or penalties. Or second, you can disagree. If you disagree, you can appeal or enter into mediation with the IRS.
Second, the agent may determine that your case has sufficient criminal potential that it should be referred to Criminal Investigation. This can happen anytime during the audit process, but it often happens toward the end after the agent consults with an IRS fraud coordinator.
If your audit does turn criminal, can you just pay up and move on – with the expectation that the criminal problem will go away? Unfortunately, that is wishful thinking. Payment of the tax won’t technically deflect a criminal investigation or prosecution. In appropriate cases, payment may permit you to argue that you really wanted to pay the taxes that you owed all along and, when first advised that you may have underpaid, moved promptly to pay.
However, the government cannot generally accept that as a resolution of the criminal case because if it did, every person would simply pay the tax. Indeed, the deterrent effect of the criminal justice system would be gutted if every taxpayer who underreported his income could do so with the idea that, if caught, all that he would have to do is simply pay any taxes, penalties, and interest.
Taxpayers who think they can wait until they hear the IRS’s drums beating and their guns being fired off outside their home before acting are sadly mistaken. Indeed, that was the same trap that the holders of UBS foreign bank accounts fell into in 2009. These UBS customers were told over and over again by the Swiss bankers, “Don’t worry. Swiss bank secrecy is impenetrable. The U.S. government will never be able to obtain your account information.”
And they never did, until UBS decided that it needed to save its own hide. That was when the bank threw its U.S. customers under the bus, turning over the names and accountholder information of thousands of U.S. customers.
The waiting game is a dangerous one to play. Indeed, to the extent that the IRS already knows that you are the holder of an undisclosed offshore account, it is too late to participate in any of the IRS’s voluntary disclosure programs.