Audits on the rise amid a resurgent IRS

Nobody wants to be audited by the Internal Revenue Service. But somebody has to be.

The IRS audited 3.8 out of every 1,000 returns, or 0.38%, during its fiscal year 2022, down from 0.41% in 2021, according to a recent report from Syracuse University’s Transactional Records Access Clearinghouse. That percentage is expected to rise in 2023 after the Inflation Reduction Act, which became law last summer, increased the budget for the IRS by $80 billion over 10 years.

InvestmentNews caught up with Yvonne Cort, lead tax compliance and tax controversy partner at Capell Barnett Matalon & Schoenfeld, to find out how the jump in IRS funding will affect audits going forward, as well as what individuals should do if they get a fateful letter saying they owe a significant amount.

InvestmentNews: Do you expect a step-up in IRS audits in 2023?

Yvonne Cort: The IRS has had cutbacks and been short-staffed for many years. This is a revenue-producing arm of the government and it is chronically underfunded, with outdated technology. Many long-term, experienced agents have retired. The recent increase in funding is allowing the IRS to hire additional staff and train more agents to handle complex audits for businesses and high earners. In the past few years, for example, very few millionaire returns have been audited. In addition, the IRS has had a decrease in audits for many years, and they are now working on bringing the number of audits back up to prior levels.

IN: Is the IRS looking for something specific from individual filers? What about non-filers?

YC: The IRS would like all taxpayers to file their returns on time with accurate information. The IRS may investigate for criminal fraud where the taxpayer is willfully and intentionally not filing required returns. The IRS has also been cracking down on taxpayers who have an obligation to file information returns and fail to do so, especially if the taxpayer’s actions are willful. This includes reporting foreign bank accounts, or inheritance of foreign assets, over a certain threshold.

The penalties can be high. Failure to file a required Form 3520 for an inheritance, even though no tax is due, can lead to penalties up to 25% of the amount of the asset. Penalties for willful failure to file foreign bank account reports can be even higher. 

IN: What if you’re a business owner? What are the red flags there?

YC: In an audit, the IRS will ask business owners to prove the income and deductions taken on the tax return. Records must be kept showing that deductible expenses were paid by the business and had a business purpose. For small businesses and sole proprietors, it’s not always obvious that the purchases were for the business, and record keeping is key. Recently the IRS has opened audits focusing on the employee retention tax credit, and also audits regarding reasonable compensation for services performed by shareholders of subchapter S corporations.

IN: Second homes and residency exposures are always tricky for filers. How do you prove you are a resident of where you reside?

YC: Each state has its own rules and requirements. In New York, the burden of proof to show a change of domicile is on the taxpayer moving out of New York. The taxpayer must show documentary evidence of strong ties to the new place, that they have made it their home, and that they have weakened their ties to their New York residence.

A taxpayer who is domiciled outside of New York and has a second home in New York may be subject to NYS tax on worldwide income if they spend more than 183 days of the taxable year in New York. Any part of a day counts as a day. The taxpayer must prove with documentary evidence, such as cellphone records and in-person purchases, where they were on every day of the year, to show that they were under the 183-day threshold.

IN: What happens when you unexpectedly get that letter saying that you owe an astronomical sum? What’s the first step?

YC: The first step is to confirm that the numbers are based on a filed return. Sometimes, if no return is filed, the IRS will prepare a return for the taxpayer. With incomplete information, the figures could be wildly inaccurate. If the numbers are correct, the next step is to consider whether you might be eligible for payment over time through an installment agreement, or a settlement for a smaller amount, through the Offer in Compromise program. The IRS can be flexible in setting up payment plans depending on the amount owed.

Taxpayers should not ignore the notices. The IRS will pursue collection and this could result in levying bank accounts, placing liens on your home, garnishing your salary, and even refusing to issue a passport. There are appeal rights prior to a levy and you don’t want to miss those deadlines.