Chances of being audited by the IRS are greater under the following circumstances:

1) You have large amounts of itemized deductions on your tax
return that exceed IRS targets.

2) You claim tax shelter investment losses on your tax return.

3) You have complex investment or business expenses on your
tax return.

4) You own or work in a business which receives cash and/or tips
in the ordinary course of business.

5) Your business expenses are large in relation to your income on
your tax return.

6) You have rental expenses on your tax return.

7) A prior IRS audit resulted in a tax deficiency.

8) You have complex tax transactions without explanations on
your tax return.

9) You are a shareholder or partner in an audited partnership or
corporation.

10) You claim large cash contributions to charities in relation to
your income on your tax return.

11) An informant has given information to the IRS re: unreported
income.

IRS Audit of Tax Returns
Tax returns are selected for audit based on the following criteria:
1) High DIF Score – An IRS numeric score (“DIF Score”) is assigned to taxpayers (by a computer program called the Discriminant Income Function). A high DIF Score portends a tax audit.

2) Third Party Information Reporting – Third party information, (e.g., Forms 1099, W-2), does not match tax return information.

3) Third Party Sources – Tax returns audited based on third party source information on inaccurate tax filings, non- compliance with tax laws. Third party sources include: media, public records or informants.

High Risk Tax Audit Targets
Your chances of being audited depend on:
1) What type of income you report.
2) The amount of income your report.
3) The type of business you’re in.
4) The tax deductions you report.
5) Your past history with the IRS.

Qualified Intermediaries – Foreign Recipients of U.S. Income

Foreign financial institutions that enter into an agreement with the Internal Revenue Service, known as qualified intermediaries (Qls), may serve as withholding agents. If so, they are fully liable for all taxes owed by a foreign beneficial owner and must report the income paid to each recipient on a Form 1042S (filed annually). Without this withholding requirement, there would be no effective way to enforce taxpayer compliance because foreign recipients are generally not required to file U.S. tax returns to report U.S. income.

Nonresident aliens and other foreign persons who earn U.S.-source income are required to report this income on Form 1042-S (Foreign Persons’ U.S.-Source Income Subject to Withholding). This income is subject to a flat, statutory withholding tax rate of 30 percent. However, this rate is frequently reduced or eliminated by an income tax treaty or statutory exemption.

Income that is exempt from taxation because of a tax treaty or certain other exemptions must still be reported. U.S. individuals, corporations, or other entities paying U.S.-source income to foreign persons are required to withhold taxes on this income (except where statutory or treaty exemptions apply) or to appoint a withholding agent (normally a U.S. financial institution).

Foreign Account Tax Compliance Act (FATCA): IRS Audits and Statute of Limitations

I. Pre-FATCA

1. Three year statute of limitations for the IRS to propose assessments after a tax return was filed.
2. Six year statute of limitations if 25% or greater omission from gross income.
3. Civil fraud unlimited statute of limitations.
4. Undisclosed foreign transactions (e.g., failure to file Forms 5471, 8865, disclose 10% or more interest in a controlled foreign corporation or foreign partnership) suspend 3 year statute of limitations until the foreign information is provided to the IRS.

II. FATCA (Effective 3/18/10)
As of 2010, six year statute of limitations on omission of more than $5,000 of unreported income from undisclosed foreign bank account.

Suspension of three year statute of limitations across the entire tax return, all items, not just undisclosed foreign accounts for failure to file:

a. Reports of foreign financial assets (i.e., assets over $50,000) new form 2010 attached to amended part of Form 1040 tax return.
b. Annual reports required to be filed by a passive foreign investment company.
c. Election of Passive Foreign Investment Company (PFIC) shareholder to have the PFIC treated as a Qualified Electing Fund.

In 2010, under FATCA, the IRS may aggressively pursue audits by a statute of limitations which remains open for six years or is suspended indefinitely for undisclosed foreign transaction.

Increased IRS Tax Audits (2011)

In 2007, the IRS increased tax audits which produced 22% more tax revenue (2007: $59B, 2006: $48B).

2007 IRS Tax Audit rates increased for both individuals and businesses as follows:

Individuals
1. Audits of individuals with income over $1 million increased 84%.
2. Audits of individuals with income over $200,000 increased 29%.
3. Audits of individuals with income over $100,000 increased 13%

Business
1. Audits of S-corporations increased 26%.
2. Audits of partnerships increased 25%.
3. Audits of general businesses increased 14%.

The recent decline in tax revenues (2009: $48.9B, 2008: $56.4B) portends increased IRS audits in Tax Years 2011 (forward).

IRS/Estate Tax Audits
In 2010, the average amount of additional tax the IRS recommends Taxpayers owe after an estate tax audit is $363,149.

Estate tax filings by Taxpayers with estates of at least $3.5M increased 33% between 2001 (9,440) and 2007 (14,281).

While estate tax filings increased for estates over $3.5M, the total number of estate tax returns filed decreased 64% between 2001 (108,071) – 2007 (38,031).

The reduced number of estate tax returns related to the estate tax exemption (per individual) rising from $675,000 (2001) to $2,000,000 (2007).

New IRS Audit Targets (2010)
The IRS does not conduct random audits but does conduct “research audits” that will test compliance in business tax categories. In 2010, IRS research audits target payroll taxes.

In 2009, the IRS increased tax audits of tax-exempt organizations by 28%. In 2008 there were 7,800 tax audits. In 2009 there were over 10,000 tax audits.

Total Revenue collected from IRS Tax Audits/Collection:
2009 – $48.9 Billion
2008 -$56.4 Billion
2007 – $59.2 Billion

In 2007, 2008 more revenue was collected from settlement of major tax shelter cases (e.g., drug maker Merck and Company paid $2.3 billion [tax, penalty, and interest] to settle a tax dispute for Tax Years 1993 – 2001).

IRS Income Tax Audits (as of 9/30/09)

For the year ending September 30, 2009, the IRS conducted 1.4 million audits of individual returns:

1. Income Under $200,000 – 1% Chance of Audit

2. Income $200,000 – $999,999 – 3% Chance of Audit
(11% Increase in IRS audits from Tax Year 2008 to Tax Year 2009)

3. Income $1M+ (or more)
Chance of Audit: 5% (Over $1M); 10% (Over $10M)
(30% Increase in IRS Audits from Tax Year 2008 to Tax Year 2009)