The IRS Is Cracking Down on More Taxpayers
Martin S. Kaplan, CPA
The IRS has been stepping up efforts to make sure that taxpayers are
paying up, especially as the federal budget deficit soars. About
40,000 more individual tax returns were audited in fiscal 2009 than in
2008 — and the number has more than doubled since 2000. For 2010, the
tentative federal tax-enforcement budget is up nearly 10% from last
There’s no way to absolutely audit-proof a tax return. However, there
are steps you can take to minimize the chances that the Internal
Revenue Service will challenge yours, including ways to make sure that
you don’t have any of the new potential red flags that the IRS is
targeting. To reduce the chances of an IRS audit…
REPORT ALL YOUR INCOME
In the current economic climate, unreported income is a major concern
of the IRS, especially if you are self-employed and report income on
Schedule C of IRS Form 1040. The IRS estimates the annual “tax gap”
between what taxpayers should pay and what they actually pay at $290
billion, and has said that under-reported income accounts for 80% of
this tax gap.
An agent may look beyond your W-2 forms and 1099 forms that report
income. He/she may examine all of your checking and savings accounts
from December of the year prior to the year that is under examination
through January of the following year — 14 months in all. You may
have to provide that information for your children’s bank accounts,
too. The agent will be looking for deposits substantially in excess of
the income you reported.
You’ll be asked to explain any deposits that were not classified as
income, such as proceeds from a home-equity loan, account transfers,
an inheritance and gifts.
What to do: Make sure that you report all of your taxable income. Go
over all of your bank deposits as an IRS agent might, and see if you
can account for all deposits in excess of the taxable income you
MORE INCOME = MORE VIGILANCE
With income of $200,000 or less, you have about a 1% chance of being
audited, according to the IRS. Audits of taxpayers in this income
group rose only slightly from 2008 to 2009. With income of more than
$200,000 up to $1 million, your chance of an audit triples to about
3%. Audits of such taxpayers rose by 11% from 2008 to 2009. And with
income of more than $1 million, your chances of facing IRS scrutiny
shoot up to more than 6%. Audits of seven-figure-income taxpayers rose
by 30% from 2008 to 2009.
What to do: The higher your income, the more vigilant you must be
about avoiding errors, omissions and questionable deductions. There
also is more reason to hire a professional tax preparer. And there may
be more reason to lower your taxable income by investing in tax-exempt
bonds and other means.
DON’T CALL A HOBBY A BUSINESS
Be cautious about reporting as a business any hobby that is only
minimally profitable — an increasingly common practice that the IRS
frowns upon because you are not allowed to deduct losses from a hobby
(but you can deduct losses from a business).
A true business may lose money, of course. As long as you have records
showing that you made a legitimate effort to create a real business,
you can deduct the loss. This means running the activity in a
businesslike manner — with a business plan, a separate business bank
account, good records of income and expenses, etc.
If you report business expenses, including auto, travel and
entertainment expenses, that are high relative to your income, that
also could draw extra scrutiny from the IRS. Keep thorough records of
income and expenses for your business.
Be aware that you do have to report all income from a hobby. The good
news is that you can deduct expenses of the hobby to the extent of
BE CAUTIOUS ABOUT HOME OFFICES
In addition to unreported income, IRS examiners often focus on
deductions for a home office. Therefore, filing Form 8829 (Expenses
for Business Use of Your Home) might attract IRS attention and trigger
What’s new: When a taxpayer who is audited has filed Form 8829, many
IRS districts now are making it mandatory for a revenue agent to
physically visit the taxpayer’s home by appointment. During the home
visit, the agent will look around and take pictures to determine
whether there really is a home office, whether it’s set up exclusively
for business and how large a portion of the home is taken up by the
What to do: Consider restricting the square footage you report for a
home office to less than 20% of the total space in your home. You
might end up with a slightly lower tax deduction than you are
technically entitled to, but you may reduce your exposure to an audit.
You even may want to avoid declaring a home office at all.
PROVE YOU DONATED
The IRS appears to be taking a much closer look at cash and noncash
charitable donations, especially ones that are very large relative to
the taxpayer’s income. Giving 10% of your income to charity is far
above the norm, which is around 2%. Thus, donating large amounts
relative to your income may be a red flag to IRS examiners. Gifts of
property, especially those valued at more than $5,000, often draw
All charitable deductions must be backed up by written verification
now, such as a letter from the charity or a bank record of the gift,
or, for cash donations under $250, a bank record recording the gift.
What to do: If you really donate substantial amounts and have
supporting evidence, such as receipts… letters from the recipient
organizations… and/or your bank statements, take the deductions.
Avoid making cash donations — it’s better to use a check or credit
BACK UP HOME BUYER’S CLAIM
New laws in 2008 and 2009 created tax credits of up to $8,000 for many
first-time home buyers and $6,500 for many repeat buyers.
However, the Treasury Department found that about one out of every 10
claims for the tax credit is faulty, for a total of more than $600
million in claims that will not be allowed. The IRS has frozen
thousands of tax refunds and initiated more than 100,000 examinations
of questionable claims.
Examples: More than 580 people under age 18 (including a four-year-
old) claimed the credit, even though they are not eligible. The IRS
suspects that some high-income parents (who were not eligible for the
credit) had their low-income children claim the credit. Another,
perhaps more innocent, mistake might be claiming the credit if your
income was over the limit.
What to do: To avoid inviting an audit, be familiar with all of the
requirements for the home buyer’s credit, and follow them to the
letter. For details, go to http://www.HomeBuyerTaxCredit.com. Be sure to
attach Form 5405 and proof of closing to your tax return.
DON’T EXAGGERATE MORTGAGE INTEREST
During the housing boom, many people refinanced their homes with “cash-
out” mortgages, pulling out home equity to use for living expenses. In
2009, the IRS announced that it will extend a regional project
scrutinizing mortgage interest to a nationwide level by December 2011.
The regional project found many people reporting large mortgage
interest deductions in relation to their income — a potential audit
What to do: If you are reporting, say, $20,000 in mortgage interest
payments but only $25,000 in income for 2009, you would be wise to
attach a brief statement explaining how you can handle such a big
mortgage — for example, that you are tapping your savings to pay the
DECLARE OVERSEAS ACCOUNTS
The IRS has announced that it expects to collect $8.5 billion in back
taxes from Americans with foreign bank accounts over the next few
years. The IRS is pressuring foreign banks to name names. For example,
in 2009, the US and Switzerland reached an agreement requiring Swiss
banks to provide account information if the IRS suspects any tax
evasion by account holders.
What to do: If you own or have authority over a foreign financial
account, you are required to file a Report of Foreign Bank and
Financial Accounts (FBAR) to the IRS if the aggregate value of all
your foreign accounts exceeds $10,000 at any time during the calendar
year. Be sure to do it.
Bottom Line/Personal interviewed Martin S. Kaplan, CPA, who has a
private practice based in New York City. He is a frequent guest
speaker at insurance, banking and financial-planning seminars and
author of What the IRS Doesn’t Want You to Know.