The taxman cometh: IRS audits likely on the rise

As if you don't already have enough money worries. This is the year to double, no, triple-check, your taxes before filing. The IRS is looking for the money it's owed with renewed vigor, and that means a lot more people can expect to be audited. Why now? It's not hard to guess.

We've been hearing for months that the economy is finally on its way up, but the numbers don't actually bear that out.

As of last month, the federal deficit weighed in at a record $1.42 trillion and, depending on what Congress does, could double within the year. Estimates are that within the next ten years, the deficit will hit $9.1 trillion. Increases in the budget have been tapped for bailouts, CASH for clunkers, the first time homebuyer's credit and the controversial new health care plan. The problem? There's no money to pay for all of these programs.


It's clear that Congress has no plans to cut spending any time soon. In fact, despite the budget woes, it's busy increasing spending. The proposal to extend the first time homebuyer's credit alone is expected to cost more than $10 billion -- that's $2 billion more than the program's first go 'round.

So that leaves Congress with two choices: Increase taxes, or increase enforcement. In an election year, which do you think it'll choose?

Right. Tax professionals expect to see an increase in audits and assessments for taxpayers in the near future. The IRS estimates that it fails to collect about $345 billion in taxes each year, with more than half of that coming from individual taxpayers. As the number of taxpayers go down and the number of planned audits go up, your chances of becoming an audit target may increase. In fact, while traditionally, your chances of being audited were about 1 in 150, predictions are that those odds will increase to closer to 1 in 99.

What are your chances of becoming a target? If your return consists largely of a form W-2 and a few deductions, your risk is likely low. The more deductions and "tax preference items" that you report, the more likely you are to make a mistake or cause a flag to be raised.

Statistically, your chances of being pulled for audit will also increase if you're a small business owner or partner. That's bad news for mom and pop shops, which account for about 80% of all businesses.

Your risk also goes up if you are considered a high wage earner. That's good news for the nearly 44% of zero tax filers, but not so great for the top 25% who already feel bombarded by requests to pay more taxes.

Why the disparity in audits? It's called targeted enforcement and is a tool that the IRS uses to identify taxpayers in groups that have, for various reasons, been brought to the attention of the IRS. Targeted enforcement is nothing new for the IRS. What is new is the shrinking pool of potential taxpayers.

That means that as the IRS ramps up its reporting audits under programs like the Automated Under Reporter program, more taxpayers should expect to see notices from the federal government. About 16 million tax returns each year are tagged as having a potential discrepancy -- out of 140 million returns filed last year, that works out to more than 10% of returns noted as catching the attention of the IRS. About 30% of those are pulled out and looked at by an IRS auditor.

What happens with pulled returns varies from taxpayer to taxpayer based on your individual circumstances. You may simply receive a notice that your taxes have been recalculated with a request for more money. If there is a question about a specific deduction or expense, you may receive a request for more information. In some cases, you will be asked to sit down with an IRS examiner and answer questions and provide more information in person. In that event, you'll probably want to retain the services of a tax professional who can assist you with the examination.

It awaits to be seen what effect increased enforcement will have on the economy, specifically with respect to small businesses. While some increased enforcement makes sense, it's likely that the taxpaying public will have more support for the pursuit of targets like offshore tax cheats than putting a bulls eye on small businesses. If the IRS is seen as too aggressive in its efforts to collect revenue from an already shrinking pool of taxpayers -- especially to pay for programs perceived to be helpful to those not paying as much -- there is likely to be some backlash. The magnitude of the backlash will depend on the perception of how harshly the IRS is chasing "average" taxpayers.

Remember, though, that IRS doesn't make the rules: Congress does. Mandates to increase collections are coming straight from Capitol Hill. That's where the real backlash will likely be felt. In 2010, a key election year, it will be interesting to see how that plays out.