Brown & Streza Blog
Oct 6

Written by: David Keligian
10/6/2011 10:53 AM  RssIcon

Many politicians have repeatedly talked about the need for “the rich” to pay more income taxes. Even Warren Buffet has joined the debate. Regardless of whether Congress acts, the IRS has already taken matters into its own hands and has started scrutinizing wealthy taxpayers to an unprecedented degree.

The audit rate for taxpayers with an annual income of more than $1,000,000 is already eight times higher than the general population, which had a 1.1% audit rate. For those with $10,000,000 or more in annual income, the audit rate climbs to almost one in five returns—almost 20 times higher than the general population. However, the IRS is planning on increasing audit rates on wealthy taxpayers even more.

The IRS effort involves a new “wealth unit”. Audits will be conducted by a team of IRS agents who will focus not only on a taxpayer’s individual return, but the returns of all related entities. The scope of these audits will be much wider than a typical income tax audit.

For example, the IRS has begun reviewing recorded deeds to see if taxpayers transferred property without filing gift tax returns. They are also focusing on losses from flow through entities that may be subject to the passive loss rules. (Those rules restrict a taxpayer from deducting losses from passive investments against salaries and other non-passive income).

There has also been much publicity about the IRS’s recent efforts to find unreported foreign assets and income. Unlike the situation in the past, foreign banks and investment firms are now providing the IRS with information regarding holdings at their institutions by U.S. taxpayers.

There are a number of steps you can take to lessen the chances of an audit. Examples include avoiding the use of Schedule C (used for sole proprietorships), because Schedule C’s have high audit rates. (From a legal standpoint, a business should never be operated as a sole proprietorship anyway. It should be held in a separate legal entity such as an S corporation or LLC that provides liability protection to the owner).

Other steps to minimize the chances of an audit include providing complete explanations, including supporting documentation, on any items that appear unusual on a tax return (as opposed to waiting until the IRS contacts you, leading to the possibility they will look at other issues as well). Finally, protective measures include doing the things that Brown & Streza excels at—making sure routine corporate and business transactions are documented as they occur. Shareholder loans, for example, should be documented with promissory notes, with your accountants in the loop so that the loans are consistently reflected as such on your financial statements.

Politicians have figured out that they don’t need to raise tax rates to increase taxes. More audits can achieve the same result. There are various areas where the IRS is again beginning to “crack down” on perceived abuses, including the use of independent contractors. Regardless of what happens to tax rates, you can expect more frequent disputes with the IRS.

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Categories: Tax Policy
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