Avoiding an Audit

The IRS is cranking up its audit machine this year. Here's what to watch out for.

Suffering through an IRS audit is one of those things — like public speaking — that makes most of us sweat by just thinking about it. And unfortunately, the IRS is enforcing the nation's tax laws with renewed vigor, so you can expect a higher statistical chance of being audited in the future. How much higher remains to be seen, but I advise increased caution and attention to detail with your 2004 return.

The surest way to receive unwanted attention from the feds? Claiming what appear to be wildly excessive itemized deductions. That's always been the case. (Don't let that stop you from claiming all legitimate write-offs. If your deductions are well above the norm (see table below), just make sure you have solid documentation.) But the feds are now implementing several new measures designed to nail scofflaws who've been slipping through the tax collector's net with relative impunity. So if you've employed any of the practices described below, consider yourself warned.

Crackdown on Offshore Credit Cards
Here's a great tax-saving concept: You transfer cash into a bank account located in an offshore tax haven. You're told that you won't owe any taxes on the income or future earnings generated in the account. How do you get your hands on the money when you need it? Simple. Use your offshore bank credit card, issued as part and parcel of the deal, to hit the ATM and charge expenses. You'll then pay the resulting credit-card bills with your offshore cash stash. Sweet!

Surely, you will not be surprised to hear that this is an illegal tax-evasion scheme and that misguided participants can be caught, despite promoters' claims to the contrary. As part of the crack-down, the IRS filed several "John Doe" summonses to obtain records from 70 companies (including Disney (DIS), Hilton (HLT) and Air Canada) regarding credit-card transactions between 1998 and 2001. Previously, the IRS filed seven other lawsuits to scoop up records from companies that process MasterCard transactions. Yet another lawsuit sought MasterCard International's records for accounts set up in Antigua and Barbuda, the Bahamas and the Cayman Islands. The IRS is also moving to gather information about MasterCard, Visa and American Express account holders in 77 other countries.

What the government is after, obviously, is the identity of anyone who may have signed up for offshore credit-card deals to evade taxes. The IRS believes more than a million U.S. citizens hold cards issued by foreign banks. While many folks no doubt have perfectly lawful reasons for doing so, a million seems like a suspiciously big number to the IRS — especially when a much smaller number of taxpayers admit to having foreign bank accounts. (Your Form 1040 requires you to tell the IRS if you have any foreign bank accounts.)

Other IRS Initiatives
Here's a quick summary of other major projects the IRS has on the front burner.

Find unreported income. The IRS has developed a new computer program to identify returns most likely to have underreported income. (How will it do so? Nobody knows. It's proprietary government information.) In the past, IRS computers focused more on fingering returns most likely to have overstated deductions.

Failing to report income can get you into a whole lot more trouble than puffing up your deductions a bit. Why? Because it's a very tough sell to claim you didn't realize that you have to report all your income to the IRS. In contrast, the rules for deductions are often so murky that even the most honest taxpayers can make mistakes.

Advice: Report all your income. No exceptions.

Match Schedule K-1s reporting "pass-through" income and deductions from partnerships and S corporations to returns filed by owners of these entities. The IRS believes income from partnerships and S corporations is often underreported, while deductions are often overstated. Until recently, no serious attempts at matching the more than 20 million K-1s issued annually had ever been undertaken. But this particular taxpayer holiday is now over. The new IRS matching effort means it's now critical to properly reflect Schedule K-1 tax information on owner returns.

Advice: If you own interests in partnerships and/or S corporations, consider hiring a competent professional to prepare your returns. If you insist on doing the work yourself, please be careful.

Shut down "Section 861" schemes. Promoters of these bogus deals claim you can rely on Section 861 (which has to do with the foreign tax credit) to dodge taxes on any income that's not from foreign sources. Under this scheme, you're told to file amended returns to claim refunds of taxes previously paid.

Advice: Don't fall for these scams. You owe U.S. taxes on your U.S. income as well as any foreign-source income. Sorry about that!

Shut down abusive trust deals. Promoters claim you can contribute business and income-generating assets to a trust, and thereby legally avoid paying federal income taxes.

Advice: Don't be a sucker. You generally owe taxes on income generated by assets you control, unless they're owned by a separate taxpaying entity, such as a corporation. Putting assets into a trust that you control won't change that. That's because the trust is considered a "grantor trust" owned by you, which means the trust's income is taxed to you.

The Last Word
There's a world of difference between taking advantage of legitimate tax-saving maneuvers (which I regularly cover here) and falling prey to a tax scam. Remember: You are required to pay only the amount of tax that you legally owe. Whittling that number down by any legitimate means is a worthy objective for anyone who wants to be considered financially astute. On the flip side, paying the taxes that you legally owe is a small price for the privilege of living in this great country.

Average Deductions by Adjusted-Gross-Income Level
$30K-50K $50K-100K $100K-200K $200K and up
Interest Expense 6,850 8,364 11,825 21,998
Taxes 3,187 5,173 9,785 35,815
Contributions 2,066 2,530 3,875 17,354
Medical 4,994 5,672 10,969 28,305
Total itemized $13,096 $16,777 $25,768 $65,923
Percent itemizing 39.6% 70.9% 91.5% 93.8%
Source: Winter 2003-2004 IRS Statistics of Income Bulletin
The above numbers are from returns for tax year 2002 (the latest available figures). They reflect averages based on taxpayers who actually claimed these deductions. For example, only a small percentage claimed medical write-offs because only expenses in excess of 7.5% of adjusted gross income can be deducted. This is why the average "total itemized" number doesn't represent the sum of the averages.