Are You Afraid of the IRS?

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Most of us think of the IRS as a government agency about which which we know very little and probably want to keep it that way. Some of my tax preparation clients here in Maui dread the slightest interaction with the IRS because it can mean financial ruin and prison. That perception of the IRS contains a only a tiny bit of reality.

You might be unaware that the IRS publishes a lot of data about their activities. You might be surprised what you’d find hiding in plain sight on their website. And although they do Ever wonder how many people the IRS sends to prison? Last year it was around 3,000. Most of them richly deserve it. You, on the other hand, probably don’t.

Let’s set something straight about the IRS and you: They are not going to put you in prison.

Wait. Are you a drug dealer, or some other kind of criminal? Maybe an identity theft specialist or a tax refund fraud schemer? No? A movie star? You’re not? OK, then you have almost zero chance of going to jail as a result of interactions with the IRS.

But… and here’s the but that makes the IRS such a feared institution… you never know. You never know if you’re going to get hit by lightning either. But you generally don’t go around worrying about it. However, looking closely at the statistics on lightning strikes and IRS criminal prosecutions, if you are not an actual criminal committing willful fraud (that doesn’t include mistakes, misunderstandings, ignorance, bad reading glasses or anything else other than a conscious intent to defraud) your chances of getting hit by lightning are much (much) higher than getting sent to jail as a result of an audit notice.

So prison is rare, but audits are not. About a million a year are completed by IRS revenue agents. People always have a lot of questions about audits. Certainly an IRS audit isn’t much fun but your chances of being selected for one are less than 1 in 200. These examinations can be uncomfortable but there are no bright lights or locked interrogation rooms. If you’ve been loading up on questionable deductions you can’t prove the legitimacy of, you’ll pay tax. Plus penalties. Plus interest. If you’ve been particularly naughty, there are special negligence and other penalties.

If you are skimming this article, slow down for this next point. Hiding income from the IRS is not looked upon in the same light as not being able to prove up deductions. It’s one thing to lose receipts, and quite another if you fail to report that sixty thousand you won in Vegas. Under-reporting income is what lands most people in jail. Most people who actively engage in hiding income are criminals. Actual bad guys - guys who lie, cheat, and steal for a living. And I know that’s not you or you wouldn’t be reading a blog written by a CPA in Wailuku, Hawaii. (I assume?) So, that 1099 you forgot about and under-reported your income by $5,000? No, they’re not going to put you in jail for that one. But they very likely will come looking for their money.

I would advise you of course to neither hide income nor claim dubious deductions. But if you’re tempted, the former is much more likely to cause you serious trouble than the latter.

And although there are a million audits taking place every year, statistically speaking not that many people actually get audited and any competent CPA or lawyer can get you through one. I recommend you call a local Maui CPA or attorney if you get an audit notice. Again, if you’re not doing anything wrong other than filing tax returns with unintentional errors, all you’ll be facing is opening your checkbook and settling up.

Another favorite question of my clients involves the ‘red flag’. That question would require I know something about the IRS audit selection algorithm. The one thing we know for certain about the statistical details of IRS audits after they happen is: darned near everything. The one thing we know about the IRS audit selection algorithm: nothing. That doesn’t mean the IRS audit program and its results are a complete black box. If you are fluent in Spreadsheet, you can find out just about anything you’d want to know about the details of the IRS audit program:

  • Of 195 million tax returns filed (including individual, small business, corporate, and estate returns) a little over a million, or about .5% were audited.

  • Of those million audits, three in four are ‘correspondence’ audits. These audits seek specific information or documents via mail. The average taxpayer undergoing a correspondence audit in 2017 paid around $6 thousand in assessments.

  • Of the 250,000 ‘field’ audits, the average assessment was around $20,000. Being selected for a field audit means you get to meet with your very own IRS Revenue Agent. They have badges and everything. But they generally don’t flash them.

  • The IRS audits rich people (incomes of over $1 million) over three times as often as taxpayers making $25 to $100 thousand a year.

  • If you’re a huge company with a $20 billion plus balance sheet: you chances of an audit are greater than 50%

As you can see, the IRS usually goes where the money is. And if you dive into the published statistics you can figure out a few things about who’s going to be audited. If you make millions (or billions) you’re much more likely to be audited. If you don’t make a lot of money chances of being selected for an audit are much lower. If you’re audited anyway, they will want their money, but are not generally are not looking to put you in an orange jump suit.