DEDUCT IT — ODDS AGAINST AN AUDIT ARE GOOD

The odds that you’ll actually get tapped for an IRS audit are still extremely low. Should you be more aggressive in your tax planning? Sure — so long as you can justify what you’re doing.

Have you ever thought of bungee jumping? Have you skydived or thought about exploring the ocean floors? Would you rather gamble in Las Vegas or lie on the beach? Just how much risk do you enjoy taking?

If you really get off on the adrenalin rush of risk taking, then the tax game may be for you.

No, I’m not advocating cheating on your taxes. What I am suggesting is that there are situations where the tax law may be vague or subject to different interpretations and, with good substantiation, you can use the law to trim your tax bill. But there’s risk in the strategy. The IRS might disallow your move, and you have to pay up.

Remember, our tax code is not known for its clarity or its simplicity. There have been many tax decisions where four out of nine of our top jurists on the Supreme Court got the answer wrong! Just remember that.

But, how about the know-it-alls from the IRS? Try calling the IRS. In 2002, they only answered 68% of calls into their toll free lines. And, if you got through, how accurate were their answers? With respect to tax law questions, they were WRONG 19% of the time. If you asked a question about you own account, they were still WRONG 26% of the time!

In a study by IRS investigators from July to December 2002, IRS Service Centers gave incorrect answers to 43% of the tax law questions. About 500,000 taxpayers who visited the centers during that period were estimated to have received incorrect responses. And guess who pays when they get a wrong answer from IRS? The taxpayer who got the wrong answer, that’s who!

So, if you’re going to push the envelope, will you get audited? Probably not, but you need to understand how people come to be audited. Here’s what you need to know.

Fewer of Us Are Being Audited

The latest numbers have seen an enormous decrease in the “audit rate” — the number of returns examined divided by the total number of returns filed the previous year.

The audit rate for fiscal year 2002 was only 0.57% — about 1 in 175 returns. That’s more than the 0.49% rate for 2000 but still only about a third of the 1.67% rates for 1995 and 1996.

The total number of individual returns examined in 2002 rose to nearly 744,000, from a fiscal year 2000 low of about 618,000. But audits of returns showing income of more than $100,000 actually declined to 0.86% in 2002 from a rate of 3.21% in 1996. It was up from 0.79% in 2001, but still way below the 1.40% rate as recently as 1999.

But here’s what’s caught the attention of both the Bush administration and Congress. The General Accounting Office estimates that 1 million to 2 million Americans have credit-card accounts in tax-haven countries, and these fraudulent activities cost the Treasury $20 billion to $40 billion a year. Do the arithmetic. That’s $20,000 to $40,000 per tax cheat — about what the rest of us hope to make in an entire year! The offshore tax-shelter business has flourished because there’s actually little real financial risk. Investors are shielded from basic IRS penalties by attorney’s opinion letters ratifying the deals. This is big money we’re talking about here. Yet, IRS feels it is more effective to terrorize small peanuts taxpayers like you and me, rather than engage the “big cheese” tax cheats to whom offshore tax evasion scams appeal.

As a result of this, the IRS is taking baby steps to fight back, including getting banks and credit-card companies to disclose the names of customers with offshore accounts — in hopes of manually finding accounts that are set up for the sole purpose of concealing income. The reality is, they haven’t caught very many. How can you tell? Because they have nothing with which to propagandize the news media. Whenever they want to intimidate the rest of us, IRS likes to leak case details of big name people who are up on tax fraud charges. A silent IRS means an unsuccessful IRS, folks. And IRS is awful quiet on this one, aren’t they?

The reality is, IRS hasn’t caught very many. How can you tell? Because they have nothing with which to propagandize the news media. Whenever they want to intimidate the rest of us, IRS likes to leak case details of big name people who are up on tax fraud charges. A silent IRS means an unsuccessful IRS, folks. And IRS is awful quiet on this one, aren’t they?

The IRS began the so-called “audits from hell” in the fall of 2003. They’re now called National Research Program (NRP) audits. It’s about us small peanuts taxpayers, not the “big cheese” tax cheats. Here’s what they’ll entail:

Your odds of winning the Powerball lottery in 2002 were 1 in 80 million. Your odds of facing an audit from hell are 1 in 65,000. A grateful nation appreciates your sacrifice.

Still, in many cases, the difference between a legitimate tax shelter and “abusive non-compliance” is whether you win the “lottery of the numbers.”

Are You Doing Something Out of the Ordinary?

Most individuals are selected for audit on a random selection basis or on what’s known as your DIF score. That’s where the IRS compares your deductions with other taxpayers comparable to you.

If you have a Beverly Hills, California zip code, the IRS might want to know why your income is so low. Alternatively, if your zip code puts you in a distressed neighborhood and you report minimal income, the IRS is going to question a five-figure charitable deduction. The more “inconsistencies” that exist, the more the computer is going to click and the greater the odds that a real human being is going to review your return with you.

Substantiation Is the Key

If you’re way above average for a specific deduction, I strongly recommend that you attach substantiating documentation to your return. That is, quantify exactly the deduction you’re claiming, and be able to point to the section of the tax law that permits it. Here are two possible — albeit extreme — scenarios so you know what I mean.

In both cases, substantiation at the beginning gives the IRS the proof that it wants without having to contact you. More importantly, it may actually decrease your audit odds. You’ve just proven to them that you know how the system works and that you’re ready to play.

The IRS doesn’t want to audit those who know the rules and are ready with substantiation. That costs them examination time and doesn’t generate any additional revenue.

Get aggressive! What’s your downside? As long as it’s not clearly fraud, if you have at least an arguable position, you’re probably only facing having to pay the tax you would have paid anyway, plus an interest charge, currently at 4% a year.

But you’ve had the use of the dollars you would have paid in taxes. It’s like borrowing the money at a 4% rate, with no points. If that’s your cost, and only if you get audited, your actual risk is minimal — especially with an audit rate of 0.57%.

But What If . . .

You don’t have perfect substantiation? If you have a legitimate expense or charitable contribution and you lost your receipt, don’t be afraid to claim that deduction. Even with the IRS again doing “super audits” where every number on your return is subject to review, the odds are still in your favor that you won’t be audited.

After all, according to the IRS's own Audit Guidelines for Examiners, adequate evidence does not require complete documentation. Statements made by the taxpayer or others may serve as adequate evidence in an audit.

And, if you do get “caught,” a 2003 Senate Finance Committee hearing revealed that 60% of identified tax debts are not pursued and that 75% of taxpayers who don’t even file a return get away with it!

Do you feel lucky? If so, “when in doubt — deduct it out!”