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IRS Switches Auditing Gears – Goes After Wealthy Tax Cheats
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Introduction – Learning from Willie Sutton
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When famous bank robber Willie Sutton was asked why he robbed banks, he was reported to say, “because that’s where the money is!” His response became known as Sutton’s Law – the idea of looking for the obvious, rather than getting bogged down in the obscure. Taking a page from Willie Sutton, IRS, in an abrupt change in strategy, has announced that henceforth, it will focus audit resources on wealthy taxpayers, rather than continue its practice of hounding the working poor regarding their child care credits.

 

When asked about this about-face, IRS Commissioner Charles Rossotti made the following Sutton-like observation: “The fact is, people who make more than $100,000 pay more than 60 percent of the taxes, and we need to focus there.” According to Rosotti, the new IRS focus on high-income individuals was to “protect the crown jewel, which is the fairness and faith the honest taxpayer has in the system.” IRS states that it intends to focus on four key problem areas: Offshore credit card abuse; High-risk, high-income taxpayers; Abusive schemes and promoter investigations; and Non-filing by higher-income taxpayers. Tax Audits by Computer, Rather Than Trained Individuals Recent articles in The New York Times and other publications focused on the disparity of audits conducted against the working poor compared to the wealthy.

 

IRS audits relied more on computer matching, rather than personal investigations, evidently embracing the theory that it was easier to audit a million poor taxpayers through computer matching of tax information who owed an additional $100 each, rather than spend the resources necessary to audit 100 wealthy individuals who might owe $1 million. In each case, the government raises the same amount of money, but the current IRS approach took from those who could least afford it. For instance, last year one in 47 people who claimed the earned-income tax credit were audited, compared with one in 145 taxpayers making over $100,000. Criticism of allocations of auditing staff is valid Mr. Rossotti admits, and informs us that the agency has been working on it for a long time. One should not expect quick results though. IRS has lost many experienced agents as a consequence of retirements and buy-outs since passage of the Restructuring and Reform Act of 1998 and IRS acknowledges that training, supervising and administering new personnel takes considerable time and thereby limits how quickly the agency can shift resources to compliance.


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Auditing the Poor Backfires
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Relying on computers with outdated audit algorithms to examine the tax returns of the “little guys” proved to be an exercise in futility. First, these taxpayers have limited financial resources to pay additional taxes, penalties and interest, even if they made errors on their returns. Second, Commissioner Rossotti admitted that, auditing the working poor produced a growing number of audits where people owed no additional taxes or even owed less than they had paid. Much of the problem relates to the rapid changes in the tax laws and IRS’s inability to produce effective “real-time” audit criteria related to those changes. Thus, it would seem expedient for IRS to apply Sutton’s Law and redirect the focus of its shriveling audit resources to areas that can prove most lucrative.
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Underreporting Income
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IRS admits that cheating is rampant among those who can control what is reported to IRS on tax returns, such as investors and owners of businesses. In fact, IRS claims that 20% of the funds held in investment partnerships and LLCs is not being taxed. Prodded by Congress and news stories, IRS has decided that just because tax returns of wealthier individuals are understandably more complex is no reason to shift investigations away from them. But don’t expect a quick result; It is estimated that it will take two years to complete the change in strategy. Major accounting firms, investment houses, law firms and tax boutiques sell complex devices to people who claim that tax laws are invalid or apply only to a few Americans. The Ernst & Young accounting firm sold four techniques including one that used foreign currency transactions to eliminate taxes.
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Targeting Unreported Income
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IRS has developed an “Unreported Income Discriminant Index Formula” which rates the probability of inaccurate information and income omitted from a tax return. IRS will pay special attention to pass-through entities (partnerships, S corporations and limited liability companies), since it believes that pass-through entities understate taxable income (either by under-reporting income or over-reporting deductions) by 20% or more.

 

Also, IRS has targeted national tax scams such as frivolous return arguments; slavery reparation claims; and employment tax schemes for audit and will now actively monitor the internet for tax-scam promotions. IRS Takes Notice of Offshore Banks Facilitating Tax Evasion In addition to using complex domestic partnerships and LLCs to underreport income, IRS has concluded that some wealthy taxpayers engaged in tax cheating through the use of off-shore bank accounts. These accounts are openly sold through the Internet, usually with other tax-evasion schemes, such a “pure trusts” or phony companies which are used either to hide income or produce bogus deductions through fake invoices. Eileen J. O’Conner, assistant attorney general for the Justice Department’s tax evasion division, said in a recent release, “Offshore accounts have enabled people to evade billions of dollars of income taxes each year in the United States. . . .”


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A $70 Billion Pot of Gold
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Noted international tax attorney Jack Blum, the author of several studies involving money laundering, submitted an affidavit filed with an IRS petition, in which he estimates that the U.S. Treasury loses $70 billion a year through offshore evasion by individual taxpayers and said that $3 trillion is deposited in these tax haven banks. The banks market bank secrecy laws as evidence of the protection they afford taxpayers from tax authorities, according to Blum.
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The Increased Use of Off-Shore Credit Cards
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Taxpayers being investigated include executives of publicly held companies, business owners, and investment professionals who use offshore credit cards to pay for expenses including travel, living, and big-ticket items. In addition to tax evasion, off-shore credit cards have been criticized by the General Accounting Office in a report issued August 21st relative to money laundering – estimated at $500 billion annually. Investigations by Congress and IRS indicate that credit card accounts maintained in offshore jurisdictions are vulnerable to money laundering.
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Court Action Again Tax-Scam Promoters
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Recent civil court actions that forced promoters of abusive tax schemes to turn over lists of customers are already proving their worth. After the client list of one promoter was obtained, according to IRA a taxpayer filed amended tax returns for the last two years and attached a check “for tens of millions of dollars.” Rossotti assures us that promoters who tell clients their schemes are lawful because IRS has failed to prosecute them “may be under grand jury investigation right now, but by law we can’t talk about it” until indictments are handed up. The whole idea, Mr. Rossotti said, is to change the culture of the IRS in a way that focuses enforcement efforts “on those who represent the biggest threats to the tax system” and then they can either choose to pay up or go to prison.
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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.