April, 2002 Hot Topics - Part 1 of a 2-part Series [an error occurred while processing this directive] Introduction [an error occurred while processing this directive] For anti-government fanatics, the news could not be more reassuring: Now that IRS auditing practices have been exposed, those annoying government conspiracy theories expounded by left-wing and right-wing politicos seem closer to reality than many would have thought.

While there is no evidence of an actual government conspiracy against the middle-class and working poor, it is clear that IRS tax enforcers give the wealthiest 5% of taxpayers a virtual free-pass while concentrating their efforts on the remaining 95% of all taxpayers - salaried employees and those seeking tax credits for the working poor. Evidently, when the IRS commissioner claimed his agency would be "kinder and gentler," he was referring to treatment afforded the wealthy. Indeed, it appears that IRS bears its notorious fangs only when it comes to wage earners and the poor.

While an IRS audit notice of audit still strikes fear in the hearts of many Americans, unless you receive W-2 income (wages, salaries, commissions) or work for yourself and earn $25,000 or less, the chances of actually hearing from IRS range between slim and slimmer - according to a recent New York Times article entitled "Affluent Avoid Scrutiny on Taxes Evan as I.R.S. Warns of Cheating" (4/7/02). If you receive income from partnerships, S corporations or trusts, the chance that those entities will be audited is almost non-existent.

Mining for Chump Change Instead of Gold [an error occurred while processing this directive] What gives? Why do the rich escape audit while the government cracks down on middle-class working stiffs and the downtrodden? The answer is that computers have taken over most of the audit function and are programmed to compare W-2 wage statements received by employees, but not K-1 statements issued by partnerships, S corporations and partnerships. IRS computers can easily match wage statements reported by an employer with income claimed by the employee on Form 1040, but those same computers are not programmed to match income reported on K-1 forms to an individual's Form 1040.

Wage Earners and the Poor [an error occurred while processing this directive] Wage earners are clearly losers when it comes to IRS scrutinizing cheating on reporting taxes. We have known that IRS audits the working poor in ever-increasing numbers compared to the wealthy, but it is not common knowledge that IRS computers do not track business and investment income. This, despite the fact that tax officials warn that tax dishonesty is on the rise among affluent Americans.

The focus of Congressional action since 1995 has been on the working poor who actually file tax returns, which results in an average $9 billion annual recovery for government coffers. Contrast this to other forms of cheating by the wealthiest Americans, estimated to be more than $300 billion annually.

The reasons for this emphasis on middle and low-income taxpayers and not the wealthy relates to ease of collection: Evidently, IRS would rather collect $100 from one million taxpayers, than $1 million from 100 taxpayers - the revenue is the same and it is easier to soak the middle-class and poor through computers (including hostile computer-generated letters demanding documentation), rather than send in actual auditors to scrutinize the wealthy, with their obscure, complicated transactions, and battalions of CPAs and attorneys.

The system is clearly geared toward examining salaried employees rather than those living on investments or business earnings. Employers must report wages in detail to IRS on W-2 forms (independent contractor compensation is reported on form 1099); banks report interest earned on savings accounts and payments on home mortgages; churches and charities must issue receipts for donations in excess of $249.99; children are required to have a social security number in order to be claimed as an exemption on tax returns. IRS compares entries on individual tax returns with those reported by these entities and if there is a mismatch, the return is selected and the taxpayer is automatically sent a notice.

The Earned Income Credit [an error occurred while processing this directive] By Congressional decree, Americans who apply for the Earned Income Tax Credit must adhere to even more stringent requirements. These individuals, in order to receive the credit which can be as much as $4,008 for a low-income working family, may be required to produce marriage licenses, school report cards for children claimed to be living in the home and such other evidence determined relevant by IRS examiners. Often, these people do not have resources to hire professionals to represent them before IRS and many are not proficient in English. Clearly, the working poor are easy prey for IRS examiners.

In contrast, no such rules requiring documentation apply to the residence exclusion, where married taxpayers may exempt up to $500,000 in profits from the sale of their home.

A Virtual Free Pass for the Wealthy [an error occurred while processing this directive] Unlike American workers and the poor, taxpayers comprising the wealthiest five percent have much less stringent standards imposed. The government apparently trusts these people to report each and every dollar of income or profit earned. Many own businesses, collect rents from tenants and reap gains on stocks and other investments, including partnerships.

When it comes to reporting their income, business owners and landlords are not constrained by a W-2 type reporting apparatus to monitor the accuracy of their tax returns. There is no third party, such as an employer or bank, to verify or contradict what they put on their tax returns. Brokerage houses report only the total amount received when securities are sold; the investor is free to report the amount of actual taxable profit. By simply overstating the initial purchase price of securities (the adjusted basis), taxable profit can be reduced or eliminated and it requires an actual, "hands-on" audit of the taxpayer specifically focusing on stock basis issues to discover the misstatement.

No Such Luck If You're A Waiter [an error occurred while processing this directive] Rather than focus on the billions of tax revenue lost through dubious and illegal tax schemes employed by individuals and corporations, IRS instead, is busy making sure waiters and waitresses are properly reporting their tip income. In fact, IRS does not trust these workers to report their income accurately, so it relies on a formula that could substantially overstate the actual amount of tip income received.

As an example of IRS's relentless pursuit of the "little guy," a San Francisco restaurant is currently battling IRS in a pivotal lawsuit being heard by the U.S. Supreme Court where potentially millions of dollars are at stake over how to calculate tips for service workers. IRS lost in the court of appeal, but the Bush Administration's Justice Department, conceding no ground to waiters and waitresses who earn tip income, has appealed to the Supreme Court.

This case could decide how payroll taxes are accounted for at the nation's 200,000 restaurants - indeed everywhere workers earn tips. Not trusting waiters and waitresses to properly report their tip income, ten years ago, IRS calculated that tips should total 14 percent of a restaurant's gross receipts.

Fior d'Italia, in San Francisco's North Beach, complained that it used its employees' self-reported tip income to calculate its tax bill. The restaurant reasonably believed that if the IRS did not agree, they should take up the matter with the individual taxpayers rather than require restaurateurs to be "tip police" for the agency. Nevertheless, IRS assessed the restaurant $23,000 in Social Security tax liability.

Another important issue in the case is whether waiters actually take home 15 percent of diners' tabs. It is common practice for a waiter to share tips with other employees, i.e. maitre d'hotel, bartender and busboy. These deductions usually leave the server with about 9 percent of a 15 percent tip; and some guests don't tip at all. Still, taxes are due on these phantom amounts.

Illustrating its efforts to "beef up" tax collections, the justice department pointed out to the court that as a result of its emphasis on stronger enforcement of tip compensation, workers reported $14.3 billion in tips in 1999 versus only $8.5 billion in 1994 an increase of some 59 percent. Of course, they fail to point out that during this same period the Dow Jones Industrial Average grew from 4,000 in 1994 to nearly 12,000 in 1999; an increase of some 300 percent which could largely account for an increase in restaurant meals, thereby boosting tip income proportionately.

THE LESSON: While wealthy individuals and corporate America can create trusts, partnerships and skillfully crafted companies, often in offshore locations, in an effort to avoid paying income taxes, IRS focuses its attention on food servers, those hard-working folks who are in the lower to middle segment of the economic spectrum.

Cheating Made Easy - Just form a partnership [an error occurred while processing this directive] Income reported by entities such as partnerships, limited liability companies and trusts are never matched to individual income tax returns according to IRS deputy commissioner, Dale Hart. This remains true despite a proliferation of abusive trust schemes adopted by individuals for the sole purpose of avoiding paying taxes. And K-1 income, income from partnerships, has never been matched to individual returns despite the fact that as much as $1 in every $5 from partnerships goes unreported.

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